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A Review of MarketThoughts

(November 27, 2005)

Dear Subscribers and Readers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  For now, we are still completely neutral and in cash.  The market remains very overbought in the short-run - with the Dow Industrials, the S&P 600, and the Russell 2000 just within a hair's breadth of besting their recent highs (the latter two their all-time highs).  My guess is that any "breakout" of these indices will be accompanied by the popular media declaring a "new bull market" and will subsequently result in more retail investors being pulled into the stock market.  Contrary to popular belief, I believe that any investors that will be buying will be sorely disappointed - as I have outlined over the last few weeks - given that many of our longer-term indicators are now rolling over, such as our MarketThoughts "Excess M" indicator, as well as the fact that both the U.S. Federal Reserve and now the European Central Bank will remain in a tightening basis at least until January of next year.

I would like to begin this commentary by reiterating our beliefs and the purpose of us writing this commentary - along with what we are seeking to achieve by starting the MarketThoughts discussion forum.  It has been a little bit over a year since we started "seriously" focusing on this website, and both my partner/webmaster, Rex, and I are very happy with what we have accomplished so far.  We have met many friendly folks (such as many of our subscribers) along the way - people that have helped us quite a bit and whom we have learned a lot from.  Not surprisingly, many of these people are actually our current subscribers - folks who are always willing to learn and to share your ideas with us.  For this, we thank you.

The mission of this site is two-fold - to help our readers navigate these treacherous and ever-changing markets - as well as to educate our readers and help ourselves learn in the process as well.  Advice usually isn't worth anything unless one understands where we are coming from.  Hopefully, we have been able to do this for our subscribers over the last 12 months or so.  I understand that there are many readers who are more focused on the long-term - readers that are worried about their retirements, kids, and their careers and jobs.  Over the last 12 months, we have discussed issues that should be close to these readers' hearts, such as our three-piece article on China, our discussions of globalization, rising energy prices, aging demographics, as well as new trends and ideas that could affect our economy and the structure of our economy.  For readers who are more venturesome and who crave the markets and original trading ideas, we have also discussed ideas that are not mainstream, such as calling for a new dollar bull market in our May 1st commentary, the upcoming bull market in natural gas in our July 30th commentary, as well as our latest call on copper in last weekend's commentary.  Speaking of trading, we also discussed what to do and what not to do in trading, as well as the importance of knowing your own psychology and finding the trading strategy that suits your own psychology.  At some point in the next month or so, we will reorganize our archives just to make it easier on you to search for past commentaries based on the topic you're looking for.

So Henry, what is your current longer-term view of the world economy and the U.S. stock market?  I believe as we enter the 21st century, true globalization will come of age.  That is, as exemplified by the "opening up" of the Chinese and the Indian economies, trading barriers will come down - including the virtual elimination of tariffs, quotas, and government subsidies of certain industries.  In such a world, we should pay attention to the teachings of the late 18th/early 19th century British economist David Ricardo (not only because he came up with great theories but because he also successfully used his beliefs to accumulate a fortune in the financial markets) - especially his teachings of the theory of "comparative advantage."  Such a theory dictates that the United States will at some point become a virtual full-service economy - with finance, technology services (such as intellectual property), and the media/entertainment industry (I will call them the "three predominant industries") being at the top of that list.  General manufacturing such as the auto, steel, and textile industry will all relocate overseas (the only manufacturing that will remain locally is specialized manufacturing or manufacturing that is essential to national security).  Unfortunately for manufacturers and for manufacturing workers, this is the logical path to take if the U.S. is to remain as the number one economic power going forward.  Whoever controls the "three predominant industries" will control the world (as a "tribute" to Mayer Amschel Rothschild who once stated: "Give me control of a nation's money and I care not who makes her laws.") so to speak, and right now, the U.S. still reigns supreme.

For hundreds of years, both the modern Chinese and Indian civilizations were proud peoples - not only because they had accumulated vast amounts of wealth but also because they were very technologically advanced on a relative scale.  That is until the onset of the Industrial Revolution, of course.  There is now no doubt that both the Chinese and the Indians will do their utmost to catch up with the "west" in terms of both standard of living and in terms of stature.  Going forward in the 21st century, many new names on the Fortune Global 500 list will be Chinese and Indian companies (the Indians are still far behind the Chinese in this "race" to the Global 500, however).  At the same time, "newer" companies such as Microsoft, Dell, Oracle, Cisco, Amgen, Amazon, Google, eBay, and Yahoo will continue to move up the rankings - displacing older and more familiar names such as SBC, AT&T, Xerox, Delta, Northwest, Delphi, and not to mention - General Motors.  Unfortunately, one is hard-pressed to find companies that are similar in nature to Google, eBay, and Yahoo, for example, in the Western Continent, and given its hugely deteriorating demographics, high tax structure, and lack of innovative/capitalistic spirit (for example, Germany is still essentially a manufacturing economy today), one's logical conclusion is that Western Europe will continue to lose its clout as a group in the world economy going forward.

That being said, the 21st century and the advent of the internet will result in the huge empowerment of the individual - should one choose to accept that role.  While nation-states can fight among themselves for bragging rights, that does not mean you, as a citizen of the United States, will "lose out" should the U.S., for example, lose her place as a technology leader.  As long as the U.S. possesses a business-friendly environment, and as long as there is ample financing, a free press, and access to education, I believe that one can still choose his or her destiny.

As an aside, I highly recommend reading the latest December issue of Inc. Magazine, which had chosen Ms. Ping Fu as the entrepreneur of the year.  Ms. Fu is the President and CEO of Raindrop Geomagic - a company that designs software to better enable many of the products and objects in the physical world to be represented in digital form.  This is important, since 99% of our physical world does not have a "digital representation."  In Ms. Fu's words, such a "digital convergence" will mark a great change in the manufacturing world - paving the road for customized products, rebuilding "classic products" through reverse engineering, as well as cut down significantly on manufacturing time due to great improvements in quality management.  In a somewhat bold statement, Ms. Fu claims that such a technology can potentially mean an end to the outsourcing of manufacturing - as better products can be built locally using this kind of platforms as well as on a relatively low-cost basis (as a side note, this still doesn't help the unionized workers at GM, since the prerequisite for operating such software is most probably at least a B.S. in Computer Science at an accredited university).

As for the stock market, this author still believes we are currently in a secular bear market - a secular bear market that began in early 2000 and that will most likely be similar in nature to the 1966 to 1974 secular bear market.  While earnings will most likely continue to grow in general (much more in the finance, technology and entertainment industries than the manufacturing industries, however), my guess is that P/E ratios will continue to come down to more historical norms.  Let's now take a look at the following long-term chart showing the historical P/E ratios of the S&P 500 from 1925 to October 2005, courtesy of

S&P 500 Index Relative to Normal P/E Range 1925-2005 - Current P/E of approximately 20 still overvalued relative to historical norms.

The current trailing P/E of the S&P 500 is now slightly over 20 - which is a historically overvalued reading.  If one extends this study back a further 100 years, investors will invariably see that the P/E of the stock market (as defined by the S&P 500) have swung between an "undervalued" condition and an "overvalued" condition (with minor spikes below or over those levels) - generally defined as a P/E of 10 and 20, respectively.  As always, however, there are those in the "this time is different" camp claiming that P/E ratios do not matter anymore, chiefly because of two reasons:

  1. We are currently living in an era of low inflation of low interest rates, and compared to the valuation of bonds, equity valuations are undervalued.  With this argument, it is important to keep in mind that such a valuation model which incorporates bond returns have only worked during the last 20 years or so.  Interestingly, however, the best time to buy stocks is when real interest rates (interest rate less inflation) are high - for example, during the early 1930s and 1980s.  Moreover, it should be remembered that this same "relative valuation" argument could be applied to bonds in the early 1970s - when bond yields were nearing 8% and were beating both earnings and dividend yields hands down - and yet, bonds continued to dive through the 1970s as a great inflationary wave took over.

  2. The earnings of S&P 500 companies are less cyclical and less sensitive to both economic cycles and economic shocks - primarily because of the emergence of services companies or companies that outsource their manufacturing to other (usually foreign) companies, such as ACS, Adobe, Amgen,, Dell, eBay, Electronic Arts, General Electric, IBM, Microsoft, Nike, Oracle, Starbucks, and Yahoo.  In other words, these companies have relatively low fixed costs, and thus relatively less financial leverage.  This author believes this is a valid argument, but IMHO, this doesn't justify a long-term P/E ratio of 20 or over for the S&P 500.

As I have argued, reason 1) does not hold water, so let's discuss reason 2), which does have a valid and logical claim, IMHO.  However, it is important to keep in mind that the majority of companies in the S&P 500 still have similar cost structures as they were ten years ago, aside from the obvious technology improvements since that time.  For every Microsoft, there is still an Intel (which does its own manufacturing), a Phelps Dodge, as well as a Merck.  Moreover, despite what Americans think otherwise, the skilled labor force in both China and India is not limitless (as an aside, this author has been getting dismal customer service from Dell ever since he bought his new laptop).  Finally, as I have argued in previous commentaries, earnings as a percentage of GDP is now (2Q 2005) at a high not seen since the first quarter of 1969 - suggesting that every little bit of potential earnings have more or less been squeezed.  Following is a quarterly chart showing the absolute levels of corporate profits and corporate profits as a percentage of GDP from 1Q 1980 to 2Q 2005:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 2Q 2005) - Both corporate profits and corporate profits as a % of GDP rose to a new all-time high in the second quarter of 2005.  The former increased from $1,080.1 billion to $1,141.3 billion  while the latter increased from 9.0% to 9.4% - surpassing the 3rd Quarter 1997 high of 9.3% and now at a high not seen since the first quarter of 1969.  This rate of 9.4% is suggesting to me that the profit cycle is maturing - i.e. the easy money has definitely been made.

While this author can conceivably raise the long-term "fair valued" P/E from 15 to 17, I still don't see how the bulls can justify a P/E of 20 or over for the S&P 500 in the long-run.  Even if it can be justified, however, readers should note that P/E ratios often fluctuate around the long-term mean, and ever since the spring of 2000, the long-term trend of "P/E expansion" has definitely switched from up to down.

In the longer-run, it is my belief that this market will head into trouble going into 2006.  As I have mentioned before, the recent speculative activity in the stock market (not to mention both the precious and the base metals) is getting very frothy - especially in the face of a continued tightening by the Fed as well as the threat of a tightening by the European Central Bank.  Since the last time we showed our MarketThoughts Excess M indicator, liquidity has still been trending down.  This continued "drawdown" in liquidity is also shown by the action of the relative strength of the Philadelphia Bank Index vs. the S&P 500 over the last six months:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3) Relative strength of the Bank Index finally broke through support convincingly approximately nine months ago and and has stayed down since - with the exception of a back-kiss off the same line 30 weeks ago.  Note that relative strength of the Bank Index is now again trying to push through major resistance.  If it succeeds, then the life of this bull market has most probably been extended.

As described on the above chart, the relative strength of the Bank Index vs. the S&P 500 broke through support 30 weeks ago - suggesting the development of a liquidity crunch.  As I mentioned to a subscriber, we like to use relative strength as opposed to looking at absolute levels of the Bank Index, simply because relative strength is the strictest measure of liquidity, while the absolute level of the Bank Index takes into account both liquidity and the "animal spirits" currently lurking in the stock market.  While relative strength of the Bank Index has rallied spectacularly since its three-year low eight weeks ago, subscribers should note that it is now bumping up against a major resistance line.  Should relative strength of the Bank Index manage to break out, then this bull market should most likely be extended for at least another six to 12 months.  If not, then there is a strong likelihood then this cyclical bull market will end after this current rally is done - most likely within the next three to four months.  For now, we will just sit back and see - things are about to get interesting!  For readers who want to read more about the current liquidity situation, I urge you to go and read John Mauldin's recent "Outside the Box" article on "Deteriorating Global Liquidity".  The original author of the article is Mr. Niels Jensen, President of Absolute Return Partners.

Before we go on and discuss the most recent stock market action and our popular sentiment indicators, I want to show our readers one more interesting-looking monthly chart.  Without looking at the title, I encourage our subscribers to take a guess on what the following chart is showing:

Cross rate of the Euro vs. the Japanese Yen - Any breakout from here would be immensely bullish for the Euro vs. the Yen, but this author is not betting on it.

The above is a long-term, monthly charting showing the cross rate of the Euro vs. the Japanese Yen (Yen/Euro).  Not only has the collective currency of the Euro Zone been on a long-term downtrend with the Japanese Yen for the last 20 years, it is now actually bumping up against its long-term, declining resistance trendline.  Any upside breakout from current levels will be bullish for the Euro and bearish for the Yen, but current fundamentals do not support such a breakout.  Without going into Japan's favorable current accounts (which would make a good argument for a stronger Yen going forward), it is important to note that many players are now short the Japanese Yen.  How do we know this?  While we do not think that there has been a Yen carry trade, what we do know is this:

  • Many Japanese pension funds have been investing in higher-yielding U.S. Treasuries over the last few years since government bond yields have been dismally low in other developed countries and in particular, Japan.  Historically, these pension funds have hedged their currency risks by taking a short position in U.S. dollars vs. the Yen.  This was a very cost-efficient hedge when overnight rates were at 1% - it isn't anymore when overnight rates are at 4%.   That is, pension funds have been quietly taking away their hedges, thus pushing down the Yen in the process as they are forced to purchase U.S. Dollars.  Coincidentally, this "new strategy" has worked immensely well, since Japanese pension funds have been getting the high yields as well as the currency appreciation.  As other Japanese pension funds jump on the bandwagon, the pace of the decline in the Yen has accelerated.

  • Most of the recent uprise in the Japanese stock market has been due to foreign buying - and these same foreign investors have been hedging their currency risks by shorting the Yen or borrowing the necessary Yen to buy Japanese equities.  Both American and European investors have been doing the same type of trades - and thus they have managed to push down the Yen against both the U.S. Dollar and the Euro in the process.

Historically, upward adjustments in the Japanese Yen have been very painful for those that are caught on the wrong side of the trade.  Just ask Julian Robertson of the Tiger Fund back in 1998 - when the Yen appreciated 15% in a matter of just over an hour!  And with many world investors now short the Japanese Yen (and with the Japanese having a favorable current account), this author believes that the possibility of an upside breaking out in the Euro/Yen cross rate is most probably slim to none.  In fact, the above chart now looks bearish for the Euro vs. the Yen.

Let's now take a look at the most recent action in the stock market.  The market continues to surge on the upside - although the rally during Thanksgiving week has been relatively calm vs. the action of the preceding four weeks.  Readers must be bored of this by now: But in the short-run, the market is very overbought, and thus is vulnerable to a significant correct at any point in time.  For readers who are interested, I will provide periodic updates of the technical condition of the market in our discussion forum, and we will definitely alert you in our regular commentary should we believe the market is close to topping out.  For now, it is sufficient to mention that most major market indices are now at or near four-year highs, with the Dow Transports and the mid cap and small cap indices breaking or in the midst of breaking out from their all-time highs.  As for the Dow Industrials, it is now a mere nine points from breaking out of its March 4, 2005 closing high - which will be accompanied by a new four-year high.  Again, over the intermediate term, the current uptrend remains intact.  Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to November 25, 2005) - For the week, the Dow Industrials rose 165 points while the Dow Transports again rose (for a fifth consecutive week) for a gain of 38 points.  Ever since its low five weeks ago, the Dow Transports has appreciated an astounding 15.3%!  In our commentary last week and the week before, I stated: 'My guess is that the Dow Industrials will eventually surpass its March 4th high of 10,940.55, but definitely not its all-time high.'  The action of last week has nearly brought this to fruition, as the DJIA is now only 9 points from its March 4th high - ending at 10,931.62 for the week.  My guess is that any breakout of the Dow Industrials will result in more retail investors being pulled in - but which will ultimately disappoint most investors.  For now, we will continue to stay neutral and not chase any rallies from current levels.

Over the last few weeks, I have been constantly stating that the Dow Industrials should surpass its March 4, 2005 high of 10,940.55 in the coming weeks, and my guess is that sooner or later in the next several weeks, it will - even if it does happen to sell off in the interim.  Please note the following from last week's commentary: "It is to be said here that at the tail-end of all bull markets, the market usually stays irrational longer than anyone thinks.  Such was the case with gold and silver in January 1980, the Nikkei in 1990, as well as the NASDAQ Composite in early 2000.  This is what has been happening with copper, as well as the stock market.  If the cyclical bull market is to end soon, then we should have a "blow-off" of significant proportions - a blow-off which should definitely take the Dow Industrials above its March 4, 2005 highs - thus sucking in all the investors who are currently on the sidelines.  Only then would this cyclical bull market finally end.  Please note, however, that this author is not looking for an all-time high in the Dow Industrials, although stranger things have happened." I still stand by this statement.  Whether the cyclical bull market will end in the next few months will depend greatly on global liquidity, and while the verdict is not over by any means, it is getting close - readers should continue to watch the Bank Index very closely and for any signs of a rate hike by the European Central Bank in the coming days.

Let's now discuss our most popular sentiment indicators - starting with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials.  The latest weekly reading finally notched a 40%+ reading in the latest week - rising from a reading of 32% to a highly overbought reading of 41%.  Such an overbought reading hasn't been witnessed since late July.  Please keep in mind, however, that market rarely top out with the first 40%+ reading in this survey, as highlighted by the fact that the ten-week moving only rose slightly from 11.2% to 13.1% - a still oversold reading from a long-term standpoint, suggesting a continuation of the intermediate uptrend:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - For the first time since late July 2005, the Bulls-Bears% Differential in the AAII survey notched a 40%+ reading for the week, rising from 32% to 41%.  No doubt, this survey is now very overbought.  However, it is important to keep in mind that markets rarely top out with the first 40%+ reading in this survey.  This is highlighted by the fact that the ten-week moving average, meanwhile, rose from 11.2% to 'only' 13.1% - hardly an overbought reading over a longer time period.  For now, we will remain neutral in our DJIA Timing System, unless the market experiences a sharp-enough correction which will allow us to jump in.

The Bulls-Bears% Differential in the Investors Intelligence Survey remained pretty much steady in the latest week - with the latest weekly reading rising from 30.2% to 30.4%.  Meanwhile, the four-week moving average increased from 22.8% to 23.1% - again, suggesting a continuation of the current intermediate uptrend, even though on a very short-term basis, the market is still hugely overbought:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey remained steady in the latest week - rising from a reading of 30.2% to 30.4% - continuing the short-term uptrend from five weeks ago.  The four-week moving average, meanwhile, increased from a reading of 22.8% to 23.1%.  This survey is still implying more upside in the intermediate term, although this does not mean there won't be any corrections or consolidation in the short-run.

In last week's commentary, we stated: "Both the readings in the AAII and Investors Intelligence Surveys are implying a continuation of the current intermediate uptrend, even though on a very short-term basis, the market is hugely overbought and should correct or at least consolidate over the next couple of weeks.  Again, for subscribers who choose not to go long, this author would not recommend going short either - unless you really know what you're doing.  The end-of-the-year action is known for its short squeezes.  Better to sit back and enjoy your upcoming Holiday time."  At this point in time, nothing has changed over the last week to change my position on this.  Unless one is very familiar with certain individual stocks (or commodities), I just do not sit any good opportunities in the stock market right now.

Just like the AAII survey, the latest weekly reading in the Market Vane's Bullish Consensus made a significant jump - rising from 64% to a highly overbought reading of 69% for the week. The four-week moving average increased from 62.0% to 64.3%, and while the four-week moving average is also now overbought (albeit mildly overbought), this, along with the AAII survey suggests to me that the intermediate term uptrend is still very much intact, for now:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus jumped quite a bit from 64% to 69% in the latest week - signaling an extremely overbought reading at least on a weekly basis.  Meanwhile, the four-week moving average increased from 62.0% to 64.3% - a mildly overbought reading relative to the readings since January 2004.  The most likely scenario is for this survey to trend higher in the coming weeks, although in the short-run, the market is still very overbought and is prone to a correction at any time.  Just like the AAII survey, the market rarely tops out with the first overbought reading from the Market Vane's Bullish Consensus.  For now, we will remain completely neutral in our DJIA Timing System.

At this point, all of the three popular surveys that we keep track of are still sufficiently oversold to give us some further upside, although any new highs here may take a longer time to achieve given the fact that the market is now so overbought in the short-run.  Over the next several weeks, this author will be looking for a new four-year high on the Dow Industrials, as well as a new all-time high on the S&P 600 and the Russell 2000.  Bears should definitely stay on the sidelines for now.  However, this stock market will most probably again be "a short" once the four-week or ten-week moving averages of these surveys become overbought.  For now, we will remain completely neutral in our DJIA Timing System.

Conclusion: While the financial markets and the world/U.S. economy will continue to be treacherous going forward, it will also offer a very exciting ride (for readers who get excited about changes).  There will be ample opportunities and investing ideas for the ones who take the initiative to understand our "new world" - especially the fast-developing countries of both China and India.  These two "emerging economies" cannot be stopped - and will do anything to reclaim their former glories in world history - and while this unprecedented development will enrich many Americans and foreigners in the process, it will also inevitably cause mass dislocations for certain professions and whole industries.  Of course, industries such as the financial, technology, and entertainment industries will never go out in style in America, and I urge subscribers or kids of subscribers to go out and pursue your opportunities should you feel you have a talent and a passion for careers in any of these three industries.

In the longer-run, this author still believes we are in the midst of a cyclical bull market within a secular bear market - just as I have reiterated over the last few weeks.  If so, then we may be near the tail-end of this cyclical bull market, given the already long length of this current cyclical bull market and given the continuing decline of liquidity on a global basis.  Finally, this author contends that given the long-term trend of the Euro vs. the Japanese Yen, the latter may now be again in the midst of a secular rise against the former - which is simply a continuation of the long-term downtrend of the Euro (collectively the currencies in the Euro Zone before the formal adoption of the Euro) against the Yen for the last 20 years.

Signing off,

Henry K. To, CFA

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