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Identifying Trends and Risks for 2007

(January 1, 2007)

Dear Subscribers and Readers,

I hope every one of you has had a great New Year's, not to mention a great 2006.  The year 2006 was especially difficult for many retail investors and traders, as both the lack of volatility and the lack of a “capitulation low” (the closest we came to a capitulation low was during the decline from May 10th to mid July) frustrated many of those who were looking for a solid bottom in the stock market.  Rather, the Dow Industrials experienced a “mere” 8% decline from May 10th to mid July and, except for a small scare during mid August, has never looked back since.

Before we continue with your commentary, let us 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 1,078.15 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 958.15 points

As of Monday afternoon on January 1, 2007, 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 (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel, 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. 

In the short-run, the market probably still has further room to go on the upside, even though investors' sentiment have gotten more bullish (which is bearish from a contrarian standpoint) and given the continued divergence of the Dow Transports from the Dow Industrials on the downside.  Ironically, I believe that the most bearish scenario in the short-term would be for the Dow Industrials to rise towards the 13,000 level on mediocre breadth and volume over the next few weeks.  Should the market experience a correction (which is not too likely) or should there be further consolidation over the next few weeks, then the Dow Industrials can probably rally significantly above 13,000 over the next few months.  Make no mistake: The Dow Industrials will only experience a short-term top if there is more bullish sentiment – and right now, we just don't have that.  Ironically, the bullish sentiment that I am looking for may only start appearing if we get some kind of good economic news – such as higher-than-expected retail sales across the board or a higher-than-expected reading in the ISM (manufacturing and service) indexes.

Let us now cut to the chase and discuss our outlook and potential risks to the world financial system for 2007 – starting with the equity and bond markets, proceeding to the currency markets and the commodity markets in next weekend's commentary.  Without further ado…

The World's Stock Markets and Economies

In a similar “outlook” commentary that we authored last year for 2006, we started off with a quote from Warren Buffett and another quote from Benjamin Graham.  I am going to skip any references to Mr. Buffett this year, but I would like to start off with a quote from the 1973 (Fourth Revised) Edition of “The Intelligent Investor.”  In a section discussing “new common-stock offerings,” Graham states:

Somewhere in the middle of the bull market the first common-stock flotations make their appearance.  These are priced not unattractively, and some large profits are made by the buyers of the early issues.  As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant.  One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history.

In our prior commentaries, I discussed that based on relative valuations (equities relative to bonds, commodities, and real estate), retail investor sentiment, along with the amount of liquidity and the leverage in the financial system, the U.S. stock market is definitely still not close to a top just yet.  This is confirmed by the above snippet from Benjamin Graham.  That is, despite the recovery of the IPO markets over the last few months, the level and “quality” of activity is still not representative of an imminent top in the stock market.  What would construe as an indication of an imminent top, you may ask?  While things will most probably not get as crazy as the late 1998 to early 2000 period (and probably won't for at least the next decade), I would not be surprised if we see the IPO market “open up” to many of the speculative biotechnology or “nanotechnology” issues before we see a significant top in the stock market.  Most likely, such an imminent top will be accompanied by a relative underperformance of the blue chips vs. the most speculative issues.

As for relative performance from a geographical standpoint, I expect the U.S. equity markets to outperform the European, Asian, and Emerging Markets (with a portion of that coming from strength in the U.S. Dollar Index, which I will illustrate later in next week's commentary).

So Henry, why the relative overperformance?  Let us first start with Western Europe (or the countries comprising most of the Euro Zone).  As we have discussed previously in our commentaries, there are four primary – perhaps not mutually exclusive – reasons (not including the potential underperformance in the Euro vs. the U.S. Dollar):

  1. As illustrated by the Bank Credit Analyst, the U.S. economy has historically tended to lead European economic growth by approximately six months.  Given the dip into negative territory in the ECRI Weekly Leading Index during August and September 2006, and given its most recent rise, there is a good chance that the U.S. economy is now actually reaccelerating after the most recent slowdown during both the 3Q and 4Q 2006.  Should that be the case, then there is a good chance that European GDP growth has already peaked and should slow down going into the 1Q and 2Q of 2007.

  2. Historically (and this remains true today), European manufacturers (including German manufacturers, despite the “quick fix” reforms we have seen over the last 12 months) have been the highest-cost manufacturers in the world.  In an inflationary boom (a period which we had experienced from October 2002, and arguably to May 10, 2006) – when manufacturing and mining capacity is strained around the world – the best assets to invest in is so-called "hard currencies," commodities, and very cyclical industries such as manufacturing, agricultural industries, and mining companies. This is especially true in Europe - where rigid labor policies have made wages very sticky on the downside and where automation is not as valued as in the US or Asia. As a result, the European economy benefited in a significant way, despite continuing structural problems in the European financial and labor system.

  3. In the 21st century information age, one of the best gauges of future and sustainable economic growth is the amount of R&D spending a country or a region is willing to spend.  As measured by a recent Bureau of Economic Analysis study, R&D spending has historically been in the range of 2.3% to 2.5% of GDP.  The U.S. is set to spend approximately $330 billion R&D spending in 2006 (approximately 2.6% of GDP), followed by China at $136 billion, and Japan at $130 billion.  Meanwhile, the EU-15 (which includes the UK) will spend approximately $230 billion, or 1.9% of GDP.  Among the major countries, Germany is projected to spend 2.5% of GDP, France 2.2%, Italy 1.1%, UK 1.9%, and Spain 1.1%.  Interestingly, the 2.6% U.S. number is approximately the same amount that the U.S. is spending every year on education.  Contrast that to France, Germany and Italy – which collectively spends about 1.1% of GDP.  Today, the university systems in many parts of Western Europe are in shambles – as demonstrated again in 2006 when the U.S. swept the Nobel Prizes with the exception of the Nobel Peace Prize.  Going forward, only a combination of high R&D and education spending will be enough to sustain high economic growth going forward, and on this score, only the U.S. qualifies – with China in a distant second.

  4. The rise of the VAT in Germany from 16% to 19%, and the raising of income taxes in Italy all across the board.  While this will definitely dent European GDP growth, readers should keep in mind that this will also serve to “cannibalize” retail sales in Germany – at least for the first quarter of 2007, as many households sought to buy consumer items before the increase of the VAT in the latter parts of 2006.

As for Japan, while P/Es are still relatively high (at approximately 25), compared to P/Es of U.S. and European large caps, it should be noted that profit margins of Japanese corporations have a lot of room to expand.  Japanese equities are doubly (or triply) attractive given the relatively low yields of Japanese bonds, and the undervalued Yen (on a purchasing power parity basis, especially against the Euro).  Besides exporters like Toyota, Honda, or Sony, however, there are still not that many high-quality, global companies in Japan.  Moreover, the economic news coming out of Japan has continued to disappoint.  Coupled with a central bank and government that have continued to implement bad economic policies over the last decade and a half, and you can count this author as being “skeptical” of Japan.  Bottom line: I will not buy Japanese large caps until we have seen a significant sell-off sometime in 2007.

As for any upcoming risks to the equity markets in 2007, the culprits are usually tight money, increased risk aversion of retail investors, or a combination of exogenous factors that could create a credit crunch, such as a crash in another asset class, including housing, emerging markets, and/or a bankruptcy of a large global corporation.  Such market events are usually preceded by a declining bond market or an increase in corporate bond or emerging market yields (which do not exist today).  Given the $160 billion sitting on the balance sheets of private equity shops, the immense cash levels held by U.S. corporations, and the ample amount of reserves held by foreign central banks, this author currently does not see any evidence of “tight money” or a potential credit crunch going into January.  I also do not see any imminent increase of risk aversion of the part of retail investors, as current retail investor sentiment is still not overly bullish and as valuations still remain reasonable.  Moreover, much of the recent rise in stock prices have occurred in blue-chip, large-cap names – as opposed to small caps or stocks that are very speculative in nature (such as technology, biotechnology, or nanotechnology stocks).

We will be more specific as we get further into the year, but for now, this author sees the potential risks to the equity markets in 2007:

  1. In last year's “outlook commentary,” I discussed that a significant risk for 2006 was a significant decline of “Mortgage Equity Withdrawal” which would subsequently lead to a slowdown in consumer spending – in the process shaving off approximately 1% to 2% of GDP growth.  In retrospect, this slowdown scenario (fortunately for this author) panned out later in the year, although it had only led to an 8% correction in the Dow Industrials.  This year – given the recent strong bounce in the ECRI Weekly Indices, and given the resurgence of the global stock markets from mid-July, there is a chance that U.S. economic growth will reaccelerate as soon as later this month.  If that is the case, then interest rate cuts will be off the table for May 2007, and may even be indefinitely postponed.  Should inflationary pressures come back (watch the labor markets and manufacturing capacity), then we could even have another rate hike scare later in the first quarter.  Given that the market currently does not expect any further rate hikes, such a scenario will probably spook the U.S. stock market (although it will also provide the U.S. Dollar a much-needed boost).  In other words, last year's risk was “slowdown,” and this year's risk is most probably “resurgence” of economic growth with the potential to trigger an inflationary scare.  Interestingly, many of the economists and analysts now calling for a recession in 2007 also missed the mark in calling for an economic slowdown last year.

  2. A quicker-than-expected rise in the stock market, led by huge private equity buyouts (the money – worth over $600 billion in buying power assuming 4X leverage - will definitely go into equities sooner rather than later).  Fortunately for our subscribers: Prior to the inevitable crunch, there will be ample signs of an impending top, such as significant buying enthusiasm from retail investors, widening corporate bond spreads, and higher bond yields in general as money gets tighter.  Prior to the impending top, I also expect the Barnes Index to reach a level above 80 and possibly even 100.

  3. The failure of General Motors to renegotiate its labor contracts with the UAW on terms that are more favorable to the former.  Going forward, labor relations and retiree and healthcare costs will be the primary determinants of whether GM will survive.  I know, I know, we survived Hurricanes Katrina and Rita, Refco, and the collapse of Amaranth advisors unscathed – but a GM bankruptcy may have more adverse effects, as many hedge funds have written CDS insurance on GM bonds (it has been increasingly difficult for hedge funds to outperform the market).  Should GM unexpectedly default on its obligations, then many hedge funds may be unexpectedly caught the wrong way – leading to a general liquidation of assets as they raise cash.

  4. As I alluded to in an earlier commentary, many Central and Eastern European countries are running unsustainable current account deficits (over 8% and even 10% of GDP).  Should consumer spending collapse in Poland, Hungary, or Turkey sometime in 2007, then Western Europe and many of its companies (which have seen a significant amount of export growth to these countries) will also take a hit.

Let us now shift back to the more short and intermediate term and discuss the most recent action in the U.S. stock market via 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 29, 2006) - 1) For the week ending December 29th, the Dow Industrials rose 120 points while the Dow Transports rose 50 points. The most recent divergence of the Dow Industrials by the Dow Transports is still in place, as the Dow Transports has failed to confirm the strength of the Dow Industrials over the last five weeks. Going forward, if a further rally in the Dow Industrials (possibly to 13,000?) is not confirmed by a new high in the Dow Transports, then it will be time to sit up and take notice. 2) After over six years, the Dow Industrials has finally surpassed its all-time high (on October 3, 2006) of 11,722.98 made on January 14, 2000, while the Dow Transports surpassed its all-time high of 3,783.50 (made on May 12, 1999) way back in December 2004.

For the week ending December 29, 2006, the Dow Industrials rose 120 points while the Dow Transports rose 50 points.  As mentioned on the above chart, the Dow Transports has been the weaker index for over five weeks – and this weakness in the Dow Transports is still bothering me.  For now, however, the intermediate uptrend remains intact.  True, the Dow Transports is now below its November 3rd low of 4,612.69, but given the favorable price action in many of the other major indices, and given the still relatively tamed valuations of stocks vs. bonds, this author will give the market the benefit of the doubt and assume the uptrend still remains intact.  A further red flag, however, will be raised if a further rally in the Dow Industrials (possibly to 13,000 or over?) is not accompanied by at least a new rally high (to over its November 22nd high of 4,867.49) in the Dow Transports.  For now, we continue to remain 100% long in our DJIA Timing System, although we will most probably scale it back to a 50% long position should the Dow Industrials rise quickly to approximately the 13,000 level on weak breadth and on a non-confirmation by the Dow Transports.  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 27.6% for the week ending December 29, 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 29, 2006, the four-week MA of the combined Bulls-Bears% Differentials declined from 25.6% to 27.6%. Even though sentiment has continued to get more optimistic - especially since the mid August bottom - it is still not close the extremes we have witnessed at various points we have witnessed over the last few years. Bottom line: The intermediate trend is still up for now.

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 dip slightly from mid November to mid December.  While this reading is still overbought, it should be noted that this indicator is still not at a bullish extreme, and thus the possibility exists for a further rally in the stock market before we see “too much bullishness.”  Moreover, the Rydex Cash Flow Ratio (currently at 0.88) is still suggesting that we are nowhere near close to “exhaustion.”  In other words, the potential for a further rise in the stock market is still very much in place.  Following is a daily chart of the Rydex Cash Flow Ratio vs. the S&P 500, courtesy of Decisionpoint.com:

Rydex Cash Flow Ratio vs. the S&P 500

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 pulled back from mid November to mid December but is now on its way up north again. The fact that the 50 DMA has caught up with the 20 DMA 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) and after dipping slightly from mid November to mid December, is now on its way up again.  Meanwhile the 50-day moving average is still rising, coming in at a reading of 142.3 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 given that the 50-day moving average has not only caught up with the 20-day moving average, this suggests that there is a good chance the stock market will continue to rise for the foreseeable future (although as we have said before, we would not mind shifting our 100% long position in our DJIA Timing System to a 50% long position should the Dow Industrials rise to close to the 13,000 level on weak breadth and on a lack of confirmation by the Dow Transports in the short-run).

Conclusion: 2007 promises to be a more interesting year than 2006, as much of the risks in 2006 (housing crash, consumer spending slowdown, four-year cycle lows, etc.) were more or less anticipated by investors in advance (leading to a lackluster market for most of the year until after mid-July).  To some extent, investors are still relatively cautious going into 2007, but I believe for the most part, they are looking at the rear view mirror and worrying about the slowdown that occurred in 3Q 2006 – not going forward.  Going forward, this author believes the risks to the equity markets are a reacceleration of U.S. economic growth (initially accompanied by good news but then followed by an inflation scare), a deterioration in investment opportunities and rising valuations as private equity investors put their $600 billion in buying power to work, and exogenous factors such as a potential GM bankruptcy and/or a significant slowdown in Central and Eastern Europe, given that their current account deficits are not sustainable.  In the meantime, I expect the U.S. stock market to continue to rise for the foreseeable future – and to outperform most other equity markets in the world in 2007.

Again, we remain 100% long in our DJIA Timing System, although we may shift to a less bullish stance of 50% long should the Dow Industrials experience a quick rise (on weak breadth) in the short-run.

Signing off,

Henry To, CFA

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