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The Evolution of the Markets

(August 20, 2006)

Dear Subscribers and Readers,

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 on the morning of 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 August 10th commentary (“Is Our Short-Term Scenario Busted?”).  Like this author mentioned in our mid-week commentary, however, subscribers could have used our service as a contrarian indicator at that time, as the market rallied early last week and never looked back.  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 two weeks ago), a tightening Fed (the effect of the latest rate hike campaign is still yet to be fully felt), the lack of an oversold condition in the major market indices during the bottom a week ago, the fact that we are way overdue for a 10% correction in the Dow Industrials or the S&P 500, and the relatively low volume during the recent rally.  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.  For now, we are cautiously bullish, but since the market is now way overbought on a short-term basis, we will stay on the sidelines for now and re-evaluate the market fully after the Labor Day Weekend.  However, should the market correct on weak downside breadth and low volume in the coming days, don't be surprised if this author chooses to shift back to a 50% long position in our DJIA Timing System.

Important Note: A recent survey of CEOs conducted by the NYSE reinforces the prevailing corporate belief that retirement benefits are not relatively important to retaining employees.  In an 11-category survey (said categories including cash bonuses, stock incentives, education assistance, flexible schedules, etc.), the CEOs in the NYSE survey ranked “retirement benefits” as the third-to-last category as having the most importance on employee retention going forward in 2007.  Coupled with the passage of the Pension Protection Act last week, this adds further uncertainty to the future of defined benefit pension plans for corporate America.  For readers or subscribers who are over the age of 40 and who still participate in a defined benefit pension plan: Be proactive now and let your CEO know the importance of a defined benefit pension plan to you and your family!

Before I go on to discuss the evolution of the financial markets, I want to discuss the evolution of the global economy.  Not only are the forces for globalization accelerating (The Association of Southeast Asian Nations, or ASEAN, are now fast-tracking plans to create an EU-Style single market by 2015), but the way that we are doing business (or living life) is now evolving much more quickly as well.  If you will recall, this author discussed the online community, “Second Life” in our May 14, 2006 commentary.  For those who do not go online very often, “Second Life” is a sim-like online community where folks can interact, explore, buy and sell goods, start a business, or even develop virtual real estate – all using its own virtual currency (which is convertible to U.S. dollars).  Many folks on “Second Life” are now operating their primary businesses in the online community, and corporations like Wells Fargo, Toyota, and Adidas have caught on to the “craze” as well.  The number of subscribers has literally exploded in the last 14 to 15 months from 20,000 to approximately 250,000 today.  Plans are now in place to develop a more “business-friendly” environment in the online community – such as creating a “Second Life Chamber of Commerce” or to create a place for online business mediation and arbitration.  Going forward, many more businesses will have virtual offices in online communities like “Second Life” or even start businesses in these communities.  Potential language barrier aside, one will eventually, literally, be able to sell to the entire world.  Going forward, this will transform how governments and corporations think about business – especially as the world economy continues to shift to a more service-based society.  For example, will the next generation of U.S. software companies relocate their headquarters to Hong Kong, given that no corporate taxes are imposed there?  There will be no need to have a physical location aside from a PO Box, as these companies can “create” several different offices in virtual online communities.  These companies can literally hire from all over the world, and employees can simply stay at home and move from office to office by logging on to different websites.  This is one reason why the structural story of both lower corporate and income taxes in the United States will remain intact for the foreseeable future (it is thus no surprise that even Australia and New Zealand have been trending towards lower corporate and income tax rates).  Let us now move forward to the concept of evolution in the financial markets.

Ever wonder why the market is so difficult to predict in the short or even intermediate term?  Ever wonder why so many folks “get it wrong,” even though they had learned so many “lessons” doled out to them by the financial markets in the past?  Part of it is because things are usually only clear in retrospect – and reading the mainstream media definitely won't help unless all you want to learn a bit of history,  Another major reason is the constant evolution of the stock and financial markets.  We as humans tend to focus on the immediate past, along with the important variables that have impacted the market the most in the immediate past.  In each successive bull or bear market, there are always different underlying forces at work – forces that are not currently known until after the fact.  The genius is in seeing these forces before they happened or while they are happening.  This is what makes figures like Winston Churchill one of the geniuses of the 20th century.  By the time most people figured out what he was implying in his “Iron Curtain” speech at Westminster College on March 5, 1946, it was already too late.

Of course, we all now have the knowledge and the capability to do the same analyses that Peter Lynch did in the 1980s with minimal effort.  Instead of having to run to the local library during lunch or after work to get the latest version of the 10-Q or 10-K, we can now download them over the internet at 2am in the morning on Saturday after coming back from the local bar.  Instead of having to input and update all the data manually on your very-expensive PC and an archaic version of Lotus 123, we can now also download ten years of history on MSN Money for free.  Present value analysis?  Black-Scholes valuation using Monte Carlo Simulation?  How about checking out the Egyptian stock market or the futures market in the Fed Funds rate?  Oops, I forgot that we did not even have a futures contract in the Dow Industrials ten years ago, let alone a futures contract on the Fed Funds rate.

Our point is: The playing field has been leveled to a certain extent – but being able to invest successfully in the stock market or to speculate successfully in the financial markets is all about holding a relative advantage over other financial players.  The stock market is arguably as competitive if not more competitive than ten years ago – given the proliferation of hedge funds, private equity firms, and other professional investors all with much better tools and information than most retail investors.  This is the case with international markets as well, as many “locals” have now joined the financial world and are investing in their own stock and real estate markets.  Ten years ago, trading in markets such as South Korea, Malaysia, Brazil, Turkey, Thailand, and Argentina were dominated by half a dozen investment banks or hedge funds (e.g. “mega funds such as Quantum or Tiger) operating out of New York.  Today, that is no longer the case, as the “locals” are now supplying a significant chunk (if not most) of the liquidity.  Moreover, I know this sounds like a cliché – but the evolution or change in financial markets are changing much more quickly nowadays, and will continue to change more quickly for the foreseeable future.  Speculators such as Soros or Robertson were able to take advantage of the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s for a very long time – ending with the “breaking of the Pound” in 1992.  Today, Central Banks of the world are much more knowledgeable, and “inefficiencies” in the world's major currencies have become much more difficult to exploit.  After all, how long have the Chinese Renminbi bulls been waiting for an “inevitable rise” in the Chinese currency against the U.S. Dollar?

With that said, it is important to bring with us this mindset whether you are thinking of buying or shorting the markets today.  On the one hand, one can try to predict what the economy will do this quarter and the next – based on many factors such as the slowing housing market, the U.S. Dollar (said direction which is pretty difficult to predict as well), oil and natural gas prices, and other exogenous factors such as the 2006 hurricane season (which I have already discussed), Iran, the Israeli-Hezbollah conflict, North Korea, and how your mother-in-law feels tomorrow when she wakes up, etc.  Even in the off chance that one can predict the precise amount of economic activity this quarter and in 2007, there is no way to tell how this will affect stock market prices or even interest rates.

Today, this author sees a slowing U.S. economy, and nothing else.  This is what this author had “predicted” would occur in January this year.  In retrospect, it was a “cowardly” call – given elevated energy prices and an inevitable slowdown in the residential housing market – even though many economists at the time were still predicting 3% to 4% growth for 2006.  However, the slowdown call was a high probability call, and it remains so today.  To be calling for a recession in 2007 implies you have some advanced information – information that even Ben Bernanke, Alan Greenspan, Warren Buffett, George Soros, or Henry Kravis are not privy to.  Again, this author does not see a U.S. recession up ahead (although he reserves the right to change his mind over the next few months).  Instead, what this author is seeing is the lowest valuations (on a P/E basis) that we haven't seen since 1994 in many of the U.S. large caps such as WMT, MSFT, INTC, ORCL, GE, SYY, etc.  If crude oil prices were at $60 a barrel instead, we would actually be seeing valuations that we have not witnessed since 1988 in many of the U.S. large caps.

This relatively low valuation in the U.S. large caps is also being accompanied by extremely bearish sentiment – sentiment that can be witnessed in both the AAII and the Individual Investors Survey, the high amount of mutual fund outflows from domestic large-caps over the last two years, and the fact that the U.S. has been the most unattractive place to invest for international investors since the inflationary days of the late 1970s to early 1980s (because of the Patriot Act and the fact that the developing markets have been maturing very quickly over the last few years).  Such a scenario and bearish sentiment in the U.S. stock market in general have not been witnessed since October 2002.  I have been mentioning this over the last couple of months and I will mention this again: Long-term investors who have spare cash on the side should start nibbling on the U.S. domestic large caps and be prepared to add later this year no matter what the market does in the meantime.

But Henry, what about all the “buzz” about how the stock market has nearly always experienced a decline after a pause in the Fed rate hike campaign?  Well, this will depend on which time period you study.  If one focuses strictly on the late 1950s to 1981 period, then this will be a resounding “yes.”  Following is an exhibit courtesy of Morgan Stanley chronicling the various Fed's rate hike campaigns since 1959 along with the subsequent 12-month performance of the S&P 500, the U.S. long-term Government bonds, and the CPI following the pause.  Please note that the following does not include the “mini rate hike campaigns” of 1987 or 1997:

Mixed Returns Follow Fed Tightening Cycles

Note that the 12-month performance after the April 1966 and May 1974 pauses were both positive, but please keep in mind that it was not a happy time for folks who had to endure those rate hike campaigns:

  1. From February 9, 1966 to October 7, 1966, the Dow Industrials experienced a 25% decline from 995.20 to 744.30.  For investors who capitulated during those eight months, the fact that the market was 6.9% higher 12 months after April 1966 certainly was not a consolation.

  2. From January 11, 1973 to December 6, 1974, the Dow Industrials experienced a 45% decline from 1,051.70 to 577.60.  By the time the Fed paused in May 1974, the Dow Industrials had already declined to approximately 800 – accounting for already half of the 45% decline.  As a result, it should not come as a surprise that the market actually rose 9.54% for the 12-month period after the May 1974 pause.

The experience during the 1980s to the end of the 1990s was different, however, as the market experienced substantial outperformance during the 12-month period after the end of each of the Fed rate high campaigns.  This author believes that there were two major reasons for such a sea-change:

  1. After the near hyperinflation of the 1970s and early 1980s, the Federal Reserve became more pre-emptive in all their subsequent rate hike campaigns – making sure to hike earlier and err on the side of caution.  This has the effect of slowing economic growth earlier in the cycle and making sure that the economy does not get “too hot to handle.”  This also meant that the Fed does not have to overshoot in the latter stage of the economic cycle a la the late 1960s and the 1970s decline subsequent to each rate hike pause.

  2. The United States experienced a structural and consistent decline in inflation during the 1980s and 1990s – thus allowing the P/E ratio to steadily increase during those two decades.  This also had the effect of muting any stock market declines after the end of each rate hike campaign.

So where do we stand today?  This author would argue that both Greenspan and Bernanke had been pre-emptive in their current rate hike campaign – raising the Fed Funds rate as early as June 2004.  The current rate hike campaign was also very well communicated (with the possible exception of this year but overall, this has been a very transparent Fed especially compared to the Fed of the 1960s and 1970s) – thus significantly decreasing any chances of a hedge fund blowup or a sovereign default.  At the same time, however, the period of structural disinflation of the 1980s and 1990s is most likely over – thus removing a significant pillar in the stock market going forward.  The $64 billion question is: Can structural deflation from China and other emerging markets (which would effectively cause a decline in real interest rates) replace the structural disinflation that we had experienced during the previous two decades?

The following chart (again, courtesy of Morgan Stanley) suggests that the Fed has definitely been pre-emptive in their current rate hike campaign – as investors had already been discounting an inevitable slowdown in the economy by hammering down the P/E of the S&P 500 from 2004 to YTD 2006:

P/E Rarely Contracts Four Years in a Row

However, more importantly, readers should note that the P/E of the S&P 500 has rarely contracted for four years in a row.  The Panic of 1907 resulting in the near-collapse of the entire U.S. financial system could not do it.  Neither could the early years of World War I nor World War II (the market bottomed in the middle of 1942 and thereafter experienced a four-year bull market).  The only two exceptions were during the intervening years of the Great Depression (keep in mind that the period from 1934 to 1936 was a great period for the U.S. stock market even though P/Es contracted) and the structural near hyperinflation we had experienced from 1976 to 1979.  Unless crude oil prices rise to $100 or $120 barrel going into next year or unless foreign investors start dumping our Treasuries en masse, there is no reason to expect a fourth consecutive contraction in P/Es going into 2007.  And even should P/Es continue to contract in 2007, readers should note that the stock market does not have to decline.  In fact, my guess is that the stock market will remain range-bound in 2007 in the worst case scenario.

As an aside, this author believes that crude oil prices have topped out for this cycle – for the many reasons that I have discussed in our previous commentaries (such as an expected benign hurricane season and the non-confirmation we are currently witnessing on the Dow Transports and the OIH).  And for readers who are skeptical, I now want to again rehash the following EIA chart that we showed you in our previous mid-week commentary:

Growth in World Consumption and Non-OPEC Production

As shown by the following chart courtesy of the EIA, the growth in Non-OPEC oil production is expected to exceed the growth in world oil consumption by the first quarter of next year – for the first time since the third quarter of 2003.  More importantly, the above projection does not take into account the latest interest rate increase imposed by the Chinese central bank nor the Indian central bank.  The above projection also does not take into account a significant slowdown in the U.S. economy.  While this author certainly does not see an oil price of $40 a barrel next year, I definitely will not be surprised if we see a print below $60 a barrel.  A $10 decline in the oil price would add an additional $200 million in liquidity on a daily basis to the U.S. economy.  Put another way, the U.S. consumer will be able to transfer approximately 1% of his total expenditure from energy-related to more discretionary spending.

Going into 2007, this author is bullish, but in the meantime, the market remains short-term overbought.  Moreover, even though this current rally is showing a lot of promise – this author will definitely not jump to any conclusion until significant volume comes in after the Labor Day Weekend.  For now, we will keep a close watch on the following indicators in order to see if this current rally is sustainable:

The Homebuilders ETF

As this author has discussed in our commentaries for many months now, the homebuilding sector has been one of the leading indicators of the current cyclical bull market.  We cited the homebuilders as a “red flag” for the stock market when many of the homebuilding stocks topped out in late March and early April – even as many of the gurus and the mainstream media was still bullish on the stock market.  The most recent action (daily chart below) in the homebuilders ETF has been encouraging – in that it put in a higher low early last week for the first time since its top in early April:

XHB (ST SPDR Homebuilders ETF) AMEX - It is very encouraging that the XHB actually put in a higher low early last week for the first time in a long time.  The question now is: Can it pierce its high of early August as well as its 50-day moving average?

As the above chart mentioned, one of the signs that we will be watching for is whether the Homebuilders ETF can penetrate its 50-day moving average, as well as its early August intraday high of $33.77.  It will be a very encouraging sign for the overall stock market if it does.

The Dow Jones Utility Average

Historically, the Dow Utilities has led the overall stock market by 3 to 12 months.  During the first half of 2006, I stated that the underperformance of the Dow Utilities was also a red flag for the stock market, as it had topped out in early October 2005 and actually put in a lower high in late January 2006.  The Dow Utilities continued to underperform going into early May – which in retrospect was a great warning sign to stock market bulls (see the following weekly chart of the Dow Utilities): 

$UTIL (Dow Jones Utility Average) INDX - 1) The Dow Utilities topped out in early October 2005 and proceeded to put in a lower high in late January 2006. 2) If the Dow Utilities can *close* above the 440 level, this will be doubly reassuring to the stock market bulls.

As mentioned on the above chart, a Dow Utilities close above 440 is the key for a more bullish stock market scenario right up ahead.  At the close on Friday, the Dow Utilities stood at 438.13.  We are now fractions from a close just above 440.

The NASDAQ Daily High-Low Differential Ratio

Readers who are not familiar with this indicator can learn more about this ratio on our education page.  Apart from being an overbought/oversold indicator, one can also use this as a breadth indicator or as a confirmation to the daily action on the NASDAQ Composite.  The latter is especially powerful if the NASDAQ is rallying from an oversold condition – which is definitely where we currently are given that the NASDAQ Daily High-Low Differential Ratio has effectively been in negative territory since May 11th.  The following chart shows the daily high-low differential ratio of the NASDAQ Composite vs. the NASDAQ Composite from January 2004 to August 18, 2006:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to August 18, 2006) - The NASDAQ High-Low Differential Ratio finally again touched positive territory last Wednesday - hitting 0.41% after three unsuccessful attempts to remain in positive territory since May 11th. Early signs are encouraging, in that it remained in slightly positive territory on both Thursday and Friday. The sustainability of the current rally in the NASDAQ will be hugely dependent on whether this ratio can remain in positive territory for the foreseeable future.

If the NASDAQ Daily High-Low Differential Ratio can remain in positive territory going into or during parts of the inevitable correction, then this will be a strong signal that the current rally in the NASDAQ Composite is sustainable.  As of Friday at the close, the ratio stood at 0.38% - just slightly into positive territory.  In terms of importance, this author will actually place this indicator as “number one” ahead of both the Homebuilders ETF and the Dow Utilities – at least in the short-run anyway.

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 18, 2006) - For the week ending August 18th, the Dow Industrials rose 293 points while the Dow Transports rose 245 points - giving us the first simultaneous rise in both Dow indices since the week ending June 30th. This is very encouraging action - especially in light of a strong showing in the Dow Utilities as well (a close above 440 in the Dow Utilities would be further confirmation of a going-forward bullish picture). For now, we are going to wait for the inevitable correction. Should any upcoming correction be weak in breadth or accompanied by low volume, then there is a good chance that this rally in both the Dow Industrials and the Dow Transports will exhibit significant follow-through.

For the first time since the week ending June 30th, both the Dow Industrials and the Dow Transports closed higher for the week – the former rising 293 points and the latter 245 points.  While this is encouraging, – especially in light of the recent strength of the Dow Utilities – readers should continue to wait to see if we can experience any follow through.  Any follow through will most likely occur only if any upcoming decline is accompanied by weak breadth or low volume (or preferably both).  However, any follow through will most likely not come until after Labor Day Weekend, as a strong rally cannot be sustained unless we have strong volume.  Readers please stay tuned.

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% in late June to 7.1% 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 (now at 7.1%). But we have seen much lower readings prior to early 2003 - and until we get confirmation from the action after Labor Day Weekend, this author isn't going to buy these markets just yet.

From a probability standpoint, there is a good chance that this survey has now bottomed and reversed – suggesting higher prices over the near future.

Conclusion: As I have mentioned many times in our commentaries over the last couple of years, subscribers will need to continue to evolve with the stock market in order to be a successful investor or speculator going forward.  In troubled times, always plant your feet firmly on the ground, and look at “old-fashioned” metrics such as valuations or stock market sentiment.  Please also refer back to Lesson Three in our commentary entitled “On Jesse Livermore and His Legacy.”  Let me quote: “Jesse Livermore has been able to successfully trade the stock and commodity markets over a period of more than thirty years not only because of his intelligence, cool-headedness, trading skills, and his far-sightedness.  He was able to do this successfully for such a long period of time primarily because he was able to evolve.  He adopted a more long-term, buy-and-hold-like strategy when he shifted his trading from the bucket shops to the New York Stock Exchange.  He was also eager to learn something new everyday.  He was also flexible - whether on the long or short side or just being in cash.  He figured out when there were opportunities in the stock market, and figured out what strategy to adopt and when there were not.  He also made friends with very successful people - whether they were businesspeople or great financiers.

In light of the new powers vested in the Federal Reserve, the SEC, and in the government after the Great Crash of 1929, the environment for both stock market and commodity market speculation has changed – and Livermore had failed to see that.  Another great figure in 20th century financial history, Philip Fisher remarked in his ground-breaking work "Common Stocks and Uncommon Profits," that times have changed and that the way to make the most money over the long-run is to find great stocks and hold them for the long-run through thick and thin.  The old way of speculating and making money by catching the inflection points of boom and bust cycles was gone with the advent of the Federal Reserve and the maturing of the SEC and the new regulations.  And that is how Buffett made his fortune – not by betting on the inflection points of boom and busts cycles, but by investing in sound common stocks at very cheap prices.  I believe this theme will continue to hold in the 21st century – and even extending to previously “emerging markets” such as South Korea and Brazil.  The old ways of betting on the boom and busts cycles of the economy will continue to get older going forward – and now is the time to start buying U.S. domestic large-caps.

As for the short-run, this author is still choosing to sit on the sidelines right now.  The market now looks good, but it is short-term overbought.  For now, we will wait for the inevitable correction and continue to observe the action going into and immediately after Labor Day Weekend.  But should the market corrects on relatively weak downside breadth and low volume in the coming days, don't be surprised if this author chooses to shift back to a 50% long position in our DJIA Timing System.  Again, readers please stay tuned.

Signing off,

Henry To, CFA

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