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Random Thoughts on Life, Trend Changes, and Demographics

(November 19, 2006)

Dear Subscribers and Readers,

Let's first do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 957.56 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 837.56 points

From a Dow Theory standpoint, the most important development of last week was the 169.52-point rally in the Dow Transports. On Thursday, the Dow Transports closed at a new rally high of 4,881.57 – making it the highest close since July 6, 2006 and only 117.38 points away from its all-time high of 4,998.95 made on May 9th . As of the close on Friday, the Dow Transports closed at 4,847.72, and 151.23 points away from its all-time closing high.

From a Dow Theory, breadth, liquidity, valuation, and sentiment standpoint, I still do not see any impending top for the stock market just yet. As a matter of fact, there is a reasonable chance that we are only seeing the beginning of the rally in many growth stocks. While there will be inevitable corrections along the way, there is a good chance that we won't see a significant top in the stock market until early next year and probably not until the S&P 500 has touched the 1,500 level. Of course, this is purely conjecture for my part, but this is what I am seeing now. Unless the market “blows off” to the upside and we see a 5% rally in the next two weeks, I will say that the stock market is “safe” until the rest of this year. Unlike what occurred at the end of last year, there is also not much “tax selling” pressure to speak of to cause any stock market declines in the final week of December.

Random Thoughts: On Life and On Trend Changes

Over the last couple of weeks or so, I have been listening to an audio biography of Andrew Mellon – the successor to the first generation Mellon fortune and the precursor to the Mellon Bank in Pittsburgh . After his retirement from the banking industry, Mellon was appointed the Secretary of the Treasury from 1921 to February 1932 (under Presidents Harding, Coolidge, and finally Hoover ). Taking the initiative on tax reforms (dubbed “the Mellon Plan”), he was soon to become the most popular on both Wall Street and among business people across the United States , but as usual he stayed too long. He did not particularly like Herbert Hoover – and at the ripe old age of 73, he should have resigned in 1928 to focus his life both on the arts and philanthropy – as the subsequent crash of 1929 and the Great Depression tarnished his reputation for years to come both in the United States and in his hometown of Pittsburgh (the animosity within Pittsburgh was mainly the result of this refusal to save the Bank of Pittsburgh with $1 million of his own money). At the risk of impeachment, he was asked instead to resign and take on the ambassadorship to Great Britain .

Of course, all of this is in retrospect – and no one could have foreseen the tragic consequences of the stock market speculation, the precarious finances of Western Europe and the resulting bank failures, and the subsequent passing of the Smoot-Hawley Tariff Act.

Coincidentally, however, I am also now going through Robert Rubin's biography “In an Uncertain World” – the former Secretary of the Treasury under President Bill Clinton from January 1995 to July 1999. And as a student of history and financial market history, one has to wonder whether Mr. Rubin “got out” simply because he saw that the market was about to implode and that there could be catastrophic consequences for him if it did. In a March 5, 2000 email (five days before the all-time in the NASDAQ) I sent to my family, friends, and most of my associates, I quoted the following statement from Robert Rubin from the following CNN article :

"But I do think it is enormously important that people who focus on investing decisions, and all decisions in business life, maintain their discipline with respect to projections, with respect to taking into account risks, with respect to valuation."

In that email, I had already questioned why Mr. Rubin had resigned his cabinet post as Secretary of the Treasury in July 1999 – basically implying that he had already foreseen a major crash in the U.S. stock market. Of course, in his autobiography, Mr. Rubin did not use this line of reasoning – and merely stated that 6 ½ years in his cabinet post as Secretary of the Treasury was long enough.

In retrospect – even though we only endured a mild recession – that was one of the shrewdest moves, not only in public life but in private life as well. After all, how many folks can go out at the top of their game – away from the public spotlight when everything is at their brightest? Michael Jordan, perhaps? Most would simply choose to stay on past their peaks – not only in performance but in popularity as well.

Anyway, the gist of all the ramblings above is this: There is a time for everything. If you believe in God, you will believe that God “appoints the times and the seasons” and that only God is in control. Even if you do not believe in God, you – as a market participant – should know that no one has absolute control in the market or the U.S. economy, least of all you having control over the performance of your investments. In life as well – your hard work and effort can only go so far. Sometimes, luck may push you over the edge to the next promotion, or conversely, push you over the edge and burn you out. For most people, the peak in their careers often happen before the day that they retire – and unless you really love what you are doing and/or do not have the means to change careers or find another role within the company – using your success at your peak as a springboard to something else may be a better option.

Psychologically, it is also very difficult to “get out” at the top of your game. This is just human nature, but subscribers should also keep this in mind: Pride or arrogance usually comes before a fall. Does this mean that one should quit after a big promotion? Most definitely not. After all, who is to say one cannot become the CEO of the same company? Just do not be too cocky about the promotion – and always keep in mind on who (support of your coworkers, your boss, etc.) and what (hard work, persistence, nice personality, etc.) got you there in the first place. Try to be level-headed, and make a fair and honest judgment (perhaps 6 to 12 months down the road) on whether this job is really the right job for you and whether your chances (or dreams) of getting the next big promotion is reasonable. It is interesting to note that the highest rate of job failures does not happen at the local McDonalds, but instead in that executive suite upstairs .

From a stock market or financial market standpoint (just like the perspective of the fashion designer or the politician) – this holds especially true, as trends, industries, and companies come and go. Bull markets turn into bear markets, and vice versa. Beware of this constant change. Certain investing styles also come and go. The lesson is this: When trends do change and you are caught on the wrong side: Do not ask questions, do not pass go, just take whatever you have and run. Or, in the words of Warren Buffett's two rules:

Rule #1: Don't lose money.

Rule #2: Don't forget rule #1.

This is not too dissimilar to the constant dilemma of the fashion designer. No matter how great one's design is – you just cannot sell any of our wares unless your style is in fashion at that particular point. And given how quickly everything changes nowadays, this is becoming more and more difficult. From a political standpoint, a great example is the career of Winston Churchill – whose career virtually ended in 1931 but whose reputation and career revived very quickly with the dawn of World War II – becoming Prime Minister of Great Britain at the ripe old age of 65. A final example could also be attributed to Churchill – when he lost the general election of 1945 even as he was widely regarded as a great leader. World War II had ended, and even a man like Churchill had to resign himself to fate and to times that have radically changed.

Random Thoughts on (More) Trend Changes and on Demographics

As can be seen from our past commentaries over the last three to four months, we have been bullish for most of the summer and now into Thanksgiving and most probably will remain bullish until the end of this year. While the stock market has continued to reinforce our views, I am not (and neither should you) under the illusion that the stock market can continue to rise forever. At some point, this bull market in stocks will inevitably turn into a bear market. For now, however, there is still no sign that the market is in the midst of exhaustion. On the contrary – as I have mentioned in our discussion forum – there is a good chance that retail investors are just starting to come back into the stock market. As Mark Twain would say: “The rumors of the death of this bull market has been greatly exaggerated…”

Moreover, I am also under no illusion that the stock market is overvalued on a historical (P/E basis). That being said – on a relative basis – U.S. stocks in general are still undervalued relative to bonds, real estate, and commodities, and thus should be bought. At this time, the author just do not see any protracted decline in the U.S. stock market until we see a liquidity squeeze (resulting in widespread deflation) and/or until after another 100-point rally in the S&P 500.

For the first time in modern history, many Asian, Eastern European, and Latin American countries are now in the midst of industrializing and are now also making significant contributions to the post-industrial world. The list – South Korea , China , India , Vietnam , Turkey , Poland , Russia , Brazil , and Argentina – can just go on and on. At the same time, the world's financial system has become much less volatile – thanks to an evolving modern banking system in many of these countries (not to mention a revived banking system in Japan), better central bank transparency, and thanks to continued financial securitization which allows the diversification of risk among a great number of individual investors.

While financial “dislocations” or financial crises may now be fewer in number, I am, however, in the camp that whenever one does occur (and they will inevitably occur), the ensuing crisis will be greater in proportion than whatever we have witnessed beforehand. Many folks balked when I said in 2000 that the stock market mania/bubble at that time was greater than the one in 1929 – whether it is measured via percentage participation, the amount of leverage in the system (the majority of stock market investors did not utilize 10% margin in 1929, contrary to popular belief), or the rate at which the stock market had risen. Despite the fact that the public has become much more educated in general in the last 70 years, human nature just doesn't change (evolution of the mind cannot change in a mere 70 years). As for the current boom in Asia – all I have to offer right now is this: The Chinese, and Asians, in general have much more of a gambling nature/culture than Americans or Westerners ( Macau is scheduled to overtake Las Vegas as the gambling capital of the world either this year or next year). And given the lack of experience in Central Banking or in regulating the stock and futures markets in Asia , there's a good chance that the next bubble in Asia or around the world will be greater than anything we have ever seen. For now, however, it is not a concern just yet.

In February to March 2000, I not only told my family, friends, and associates that the secular bull market was making an impending top, but that “buying the dips” would not work from that point forward. Few believed me at the time (even many of those who did get out in spring 2000 subsequently got back in later in the year or in early 2001). Going forward, I will definitely try to look out for as many signs as possible for an impending bubble or a financial dislocation. Of course, I cannot promise that I will be correct 100% of the time, but I personally feel that your retirement money is probably safer “in our hands” rather than putting it in the hands of the mainstream media or with your local stockbroker.

Speaking of retirement, I urge you to read our latest thread on our discussion forum regarding the coming demographic changes – not just in the U.S. but across much of the developed world as well. To put it briefly, the impending “boomer bust” scenario that are being put forth in many of the mainstream media sites may be too simplistic in nature. One cannot paint a total or potential picture of the coming economic or stock market changes for the developed world without looking at a breakdown of wealth and income distribution, advances in medical technology, a shift in retirement lifestyles (many of those over 65 are now continuing to work after retirement – and it is easier to do so in a non-manufacturing sector than say, working at the Detroit auto plants), and the rising wealth of China, India, Brazil, Russia, and Vietnam. Personally, this author is optimistic – but like I mention in the discussion forum – I will continue to keep myself up-to-date on this situation and inform our readers of any new developments.

As for those who are still a decade or more away from retirement and are sitting in bonds or cash, I urge you to consider shifting some of your money into at least one of the following funds in your IRA: the Vanguard S&P 500, Vanguard Total Stock Market, or the Vanguard Global Equity Fund. These are all low-cost options and which will give you a good diversification into either the U.S. or the global equity markets. Unless we become mired in a global recession/depression for the next ten years (which is not very likely to occur at this point), then there is a very good chance that U.S. or global equities will outperform bonds and cash over time. While CDs yielding at 5% may appear attractive to many folks, it really isn't given that it is only yielding 2% after inflation. And if you are not investing in a CD in a tax-deferred account and your marginal tax bracket is the highest at 35%, then you are effectively earning a zero return ((5% * 65%) + 1) / (1.03) = 1.0024, or an after-tax, after-inflation return of 0.24%).

Psychologically, putting some money into the stock market (presumably after a correction) will allow you to have some “skin in the game,” and thus will allow you to get some sleep as your friends make money and brag about it. After all, many folks who had only “invested” in CDs or bonds all their lives ended up putting a substantial amount of their savings into the stock market at the top in early 2000 and proceeded to lose a significant part of it over the next few years.

A Question on “Foreign Reserves” and Final Thoughts

As I mentioned in our last weekend's commentary, it has been awhile since we last published our chart showing the relationship between the change in foreign reserves held in the custody of the Federal Reserve vs. the change in the U.S. Dollar Index – so I feel a more detailed explanation of the former is in order.

As I mentioned in our May 1, 2005 commentary:

Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard as opposed to the Gold Standard that has been in place since the end of World War I.  Therefore, as world trade expanded, the demand for dollars has continued to increase - and with it, the continuing increase of foreign dollar reserves held at the Federal Reserve Banks.

In the short-run, however, if foreigners have no need for U.S. dollars, then they will invariably deposit those dollars at the U.S. Federal Reserve – a sign that the supply of the U.S. dollar is in surplus and a good leading indicator of an upcoming U.S. dollar decline. In other words, the amount of foreign reserved held in the custody of the Federal Reserve has always acted as a “buffer zone” for the working capital needs of the world – a world which has historically seen trade dominated in U.S. dollar form. Conversely, if there is a greater-than-expected need for U.S. dollars, then foreigners will draw on these reserves from the Federal Reserve – a sign of higher demand for U.S. dollars and therefore a good leading indicator of an upcoming U.S. dollar rally. And given that sentiment is still very bearish for the U.S. dollar, I believe that there is now a good chance that the U.S. dollar index will be higher by the end of this year than where it is currently at.

Some Final Thoughts: Financial dislocation, change in trends, demographics, U.S. dollar, changing careers, etc., you name it – and MarketThoughts will be there to discuss any thing that would be of interest to subscribers going forward. We are always here to help and to share our ideas – so subscribers please feel free to email us, ask us questions, or give us suggestions. And yes, I will be back in the middle of this week and give all of you're a mid-week commentary before I leave for Vegas this Friday. That four-hour driving trip certainly beats having to sit on a plane and going through security, etc.

As for the stock market, I still do not see any signs of an impending top – so continue to hold on to your favorite individual stocks if they are still in well-defined uptrends . The “party” will inevitably end at some point, but now is not the time to get out. I have a feeling that those who are still currently engaged in “top calling” (or shorting the stock market) will be very disappointed come the end of this year.

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