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A Merry Christmas to All

(December 25, 2005)

The author would like to reemphasize the dangers of not being informed or protecting yourself when utilizing the internet.  Sure, the internet is an exciting, ever-changing, and vibrant place, but just like with many medium that provides a significant amount of profit opportunities, there are also many unscrupulous individuals praying for you to make a misstep - anything that would give them your identities or credit information.  For a great discussion on the growing problems of the internet today, I encourage our readers to read the latest article entitled: "The Internet is Broken" on MIT Technology Review.  Quoting from the author, David Talbot: "Indeed, for the average user, the Internet these days all too often resembles New York's Times Square in the 1980s.  It was exciting and vibrant, but you made sure to keep your head down, lest you be offered drugs, robbed, or harangued by the insane."  Case in point: The author just received another message purporting to be from Paypal asking me to update our account information - since supposedly, they are going to require more detailed information from the users starting in 2006.  Don't believe this for a second.

Note: As I said over the last two weeks, this will be a very abbreviated commentary, since I am going to spend most of time today and next week with family and with my fiancé (this commentary was originally written on December 25th).  I was going to write this commentary yesterday, but we ultimately ended up doing some last-minute Christmas shopping instead.  For me, this was a grueling experience - much more so than trading stocks or analyzing the financial markets!  Fortunately, and surprisingly, the "traffic" at the malls was very subdued - even for a typical Saturday afternoon.  This was further confirmed with a few calls to friends in the Houston area - as well as by the following article.  Note that this author is a "fan" of AEOS - and may actually buy the stock for his own account should we see any weakness in the next few trading days in light of the slower-than-expected retail sales yesterday.

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.  At this point, this author has no position in the stock market - but again, one strategy that this author is thinking of implementing is buying fundamentally strong stocks that may be subject to tax-loss selling in the next few trading days.  Please keep in mind that the final day to do any tax-loss selling is December 28th, as stock trades take three business days to settle.  Some stocks that I am currently thinking about are BUD, SNDA, SAFM, and AEOS.  As always, this should not be construed as specific investment advice.  For readers who are thinking of buying GM to take advantage of tax-loss selling, I do not recommend it - even as a short-term trade based on technicals - given that technically it usually takes many days for a stock such as GM to hammer out a bottom, as there are so many shareholders that will be willing to sell the shares on any slight up-tick of the stock.  A V-bottom formation usually only occurs in small cap stocks - not large caps like GM.

As usual, this is the time of the year when "the best of Wall Street" offers their stock market (as well as other economic) predictions for the upcoming year.  As usual, these predictions are universally bullish - with the average estimate coming in at approximately 1340 for the S&P 500.  Abby Joseph Cohen is predicting 1400 by year-end 2006, while Prudential's Edward Keon is predicting a huge advance to 1530.  Meanwhile, the most bearish strategist is JP Morgan's Abhijit Charabortti with a prediction of 1125 by year-end 2006.  Interestingly, he was the most accurate out of all the strategists for 2005, with a prediction of 1275 by the end of this year (he will remain the most accurate unless something unforeseen occurs in the next few trading days, of course).

More interestingly, however, is the fact that the majority of strategists out there are calling for large cap growth (again) to outperform the stock market in 2006.  On the surface, this seems logical, as large cap growth stocks (such as Disney, Home Depot, Motorola, Dell, etc.) have been underperforming ever since this cyclical bull market began in October 2002, as well as the fact that many of these stocks are now significantly undervalued relative to other asset classes in the stock market.  However, the fact that the majority of strategies (including none other than Motley Fool) are again calling for a resumption of the large cap growth bull market makes me very skeptical from a contrarian standpoint.  At this point, individual investors are still shunning large cap growth (which is very understandable considering the drubbing in large cap growth they took during March 2000 to October 2002) - and at the same time, a huge source of investment funds of large cap growth - mainly international and Middle Eastern investors - are still very reluctant to invest in the U.S. stock markets given the renewal of the Patriot Act, etc.  This last reason is more anecdotal - but it makes perfect sense given that large cap stocks in nearly all other developed countries have been hugely outperforming U.S. large cap stocks in the last couple of years.

Going forward into 2006, I believe "hard" commodities such as the metals and energies will underperform the markets - given their huge gains in 2005 and given that liquidity has continued to decline (as signaled by our MEM indicator) as well as a decreasing propensity to take risks going forward (as signaled by the flattening and high possibility of an inversion in the U.S. yield curve).  Don't get me wrong - I still believe that commodities are now in a secular bull market.  However, I now believe the bus is too crowded and speculation is too rampant - all the more bearish given declining liquidity.  As in all secular bull markets, there are mid-cycle slowdowns and cyclical bear markets to deal with, and this latest secular bull market in the metals and energies are no different either.  As an interesting aside, we may see of the money that has been going to the metals and the energies go to the soft commodities instead - a very alluring potential trade given that soft commodities such as cotton or corn have no historical correlation to the Fed Funds rate or economic growth, for example.  The fact that we have basically seen no speculation in these commodities in the last couple of years coupled with the development of these futures markets in China suggests that 2006 could be the year when soft commodities finally enjoy a long overdue boom.

To understand globalization and what it means for your investments or livelihoods going forward, I continue to believe that studying China and India is the key.  As I have mentioned many times before, both China and India is "the real thing" - even though I have "complained" quite a bit about the business models of many Chinese businesses over the last 12 months.  Like I mentioned in our discussion forum, many of the manufacturing businesses in China have fundamentally flawed business models.  That business model is to expand and "get big" as quickly as possible - such that when a slowdown does occur, the government will have no choice but to bail out the business.  As a result, there is now a huge overcapacity in many sectors of the economy.  This year, the Chinese manufacturing sector is poised to rack up a negative profit margin of $15 billion.

During 2005, China became a net exporter of steel for the first time in history.  As I am currently typing this, there is another 70 million tonnes of capacity being constructed, with an additional 80 million tonnes of capacity having been already approved for construction (for comparison purposes, the entire production output of the Indian steel industry is less than 40 million tonnes).  Steel production in China for the first 11 months of 2005 has also increased more than 25% from the first 11 months of 2004.  At the same time, there is also a huge overcapacity in the auto manufacturing sector of 2.2 million vehicles - with another 2 million in capacity being constructed as we speak.  Ditto with commercial real estate.  Interestingly, the surplus in steel production will be further exacerbated should the overcapacity corrects in the auto manufacturing and the construction sector.  For folks who are working in the domestic auto industry - one way to "solve" this overcapacity problem is for the Chinese to export some of their better quality cars to the U.S. markets - which is due to happen as early as 2007.  Similar to what has happened to both the domestic textile and steel industries, I just do not see how GM or Ford can continue to survive in their current states - unless they shift most of their manufacturing base to China or Vietnam, etc (and adopt a similar "platform model" similar to Dell's business model).

My guess is that this gross misallocation of capital in China will all come home to roost sometime in 2006.  Any further rally in energy or metals prices will bankrupt many of the manufacturing companies in China. And when that happens, capacity is going to be "shot to pieces." Before that happens, however, the federal government may voluntarily come in and restrict further investment and construction in various sectors - but so far, they have not quite succeeded. But in my view, it doesn't really matter - the government, a further run-up in commodity prices, or weaker U.S. consumer spending will do the job. The hard commodities are merely going through a classic boom/bust cycle, and my guess is that there will be some significant downside in both energies and metals during 2006.  As for my views in the longer-run; yes, I believe both China and India are the "real thing" and will therefore continue to consume commodities at a ferocious rate going forward (the current overbuilding in China is not unprecedented in modern economic history, as exemplified by the railroad boom in the U.S. in the late 1800s (anarchy in the railroads ended when JP Morgan was brought in as the arbiter which resulted in the "Corsair Compact") and the telecom bubble of the 1990s). The secular bull market in commodities is on (compounded by the fact that many commodity hedge funds are now being started), but my guess is that at some point in 2006, we will see a classic mid-cycle slowdown. Just like any correction/cyclical bear within a secular bull market, it will be relatively quick but SHARP. So my advice is to be very careful if one chooses to invest in any energy or metals stocks right now.

This author believes that the continued ascension of both China and India in the world economy will generally lift the standards of living for the population of developed and developing countries alike.  The proliferation of the internet will continue to "democraticize" access to true knowledge across the globe.  Fewer policy mistakes will be made; and cooler heads will prevail.  There will also be more policy transparencies.  Of course, just as with any fundamental shift or change in the U.S. and global economy, there will be winners and losers - so the key is for our subscribers to make sure that they are not on the losing side.  The author is generally a very practical person.  Instead of protesting about outsourcing or dwelling on the loss of the U.S. manufacturing base, my advice would be to continually educate yourselves and your children going forward.  The best long-term security is to take informed or educated risks when you're young (and thanks to the advances in technology, you're never too old to start) - whether that is with starting a business, investing your funds, or investing time in your career and striving for that promotion.  Folks who specifically try to find security in their lives will inevitably get none - just ask the folks at Delphi who are now taking huge pay and benefit cuts (or the folks who opted for appeasement with Hitler during the 1930s).  There is no such thing as a "free lunch."  Folks who strive for security in their jobs or careers are not dissimilar to the folks who are invested in cash or bonds nearly 100% of the time.  That is, ultimately when it comes to retirement, you will find yourself well short of your monetary goals (it is also interesting to note that governmental DB pension plans are even more underfunded than private DB pension plans).  Prudent and educated risks (as opposed to folks speculating on Californian homes or gold futures) should be appropriately rewarded - and that is what I think the Bernanke Fed will strive to do going forward (with his policy of setting specific targets for inflation and even more transparency than the Greenspan Fed).

As a result of the upcoming underperformance of commodities, this author believes that the U.S. Dollar should do well against the major commodity currencies of the world, such as the Australian Dollar, the South African Rand, as well as the Canadian dollar in 2006.  The Euro will also continue to underperform, as I have explained why in many of our past commentaries.  The Yen, however, is now most probably in a multi-month uptrend - and as I have mentioned in many of our past commentaries, this author believes that the secular bull market of the Yen vs. the Euro is now back in play.  My target for the U.S. Dollar Index in the upcoming year is a level of 95 or higher.

Okay, enough predictions for now - let's end this "abbreviated commentary" with a discussion of the most recent action in the stock market.  There is only one word to describe this: Boring.  This is to be expected; however, as trading volume has declined dramatically given many Wall Street and hedge fund traders are now taking time off from the markets.  While the Dow Industrials continued its consolidation phase last week by only appreciating 8 points, the Dow Transports was more volatile, declining 34 points on Monday but ultimately ending up 124 points higher for the week and making another all-time high in the process.  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 December 23, 2005) - For the week, the Dow Industrials rose a mere 8 points while the Dow Transports rose a whooping 124 points - thus requiring us to again change the scales of our chart for the umpteenth time since late October. The ability of the Dow Transports to continue to rise - despite it being so overbought - is nothing short of impressive. On the other hand, the inability of the Dow Industrials to confirm on the upside (by bettering its March 4th high) is definitely a cause for concern - even if the Dow Industrials surpasses the 11,000 level in the coming weeks. My guess is that any breakout of the Dow Industrials will result in more retail investors being pulled in - which will represent the 'final blowoff' for this cyclical bull market. For now, we will continue to stay neutral and not chase any rallies from current levels.

Since the Dow Transports has been the leading Dow index throughout the entire cyclical bull market, this author will have to conclude that this latest rally in the Dow Transports is most probably a sign of things to come for the Dow Industrials.  That being said, the inability of the Dow Industrials to confirm the Dow Transports in the latest week by bettering its March 4th highs is definitely worrisome in the longer-run, but for now, it is a virtual certainty that the Dow Industrials will surpass the 11,000 level in the upcoming weeks.  For readers who have been thinking of implementing the "tax-loss selling strategy" (i.e. buying fundamentally strong stocks that have succumbed to tax-loss selling in recent weeks), it is this author's contention that the market should remain friendly to the bulls at least in the next three weeks (before the first serious round of IPOs are released to the market in the third week of January).  As for potentially shorting individual stocks or the major stock market indices, this author will also wait until the third week of January before considering implementing such a strategy.

Let's now discuss our most popular sentiment indicators.  In a nutshell, our most popular sentiment indicators are still consolidating after getting very overbought a couple of weeks ago, but have gotten more oversold since then.  Similar to last week, most of the evidence suggests higher prices to come over the intermediate term.  Let's now start with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials.  During the latest week, the Bulls-Bears% differential readings in the AAII Survey decreased from 24% to 13%.  The readings over the last few weeks are still consistent with a stock market that is in a neutral to up trend:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey decreased further from 24% to 13% in the latest week - a ST oversold condition. Meanwhile, the ten-week MA, increased slightly from 19.2% to a neutral reading of 21.4% - hardly an overbought reading over a longer time period and suggests that the bias still remains up (this author would not start to 'panic' until at least we see a 25%+ reading). The bias of this survey still remains up - and should continue to do so at least until we get another severely overbought reading such as a 40%+ weekly reading. For now, we will remain neutral in our DJIA Timing System. In the short-run, the bias of the market still remains up - and is therefore a friendly environment for investors who want to 'play' stocks that have been subjected to tax-loss selling over the last few weeks.

Meanwhile, the ten-week moving average increased from 19.2% to a neutral reading of 21.4% - still suggesting that the intermediate uptrend remains intact.  Like I have been saying for the last few weeks, this author would not call an imminent top in the stock market until we see at least a 25%+ reading in the ten-week moving average of the Bulls-Bears% differential in the AAII survey.  More likely, however, I would like to see a reading in the ten-week moving average of 30%+.

The Bulls-Bears% Differential in the Investors Intelligence Survey decreased from 37.2% to 34.0%.  Meanwhile, the ten-week moving average increased from 26.0% to 27.8% - again, suggesting a continuation of the current intermediate uptrend.  However, bulls should keep in mind that the ten-week moving average is now starting to become overbought:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - 1) The Bulls-Bears% Differential in the Investors Intelligence Survey decreased from 37.2% to 34.0% - still a pretty overbought reading but definitely not high enough to signal a significant top in the stock market (we will need a 40% reading before I would be willing to make that call). Meanwhile, the ten-week moving average increased from 26.0% to 27.8% - also suggesting that the intermediate uptrend is still intact.

Over the next few weeks, the probability still favors a continuation of the intermediate uptrend at least until the third week of January - when the revamping of the IPO calendar usually starts sucking liquidity from the stock market.  Again, buying the fundamentally strong issues that have succumbed to tax-loss selling in the last few weeks may not be a bad strategy over the next couple of trading days.  Moreover, should the market just continue to rally from current levels, there is a good chance that this author would be shorting the major market indices come the third week of January.  For that to happen, however, I will need to see an upside confirmation by the Dow Industrials (by surpassing the 11,000 level) and a possible further rally to the 11,200 to 11,300 level.  Once we get such a confirmation (and hopefully a subsequent further spike up), then this author will go 50% short (our maximum allowable short position) in our DJIA Timing System.

The Market Vane's Bullish Consensus continues to surprise on the upside - declining only slightly from a highly overbought reading of 70% to a still overbought reading of 69% in the latest week.  Meanwhile, the ten-week moving average increased from 64.0% to 65.1% (from now on, we will only be looking at the longer-term ten-week moving average, instead of the four-week moving average) - which is starting to become overbought but not officially in the "danger zone" just yet.  This is further confirmed by the relatively "benign" ten-week moving average reading from the AAII survey:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus declined slightly from a highly overbought weekly reading of 70% to 69% in the latest week - which is still very overbought any way you look at it.  Bulls should be very careful here. Meanwhile, the ten-week MA rose from 64.0% to 65.1% - which is still not in the 'danger zone' although it is getting close. For now, this is being confirmed by the relatively 'benigh' ten-week MA of the AAII survey - suggesting that the 'tax-loss selling' strategy (buying those issues which have succumbed to tax-loss selling in recent weeks) may not be a bad idea in the upcoming days. For now, we will remain completely neutral in our DJIA Timing System.

For now, the author's immediate concern is to assess whether the stock market is strong enough to implement our "tax-loss" selling plays (by buying fundamentally strong stocks in the next couple of trading days).  From both a liquidity and a sentiment standpoint, the market should be strong enough to accommodate such plays until at least the third week of January.  Depending on what happens from now to that point, there is also a good chance we will be shorting the major market indices come the third week of January - should the Dow Industrials become overbought and rise to over the 11,000 level and possibly spike to the 11,200 to 11,300 level. 

Conclusion: Since it seems like it is everyone's business to make predictions for 2006 nowadays, my official "guess" for 2006 is a more volatile financial market - further compounded in changing trends in various markets and a changing stock market environment.  From a liquidity and a sentiment standpoint, there is a good chance that the cyclical bull market in metals and energies will end sometime in 2006 (most likely in the first few months of the year - and my guess is that crude oil, gold, and silver have already topped for this cycle), which should serve as a leading indicator for the cyclical bull market in stocks.  All this should be accompanied by a stronger U.S. dollar at least for the first six months of 2006 - with a target of 95 for the U.S. Dollar Index sometime during the year.  For now, let's just take it one market at a time. 

Besides the tax-loss selling play and besides a short on the major market indices come the third week of January, this author is still very much interested in a potential copper trade - even though my initial strategy (simply shorting March 2006 copper on December 20th) did not work out.  Similar to a potential trade in the major market indices, there is a chance this author will be shorting March 2006 copper again during the third week of January should the contract gets more overbought from current levels (relative to its 50-day and 200-day moving averages).  Meanwhile, the intermediate uptrend in the stock market continues to remain intact, and should continue to remain so until at least the third week of January.  For now, we will remain completely neutral in our DJIA Timing System, and if all goes according to plan, we will establish a short position in the third week of January should the market continue to rally until that point.

Signing off,

Henry K. To, CFA

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