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A Buying Point is Near

(July 30, 2006)

Dear Subscribers and Readers,

It is no surprise that American consumers are getting squeezed on both ends by employers who are cutting costs – on one end as employees who are getting laid off or mediocre raises and on the other end as consumers who are losing customer service and who are finding their personal calls being directed to India or other foreign countries.  Given today's environment, any Fortune 1000 company who is providing just a little but more customized or personal service is rising above the crowd – companies such as UPS, FedEx, Dell, etc.  Make no mistake: Today's population is on the “quest for voice” and for individualism – as exemplified by the surge in popularity in websites such as MySpace.com, and Youtube.com.  In the book, “The Support Economy,” authors Dr. Shoshana Zuboff and Dr. James Maxmin discusses a new kind of capitalism that is emerging – a kind of capitalism that is based more on “psychological self-determination” where each one of us want to seek our own individual meanings – which will in turn transform our economy from an economy based on services to that of one which is based on “deep support.”  The days of mass consumerism and “managerial capitalism” are over, the authors contend – and with it, the companies that chooses not to listen to this “growing chasm” between today's consumers and corporations.  The book “The Support Economy” is a must-read for not only consumers but for corporate CEOs as well.

Our 100% long position in our DJIA Timing System was stopped out at its average entry point at a DJIA print of 10,805 on July 14th.  As mentioned in our commentary from the weekend before last, this author was looking for a way to get back into the market on the long side – as I had believed we were now entering a quick “capitulation phase” in the stock market due to the violence that was going on in the Middle East and the wide scale dumping of equities by both individual and institutional investors.  Based on my commentaries and postings over the last couple of weeks or so, we went 50% long in our DJIA Timing System at a DJIA print of 10,770 on the afternoon of July 18th – which was communicated to our subscribers by a real-time email.  We are definitely now in capitulation phase.  In our latest mid-week update, I stated that while the market may not have reached bottom yet, I had believed that we were definitely in “capitulation phase.”  As a result, it was time to start looking for a bottom and for certain stocks to buy.  As of Sunday evening, this author wants to shift from a 50% to a 100% long in our DJIA Timing System.  Given that the market ran away from us on the upside last Friday, this author will have no choice but to wait for a correction in the Dow Industrials before going fully long.  Again, this author will communicate to our subscribers via a real-time email once we decide to go 100% long in our DJIA Timing System.

I understand that many of our subscribers are concerned about the state of our economy and financial markets – including concerns such as the Israeli conflict, the popping of the housing bubble, high oil prices, an inverted yield curve – all amid a rising interest rate environment in many parts of the world, including China and India.  I will cover some of these issues in our upcoming mid-week commentary (Bill Rempel is taking the month off from doing a guest commentary), but readers should keep this in mind: A significant chunk of retail investors here in the U.S. have already capitulated from the stock market over the last 12 months – as exemplified by mutual fund outflows and the most bearish sentiment from both the AAII and the Investors Intelligence Surveys since October 2002.  At the same time, corporations are using much of their excess cash to buy back their own shares – and private equity transactions and cash acquisitions of corporations are at an all-time high.  There are also no signs of letting up, as corporations and private equity investors alike are sitting on a huge chunk of change.  Moreover, the U.S. domestic large caps as an asset class have been one of the biggest underperformers around the world since October 2002 and are now at very reasonable valuations.  In a global tightening liquidity environment, U.S. large caps tend to overperform.  Moreover, as I have mentioned before, the latest Israeli-Hezbollah conflict in Lebanon should serve to remind Middle Eastern investors the risk of investing in their own domestic markets – making the U.S. equity markets attractive to Middle Eastern investors again for the first time since the events of September 11th.  Finally, the speculators have all been driven away from real estate and most probably commodities alike.  What is the next asset class ripe for speculation?  Could it be the U.S. large caps?  Obviously, this author does not have all the answers, but as a long-term hold (at least over the next five years), U.S. large caps are now a near no-brainer.

In this weekend commentary, this author wants to make a couple of suggestions on what sectors to buy, based on classic “oversold” conditions and based on the current revival in large caps.  As this author has mentioned many times before, I now believe the U.S. large caps will set to overperform.  The Bank Credit Analyst has also recently taken up this concept in their July 24th daily commentary.  Quoting the Bank Credit Analyst: “Small cap stocks have surged into overshoot territory over the past few years, fueled by a steady diet of easy money and rapid economic growth. In fact, relative performance has reached an extreme, two standard deviations above its 20-year trend. While markets can stay overbought for a prolonged period, the conditions supporting small cap outperformance have begun to fade: liquidity is draining from the financial system at the same time the main engines of growth are slowing, namely the U.S. consumer and Chinese investment growth. These forces have helped set in motion an upturn in financial market volatility and act as the catalyst to return to large cap leadership.”  Following is the relevant chart from the Bank Credit Analyst showing the trend of the S&P 600 to Wilshire 5000 ratio plus and minus two standard deviations from 1983 to the present:

Trend of the S&P 600 to Wilshire 5000 ratio plus and minus two standard deviations from 1983 to the present

As recently as mid-May, the S&P 600 to Wilshire 5000 ratio was not only at a cyclical high, but at a potential secular high as well.  Again, tightening global liquidity and a rise in risk premiums in international equity markets (due to the Israel-Hezbollah conflict) should both serve to provide a trigger for U.S. large cap outperformance going forward.

As for which sectors to potentially buy, I bet many of the technical analysts on our subscription list will balk when I mention two of the sectors that I like at the moment.  They are – in no particular order – semiconductors and retailers.  Fundamentally, the semiconductor shares are now trading near historical lows on a price-to-book and a price-to-earnings basis.  Moreover, while semiconductor sales have slowed down somewhat this year, they are still projected to grow 10% year-over-year for the rest of this year.  Starting in 2007, semiconductor sale growth should again recover, given the release of Windows Vista and given the depressed amount of capital spending by U.S. corporations over the last couple of years.  The pessimism over semiconductors is evident when one sees at the relative strength of the Philadelphia Semiconductor Index (the SOX) vs. the S&P 500, as shown by the following weekly chart:

Relative Strength (Weekly Chart) of the SOX vs. the S&P 500 (May 1994 to Present) - Relative strength of the SOX vs. the S&P 500 bottomed a week ago at its lowest level since October 2002!

As mentioned on the above chart, the relative strength of the SOX vs. the S&P 500 had just dipped below the troughs of February 2003 and August 2004 – hitting a low not seen since October 2002.  Retail investor pessimism in the semiconductor shares is further confirmed by the amount of assets held by the Rydex Electronics fund (which is as close to a semiconductor fund as you can get), as shown by the following chart courtesy of Decisionpoint.com:

Rydex Electronics fund (RYSIX) - Both the total assets and cumulative net cash flows into the Rydex Electronics Fund is at a three-year low!

Given that the semis 1) are now trading near historically low valuations, 2) have paid down a significant amount of debt since 2000, 3) have been shunned by both retail and institutional investors, and 4) should again be in high demand after the release of Windows Vista in January 2007, my guess is that we are now at or close to a buying point in the semiconductor shares.  As far as individual names are concerned, this author would suggest buying the cashflow-rich, large-cap shares in the semiconductor industry.  As an interesting aside: The last significant trough in the relative strength of the semiconductors in August 2004 also preceded a huge multi-month rally in the NASDAQ Composite.

As far as retailing shares are concerned, it looks like that many of these names have not only priced in a significant consumer slowdown, but a potential consumer recession as well.  Consider the biggest retailer in the country, Wal-Mart, a company that is currently trading at a P/E of 16, a P/S of 0.56, and a P/B of 3.40.  With the exception of 1997, all these price ratios are at a decade low (following ten-year history courtesy of MSN Money):

Ten-year history of Wal-Mart P/E Ratios

Secondly, the retailers are also trading at a significant discount relative to the S&P 500, as evident from the following weekly chart showing the relative strength of the Merrill Lynch retail HOLDRS (RTH) vs. the S&P 500:


Relative Strength (Weekly Chart) of the Retail HOLDRs vs. the S&P 500 (May 2001 to Present) - During the past week, the relative strength of the RTH vs. the S&P 500 sank to a level not seen since January 2003. This is a worrying sign, as the weakness of the RTH in January 2003 was a foreshadowing of the decline in February and March 2003. At the same time, it may be wise to start looking at retail stocks once again.

As mentioned on the above chart, the relative strength of the RTH vs. the S&P 500 dropped to a level not seen since January 2003 last week.  Unless one believes the U.S. is entering a recession or unless one believes that the S&P 500 will make a lower low in the days or weeks ahead, then the large-cap retail stocks such as WMT and HD may be worth a look here.  Both names are somewhat backed by strong hands, as Warren Buffett has been snapping up shares in the former while Legg Mason's Bill Miller has been buying the latter.

The huge oversold condition and the pessimism in the U.S. retailers can also be witnessed by the amount of assets held in the Rydex Retailing Fund, as shown by the following chart courtesy of Decisionpoint.com:

Rydex Retailing (RYRIX)

Just like the Rydex Electronics fund, the total assets and cumulative net cash flows into the Rydex Retailing fund are now at fresh three-year lows.  Sure, the U.S. consumer is going to continue to have a difficult time going forward,, but is the current pessimism in the U.S. retailing stocks justified?  To this author, it seems like everyone and his neighbor already knows that the U.S. consumer is going to be in trouble, so has it be sufficiently discounted in the retailing stocks, and if so, has it gone too far?  We will soon see – but recession or not, this author believes that the large-cap retailing stocks are good long-term holds, whether your timeframe is five years or ten years.

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to July 28, 2006) - Over the last couple of weeks, the Dow Industrials rose 480 points while the Dow Transports declined 176 points - giving us the most significant non-confirmations in the two popular Dow indices in recent memory. Since the Dow Transports has been leading the Dow Industrials from October 2002 and onwards, this author would have to give the bears the benefit of the doubt and call for a ST correction over the next week or so before the August 8th Fed meeting. On the other hand, there is also a good possibility that after four years of relative underperformance, the Dow Industrials is finally taking the upper hand and emerging as the clear leader - not just in the U.S. stock market but the global stock market as well.

The Dow Transports have now declined four weeks in a row – going down slightly more than 10% over those last four weeks.  At the same time, the action of the Dow Industrials have actually been split – declining for the first two weeks and actually rising over the last two weeks.  The Dow Transports should now rally, given the severe short-term oversold condition.  However, given that the Dow Transports has been a leading indicator of both the broad market and the Dow Industrials ever since this cyclical bull market began in October 2002, it is very conceivable that the Dow Industrials may experience some weakness this week – which should serve to confirm the weakness of the Dow Transports over the last couple of weeks.  Should there be a correction in the Dow Industrials, however, this author will not hesitate shifting from a 50% long to a 100% long position in our DJIA Timing System.

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.  The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% five weeks ago to 6.0% in the latest week – signaling that both sentiment and the stock market have definitely reversed upwards.  Moreover, given that this author will not be looking for a significant top before we see an overbought level in these sentiment indicators again, we are now some ways away from a significant top.  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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - There is a good chance that bullish sentiment has bottomed (in late June) and has now reversed - with the four-week MA of the combined Bulls-Bears% Differentials increasing from 1.7% to 6.0% over the last five weeks. Given that this author will not be looking for a top at least before we see an overbought level in these sentiment indicators again, it is definitely too early to be speaking of a top right now.

Conclusion: Subscribers who had been interested in going long the large-caps at some point may now want to start nibbling on some of your favorite names – particularly strong, cashflow-rich large caps in both the semiconductor and the retailing industry.  In our upcoming mid-week commentary, this author will discuss the more troublesome events of today, including an inevitable decline in consumer spending, high oil prices, an inverted yield curve, and so forth.  For now, this author is still bullish, and we will use any upcoming corrections to go 100% long (fully bullish) in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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