November 22, 2009

Market Insights - 22 November 2009

Dear Friends & Fellow Investors

Here is the latest issue of market insights.  For any questions, please email: .  Enjoy reading!

In This Week's Issue
▪   Weekly Snapshot
▪   Chart Of The Week
▪   US Economy Versus US Markets 
▪   More On The Dollar 
▪   More On Currencies
▪   Fed Balance Sheet
▪   A Different Approach To Financial Regulation

Weekly Snapshot
• US house of representatives approved Ron Paul's bill to "audit the Fed" (Marketplace)
• Euro area unemployment up to 9.7% (Eurostat)
• Germany's new finance minister Wolfgang Schäuble warns US on market bubbles (FT)
• Some Treasury bill rates were negative again Friday after falling below zero Thursday (WSJ)
• The euro zone exited recession in the third quarter when its economy grew by 0.4% (Economist)
• US Housing starts declined 10.6% from last month and fell 30.7% from the prior year to 529,000 (ESA)
• OECD doubled its growth forecast for 2010 to 1.9% for 30 leading economies (Economist)
• US Leading Economic Index up 0.3% in October following a 1.0% gain in September (Conference Board)
• Gold reached a new all-time high of $1,152.80 on Wednesday (eSignal)
• US Consumer Prices up 0.3% in October after rising 0.2% in September (Bloomberg)
• US Producer Price Index advanced 0.3% in October (BLS)

Chart Of The Week  
Economic sentiment and leading economic indicators throughout numerous developed countries have been rising in line with the appreciation of most major asset classes.


Data Source:

US Economy Versus US Markets
The US benchmark Index S&P500 reached a new yearly high just above 1,113 early in the week. Despite a drop off on Thursday and Friday, US markets are now up over 20% for the year and over 63% higher than the low in March-09.  The S&P 500 chart has now reached a critical technical inflection point, it’s almost a field day for technical analysts.  The major bear market trend line (purple) is now within arms reach and could potentially be broken if sentiment and momentum continues on a positive note.  At the same time, the market has been approaching the 50% Fibonacci retracement level (blue lines) as marked from the highest to the lowest points in the current bear market.  These points are critical because system traders and technical trend followers are placing their orders around these type of inflection points.  Failure to break above these trend lines typically cause markets to retrace.  A failure to break above this major trend line will trigger sell orders and protective trading strategies.


In addition to the technical signals indicating a hurdle for US stocks, we have to revisit the underlying economic conditions which, despite the recent positive GDP numbers, are showing a much less favorable picture in terms of feeding the projected earnings at which stocks are currently valued at.  By some estimates, the S&P 500 is about 20% above fair value.   Officials are pinning much of their hopes on a recovery in the housing market.  But as last month’s housing starts numbers suggest, it is still an uphill struggle which may get worse when the $8,000 tax credit for new home purchases ends.  As we noted before, a sustainable recovery cannot come from a return to (over) leveraged home purchases.  Instead, the recovery of a consumer-driven economy can only come a from a healthy labor market.  The job picture however, does not give rise to a positive outlook on earnings anytime soon.  Yet, there could be a silver lining in the much debated dollar weakness.  A weaker Dollar bodes well for US exports.  At least in the short to medium term, the US Dollar weakness may be a blessing in disguise.  

More On The Dollar
Please consider the video interview with Mark Dow, hedge fund manager at Pharo Management.

Mark Dow gives a different view on the much debated topic of the falling US Dollar.  While most of the rationale for a weaker Dollar has been focusing on the supply side thus far, he argues that the lack of demand may be the more significant factor determining the price level of the Greenback.  To his point, one should note that there has been a significant shift in attitudes since the beginning of this decade, not just for economic but also for political reasons.  All other things being equal, non-Dollar denominated assets have been increasingly appealing to international investors.  Outside of the flight-to-safety phenomenon which sparked a reprieve for the US Dollar during the financial crisis, the capital flows have been ever more one-sided and out of the US into other jurisdictions.  As the risk appetite increases, this trend will continue.  Contrary to that, there is also an increased risk of yet another bubble as more asset classes are moving in tandem to higher levels.  The potential risk of a double-dip recession and a return to deflationary asset prices may be the impetus for a stronger Dollar yet again.

More On Currencies   
Currencies have been getting a lot more attention from the general public but much of the focus in the press has been on the questionable value of the Chinese Yuan or Renminbi versus the US Dollar.   No matter where the exchange rate of this currency pair may be at, based on the current global economic conditions, each outcome creates various sets of problems for both China as well as the US.  In reality, there is no more or less desirable exchange rate as the economies of the two nations are increasingly inter-twined. 

For a change, we would like to focus on exchange rate of the Chinese Yuan (CNY) versus other currencies.  The chart below shows the exchange rates of the CNY versus the Euro and versus the Australian Dollar.  For comparison, we have also included the CNY versus US$ which is a managed rate and does not freely float. 


Almost in line with the rally in stocks since March of ‘09, the Euro and Australian $ have gained against the CNY by almost 20% and 46% respectively   China is still the largest trading partner of the US; however, as their currency, along with the US$, depreciates against other major currencies, exports to other countries become more attractive through massive price advantages from a weaker CNY.  A new focus on other export markets also makes sense from the Chinese perspective, keeping in mind that the US consumer may no longer be liquid enough to consume.  Massive pricing advantages as a result of favorable exchange rates will allow China to flood Europe and other hard-currency nations with goods from the recent build up in capacity.  It will be interesting to see however, if China can convince consumers of other nations that Chinese goods are more important than the inherent and culturally dominant desire to save rather than to consume.

Fed Balance Sheet  
The US Federal Reserve's balance sheet has grown substantially during the financial crisis. Total assets of the Federal Reserve have increased significantly from $869 billion on August 8, 2007, to well over $2 trillion until today.  As Mark Dow alluded to in the video interview above, the Balance Sheet has been relatively stable and did not increase since the end of 2008.  The chart below is a good visual representation as to why much of the stimulus and efforts by the US government have only limited impact on the real economy.  Supply-side economics may not work in the current scenario.  A focus on the demand side of the equation may produce faster and more sustainable results.

Fed Balance Sheet

A Different Approach To Financial Regulation  
Please consider Peter Smith’s article in the FT:  Australia tightens monitoring of rating agencies

You have to give it to the Australians!  They were the first of the G20 nations to tighten monetary policy and now they have shown a move towards financial regulation which makes a lot of sense, directly targeting ratings agencies in order to prevent irresponsible and obscure financial engineering.  We have expressed our dismay with ratings agencies on numerous occasions.  Conflicts of interest are caused by an inherent flaw in the system:  Ratings agencies are paid by the companies whose debt instruments they are supposed to rate.

From the start of next year, ratings agencies operating in Australia would require a financial services licence. To keep the licence, they would have to manage conflicts of interest, have resources that match the "scale and complexity" of their business, and have risk management systems.  They would need to file annual compliance reports, disclose procedures and methodologies for ratings affected by "material changes" within six months. The watchdog has closed a loophole whereby retail investors were unable to sue a rating agency if it had not given its consent to have its rating used in marketing material.

This is a very good and important step in the right direction towards more effective, not necessarily more complex financial regulation.  It is encouraging to see how fast the Australian regulators reacted and that significant disincentives are placed upon ratings agencies to '”over-rate” financial instruments.  Albeit less complex and not as liquid as US and European financial markets, regulators should look towards the Australian model in making regulation and financial markets more transparent and more effective.

Good luck and good trading!

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

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