Four Threats To Global Recovery

Nonetheless,
investors need to be aware that there are at least four major threats to the
above scenario that could send the global economy and markets for a loop. 

1. The first is
   global bond prices. We have long been telling
   investors that Greenspan’s loose money policy has traded more stability in the
   economy despite a historic stock market bubble popping for the creation of a
   bond market bubble. That bond bubble has started to pop — and it is global,
   with Japanese bonds being the most extreme example. Since mid June, global
   bonds have experienced their worst decline in many decades. 

   As we indicated in
   
   last week’s column, with the chart of 10-year bond yields, US bonds are
   starting to decline to trendline support levels that have held bond prices
   since 1984, just after the great secular bond market rally began. A further
   increase in the yield of  US 10-year bonds above around 4.75% will likely
   begin to pull the rug out of the global economic party that the plurality of
   indicators are showing. It is clear that the new dramatic shift in global
   central bank and global fiscal policy is toward ACTUALLY
   CREATING more inflation. 

   What is not clear is how the global bond market will react to this shift in
   policy. One thing that can make this policy ineffective would be if bond
   prices ANTICIPATE higher inflation, by declining
   so much that interest rates on the long-end rise enough to choke off any
   economic activity. This will EVENTUALLY likely be
   what ends the party. It is not likely to occur until it becomes clear that
   inflation is back and growing. But it is not impossible that bond prices will
   keep declining and cut things off before they really get started here. 

   So far, there is not much plurality to support bonds killing the party now.
   Corporate yield spreads have not widened dramatically, industrial commodity
   prices have not fallen sharply, and most of the other variables that would
   discount a recession are not falling into place. But bond rates and these
   variables bear close watching by investors here, because they are a
   THREAT to the preferred scenario.

    

2. Another threat is
   oil prices. So far, with oil near $30,
   economic activity is slowed by these high prices, but not enough to stall the
   emerging acceleration. However, a further crisis in the Middle East and/or
   sharply higher oil prices above the $38-$40 range will have a marked dampening
   effect on global economic activity that could derail the emerging recovery if
   prices stay there long enough. Oil prices going into this range, accompanied
   by weakening global stock prices, higher global bond prices, and evidence of
   discounting of recession (noted above) would add plurality to the view that
   oil prices were choking off this recovery.

    

3. A third threat to the global
   recovery is the impact of the dramatic shift in
   global current accounts (or excess capital). Right now, the US is
   running some of the most dramatic and large current-account deficits in modern
   history. That means we need foreigners to buy our debt in order for our
   economy and government to run. Just a few years ago, most of the current
   account surpluses were centered in Asia, as Japan and China had massive trade
   surpluses that they were happy to recycle into US bonds and assets to help
   feed their largest export market.

   But China’s domestic market has grown over the years and they are now one of
   the world’s largest IMPORTERS. Chinese imports
   have increased over 150% since 1998 growing by over $200 billion. At the same
   time, Japanese savings have plummeted by half. The result is that Asia’s
   current account surplus has declined by over 40% since 1998, even while the US
   current account deficit has soared. And where that current account surplus has
   gone is to the Middle East oil-producing nations. 

   Thus, whereas just a five years ago, over 70% of our current account deficit
   ended up in Asia where they had no problem using the money to buy US assets
   and keep our demand high, now it is only around 40%. And much of the rest is
   controlled by the Middle East oil producers. Will they be as likely to recycle
   these dollars into US assets at low bond yields? It is possible as the Middle
   East gains more control of our current account deficit that they will want
   higher bond yields and will be less likely to recycle it to the US, which they
   perceive as a potential enemy.

   This could lead to higher bond yields and a dramatically lower dollar down the
   road, in a way that could significantly affect the recovery. While this is
   more of an intermediate than short-run concern, the evidence would be
   plummeting bonds and a much lower dollar, which would pull away the punchbowl
   of the recovery much more quickly than would normally be the case.

    

4. The final risk we see to the
   global recovery (and of course there could be many we do not foresee now) is
   the wild card of another major terrorist
   attack on US soil or a dramatic pickup in the war in
   the Middle East.  A accelerating Vietnam-like guerrilla war and an
   increase in terrorist action, including another major assault on US soil,
   could kill the sentiment needed to create recovery. And this would be a pure
   shock and surprise to the markets that plurality would not anticipate. This
   adds constant risk and volatility to the markets. The only way to
   ATTEMPT to watch this variable is by keeping
   track of global intelligence services and their reading on the situation. We
   were able to warn investors last year of the developing Iraq war, far before
   it became news and before actual actions were taken last year in this way, but
   these sources are far from perfect.

Thus, despite a plurality of
variables leading us to expect that the global recovery is on track and is
developing as anticipated, investors need to understand that there are threats
to this scenario and they should watch them closely.

The euro and foreign currencies remain mired in triangle trading ranges after
steep corrections from runups earlier this year. The commodity currencies are
also correcting here, and we would expect them to eventually lead the charge
higher, as realization of the global economic recovery gaining steam advances in
the weeks ahead. However, a close by the AUD below .6400 will likely lead to
another leg down in the currencies against the dollar. Should euro 1.10-1.11
support give way, major support exists around 1.02. We suspect a sustained
trading range looms (with possible downward or upward bias) while the forces of
a chronic current account deficit clash with the realization of how much
stronger the US economy is than that of Europe. Our gold and commodity models
remain bullish, and our Forex models lead us to believe that a longer-term
dollar decline is correcting here.

Investors should continue
to cautiously add stock exposure as trade signals are generated that meet our
strict criteria, as well as allocate to our favorite segments. Our model
portfolio followed in TradingMarkets.com with specific entry/exit/ops levels
from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in 2001,
7.58% in 2002, and we stopped specific recommendations up around 5% in May 2003
(strict following of our methodologies should have portfolios up over 8.3% ytd
by our calculations) — all on worst drawdown of under 7%. 

 

Last week
in our Top RS/EPS New Highs list published on TradingMarkets.com, we had
readings of 19, 21, 43, 46, and 46, accompanied by 14 breakouts of 4+ week
ranges, no valid trades and several close calls in
(
BNT |
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Chart |
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PowerRating),
(
PETD |
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Chart |
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PowerRating),
(
WR |
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News |
PowerRating),
and
(
WLS |
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Chart |
News |
PowerRating). Note that new highs did NOT remain
above 20 last week, so the market is not yet embarking on a serious enough
internal strength to mount a serious test of the highs. Position in valid 4 week
trading range breakouts on stocks meeting our criteria or in close calls that
are in clearly leading industries, in a diversified fashion. Bottom RS/EPS New
Lows are still quite weak (through improving now) with readings of 3, 5, 1, 2,
and 3, with 1 breakdown of a 4+ week pattern, no valid trades, and no close
calls. The short side remains pretty bleak. 

 

For those not familiar with our long/short strategies, we suggest
you review my book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training module. Basically,
we have rigorous criteria for potential long stocks that we call “up-fuel,” as
well as rigorous criteria for potential short stocks that we call “down-fuel.”
Each day we review the list of new highs on our “Top RS and EPS New High List”
published on TradingMarkets.com for breakouts of four-week or longer flags, or
of valid cup-and-handles of more than four weeks. Buy trades are taken only on
valid breakouts of stocks that also meet our up-fuel criteria.

On the long side we like
(
SFNT |
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PowerRating),
(
AVID |
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News |
PowerRating) and
(
UNTD |
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PowerRating) still, the
close calls from this week,
(
BNT |
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Chart |
News |
PowerRating),
(
PETD |
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Chart |
News |
PowerRating),
(
WR |
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Chart |
News |
PowerRating), and
(
WLS |
Quote |
Chart |
News |
PowerRating), and
several close calls from past weeks, NCEB, GMR, and FCX as well as in our
favorite global sectors.  No short-side opportunities have developed via our
strategy for some time.  We also like conservative gold stocks, like FCX pfd A
and NEM, some broad EM exposure like DEMSX, Eastern Europe, China, and Thailand,
in particular — though here investors may want to tread cautiously until it is
clear that the correction/consolidation is ending.

Technicals and breadth have yet to confirm whether the trading
range will end in a new leg up or a further correction. Wait for the evidence
before getting more aggressive in terms of allocation. We’re still in a
stalemate. Continue to watch for clear leadership in leading new industries and
plurality of breakouts in those industries, for follow-through by close call and
criteria stocks, for breakouts by the averages that will confirm if this
bear-market rally has legs, and for further breadth thrusts, to tell us that a
better bullish cycle is developing here.