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Asset Allocation for the Upcoming Year

(December 3, 2006)

Dear Subscribers and Readers,

I hope all of our subscribers have had a quiet week.  This author was not so “lucky,” as most of my efforts over the past week have been fixated on the currency markets (i.e. the relentless decline of the U.S. Dollar Index over the past two weeks).  During my time off from thinking about the currency markets and central bank policies, I relaxed by reading the book “China Shakes the World: A Titan's Rise and Troubled Future – and the Challenge for America” by James Kynge, former bureau chief of the Financial Times in Beijing.  Kynge is able to masterfully communicate his message of the business implications of China (not just in America but across Europe and the rest of the “developed world” as well) – and he achieved the job in a very entertaining way as well.  While this book will not tell you how to do business in China (nor will it help the scholar who is doing his dissertation on China), per se, it will definitely give you a great perspective as to how it will impact the way business is conducted around the globe and where the profit margins will be going forward.  There are numerous anecdotal stories – which I have always found to be very important in a book on China since the widely reported data is very unreliable.  This is the perfect book and primer for not only the global investor, but the U.S. investor as well.  This is probably one reason why it was able to win the 2006 Financial Times Award for Best Business Book of the Year.

Speaking of China, the OECD has just released a report stating that China has now surpassed Japan as number two in the world in terms of R&D spending. 

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 809.13 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 689.13 points

As of Sunday afternoon on December 3rd, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been way overblown.  We are also very bullish on good-quality, growth stocks.

It is to be noted here that the ISM Manufacturing Index is a coincident indicator, and not a leading indicator.  Folks who are “relying” on the ISM, GDP, and consumer confidence numbers in order to predict the stock market going forward is playing a fool's game.  While the stock market is not a perfect leading indicator of the U.S. economy or sometimes – even the state of U.S. corporations – it is to be noted that it is very rare to find economic statistics that can actually be regarded as leading indicators of the stock market.  I myself prefer looking at things that have worked in the past – such as breadth, sentiment, and overbought/oversold indicators.  Speaking of which, it is to be noted here that the Dow Jones Utility Average – which has historically been a leading indicator of the Dow Industrials and the S&P 500 in most post World War II bull markets – actually closed at another all-time high (at 457.66) last Friday.

But Henry, isn't the economy slowing down right now?  Did the stock market or any other indicator predict this current slowdown three or six months ago?

The answer to the first question is “yes” – and the latest auto sales data suggests that the ISM Manufacturing Index should remain below 50 at least for another month.  Note I am saying “slowdown” and not “contraction” or “recession.”  As a matter of fact, the creators and the keepers of the ISM Manufacturing Index has this to say about it:  “A PMI in excess of 42 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the November PMI indicates that the overall economy is continuing to grow while the manufacturing sector has now entered a period of contraction. "The past relationship between the PMI and the overall economy indicates that the average PMI for January through November (54.1 percent) corresponds to a 4.1 percent increase in real gross domestic product (GDP). In addition, if the PMI for November (49.5 percent) is annualized, it corresponds to a 2.4 percent increase in real GDP annually."”  That is, far from signaling the U.S. economy is contracting, the latest ISM reading is still saying that the U.S. economy is still growing at a respectable pace, even as economic growth declines below potential growth.

As for the answer to the second question, subscribers may remember that the U.S. stock market (as well as major stock markets around the world) did experience a significant peak in early May of this year (during which time we were short via our DJIA Timing System) – a decline which did not end until mid-August for the most part.  For the four months ending August 2006, mutual fund outflows from domestic equity funds were the highest four-month running total since the end of October 2002 (when the last cyclical bear market ended).  If there had not been ample private equity buyouts or company buybacks, the Dow Industrials would have most likely gone down another 1,000 points before stabilizing.  As it turned out, the “professional investors” were buying hands over fist while retail investors were bailing out in anticipation of the four-year Presidential cycle low and the annual October low.  As for the world of economic leading indicators, the ECRI Weekly Leading Index had already started deteriorating in early August – suggesting that the U.S. economy was about to dramatically slow down.  In other words, both the stock market and the ECRI Weekly Leading Index had successfully foreseen a mediocre GDP growth of 2.2% in the third quarter and the latest sub-50 reading in the ISM PMI.

As subscribers should know, the stock market started pulling itself together in mid August.  With the ECRI Weekly Leading Index registering positive readings again since the first week of November, the U.S. economic slowdown (not recession) scenario remains in play.  Given that U.S. equities still remain relatively undervalued vs. bonds and commodities, subscribers should continue to hold on to their equity portfolios and their favorite individual stocks for now.

Over the last few commentaries, I have stated that the “year-end surprise” may very well be a rally in the U.S. Dollar Index.  Besides the fact that the U.S. Dollar Index is now very oversold, I have also mentioned many other reasons for being bullish on the U.S. Dollar – including an improving budget deficit this year, slowing growth in U.S. dollar-denominated foreign reserves held in the custody of the Fed, and my conjecture that the Euro Zone could very well perform significantly worse than what many economists are currently expecting.  Increasing income taxes in Italy and a VAT hike in Germany notwithstanding, it is interesting to note that many countries in Central and Eastern Europe (which have been consuming a growing proportion of Euro Zone exports over the last few years) are now running significant trade deficits – with Turkey running a $32 billion deficit for the 12 months ending September 2006, Hungary running an annualized $3 billion deficit, Bulgaria running an annualized $6 billion deficit (over 14% of GDP), and Romania running an annualized $16.7 billion deficit.  While the Hungarian trade deficit has declined approximately 15% year-over-year, it is to be noted that the trade deficits of the other three countries mentioned have grown from anywhere from 25% to nearly 50% year-over-year.  Given that exports make up a substantial part of the Euro Zone economy, it is going to be an interesting month and year ahead for the European currency.

Moreover, the latest Commitment of Traders report is showing a near-record short position in the Euro futures contracts – following is a chart showing the net positions of commercials, large speculators, and small speculators vs. open interest for the Euro, courtesy of

Net positions of commercials, large speculators, and small speculators vs. open interest for the Euro

Following is the same chart (again, courtesy of for the British Pound.  The only difference being that the commercials now has a record short position in the British Pound Sterling futures contracts:

Net positions of commercials, large speculators, and small speculators vs. open interest for the British Pound

Finally – despite all the rhetoric telling us that the rising Euro is not a concern for either the European economy or European exports, it seems like the European stock markets think otherwise.  Following are daily charts (courtesy of showing the German DAX and the French stock markets over the last six months.  Note that both the German and the French stock markets have been declining quite rapidly ever since the dollar lost its footing against the Euro right before Thanksgiving:

German DAX Composite ($DAX) and French CAC 40 Index ($CAC)

Bottom line: I still believe the U.S. Dollar will rally against both the Euro and the British Pound going to the end of this year and early next year, especially given that it is not in anyone's interest for the Euro or the Pound to rise so quickly.  Whether the dollar can sustain its rise depends on the strength of the U.S. economy in the latter part of 2007 and on whether Congress could further cut down the budget deficit.  For now, I do not think holders of U.S. dollar-denominated assets have to worry about the continual slide of the value of the dollar.

New Year's Resolution?

As the title of this commentary implies, we are hear to discuss asset allocation for 2007 – and even beyond.  It is amazing to me that most of the general population can spend 40 hours a week toiling away in their jobs but don't set aside some time each quarter to determine their asset allocations – whether it is in their taxable savings or in tax-deferred retirement accounts such as a 401(k), 403(b), or an IRA account (sorry, but I am only the U.S. terms here).  I realize that this may not be the best way to spend half a Sunday, but saving for retirement and allocating your assets appropriately is imperative for a comfortable retirement – and collectively, is a decision that is just as important as a decision to buying your primary home and finding and marrying the right partner.

For those who spend time on investments (and by definition, those that are reading this commentary is either serious about their investments or even treat investing as a hobby), let us be clear and tell you this: If you are like most Americans or mutual fund managers, your asset allocation (how much of your assets should be placed in domestic equities, international equities, bonds, cash, and so forth) is typically the primary determinant of your future returns.  Picking individual stocks isn't for everyone – especially in this day and age when nearly half of the revenues in the S&P 500 components are from overseas markets (thus requiring much more research than ever before) in a market that is dominated by nearly 10,000 hedge funds.

Before you actually determine what your asset allocation should be, you should ask yourself some questions, such as the following:

  1. What is your overall objective?  Is it to provide for retirement?  Besides retirement, do you also want to fund the cost of college for your grandkids?

  2. What is your investment horizon?  Do you need current income to support retirement?

  3. What is your risk tolerance?  In other words, what kind of portfolio would allow you to sleep soundly at night?  What would you do if your equity portfolio goes down by 20% in 2007?  Will you liquidate or rebalance (i.e. sell some bonds and buy more stocks after the decline)?

  4. Do you have any restrictions as to what you can invest?  For example, do you prefer to avoid tobacco and alcohol stocks?  If so, then you will need to opt for socially-responsible mutual funds instead.

For those subscribers who have not had a chance to work on their asset allocations (it should be noted that a proportionally high amount of funds in 401(k)s are invested in money market funds, especially after the 2000 to 2002 bear market), I encourage you to make it a priority next year.  Or better yet, make this as one of your New Year's resolutions.  For many subscribers, it may just be as simple as finding three or four different fund vehicles and then allocate your money between them in the appropriate manner.  The aim is to find low-cost, simplistic, low-turnover, stable, funds with broad diversification and representation of the investable universe.  Based on my experience, the Vanguard fund family fits this bill perfectly.

Founded in 1975 by John Bogle, Vanguard has a great reputation and is one of the few mutual fund families known for its bastion of integrity (the 2003 mutual fund timing scandals notwithstanding, even American Funds – owned by Capital Research – has been investigated by both the SEC and the California Attorney General for making payments to brokers that give it preferential treatment).  It was the first to create an S&P 500 index fund catered to retail investors (1976), a bond index fund for retail investors (1986), and an international stock index fund (1990).  Today, the Vanguard Fund Family has 114 individual funds (including fund of funds and lifestyle funds) with an average expense ratio of only 0.25%.  It also has one of the lowest turnover percentages as a group in the mutual fund industry as well as the most simplistic structure – most of its mutual funds have only two classes of shares, whereas many mutual fund families have five or more classes with many different expense and load structures.

For the simple investor, the three fund structure (consisting of only the Vanguard Total Bond Market Index Fund, the Vanguard Total Stock Market Index Fund, and the Vanguard Total International Stock Index Fund) as advocated by the following WSJ article with periodic rebalancing to adjust for changing time horizon or risk tolerance makes the most sense.  If one has zero time to focus on investments, then it may even make more sense invest in a certain LifeStyle or Target-Date fund in the Vanguard Fund Family.  For myself – if I do choose to go the mutual fund route – then instead of picking only three, I will pick six to eight different funds from the Vanguard Fund Family and adjust periodically to reflect my changing preferences for large caps vs. small caps, European stocks vs. Pacific stocks, and so forth.  For over 95% of retail investors, I do not advocate trying your luck at allocating your money between the different sector funds.  Not even most professionals can master such a strategy as to be able to beat the indices.

Let us now shift back to the stock market and 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 October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to December 1, 2006) - For the week ending December 1, 2006, the Dow Industrials declined 86.04 points while the Dow Transports declined 138.30 points.  Since the mid November highs, the Dow Transports has been the weaker Dow index, as it is now 3.6% below its November 16th high. Going forward, the Dow Transports is definitely the index to watch - especially given the recent strength in oil prices.  While the two popular indices are still somewhat overbought, readers who are long should continue to hold on for now - and not try to be *cute* in timing any subsequent corrections - as I believe that both of these indices are still in intermediate uptrends and should be at higher levels where they are now by the end of this year.

For the week ending December 1, 2006, the Dow Industrials declined 86 points while the Dow Transports declined 138 points.  As mentioned on the above chart, the Dow Transports is definitely the weaker index – but that is to be expected, given the recent strength of oil prices.  For now, however, the intermediate uptrend remains intact, although in the short-run, the stock market is still vulnerable to a further correction.  Unless the Dow Transports decline below its November 3rd low of 4,612.69 (we are currently 95 points away), however, there is still no cause for alarm just yet.  We continue to remain 100% long in our DJIA Timing System, given that the intermediate trend remains up and given that we expect the Dow Industrials to reach a higher level by the end of this year than the level it closed at last Friday.  Readers please stay tuned.

I will now continue our 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 29.4% for the week ending December 1, 2006.  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) - For the week ending December 1, 2006, the four-week MA of the combined Bulls-Bears% Differentials declined from 30.1% to 29.4%.  Given that the stock market may still be in a corrective phase and given that this indicator is still overbought, readers may want to wait for better prices before initiating new positions here.  The intermediate-term trend, however, remains up.

As mentioned on the above chart, the four-week MA of this indicator has been effectively rising non-stop since early August – although it did managed to dip slightly in the latest week.  This reading is definitely overbought, suggesting that readers who have been looking to initiate new long positions in the stock market should continue to wait until after this indicator has experienced more of a correction in the coming days.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - After rising relentlessly from late September to mid November, the 20 DMA of the ISEE Sentiment has finally pulled back significantly - declining from 138.9 on the Friday before last to 137.1 last Friday. The 20 DMA is now only 4 points above the 50 DMA. This is definitely a well-needed *rest,* and suggests that stocks should continued to be purchase *on the dips* in general.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment has been rising relentlessly since late September (bottoming at 101.5) until the middle of last month – topping out at 146.5.  Since then, it has retraced some of its rise – and is now sitting at 137.1, down from a reading of 138.9 as of the Friday before last.  Meanwhile the 50-day moving average is still rising, coming in at a reading of 133.1 as of the close last Friday.  The latest pullback in the 20-day moving average was definitely a well-needed rest for bullish sentiment – and suggests that stocks should continued to be bought in any corrections in the coming days.

Conclusion: The current bullish sentiment in both the Euro and the British Pound is getting extreme – as exemplified by the many articles over the last week declaring the imminent breaking of the old record high in the Euro and the $2 level in the British Pound (for the cover-watching enthusiasts, the latest edition of the Economist has the “Falling Dollar” as its cover article).  At the same time, the net short position of the Commercials in the Euro is near a 52-week high, and effectively at a new 52-week high for the British Pound – suggesting that speculators may have been getting ahead of themselves on the long side.  Given that the dollar is also now very technically oversold, this author is looking for a dollar rally extending into the end of this year and possibly into early 2007.

As for the subject of “asset allocation,” I believe subscribers should tackle this (if you haven't already) at your earliest opportunity.  There is no need to hire a financial planner – just be brutally honest with yourself and your family and construct an asset allocation that is suitable for your time horizon and your risk tolerance.  Rebalance quarterly – taking into account valuations, currency swings, and changing time horizon/risk tolerances.  If finding actively managed funds is something you would like over low-cost index funds, get an online subscription to Morningstar (or to the Motley Fool Mutual Fund publication).  Don't use them for their ratings, but use their expertise to analyze individual fund managers and their styles – as study after study has shown that investing style matters more than recent performance in choosing successful fund managers in the long-run. 

As for the stock market, it is still somewhat short-term overbought and is looking like it is still in a corrective phase.  However, even though both the market and sentiment is still too overly bullish on a short-term basis, the intermediate term trend remains up – as we are nowhere close to any kind of exhaustion yet.  Moreover, the relative valuation of the stock market – compared to bonds, and even real estate and commodities – is still low on a historical basis.  Moreover, it should be noted that the Dow Jones Utility Average – a stock market index which has typically lead both the Dow Industrials and the S&P 500 in post WWII bull markets – just made a record high at the close on Friday.  From this standpoint, we are definitely nowhere close to a top.  As I have mentioned many times before in both our commentaries and in our discussion forum, predicting a top is definitely the most difficult practice in the field of the investing. It is not a science, but an art. It simply cannot be done on a consistent basis. As I have said over the last few months, investors should now overweight U.S. domestic large caps and growth stocks – as opposed to cyclical stocks and anything that has to do with commodities.  Again, we remain 100% long in our DJIA Timing System and do not intend to shift to a less bullish stance for now.

Signing off,

Henry To, CFA

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