Market Outlook as at June 5, 2009

Now is a good time to ponder the million dollar question: When will the current rally take a break? Before I proceed, I like to say that I believe that this bull run has legs & may run for another 6-12 months before a cyclical top set in. Nevertheless, it maybe wise to consider the above question because we can position ourselves to take some chips off the table or delay some buying & wait for lower prices. What I've meant by a break in the rally is price consolidation that may last for 1-2 months. I will look at three areas in order to draw my conclusion; the level of retracement achieved to-date; the potential impact of a recovery in the USD; and the inter-play between the KLCI & the 80-week SMA.

Retracement of lost ground

Fibonacci retracement explains that share price or index "will retrace a large portion of an original move and find support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%". We are going to apply this to the MSCI Emerging Markets Free index (or a proxy, iShare MSCI Emerging Markets Index Funds, for reason of longer duration of available data) & the KLCI.

1. MSCI Emerging Markets Free index (and iShare MSCI Emerging Markets Index Funds)
We can see that MSCI Emerging Markets Free index ('MSEMF') has declined from its high of about 1350 in Oct 2007 to a low of 450 in Oct 2008- losing 900 points over 12 months. At its recent high of 802, the MSEMF has retraced 38% of the lost ground of 900 points. See Chart 1 below.


Chart 1: MSEMF's weekly chart as at 4/6/2009 (Source: Stockcharts.com)

Similarly, if we look at iShare MSCI Emerging Markets Index Funds ('EEM'), we can see that EEM has declined from a high of 55 to a low of 19 during the same period- losing 36 points. At its recent high of 34, the EEM has retraced 42% of its lost ground. See Chart 2 below.


Chart 2: EEM's daily chart as at 4/6/2009 (Source: Yahoo Finance)

2. KLCI
The KLCI dropped from its high of 1524 in Jan 2008 to a low of 801 in Oct 2008- losing 723 points. At its recent high of 1072, the KLCI has retraced about 37% of its lost ground in the current rally. See Chart 6 below.

In a normal recovery, it is quite common that the share price or index to retrace between 38-50% of its lost ground. So, the KLCI, MSCI Emerging Markets Free index and iShare MSCI Emerging Markets Index Funds could potentially go as high as 1162, 900 & 37, respectively if we assumed a 50%-retracement. That means the market may go up another 8-12% from here.

Recovery in the USD

From Chart 3 below, we can see that the close inverse correlation between the KLCI and the movement of USD-RM exchange rate. From May 2008 to Mar 2009, the USD was rising while the KLCI was dropping. After Mar 2009, the reverse happened with USD declining while KLCI going higher. This is partly due to a flight to safety when fund managers avoided all forms of risk-taking & sought out safe assets (such as Treasury bonds, etc) during the earlier period. The return to normalcy from Mar 2009 onwards saw fund managers aggressively seeking out risk assets, such as equities in Emerging Markets & selling off their Treasury bonds. The sharp sell-off in Treasury bonds has resulted in a sharp rise in their yield (see Chart 4 below for the movement of the yield for 10-year Treasury Bonds). The funds raised from this sell-off were transferred to Emerging Markets- strengthening the currency of the countries concerned & concurrently depressing the USD (see Chart 5 below). Of course, the USD has also come under pressure because of Quantitative Easing undertaken by the Fed in order to rescue the US banking system.


Chart 3: KLCI & USD-RM exchange rate's daily chart as at 4/6/2009 (Source: Quickcharts/Yahoo Finance)


Chart 4: TNX's daily chart as at 4/6/2009 (Source: Yahoo Finance)


Chart 5: USD's daily chart as at 4/6/2009 (Source: Stockcharts.com)

From Chart 4, we can see that the 10-year Treasury Bonds' yield ('TNX') has broken above its medium-term downtrend line. Despite the breakout, TNX is not pulling away. Why? From Chart 5, the USD may find support at the strong horizontal line of 78. Can a rebound happen here? If not, we may see the USD index dropping to its tentative uptrend line support of 73.

In a recent visit to China, the US Treasury Secretary, Timothy Geithner reassured the Chinese Government that its huge holdings of dollar assets were safe as he reaffirmed his faith in a strong US currency. China is not the only country that is nervous about its holdings of dollar assets. The US government will have to do something to back up its rhetoric and this could well lead to a stop in the current downtrend for the USD. If the recovery were to set in for the USD, then we could well see a correction for the KLCI.

Look at the 80-week SMA line

Finally, we can see that the 80-week SMA has been a good support for the KLCI for 2007. In Mar 2008, the KLCI broke below the 80-week SMA, only to recover above it after 6 weeks. However that recovery failed to cross above the 50-week SMA and it fizzled out. I believe the reverse could happen now. The KLCI has crossed above the 80-week SMA (presently at 1045). It may stay above this level for a few weeks & may even go as high as 1100-1150, before correcting back to the 80-week SMA & even 50-week SMA (presently at 1000).


Chart 6: KLCI's weekly chart as at 4/6/2009 (Source: Quickcharts)

Conclusion

Based on the above, I believe that the KLCI could go higher over the next few weeks (maybe 2-3 weeks), before making a temporary top at about 1100-1150. Use this opportunity to take some profit. It will not be easy. Selling in a rising market- like buying in a falling market- is gut-wrenching. Do it in small installment and take comfort in the belief that it is better to be generally right than exactly wrong.