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The New Pension Legislation and a Challenging Market

(August 13, 2006)

Dear Subscribers,

Before we start our discussion on the impending passage of the Pension Protection Act of 2006, let us do some house-cleaning with regards to our DJIA Timing System: Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited last Thursday morning (August 10th) at a DJIA print of 11,060.  A real-time email was sent to our subscribers announcing this shift – and the justification for this shift was discussed in our mid-week commentary last week (“Is Our Short-Term Scenario Busted?”).  At this time, this author is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which, as I have discussed over the last few months, will regain a significant chunk of microprocessor market share from AMD), GE, American Express, etc.  But in the meantime, we are still going to sit on the sidelines, given a slowing U.S. economy (for the first time in 14 months, the ECRI Weekly Leading Index has ventured into negative territory), a tightening Fed (the effect of the latest rate hike campaign is still yet to be fully felt), horrible market technicals, the lack of an oversold condition in the major market indices, and the fact that we are way overdue for a 10% correction in the Dow Industrials or the S&P 500.  Of course, if we are not careful – then the current economic slowdown we are experiencing may very well turn into a consumer-induced recession, but for now, it is still too soon to tell.

Let us now get to business.  Once it is signed into law by President Bush, the Pension Protection Act of 2006 will include the most sweeping reforms in the pension world since ERISA was signed into law in 1974.  A majority of US-based employees will soon see changes in their 401(k) or 403(b) provisions, such as a faster vesting schedule with regards to employer contributions (effective after December 31, 2006), and the ability to roll over your 401(k) or 403(b) distributions to a Roth IRA starting on January 1, 2008.  In addition, employers (beginning January 1, 2007) must offer at least three different investment options besides employer securities, and 401(k) participants must be allowed to diversify their employer contributions to other investments besides employer securities (this apply to companies who grant employer securities for their employee match).

However, the most sweeping changes did not apply to defined contribution plans (which consists of 401(k) plans), but to defined benefit pension plans.  The declining popularity of defined benefit pension plans among corporate America over the last couple of decades has been well publicized.  Defined benefit pension plans obviously has a place in corporate America, but in this day and age, it is quickly being recognized as a dinosaur – by finance as an unnecessary drag on earnings consistence and by the HR department as an ineffective tool in talent retention.  For readers who are over age 40 and who participate in a defined benefit pension plan, you should know this:

  1. In general, defined benefit pension plans tend to reward long-time employees (by the basis of their formulas) – especially those who have been steadily promoted through the ranks and who ultimately retire from the same company.  In other words, the accruals in defined benefit plans are essentially “backloaded.”  The exception to this rule is if the defined benefit is in the form of a cash balance or a pension equity plan.

  2. For long-term employees (those who spent 25 to 30 years of their working lives with the same company), the “income replacement ratio” could get as high as the 45% to 60% range if one stays until normal retirement age and if benefits are above average.  That is, the pension benefit that one will receive from the company after one retires could essentially “replace” 45% to 60% of their average income over the last three or five years preceding his retirement.  Coupled with Social Security benefits, and one essentially does not need to save too much of his or her money for retirement during his or her working life.  In other words, defined benefit pension plans can be very rich for long-timers.

In light of the declining popularity of defined benefit pension plans in corporate America, readers who are close to retirement or who anticipate staying with the same company until you retire should find out more about the provisions of your defined benefit pension plan – should your company offers one.  IMHO, the Pension Protection Act of 2006, should further serve as an incentive for corporate employers to terminate or freeze their pension plans, given the following:

  1. The new law would tighten the screws on the ability of pension plans to “smooth” their liabilities (e.g. using a four-year average interest rate to discount future cash outflows to calculate liabilities) and assets.  Going forward, the smoothing period will generally be limited to a maximum of 24 months.  We could argue all day whether this represents better disclosure, but what we know is this: The new limitation on smoothing liabilities or actuarial value of assets will increase the volatility of required pension contributions and pension expense, and this will further discourage CEOs and CFOs from starting new or keeping their current defined benefit plans.

  2. As of the beginning of this year, the required annual insurance premiums to be paid to the PBGC from defined benefit pension plans had been increased from $19 per participant to $31 per participant.  Going forward, this new $31 per participant premium will be indexed to inflation.  Not only will this increase represent a higher opportunity cost for employers who do possess a defined benefit pension plan, this will increase administrative costs as well.

  3. Other provisions of the new law includes adopting different interest rates to discount liabilities depending on the timing of the cash flows and the shape of the corporate yield curve – not to mention more disclosure items such as an expansion of the IRS Form 5500 and an additional “funding notice” to the PBGC 120 days after the end of the plan year.  In other words, the administrative costs of keeping a defined benefit pension plan are set to increase significantly going forward.

Of course, there are always ways to mitigate volatility and uncertainty in pension plan contributions and pension expense (please email me at if you are a pension plan sponsor and want to find out more about this) – such as utilizing liability-driven investing strategies (e.g. immunization) or diversifying your asset strategies into “portable alpha,” hedge funds, private equity funds, or by utilizing a combination of derivative instruments.  But at the same time – many of these strategies can get quite complex, and many CFOs (especially those who are administering small plans) may not have the expertise to deal with them at the end of the day.  Bottom line: In light of what I have just discussed, there is a good chance that the decline of defined benefit pension plans will continue going forward.

Again, for those readers who are age 40 or over and who participate in a defined benefit retirement plan, please find out more about the provisions of your plan and please discuss this with your fellow co-workers.  Know your options, and definitely plan ahead since there is a real chance that your defined benefit pension plan may not be there for you when you retire (unless you are working for one of the big oil & gas companies).  In virtually all cases, a company will provide more incentives in their 401(k) plans should they choose to freeze their defined benefit pension plans, and in the majority of freezes, older workers who are approaching retirement will always be worse off under the new “scheme.”  Should you find out that the company you are working for are undergoing HR or benefit changes, definitely strive to learn more or even actively partition for the continuation of your defined benefit pension plan (e.g. some companies have created a “two-tier” system where “grandfathered” workers can continue to stay in the defined benefit pension plan while new hires only receive benefits in their 401(k)s).

Let us now get back to the markets.  As the title of this commentary suggests, the market has certainly been very challenging since the May 9th to May 10th top – as exemplified in the “volatility” of our DJIA Timing signals over the last few months.  The good news is that our DJIA Timing System has “made money” overall - even though we were definitely too early when we started to establish a short position back in late January (our final short position was established on May 9th at DJIA 11,610).  Last week at this time, this author was looking for a significant rally after the Fed has signaled it was pausing – but it was not to be.  Since the market has always rallied *initially* after the end of a Fed rate hike campaign, this author had concluded that a rally was inevitable – especially given the bearish sentiment that had been prevalent among retail investors.  But alas, the rally we had been looking for did not emerge – and it is now back to the drawing board for this author.  Since our number one priority is capital preservation, this author also decided to take our 50% long position in our DJIA Timing System off the table and stay on the sidelines for now.

As we have mentioned many times in our past commentaries and in our discussion forum, it is now a battle between two strong opposing forces – one being the analysts and strategists (such as TrimTabs) who are calling for an inevitable 15% to 20% rally from current levels and the other being the folks who are calling for the beginning of a cyclical bear market (such as Lowrys).  One service is citing the unprecedented levels in corporate buybacks and cash acquisitions in supplying liquidity to the stock market, while another service is citing the all-time high spread between its buying power and selling pressure indices.  From this and from all the indicators that this author is watching, there is no doubt that we are seeing significant capitulation among retail and pension fund investors (the latter “diversifying” away from domestic equities into emerging markets, commodities, hedge funds, etc.) – even as both corporations and private equity investors are snapping up these same shares en masse.

Throughout history, the latter group has nearly always been right – but the $64 billion question is: At which point will they be proven correct, and can the capitulation among retail and pension fund investors get any worse?

Answer: It can always get worse.  Consider the following:

  1. Based on the valuation of the popular large-caps and retailing shares, there is no doubt that the market has already priced in a significant economic slowdown for these shares – a slowdown which this author has been looking for since the beginning of 2006.  But should the Fed go far (and we still do not know if the Fed has gone too far yet), there is a chance that we may actually see a consumer-induced recession.  In such a scenario, the market and retailing shares can definitely decline much further than they already have (more to come on the risks of a recession later in this commentary).

  2. Even though our sentiment indicators have been flashing several bearish readings over the last few weeks (which is bullish from a contrarian standpoint), this has not totally been confirmed by some of our other overbought/oversold indicators, such as the equity put-call ratio, the NYSE ARMS Index, the McClellan Summation Index (for both the NYSE and the NASDAQ Composite), and so forth.  In order to sustain a 15% to 20% rally going forward, one will need to have a very solid bottom in place, and we have not had that so far.

  3. The rallies off the mid June and late July bottoms have been very weak – both in breadth and in volume.  One of the greatest speculators of all time, Jesse Livermore, once said that to never try to short or sell at the top, but only at points where the rallies have failed or are weak.  Based on Livermore's shorting methodology, the rallies off the mid June and late July bottoms were good shorting opportunities – and these signals have not been reversed yet at this time (either through a “fully oversold” condition or a significant increase in “buying power”).

Again, the number one priority when it comes to investing or trading is capital preservation.  And based on this philosophy, this author is going to stay on the sidelines for now (for those who don't trade on margin and who have a very long-term investing horizon, etc., this is now a good time to start nibbling on the domestic large-cap brand names such as those I mentioned above).

Let us now look at what – in this author's mind (as of tonight) – will constitute a “fully oversold” situation.  Firstly, let's consider the NASDAQ McClellan Summation index.  Historically, both the NYSE and the NASDAQ McClellan Summation Indices have best been used as an overbought/oversold indicator (particularly as an oversold indicator).  The following is a historical weekly chart of the NASDAQ Composite vs. the NASDAQ McClellan Oscillator vs. the NASDAQ McClellan Summation Index courtesy of

The NASDAQ McClellan Oscillator vs. the NASDAQ McClellan Summation Index - A McClellan Summation index reading of -1,000 would at least put it on par with the oversold readings that we got in August 2004 and April 2005. This author would not consider going long until we have hit that level.

As mentioned on the above chart, the NASDAQ Composite McClellan Summation Index is now sitting at a highly negative/oversold level of -715.83.  But given the horrible action in the NASDAQ ever since April, this author is going to hold off until this indicator gets oversold – preferably until it gets near the -1,000 level.  This would put it on par with the oversold readings experienced during the August 2004 and April 2005 bottoms.  In terms of points on the NASDAQ Composite, I would not be surprised if it declines a further 100 or 150 points before we experience a significant bottom.

Another overbought/oversold indicator which we haven't discussed for awhile is the Consumer Confidence Index released by the Conference Board at the end every month.  Newer readers may not know this, but the Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint.  While it has always been significantly better in calling bottoms during a bear market, it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market – with its last successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90.  During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points.  Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to July 2006:

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to July 2006) - After one of the biggest dips in history in October 2005 (which turned out to be a good buying opportunity), the Consumer Confidence Index bounced significantly from November to April 2006 - bringing us again to the top of the range (at 109.6 - actually a high not seen since May 2002) we have experienced in this cyclical bull market. In retrospect, it was a good time to short, but more importantly, the Consumer Confidence Index was still at a relatively high level of 106.5 at the end of July - signaling that we probably haven't seen a good bottom in the major market indices just yet.

As mentioned on the above chart, the Consumer Confidence Index hit a level of 109.6 at the end of April 2006 – which in retrospect presented us another good shorting opportunity.  At the end of last month, the reading of 106.5 is still relatively high – signaling that we probably have not seen a good bottom in the major stock market indices just yet.  For a “fully oversold” condition, this author is looking for a Consumer Confidence Index reading in the 80 to 85 range.  We are nowhere close to such a reading yet, and we are definitely not going to get there by the end of this month (unless the market crashes in the next couple of weeks).

I will present a few more indicators to our readers in our mid-week commentary coming this Thursday morning.  For now, however, my preferred scenario is to wait for a “fully oversold” condition in most of our indicators and then buy that bottom – with most of my buying focused on the U.S. domestic, large-cap brand names.

For now, I believe a sustainable bottom could be put in place later this year – a sustainable bottom which could act as “a base” for a multi-month 15% to 20% rally in the Dow Industrials and the S&P 500 (note that if the Dow Industrials decline to 10,000 in the next few months, a 15% rally would only bring it back to 11,500).  However, this scenario is contingent on the fact that we only experience a 1994 to 1995 type economic slowdown, and not a consumer-led recession such as the one the U.S. experienced during 1991.  While there are many signs that we heading for such a slowdown, there is still nothing out there which has convinced me that we are indeed heading for a recession.  Sure, the ECRI Weekly Index has – for the first time in 14 months – dipped into negative territory.  But it has done so before without any negative consequences, such as July to November 2004 and June 2005.  We are also now seeing a significant resurgence of discussions of an inverted yield curve (see John Mauldin's latest commentary) – but at this point, the yield curve (assuming it is still a solidly good leading indicator of economic activity) is also not giving us very convincing signals that we are going to experience an economic recession right up ahead.

Moreover, our MarketThoughts Global Diffusion Index is still on an upward trend, suggesting that the global economy should still be able to withstand a U.S. economic slowdown or a German slowdown later next year (the latter given the introduction of a new VAT tax in Germany starting next year). For newer subscribers, I will begin with a direct quote from our May 30, 2005 commentary outlining how we constructed this index.  Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages."  Following is a history of our MGDI from March 1990 to June 2006 (the July reading will be updated and available on the OECD website in early September). 

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to June 2006) - Both the change and the rate of change in the MGDI are still giving us strong readings - suggesting that the global economy is still strong enough to withstand a U.S. slowdown or a German slowdown later next year.

The strength of the MGDI is essential to keeping our U.S. economic slowdown scenario alive – as a slowing global economy in the midst of a U.S. economic slowdown can mean many negative feedback loops around the world's economies which could in turn induce a classic U.S. economic recession.  For now, this is not happening, although we will definitely keep a close eye on all our recessionary indicators, including the ECRI Weekly Leading Index, the shape of the yield curve, as well as the readings of our MGDI.

Let us now discuss the Dow Theory.  Following is 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 August 11, 2006) - Over the three weeks preceding the close on August 4th, the Dow Industrials rose 501 points while the Dow Transports declined 212 points - giving us the most significant non-confirmations in the two popular Dow indices in recent memory. Given the drubbing that the Dow Transports had taken, it was defintiely natural to think it would be given a reprieve - but it was not to be - as the Dow Transports declined a further 237 points last week. Since the May 9th top, the Dow Transports has declined more than 17%. Since the Dow Transports has been a leading index of the cyclical bull market that began in October 2002, such a decline is definitely very ominous for both the Dow Industrials and the S&P 500.

The Dow Transports have now declined six weeks in a row – declining 16.0% over that time.  At the same time, the Dow Industrials have only declined 62 points.  The Dow Transports is now down more than 17% since the May 9th top and it is definitely due for a bounce.  Anything can happen in the short-run, but, over the longer-run, this pronounced weakness in the Dow Transports is definitely cause for concern, 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.  Unless the Dow Transports mount a 10% rally in the coming two weeks, this author would tread very carefully during September and October.

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% seven weeks ago to 4.0% in the latest week.  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) - As I have mentioned before, our most popular sentiment indicators have been and are definitely oversold - with the four-week MA of the combined Bulls-Bears% Differentials bottoming recently at 1.7% in late June. But we have seen much lower readings prior to early 2003 - and until we get confirmation from most of our other technical indicators, this author isn't going to buy these markets just yet.

Conclusion: For readers who are over the age of 40 and who still participate in a defined benefits pension plan, the most significant economic development over the last month or so for you was the Pension Protection Act of 2006.  I urge all of you to study this legislation and how it could potentially affect you.  Read the actuarial valuation reports of your pension plan.  They are available on demand.  Know that you will not understand much of the report – but at least read it and ask questions.  For those who are long-timers and who plan to retire with the same company, a change in a company's pension plan strategy could mean a pension plan benefit being ultimately slashed by as much as 1/3 or even more.  Be an activist.

As for the market, this author is still choosing to sit on the sidelines right now.  Based on my recession-watch indicators, this author is still calling for an economic slowdown scenario only.  Therefore, should the U.S. market decline to a “fully oversold” level later this year, this author would be buying with both hands.  On the contrary, this author is always looking out for the possibility of an even greater economic slowdown – and if a recession does emerge sometime next year, then all current bets will be off.  Readers please stay tuned.

Signing off,

Henry To, CFA

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