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Random Thoughts for the Rest of this Year and Beyond

(November 26, 2006)

Dear Subscribers and Readers,

I hope all of you had a great Thanksgiving (and for our non-U.S. subscribers, I hope all of you had a nice break from watching the U.S. markets)!  As I mentioned before, I am currently typing this up in Las Vegas – and more impressively, I am actually typing this up (at least the first few paragraphs anyway) with no internet access whatsoever.  Unlike my philosophy in investing, in learning, and in “how to have fun,” many of my tastes tend to be relatively conformist.  I like to watch the big box office hits, the latest electronic gadgets, and when I stay at a certain place, I like to stay where “the energy is,” and in Vegas, that place would be some of the biggest hotels on the Las Vegas Strip.  Perhaps that is why – despite my contrarian philosophy in the financial markets – I also have a “knack” for detecting the psychology of most retail investors at any given time.  Believe me, I can be as emotional as anyone else when it comes to actually putting money to work.  This is one reason why we run this website – to help us be more disciplined in gathering information/facts, creating and updating our models, and to bounce ideas off of other knowledgeable (sometimes much more) investors.  In order to be able to stave off your emotions, you need to be educated, disciplined, and to possess good guides (models).

I am currently typing this up in the Monte Carlo food court.  It is a shame, but ten years after the “internet revolution,” the hotels on the Strip still do not have universal wireless internet access.  Not even the Starbucks in the food court!  Perhaps they just want us to focus on the tables, the shopping, and the food instead.  And yes, there is internet access if you are desperate, but you will have to pay $7 for a whole 15 minutes to just have the privilege of surfing to CNN or checking your email.  Or perhaps universal Wi-Fi will somehow disrupt their electronic monitoring system (although I would like to think that Vegas or MGM most probably hires the best security folks around) or allow professional gamblers to more easily “swindle” the house (for those who haven't read “Bringing Down The House,” I definitely suggest it whole-heartedly).  I just do not know.  Here is hoping that the next five years will be more successful, but I am not holding my breadth.  MGM will probably develop a system for you to gamble in your rooms before universal wireless internet access will be a norm.

Let us 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 895.17 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 775.17 points

For the holiday-shortened weekend, the Dow Industrials declined 62.39 points while the Dow Transports declined 2.25 points.  As of the close on Friday, the Dow Transports closed at 4,845.47, and 153.48 points away from its all-time closing high.  From a Dow Theory standpoint, it is very important for the Dow Transports to confirm the Dow Industrials on the upside by bettering its all-time high of 4,998.95 made on May 9th.  For now, I will definitely give the bulls the benefit of the doubt – as the action of the stock market (and for many major indices such as the S&P 400, the S&P 600, the Russell 2000, and the AMEX Broker/Dealer Index) has been very favorable thus far.  On the other hand, if the Dow Transports does not break its all-time high and more importantly, the psychological level of 5,000 by the end of this year (on a closing basis), then this author will be very wary of the stock market going into 2007.

Random Thoughts on the Current U.S. Stock Market

As I stated in last weekend's “ad hoc” commentary: 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 will not 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.  This is still 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.

Okay, so much for this recap.  Let us reiterate why I think this rally has further to go – along with some “random thoughts” on the stock market and current events that may have an impact on the stock market.  First up is relative valuation – a theme which I have been harping on for the last three to four months, including in our September 28, 2006 commentary.  As I stated in that commentary (and in previous commentaries), we have been utilizing the Barnes Index (please see our March 30, 2006 commentary for a description) as a measure of relative valuation between the two most important asset classes with money managers and investors today – that of equities and bonds.  Following is the chart courtesy of plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:

Barnes Index

Note that the Barnes Index has been instrumental in calling the most recent top in the stock market.  In our May 7, 2006 commentary, we noted that the Barnes Index had hit a level of 67.60 – thus putting us in the “danger zone” of 65 to 70.  Sure enough, May 10th would mark the significant top of many major market indices and even equity markets around the world.  In our July 6, 2006 commentary, we stated: “Given the hugely oversold condition in many of our intermediate-term indicators, this author is revising the “danger zone” in the Barnes Index from a range of 65 to 70 to a range of 70 to 75.”  And given the 2.4-point decrease in the Barnes Index last week, we are definitely not close to a significant top in the stock market just yet.  As a matter of fact, this author would not yet worry until the Barnes Index reaches a level of 80 or above.

Any measure of relative valuations between stocks and bonds is very useful (historically, it has been a much better timing indicator than straight P/E ratios, for example) as long as 1) inflation does not get out of control, and 2) the U.S. economy does not enter into some kind of deflationary recession or depression.  More importantly, however, it can be argued that U.S. equities are also now undervalued relative to commodities, real estate, and even some emerging markets securities (such as India, for example).  This makes U.S. equities an especially attractive asset to hold at least for the foreseeable future – not only for domestic fund managers or retail investors, but for global investors as well.

Getting away from the concept of “relative valuations,” it is also important to put the current stock market rally into perspective.  After the big 28.7% rally off of the bear market lows in 2003, the S&P 500 returned 10.8%, 4.9%, and 12.0% for 2004, 2005, and the first ten months of 2006, respectively.  Given that U.S. corporate profits have enjoyed four years of consistent double-digit growth, the rally we have seen in the S&P 500 since the end of 2003 has been puny.  For a good historical perspective, look no further than the following chart (courtesy of Strategas Research Partners) showing the distribution of stock market returns for calendar years 1928 to 2005:

Distribution of S&P 500 Total Returns Since 1928

As implied by the above chart, the S&P 500 has enjoyed double-digit returns more often than not (44 out of the 78 years sampled or 56%).  Taking this into context, it is definitely a surprise that the stock market has not enjoyed much of a rally over the last three years despite 1) double-digit growth in earnings, 2) relative valuations have been screaming “buy stocks” instead of “buy bonds”, and 3) the fact that the S&P 500 is still approximately 10% away from its all-time highs.  The $64 billion question now is: Why have investors been shunning U.S. equities despite low interest rates and a continuing growth in U.S. corporate profits (not to mention an immense amount of cash sitting on corporate balance sheets)?

Over the last three to six months, I have discussed many potential reasons – but the following list is what I think contains the most important reasons (they are not in any particular order):

  1. The “pre-emptiveness” of the current Fed hike cycle, which began in June 2004.  While Fed monetary policy was relatively transparent (compared to previous rate hike cycles), the fact that most retail investors did not have a clue on when the Fed would stop also made them reluctant to invest in stocks or keep their funds in stocks for a sustained period of time.

  2. The weakness of the U.S. dollar and the rise of emerging markets, causing many retail investors to put their funds to work in international or emerging market stock funds as opposed to funds focusing on domestic equities.

  3. Speculation in real estate and commodities in 2004 and 2005 – these two “asset classes” were just much more attractive to invest or speculate in relative to U.S. equities.  Moreover, investors tend to extrapolate recent trends into the future, and so many folks were still scarred by the 2000 to 2002 decline in U.S. equities.

  4. The fact that the “four-year” or the “Presidential Cycle” low had already become consensus earlier this year – thus causing many retail investors to bail out of the stock market in advance.  From May to August 2006, the amount of mutual fund outflows reached a level not seen since the four months ending October 2002.

More recently, the bursting of the housing bubble has also made investors skeptical of the current rally in the stock market – with many analysts arguing that the subsequent decline in “mortgage equity withdrawal” will push the U.S. economy into recession by early next year.  However, as I have mentioned numerous times before, the stock market is a discounting machine, and as some would argue, is the ultimate leading indicator.  This barometer is definitely not perfect, but it is the best “real-time” measurement of the U.S. economy (or at least the state of U.S. corporations) at any point in time that we have.  In other words, I would argue that any further slowdown in the U.S. economy or the housing sector has already been discounted.  Heck, we have been warning our readers of a U.S. housing bubble as early as December 2004!

So is the U.S. stock market finally rising out of its doldrums?  While this author would definitely argue that we have already seen “capitulation” from retail investors during late August/early September of this year, there is just no way to tell as yet.  For folks who have an investment horizon of over five years, I would definitely suggest holding on to your stocks for the long-run (and for folks who are swing traders, I would also suggest holding on for now).  Any subsequent or sustained rise (a rise that could potentially take us over the all-time high in the S&P 500) would depend on many variables, such as liquidity, an expansion of world trade, new technologies, and so forth.  To some extent, the most recent decrease in both crude oil and gasoline prices have improved the liquidity situation quite dramatically, but until the Federal Reserve starts cutting interest rates, I don't believe the S&P 500 could surpass its all-time highs just yet.

On China and on Making Chinese Investments

There is no doubt that China is the “real thing,” meaning that the country – for the first time in its history – represents a great place for foreign investments and as a source of capital and consumption going forward.  For “armchair” investors who will never set foot in China but who want to make investments in Chinese companies, I believe it is essential to learn Chinese history and Chinese culture (vs. the language, which is really not that important even for tourism purposes).

For example, in last weekend's “ad hoc” commentary, I stated that: “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 that statement, I was discussing the potential for any global financial dislocations going forward – and that the next bubble could very well originate from the higher tendency of the Chinese or Asians to gamble with their hard-earned money (not just “on the tables” but in the stock market as well).  This could very well occur in the Chinese stock market or it could occur in the United States from foreign inflows in Asia.  By the end of this decade, the “trigger happy” U.S. hedge funds may be relatively tame compared to the rising Asian hedge funds or Asian retail investors.

Another trait that is important to know is the Chinese emphasis of generally placing more importance of “having face” rather than earning money or profits – as long as one is already relatively well-off.  One recent example is the acquisition of a 5% ownership in the Industrial & Commercial Bank of China by Goldman Sachs earlier this year.  As you should know by now, Goldman Sachs pulled off a feat that no one on the face of this Earth has been able to achieve in China.  It made a $3.8 billion paper profit on the heels of the ICBC IPO last month on an initial investment of only $2.6 billion.  While such a profit margin would have created a storm of fury within the government if it had occurred in the U.S. (there was no doubt the stake was very undervalued when Goldman acquired it a mere seven months ago, thanks to the numerous visits by current Secretary of the Treasury Hank Paulson over the years), many Chinese government officials were instead patting themselves on the back – given that they can now possess bragging rights for successfully dealing with the most prominent investment bank in the world!  The Goldman transaction/connection would not only be great for dinner conversations for the rest of their lives but would look great on their resumes as well.  On a more local note: At a recent CFA Society of LA lunch last week that was co-hosted with the Chinese CEO Forum, the introduction of the Chinese speakers and the board on the Chinese CEO Forum took nearly 30 minutes to complete…

More to come in our mid-week commentary.  In the meantime, please check out our MarketThoughts discussion forum for more up-to-date discussions on the stock market and other economic issues.  As always, both Rex and I remain at your service.

Signing off,

Henry To, CFA

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