The Next Big Trend and the “Double Merit” Scenario
(May 14, 2006)
Dear Subscribers and Readers,
This week, we're going to dive right in and talk about the next “big trend.” Subscribers who have been keeping track of both our commentaries and my postings on our discussion forum should know what I like best in terms of valuation relative to all other asset classes right now. That asset class is: the U.S. brand name, large to mega caps, such as INTC, MSFT, C, GE, EBAY, YHOO, WMT, and CSCO. Please note that I am not including cyclical stocks here, but rather stocks that are still on sustainable projected growth paths and who continue to innovate or diversify into other businesses that they can be good at. Sure, Microsoft's core business is now subject to the whims of the technology spending cycle, but they still have a very high-margin business and have continued (or attempted) to innovate and diversify into other businesses. The question is: Can they succeed? They have actually been losing market share to both Google and Yahoo in the search business, but that “war” still isn't over yet (today's search technology is still very rudimentary compared to what is possible in even a few year's time). Bill Gates is also now pitching the idea of “Anywhere Gaming” in order to capitalize on the recent head start of the Xbox gaming console over the Sony Playstation 3 (the latter isn't scheduled to be released until this November). Make no mistake: The industry of online gaming has been growing exponentially, and it will continue to grow exponentially as the idea gets more accepted and as broadband connections become faster and more mobile. For folks who don't believe that this can become a huge money-maker, look no further than the initial successes of the game “Second Life” – where some gamers are now doing business and making a living from playing the game. The fact that online gaming cannot be pirated makes this idea even more attractive to MSFT – who have been having a hard time trying to deal with Chinese software pirates over the last decade or so.
We switched from a 25% short position to a neutral 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. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position on Thursday afternoon, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,380.99), this position is 510.99 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 – giving us a gain of 89 points. We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275.
As I have mentioned in our weekend commentaries over the last couple of weeks, we had intended to add an additional 25% short position in our DJIA Timing System (bring it to a 100% short position) should the Dow Industrials continue to rally going into the May 10th Fed meeting. The market “obliged” early last week, and we entered our final 25% short position at a DJIA print of 11,610 on the early afternoon of May 9th. A special alert email was sent to our subscribers in real time – and a message was posted in our discussion forum alerting our subscribers of this change. As of Friday at the close, this final 25% short position was 229.01 points in the green.
Okay Henry, now that you have gotten your “scores” out of the way, what other trends do you see in the markets going forward? There are potentially many trends, but I want to go back and discuss the U.S. large caps for a second.
Okay, valuations for these large caps that I have mentioned are definitely very reasonable – especially when compared to other asset classes (such as all kinds of bonds, commodities, and real estate in both the developed and developing world – short of some asset classes in Africa). However, we are not in “dirt cheap, widespread capitulation territory” just yet – said territory which would put us on par with the 1990 bottom (in the midst of the last consumer-driven recession) or the bottom in gold in 2001 or in Asian equities in October 2002. Moreover, readers should note that the bubble in U.S. large caps only popped as recently as six years ago, and so the current downtrend in some of these stocks should continue at least for a little more while. At this point, this author will not plunge into these stocks on the long side until we see a much more oversold condition in the general market – and given that the Dow Industrials is still over the 11,000 level, this buying point probably won't come until the latter part of this year at the earliest.
As for specific trends in the markets that may not be obvious to the macro investor, this author would like to begin by discussing the S-curve – a logistic function which has been historically very useful in mapping the pace of technological innovation and subsequent adoption to maturity. The following chart is taken from NASA. There are two S-curves on the chart. The first S-curve describes the pace of advancement (or adoption) in the initial technology. As with virtually all technologies, the pace of advancement or adoption is slow at first (think of the adoption of steam engines, radio, automobiles, and the internet) and as demand reaches “critical mass” this pace tends to accelerate until much of the population has already adopted this technology. Any subsequent growth is consistent with further population or GDP growth – until a second breakthrough comes along. This second breakthrough is represented by the second S-curve. As represented by the discontinuity between the first and the second S-curve, the newer technology is usually too expensive (or has too many problems) initially (that is why the “measure of advancement of the second S-curve starts out lower than the first S-curve) – but as the early adopters continue to work on the technology (such as automobiles in the early 1900s or the adoption of cell phones in the early 1990s), the technology is eventually much cheaper and far superior. Sometimes (but not all the time), the subsequent path followed by the first S-curve ultimately turns into a reverse S-curve (such as railroad travel in the United States or union membership), although this is not shown on the below chart:
Recognizing such trends in various industries or technologies will help the stock market investor immensely – not so much to make outsized profits but more to protect his or her capital. How so? Well, recognizing such trends and studying the demise of former “great companies” will allow you to make the wrong investments. This is evident by the fact that many former U.S. blue chip companies have been devoured by such trends, such as Bethlehem Steel, Penn Central, K-Mart, Xerox, AT&T, United Airlines, Westinghouse Electric, and now GM and Ford.
So Henry, what are the current trends that you see? Since it is much easier to discuss trends that could topple companies (as opposed to trends that will make for very profitable investments), I will choose discuss those first:
- The continued adoption of the online store – and the delivery of services via the cheapest route – most likely through the internet if one could help it. The concept of the “big box” bookstore has already toppled many local “mom and pop” bookstores, but with the widespread adoption of Amazon's Z-stores, many local used book stores will go out of business as well. In a few years' time – when the beta version of Google's Library project is finally done, most of today's local bookstores will be out of business.
- The delivery of multimedia over the internet will continue to get cheaper and faster, and will result in the demise of local video rental stores like Blockbuster and Movie Gallery – if NetFlix doesn't get there first. Note that this author has devoted a whole thread to a discussion of Blockbuster on our discussion forum. Readers please feel free to contribute your thoughts to it.
- The continuing adoption of capitalism in Asia, and the continuing “migration” of jobs from the agricultural to the industrial or information sector. A college education continues to gain in importance, as the maldistribution of income and wealth (the Gini Ratio) will continue to grow in the United States. No one is indispensable in the “new economy” – and the best protection against adversity is to continue to educate yourself and change and adopt new ideas. Change is scary, but it also can be exciting. Historically, no one has done this better than Americans. A corollary to this is the continued decline of union membership – which will be further exacerbated by the eventual Chapter 11 bankruptcy of GM or Ford. Denial at GM continues to reign supreme – and it is even more amusing to see senior leadership believing that GM can get out of this mess by more or less relying on the 2007 SUV lineup – in the midst of historically high gasoline prices and when everyone knows that GM's problems have been over 30 years in the making.
- Transaction costs of many tradable goods will continue to decline – as exemplified by the rise of the discount brokers in the 1990s and the most recent explosion of derivative contract turnover not just on the local exchanges (such as the CME, CBOT, NYMEX, NYBOT, and ICE) but on the international exchanges as well. The 1990s officially meant the end of the full-service broker (the good ones can still make it by providing good research and advice and maintaining good relationships, but the industry has definitely shrunk). In the next few years, we will most probably witness the end of the full-service real estate agent – to be further exacerbated by the end of the U.S. housing bubble. Given that folks can now virtually inspect and tour a house on the internet nowadays, it really does not make sense to pay a 6% commission to buy or sell a house anymore.
All the above points may sound depressing, but this author believes that the fulfillment of these trends is inevitable. So as not to make our subscribers too depressed, I will now go on and outline a few disruptive technologies, but before I do so, I want to again discuss the economic concept of “acceleration” – a term I first discussed in our February 13, 2005 commentary (“China – Basic Background and Current Issues, Part III”). Coined by the French economist Albert Altalion in the early 20th century, the term “acceleration” refers to a very powerful demand phenomenon – that demand for certain goods or services tend to “accelerate” as the average income of society approaches a certain threshold. Acceleration takes advantage of the fact that income levels are usually distributed like a bell curve - not unlike most socioeconomic variables such as age, the level of education, or the average number of hours worked for a certain group of people in society. For example, history has shown that demand for long-term savings products is virtually non-existent until an individual earns US$15,000 or over – and as the average income of a society approaches $15,000, demand will literally explode (see below chart: the revised demand is the area between the green and the red line):
This demand phenomenon known as “acceleration” can be very powerful – as automobile and PC manufacturers found out first-hand during the 1920s and the 1990s. An off-shoot of this “acceleration theory” is Andy Kessler's guidepost to successful growth investing (as outlined in John Mauldin's “Just One Thing”) – that of identifying the industries with high demand elasticity. In Kessler's own words, high elasticity means that “lower cost creates its own huge markets.” Kessler relied on this guidepost for successful growth investing in the semiconductor industry during the late 1980s and the 1990s.
The automobile industry witnessed a confluence of both the “acceleration” and the “high elasticity” forces (the latter primarily due to the widespread adoption of the assembly line) during the 1920s – resulting in a “double merit” demand scenario (coined by yours truly) which subsequently led to an explosion in demand. The productivity increases as driven mainly by Dell and to a lesser extent, Gateway Computers – combined with increases in disposable income resulted in the PC sector experiencing a double merit scenario of its own during the 1990s. The cool thing with these two investing trends is this: Both the popularity of the automobile and the PC were already cemented prior to the 1920s and 1990s, respectively. The “only trouble” lies with the average investor's ability to find the right companies to capitalize on this “double merit” scenario. Going forward, MarketThoughts.com would be here to help you out – but we cannot do this without our subscribers. We know that there are folks out there who are infinitely more technical and have more business experience than us, so please feel free to email me your ideas or post them on our discussion forum. Remember: All you need is just one trend and you are set.
A few trends that this author is currently researching involves: RFID tags, GPS technology, and online gaming. These technologies are very popular (and are here to stay) but still have not been widely “adopted” just yet. Both RFID and GPS technologies will definitely benefit from some kind of “double merit” scenario going forward. The fact that Wal-Mart has also adopted RFID technology is further proof. As for online gaming, the widespread adoption of this phenomenon will not occur until the broadband connections become faster and more mobile (which may occur with the widespread roll-out of the WiMax technology) – even though the cost of playing games online is already relatively low today. That makes it a little bit more difficult, but there is no doubt in this author's mind that online gaming will eventually replace the TV and the cinemas as the main form of entertainment around the world. In the future, major companies can even advertise or sell their services on some of these “alternative realities” – something that many companies have already been doing in popular movies. The trouble with all this is, as always, identifying the companies that will benefit from these “double merit” scenarios. GM was king in the 1920s. Dell was king in the 1990s. Is there even a playable trend during this decade? Does Starbucks qualify? Carnival Cruises obviously does not qualify – unless one can start building those cruise liners with carbon nanotubes and refit the engines with hydrogen fuel cells (thus further driving down costs). How about SmartCode – an Israeli company that is currently selling five-cent EPC RFID tags? Or CME – as both the rise in incomes (and thus, a rise in financial education) and a drop in transaction costs should mean a continuing exponential increase in demand for financial derivative contracts?
Let's now discuss the most recent action in the stock market. Following is from last weekend's commentary: First of all, readers should note that “the tape” is still very much split – with many large caps still underperforming while small and mid caps continue to power ahead. In our January 19, 2006 “Brand Name” update, we had discussed that bull markets do not last long when the major brand names do not confirm – and since that time, three of the top five U.S. brand names (MSFT, IBM, and INTC) have declined further – while the other two (KO and GE) have only gotten marginally better. At the same time, two of the fastest-growing brand names, Google and Apple, have also underperformed the market tremendously over the last six months. This is a significant divergence – and should definitely be taken into account by our readers, even as both the Dow Industrials and the Dow Transports continue to rally to new cyclical bull market highs. The $64-million question: Will the rallying Dow Industrials “pull” the U.S. brand names up, or will the U.S. brand names lead the broad market down? History suggests that before any change in leadership (such as from small caps to large caps), the market has always corrected. Will this time be different? As can be seen in our DJIA Timing System, our answer is “no” but we are willing to change our positions should we turn out to be wrong.
In retrospect, our view turned out to be correct – although there is no way to tell at this point whether the Dow Industrials or the Dow Transports have topped out for this cycle just yet. From a bear's standpoint, it is “encouraging” to see that the Dow Utilities declined by 11 points last week – sitting right at support at the 400 level and 32 points away from its all-time high made in early October of last year. This is significant, as the Dow Utilities tend to top out three to nine months before the Dow Industrials during a typical cyclical bull market. Furthermore – despite both the Dow Industrials and the Dow Transports making new cyclical highs last week, the NYSE A/D line failed to make a new high, marking the first time it has not done so in this cyclical bull market. This is very ominous – especially given the fact that the number of new lows vs. new highs “exploded” both on the NYSE and the NASDAQ, marking the first time new lows have outpaced new highs so significantly since late October of last year. This can be witnessed in the following daily chart showing the NASDAQ high-low differential ratio vs. the NASDAQ Composite from January 2003 to May 12, 2006:
As mentioned in the above chart, the negative 2.18% reading of the NASDAQ Daily high-low differential ratio last Friday represented the lowest reading since October 27, 2005. Coming off a six-month stretch of very benign readings, this latest move into “significant” negative territory is more of a sell signal as opposed to signaling an oversold condition in the stock market. Please note that similar dips (a significant negative reading preceded by a period of benign market conditions) in the last 18 months have led to significant sell-offs, and there is no reason to believe that this time will be different.
We will reevaluate as the market gets more oversold – but at this point, the decline is still relatively early, as exemplified by technical indicators such as the McClellan Summation Index, the NYSE ARMS Index, the equity put/call ratio, and along with our most popular sentiment indicators. Sure, the VIX did jump by over 13% last Friday, but note that even with that spike, the VIX is still only sitting at the 14.19 level – which is still more than a couple of points away form the 16.47 reading during the October 2005 bottom and prior to that, the 16.92 reading during the April 2005 bottom. Speaking of the NYSE ARMS Index, let's review the 10-day and 21-day moving averages of the NYSE ARMS Index, as shown by the following chart:
As mentioned in the above chart, the 10-day and 21-day moving average of the NYSE ARMS index is currently sitting at 1.038 and 0.927, respectively – a far cry from even the “semi-oversold” condition of October 2005 (when the 10-day reading hit the 1.2 level). At the very minimum, this author would like to see a 10-day reading of 1.2, but given the continued clampdown of global liquidity, the failure of the NYSE A/D line to confirm the Dow Industrial's new cyclical high, and the inherent maturity of this cyclical bull market, this author will most probably not jump in on the long side until we get a 10-day reading of 1.3 or even higher. Readers should also know that the NYSE McClellan Summation Index is still far from oversold – and in fact, is not even in negative territory just yet.
Let's now take a look at the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:
Last week, I stated that the 210-day point and the 293-point rallies in the Dow Industrials and Dow Transports, respectively, were “impressive,” but the action of last week was even more impressive, as both indices staged a huge reversal on high volume. For the week, the two popular Dow indices declined a whopping 196 points and 117 points, respectively – all the more authoritative given that the Dow Industrials was only 80 points away from crossing its all-time high. The failure of the Dow Industrials to confirm the Dow Transports for such a long time (17 months) and given that it was so close to confirming is very reminiscent of the December 1968 cyclical bull market top. This is one heck of a non-confirmation – and I would like to ask our readers to watch this like a hawk in the days ahead.
Moreover, bond prices continue to show no signs of life even though they are now in a very oversold condition. In fact, the yield of the 10-year Japanese government bond has just hit the critical 2% level as we speak – the first time it has done so since January 1999. This suggests still higher long bond yields in both the U.S. and European markets just up ahead. At the same time, the “cheap” U.S. large cap brand names like Microsoft and Dell continues to get hit on the downside, and have still shown no signs of a reversal.
I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. Over the last month or so, the average of our most popular sentiment indicators has remained very steady – and while the short-term readings of these indicators may be more on the neutral side (relative to the readings we have gotten over the last couple of years), readers should note that these readings are still pretty overbought relative to the readings since January 1997.
During the latest week, the four-week moving average of the bulls-bears% differentials of these three popular sentiment indicators increased slightly from 22.1% to 22.7%. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week (note that I have redid the scales and shortened the time period by changing the starting month from July 1987 to January 1997):
Given that the market is most probably now in a downtrend, probability suggests that this reading will at least reach the October 2005 level before a sustainable market bottom can be reached. And again, given the weakening breadth numbers, tightening liquidity, and the lack of an oversold condition in our other technical indicators, this author won't be willing to bet on the long side here until our sentiment indicators get significantly move oversold (for example, readings that would put us at the October 2005 levels).
Conclusion: Last week, I stated that the probability of a significant stock market top continues to increase by the day- as evident by declining liquidity, historically significant divergences, as well as a “dash to trash” – a phenomenon that typically only occurs at major stock market tops. While there is probably a 50/50 chance that we have already seen the all-time high for this cycle, readers should note that time is now running out for the bulls. The longer it takes for the Dow Industrials to rally back to the level of last week's, the more likely the top has already come and gone. Readers should also be reminded of the fact that the Japanese monetary base continues to plunge – and this has been a very good historical leading indicator of the Japanese, Asian, as well as the commodity markets. As for the U.S. stock market, readers should note that the major brand names are still underperforming – and should not be bought here even though they appear “cheap.”
Going forward, I would like our readers to think more about the possibility of a “double merit” scenario in any individual stocks that you keep track of. I encourage all of you to send in your thoughts or to post them on our discussion forum. I will continue to explore this “double merit” theme in our later commentaries.
At this point, readers are urged to be very defensive and to be very aggressive in culling weaker-performing stocks from their portfolios. At this point, we will continue to maintain a 100% short position in our DJIA Timing System, but we will be looking to shift back to a 75% short position in order to control for volatility – possibly even during sometime this week. So don't be surprised, although as always, we will alert our subscribers through email should we make any changes in our DJIA Timing System going forward.
Henry K. To, CFA