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Market Correction and the Beginning of Earnings Season

(October 10, 2004)

Great news!  We have finally finished a complete revision of our website!  Kudos go to my partner and webmaster, Rex Hui for his dedication and hours to this overwhelming project!  Any suggestions and comments about our revised website are greatly welcome.

Please note that the 100% long position initiated on August 19th was stopped out on September 27th at our entry point.  The author is currently trying to find a good entry point to initiate our 25% short position in the Dow Jones Industrials sometime in the next few trading days.  Stay tuned - I will post a message on our "Special Alert" discussion forum once we have established a position.

Update on Mr. John Mauldin of I got to meet Mr. John Mauldin here in Houston last Friday and we had a great and pleasant conversation.  He is a genuine nice guy and I am glad that I was able to meet him.  I have recorded this "interview" with him and I also intend to follow up with him with more questions/clarifications in the coming days.  Readers please stay tuned - I will post this "interview" up on our website once we get final approval from Mr. John Mauldin.

Dear Subscribers and Readers:

I want to begin this commentary with a correction of last Wednesday's commentary.  I apologize for this mistake knowing that it may have influenced some of my readers to make decisions that they otherwise would not have made.  In last Wednesday's commentary, I stated that: "The AAII Bulls-Bears% Differential now only stands at 2% -- the lowest since mid-August and bullish from a contrarian standpoint.  A divergence in these two surveys is rare, and this author cannot help but think that most traders and investors out there are now very confused."  The reading of 2% was actually the reading for the Wednesday in the week before last - not the reading for last Wednesday evening.  The reading for last Wednesday evening actually increased to 37%, a very high reading and the highest reading since June 30, 2004:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - My apologies: The latest reading in the Bulls-Bears% Differential in the AAII survey is actually a high 37%, not the 2% that I mentioned on Wednesday evening (the 2% reading was actually the reading for the week before - which coincided with a minor bottom in the major indices).  Given this reading in the face of a declining market, the bear case now looks stronger than ever before.

From a contrarian standpoint, this is bearish - especially given the fact that the Dow Industrials, the Nasdaq, and the S&P 500 really haven't gone anywhere for the last several months.  This reading is further reinforced by Mark Hulbert's (from Hulbert Stock Newsletter Sentiment Index (HSNSI) - as the reading of 39.2% registered last Thursday is the highest reading we have seen in awhile.  This is particularly bearish given the market decline that we witnessed last Thursday.  From time-to-time, I tend to post important developments on our discussion forum, as our commentaries are only published every Wednesday and Sunday evening.  Readers should note that I have already posted this article on our discussion forum under the subtopic "Market Commentary" last Thursday evening, as I believe that this was an important enough development to alert my readers.

Readers who watch the market very closely should know that the end of the third quarter has just passed (I was surprised by the lack of earnings warnings) and that earnings announcements are now upon us.  Notable names kicking off the beginning of this "earnings season" includes names such as Intel, Johnson & Johnson, Merrill Lynch, Travelzoo, and Yahoo - who are all reporting on Tuesday.  Following is a confirmed schedule of earnings reports for various notable companies that are reporting this week and the Monday of next week.  I will update this table again in next week's commentary:

Earning Calendar of Various Notable Companies (October 11 to 18)

The author's stance is that the flood of earnings reports over the next few weeks will finally set the tone of the market for the intermediate term.  Will investors react positively or negatively to these reports?  Readers should also keep in mind that empirical studies have been done showing that the institutional favorites reporting negative surprises (even for just one quarter) tend to underperform the market for the next five years - and that usually the first negative surprise is followed by another one in the next quarter, etc.  It is for this reason that I am currently bearish on the homebuilding stocks.  While these stocks may not possess relatively high P/Es, I think investors have forgotten that the homebuilding industry in general is historically very cyclical and the fact that they have also suffered periods of severe underperformance in the past - sometimes for years.

So much for my predictions of the top in the housing market.  Let's turn back to earnings.  This morning, I read an article from quoting a fund manager as stating that the current profits of companies as a percentage of GDP is at 8.5% - a historically very high reading since the average reading is usually only in the range of 4% to 5% of GDP.  Needless to say, I was stunned.  Given that today's P/E ratio of the broad market is still historically high, I wondered how the market will perform going forward if profits were to shrink to 4% to 5% of GDP?  I immediately did some research - following is a chart depicting the historical readings of the Corporate Profits to GDP ratio - using data that came straight from the Bureau of Economic Analysis.  Let me just set one thing straight: Corporate profits as a percentage of GDP over the last 25 years has averaged 7.01% -- not 4 to 5% as that article had suggested!

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 2Q 2004) - Corporate profits as a % of GDP is now at 8.5% - definitely in the high range of these readings over the last 25 years.  The recent absolute growth in earnings has also been extraordinary - can this growth sustain itself given only 3 to 4% GDP growth going forward?

The bad news?  The article was correct in its claim that the current reading (2Q 2004) is at 8.5% - a very high reading compared to readings over the last 25 years.  Moreover, given that GDP growth is projected to average only 3% to 4% going forward, how likely will corporate profits continue to grow at its current pace?  Given that this indicator is at its high end of its 25-year range and given the fact that GDP growth is not projected to accelerate going forward (and combined with the adverse impact of high oil prices), my stance is that not only will earnings growth moderate or flatten going forward, but most likely, suffer another brief period of contraction.  The earnings reports and the guidance over the next few weeks will shed some light, but given what I have just mentioned (and the fact that I believe we are in the midst of a correction in the market), I don't believe investors will react kindly to these reports.

I am particularly interested on how the current high oil (and basic materials) price environment will affect companies' guidance going forward.  I don't think it's unfair to say that most companies have been rather "conservative" when it comes to budgeting for commodity costs for projection purposes.  The following chart should not come as a surprise.  Not only did the American Exchange Oil Index (XOI) managed to hold above its ten-year relative strength (vs. the S&P 500) resistance line, relative strength of the XOI vs. the S&P 500 spiked to another high last week as the November contract closed above $53 a barrel for the first time last Friday:

Relative Strength (Weekly Chart) of the Oil Index vs. the S&P 500 (August 1983 to Present) - Relative strength in the American Exchange Oil Index vs. the S&P 500 held above its resistance level (which dates back to late 1991!!) and has spiked up again!

The latest World Oil Balance data for the second quarter of 2004 has just been released by the Energy Information Administration (EIA) - and it confirms my views that there was a 2 million barrel per day surplus of crude oil floating around in the world oil markets during the second quarter.  The question is: Where did all those excess oil go?  The Strategic Petroleum Reserve here in the United States and in a comparable storage place in China (the Chinese are also in the midst of creating a similar storage facility)?  For the purpose of anticipating future prices, however, this is not important.  What is important to know is that world oil demand is typically the highest in the first and fourth quarter of the year.  With a price of $53 a barrel, has the NYMEX contract fully discounted the supply and demand situation during the next six months of historically high demand in crude oil?  I don't know but this author is not going to sit around in the stock market and find out the hard way.

Finally, let's turn to our beloved chart of the Dow Jones Industrial Average vs. the Dow Jones Transportation Average to try to get a clearer perspective from the Dow Theory point of view:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to October 8, 2004) - The Dow Industrials agained failed to break above its downtrending resistance line last week - setting up the declines of 115 and 70 points on Thursday and Friday, respectively.  The Dow Transports declined in sympathy, but it is still too early to declare a top in the Dow Transports here.  One thing's for sure: This author does not believe the Dow Industrials can hold its own given oil prices of over $53 a barrel - unless oil prices decline back towards the lower $40s level, the Dow Transports will ultimately confirm the Dow Industrials on the downside.

The Dow Industrials again failed to break above its downtrending resistance line last week - and this weakness was confirmed by a further decline of approximately 185 points in the Dow Industrials during Thursday and Friday.  At this point, however, it is still too early to call a top in the Dow Transports, although if the Dow Industrials continue to weaken, chances are that the Dow Transports will ultimately confirm the Dow Industrials on the downside.

Bottom line: Again, this author believes we will need a significant correction at least in the Dow Jones Industrials before we can mount another sustainable rally.  The reaction to earnings will be a crucial factor in the coming weeks, although given the fact that earnings as a percentage of GDP is at its high-end of its 25-year range, this author will choose to lean towards the bearish side.  It is also interesting to note that quite a number of people have mentioned the bullishness exhibited by the various "unweighted" indices (as opposed to market cap weighted) - and that the major indices should confirm these unweighted indices on the upside in due time.  Dear readers, please understand that the Dow Theory has served its students well over the last 100 years, and it will be foolish to abandon the Dow Theory now - just as the non-confirmation of the Dow Transports by the Dow Industrials is definitely trying to tell us something.  Please also note that the various unweighted indices (for example, small caps and midcaps) also made all-time highs right up to the beginning of the 1973 to 1974 bear market, as well as during the September 2001 to May 2002 period - immediately before the huge May 2002 to October 2002 decline.  When the 30 most prestigious companies in the world are underperforming the broad market, something is wrong - and readers should not try to stick around with their long positions and find out the hard way.  Finally, I am still currently looking for a good entry point to implement a 25% short position in our DJIA trading system in the next few trading days.  Readers please stay tuned.

Signing off,

Henry K. To, CFA

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