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The Author is Turning Bullish - with a Tidbit on Outsourcing

(July 19, 2004)

Dear Readers:

I want to start this commentary with the following quote that is commonly attributed to Benjamin Franklin:

"He who would trade liberty for some temporary security, deserves neither liberty nor security."

This statement has held true since the dawn of civilization and continues to hold true today.  The concept of security and liberty is mutually exclusive.  In today's uncertain times and ever-changing world, it is important to keep this statement to heart.  Individuals need to be responsible for themselves and their families - government has never been the key and never will be.  In fact, if figures such as Benjamin Franklin and Thomas Jefferson are alive today, they will be calling for a second revolution.  The only reason why America remains the top economy and the best place to do business today is because of her huge market and her relative business-friendly regulations and laws.  Please note that I mentioned the word "relative."  For example, if the European Union chooses to fully integrate all their individual economies, cut income taxes by half, outlaw all labor unions, and allow full immigration of the best economic talent from around the world - starting tomorrow - then I will be making serious preparations (and so will the world's best economic talent) to go work in Europe at the earliest opportunity.

Unfortunately, most citizens in the developed world today think that they have a right to economic prosperity and a life of leisure - things that most citizens in the developing world can probably never achieve.  Let me be clear.  Half of the world's population lives on less than two dollars a day.  A 40-hour job which pays the minimum wage is not a God-given right and never will be.  And the author is getting sick and tired of all these people who sit on their behinds and complain about the lack of jobs.  If God has given you good health, an average IQ, and the ability to talk and listen, then you can find something (or create something) which would benefit the society as a whole.  I am appalled of all the negative talk about outsourcing - and am even more appalled at all the people who totally blow the outsourcing trend to extreme proportions just so they can take advantage of this issue to promote themselves and to make money off it.  Coincidentally, figures such as Lou Dobbs come to mind.

The over 100-year old trend of outsourcing to other countries is a trend that will continue.  The elimination and replacement of relatively unskilled labor because of better technologies will also continue.  These two trends have helped steadily improve the standard of living here in America.  I have no doubt that Americans are creative and innovative enough to create more jobs as some jobs are eliminated or shipped abroad.  Consider the fact that a significant amount of jobs today did not even exist 20 years ago.  There will be many jobs available 20 years from now that the layperson of today could never even begin to imagine.  Sure, outsourcing is hurting some of our fellow Americans today, and the culprit has commonly been mentioned as the Chinese.  The media commonly likes to distort the truth in order to sell newspapers, and nowhere is this truer than the issue of outsourcing.  To help illustrate this, let's take a look at the following weekly note by John Mauldin, a brilliant economist and author of the best-seller, "Bull's Eye Investing":

If the Chinese are stealing our jobs, a brand new study by the Conference Board begs the question, "Who is stealing the jobs from the Chinese?" (As we will see, the Chinese actually lost 9 times more textile jobs than the US.)

Released last week, the study shows that between 1995 and 2002 China lost 7 times more manufacturing jobs than the US. In the off chance you have not seen the latest edition of Asian Labour News, I will quote:

"China is losing more manufacturing jobs than the United States. For the entire economy between 1995 and 2002, China lost 15 million manufacturing jobs, compared with 2 million in the U.S., The Conference Board reports in a study released today. "As its manufacturing productivity accelerates, China is losing jobs in manufacturing - many more than the United States is - and gaining them in services, a pattern that has been playing out in the developed world for many years," concludes The Conference Board study.

"According to Robert H. McGuckin, Director of Economic Research at The Conference Board and co-author of the study: "Increased unemployment has also accompanied the restructuring of the industrial sector, but per capita income has risen over the period."

The new report from The Conference Board, the global research and business membership network, is the result of a joint research project with The National Bureau of Statistics of China. The study is based on data for the 51,000 large and medium sized firms in China's manufacturing, mining and the utilities industries. While the study focuses on the larger firms, according to McGuckin, "the same patterns are observed among smaller firms."

"China is rapidly losing manufacturing jobs in the same industries where the U.S. and other major countries have seen jobs disappear, such as textiles. Matthew Spiegelman, Economist at The Conference Board and co-author of the study, notes: "The U.S. lost 202,000 textile jobs between 1995 and 2002, a tremendous decline by any measure. But China lost far more jobs in this sector-- 1.8 million. All told, 26 of China's 38 major industries registered job losses between 1995 and 2002."

The number of unemployed people in China is over 180 million - more than the entire labor force here in America.  My philosophy is this: if the poor Chinese isn't complaining, then neither should Americans complain.  If America did not outsource her textile, semiconductor, and automobile industry, then the average consumer will be paying over $100 for a t-shirt at Old Navy, thousands of dollars for electronics such as computers, TVs, and DVD players, and we will still be driving automobiles from GM and Ford that are utilizing 1970s style technology.  If Americans did not believe in the replacement of manual labor by automation, then we will have full employment all right - everyone will still be working 16-hour days on a farm just so we can eat and put clothing on our backs.

In pure economic terms, the elimination of redundant jobs and the continued trend of outsourcing should be celebrated, not frowned upon.  When highly intelligent individuals are laid off and backed into a corner, great things happen.  The great economist Joseph Schumpeter coined the expression "Creative Destruction" - a phenomenon that is witnessed during period of mass unemployment and market downturns - when inefficient companies are downsized or eliminated and when subsequent new, creative, and innovative companies rise from the ashes.  This expression remains truer than ever.  Going forward, individuals will need to take more responsibility for their own careers and constantly adapt to change (our fathers and grandfathers survived the Great Depression and World War II, why can't we rise up to this relatively minor challenge?).

But enough - let's turn to the stock market

First of all, I want to let my readers know about the state of the stock market today.  The major stock market indices such as the Dow Jones Industrials, Nasdaq Composite, and the S&P 500 currently do not come close to revealing to us the true state of the stock market.  Let's first take a look at the most obvious divergences of all to the Dow Theorist - that of the divergence between the Dow Jones Industrials and the Dow Jones Transports:

The Dow Industrials is still below the downtrend line that dates back to February - but the Dow Transports simply refuses to confirm on the downside - despite an oil price that is over $40 a barrel.

Please note that the latest decline was preceded by the lack of confirmation by the Industrials on the upside with the Transports.  At that time, the burden of proof was left with the bulls.  We now know that the bulls lost, but since the latest decline was not met with a downside confirmation by the Transports, the burden of proof now rests with the bears.  The bears now have to prove their case - a case which will be immensely strengthened by a downside confirmation of the Transports.  Failure to confirm on the downside may result in the Dow Jones Industrials in re-testing (at least) the downtrend line and perhaps rising above it.

The market is currently full of divergences.  Just two weeks ago, the unweighted S&P 500 Index, the S&P 400 mid caps, and the S&P 600 small caps made all time highs - which were confirmed by the A/D line of the S&P 500.  Since that time, these indices have gone through a ST and normal correction of three to four percent - well within the context of a cyclical bull market.  At the same time, however, the semiconductors hit a 11-month low as of the close on Friday.  The Nasdaq Composite also seemed to be in a downtrend, with its price level below both its 50 DMA and 200 DMA.  The question remains: Will the Nasdaq and tech stocks confirm the mid and small caps on the upside or will the latter join them on the downside?  I believe the answer lies in whether one believes we are still in a cyclical bull market or that the cyclical bull market has already topped out and is in the process of fully correctly itself.

The author believes that the current cyclical bull market has not topped out.  In terms of the timeframe and percentage gains after the huge cyclical bear market of January 2000 to October 2002, the performance of the current cyclical bull market (if it is to have topped out already) is still sub- par (please read our March 1, 2004 commentary for my targets as when and where the market may possibly top) compared to the cyclical bull markets within the secular bear market of February 1966 to December 1974.  Let me be clear: If the market has already topped out (way back in January/February) then the market is probably discounting something that is worse than the 1975 to 1976 or the 1982 recession, when unemployment rate doubled in 18 months and reached over 10%, respectively.  Given the state of the market and the still-loose monetary policies of the Federal Reserve (and its member banks), I believe this is a low probability event.  As a matter of fact, I still like the currently liquidity indicators, along with the fact that psychology did not reach a speculative high back at the January/February high.  Let's take a look at some of these indicators, starting with the ARMS Index:

The 10-Day ARMS Index spiked to a super high level of 1.74 last Thursday and is in the process of turning down. It has also been seven trading days since the 10-Day ARMS Index closed at a level above 1.50.

The 10-day ARMS Index reached a super high level of 1.74 on Thursday, and is in the process of turning down.  Don Hays of has noted in the past that whenever the 10-day ARMS Index reached a level of 1.50, a bottom is usually close at hand - with most of them coming within the next ten trading days.  Exceptions have been few - recent exceptions were the declines immediately after the events of September 11th and the stock market decline during March to July 2002.  Friday is the seventh day since the 10-day ARMS Index closed at a level above 1.50.   Since the author believes we are still in a cyclical bull market, the history of the 10-day ARMS Index suggests that we are at the most three trading days within an important low.

The June 2004 short interest on both the NYSE and the Nasdaq also paints a bullish picture:

NYSE Short Interest vs. Dow Jones Industrials

Please note that the short interest on the NYSE has not been this high since about a year ago.  Now, the Nasdaq:

Nasdaq Short Interest vs. Value of Nasdaq

The short interest on the Nasdaq actually reached an all-time high of 5.17 billion shares as of June 15, 2004!  True, numerous declines have been preceded by all-time highs in short interest, but in a rising or a cyclical bull market, short interest usually provides "fuel" for the upcoming rally and helps maintain the sustainability of any further up trend.  I believe that it is now one of those times.

As far as I know, no-one else has done any similar analysis in recent years, but the short interest of the Dow Jones Industrials components has, in recent months, been a good predictor of the future price level of the Dow Jones Industrials.  The June 2004 short interest of the Dow Jones Industrials components spiked to a level not seen since June 2003, suggesting that we should see more upside ahead.  Please note the huge drop in the short interest in February 2004 was immediately followed by a huge "churning" of the DJIA in the following months.  This has now been negated:

Monthly Short Interest Ratio of the DJIA Components vs. Dow Industrials

Like I have mentioned in my previous commentary, the patterns of the recent margin debt balances also look bullish.  New numbers for these and short interest would be updated in the next week or so.  Once they are, the author will provide a quick interim update.  Since June, I am guessing the numbers have gotten more bullish.  We shall see.

Turning to the Nasdaq, the author noted that the QQQ closed below its 20-day low for the fifth consecutive trading day - something which it has not done since the week immediately following the events of September 11th.  In fact, if the QQQ did not manage a mere seven cent gain on July 7th and an even smaller 5 cent again on July 9th, the QQQ would have closed below its 20-day low for nine trading days in a row.  This is a highly oversold situation.

Now, since the semiconductors are such an integral part of the Nasdaq, let's take look at the weekly chart of the Semiconductor Holders, the SMH:

SMH: PPO lowest level since February 2003, Relative Strength lowest level since June 2003

Please note that both the Percentage Price Oscillator (PPO) and relative strength against the S&P 500 have not been this oversold since February 2003 and June 2003, respectively.  Both the QQQ and the SMH are now indicating a very oversold situation - suggesting that we should have a strong bounce here assuming that we are still in a cyclical bull market. 

Finally, in his July 14th daily commentary, the Dow Theorist Richard Russell pointed out to an interesting study posted by one of his subscribers.  In that study, the subscriber pointed out to a study that was done by Richard Russell in September 1972, when he noted that the 1972 YTD intra-year volatility for the DJIA was only a mere 8% -- which is the same as today's YTD intra-year volatility for the DJIA as well.  Readers may know that the 1973 to 1974 bear market was the worst bear market since the 1937 to 1938 bear market, when the DJIA declined by approximately 45% in two years.  Russell notes that this very narrow intra-year volatility suggests either accumulation or distribution and he is betting for the latter -- which would mean that a vicious bear market decline may be close at hand.  What Russell did not mention, however, was the fact that the DJIA proceeded to make a temporary bottom in mid-October before it proceeded to blow off over 12% to an all-time high of 1,036 before the vicious 1973 to 1973 bear market set in.  Please note that I am not saying that this will happen, but this is probably my most pessimistic scenario (any blow off of such proportions in the next few months is actually longer-term bearish) - which would be ST bullish.  A more (ultimately) bullish scenario would be for the market to rise slowly but steadily; and such a scenario would also suggest that a temporary bottom is already close at hand.  Again, the author is emphasizing that if the market is to decline straight down from here, then it is discounting a recessionary scenario that is worse than the 1975 to 1976 recession and the 1982 recession, which is a very low probability event in itself.  As I have already outlined, I just do not think that this would happen.

Signing off,

Henry K. To, CFA

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