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Identifying Trends and Risks for 2007, Part 2

(January 7, 2007)

Dear Subscribers and Readers,

Before we start our weekend commentary, I want to briefly mention a New York Times article that was published over the weekend entitled “Happiness 101.”  The field of “Positive Psychology” is now the hottest field in the psychology world – thanks to pioneers such as the ones described in the article and a subscriber I met over breakfast last Friday morning, who is teaching just such a course at the UCLA Medical School.  The NY Times article is a must-read.  After all, isn't being happy (or making others happy) one of the most important goals for many people in their lives?  If not, then you are really in dire need of consulting a psychologist!

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 1,013.01 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 893.01 points

As of Sunday afternoon on January 7, 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 is most probably in the midst of a consolidation phase or a correction.  Such a correction is definitely overdue, as bullish sentiment has turned higher in recent weeks (even though the market was in a consolidation phase) and as the market has not experienced a significant correction in over five months.  Even though the major market indices probably still have more to go on the downside before we could find a sustainable bottom, there is a good chance that we have already seen a short-term bottom in energy stocks, particularly natural gas.  Over the longer-run, however – as I have illustrated in last weekend's commentary – I still believe that U.S. equities in general will be one of the best performers in 2007.  And even though I am a long-term energy bull, I continue to believe that both energy and commodity prices in general will struggle this year as they enter into a consolidation or correction phase.  Astute traders will probably be able to make money by buying commodities on the dips and selling them when they get overbought, but overall, it will be a frustrating year for energy and commodity bulls.

In last weekend's commentary, I stated and discussed our outlook and potential risks to the world financial system for 2007 – starting with the equity and bond markets.  In this week's commentary, I am going to proceed to the currency markets and the commodity markets – with a quick initial discussion of some of the sectors I like and dislike within the S&P 500.  I am also going to change the format a little bit and do the following in Q&A format, as this allows me to quickly get to the point – which will definitely help our subscribers get through this commentary without the usual headaches!

Follow-up Questions on the U.S. Stock Market

Question: How do you think energy and energy service stocks will do this year?  What about the NASDAQ, technology stocks, and the SOX?

Answer: As I have discussed before in our recent commentaries, I believe energy and other commodity prices will struggle in 2007 – even though I believe the long-term bull in energy and commodity prices remains intact.  That being said, energy and energy stocks in general are now very oversold in the short-run, driven by abnormally warm weather and the liquidation of hedge fund positions as 2006 year-end redemptions from energy hedge funds accelerated in the wake of Amaranth Advisors.  In particular, one would be very hard-pressed to find many hedge funds that are long natural gas right now (as I am finishing this commentary, natural gas prices are trading up over 30 cents on the NYMEX on Monday morning).  The oversold condition of energy stocks can be illustrated by the following chart (courtesy of Decisionpoint.com), showing the percentage of stocks in the Energy Select SPDR (XLE) that are above their 200, 50, and 20 EMAs, respectively:

Percentage of stocks in the Energy Select SPDR (XLE) that are above their 200, 50, and 20 EMAs

As shown on the above chart, the number of stocks within the XLE that are now trading below their 20 and 50 EMAs are at 10% or below – signaling a short-term oversold condition.  For folks that want to trade energy stocks here, now may be a good time to buy – especially stocks that are natural gas drillers or producers.

As for shares in the NASDAQ, the SOX, and the technology sector, I believe they will outperform the market this year – even though they look to be vulnerable to a correction in the short-run.  Part of the reason is the relatively low valuation in the technology and the semiconductor sector.  Another reason is: As a cyclical bull market matures, the “new money” tends to be more speculative in nature.  Not only is this historically true, it also makes logical sense, as the public usually doesn't enter the stock market in droves unless or until some new technology or sector captures the public's imagination.  So far, we have not had this “killer technology” in the latest bull market just yet.  This was true of the railroads in the 1850s, the industrials in the late 19th and early 20th century, the automobile, electricity, and radio in the 1920s, conglomerates in the 1960s (not to mention color TVs), PCs in the 1980s, and the internet and wireless in the 1990s.  What could be the technology or combination of technologies in the upcoming year?  It could be anything – but my bet would be on things such as stem cell research, alternative energy research (especially solar), capital spending plays spurred on by MS Vista and MS Office 2007 (although this probably won't occur until later in the year), Wi-Max, and potentially even selected nanotechnology plays such as companies that do research in new cancer fighting methods or new battery technologies.  Many of these new technologies – if adopted commercially – will have a positive impact on the NASDAQ, the SOX, and many technology stocks overall.  The speculative money will enter the market – it is just a matter of time.  As an important aside, only then will the market top out.

Question: Henry, what if I am not comfortable with buying U.S. or other equities right now?  Or what if I have too much of my assets allocated into equities and real estate?  What should I buy in this case?

Answer: Note that this should not be construed as a strict recommendation (always seek an investment advisor that knows your personal/unique situation in life), but I do not believe a CD yielding 5% is the key.  My guess is that many of our subscribers are in a high tax bracket, and given that interest from CDs are taxable, a typical after-tax, real return on a CD investment could be as low as 0.5% (a 5% return with a 30% tax rate and further deflated using a 3% inflation rate).  For folks who are in the “upper middle class” or above, investing in CDs is particularly unacceptable, as you will typically experience higher inflation rates, as many of your consumption goods (such as country club memberships, dinners at the nicer restaurants, a trip to the Caribbean, etc.) cannot be easily substituted and are not subjected to deflationary forces coming from China, India, or Wal-Mart (such as PCs or other electronic goods).  Moreover, the wealthier you are, the more you will be able to withstand short-term shocks in the equity markets and focus on making long-term investments.

Getting away from equities and CDs, I would recommend buying short-dated bonds, such as via the Vanguard Short-Term Bond Fund (VBISX) or the Vanguard Short-Term Tax-Exempt Fund Investor Shares (VWSTX), as I believe the Federal Reserve will ultimately ease no later than the second half of this year.  Aside from a decent yield on these funds, you will be able to obtain some capital appreciation as well.  I also would not recommend anything in the Euro Zone or Japan, given that the bond markets of both regions offer little or no value, and given the fact that I am bearish on the Euro and neutral on the Japanese Yen.

The Currency Market

There is now a good chance that we have seen a significant bottom in the U.S. Dollar Index in early December 2006.  Let us first take a look at the oversold condition of the U.S. Dollar Index during that time:

USD Index vs. Percentage Deviation from its 50 DMA (December 1985 to Present) - The percentage deviation of the USD Index from its 50-day moving average hit a level of negative 3.55% on December 1st - the most oversold level since May 16, 2006. Given this huge oversold condition, bearish sentiment, and an improving U.S. economy relative to both the Euro Zone and Japan, chances are that the U.S. Dollar will continue to rally over the next few months.

As shown on the above chart, the percentage deviation of the U.S. Dollar Index in early December 2006 hit a level of negative 3.55% - representing the most oversold condition since May 16, 2006!  Moreover, bearish sentiment was very widespread during that time, as exemplified by a cover story on the Economist and a speech from former Fed Chairman Greenspan noting that the U.S. Dollar still has further downside to go (the last time Greenspan publicly stated of a dollar bear in March 2005, the U.S. Dollar Index actually bottomed on the same day and mounted a huge rally over the next four months).  Historically, Greenspan's timing has been very useful as a contrarian indicator.  Another example is this following statement on January 7, 1973, right before the 45% decline in the Dow Industrials over the next two years: “It is very rare that you can be as bullish as you can now.”

In many of our most recent commentaries, I have also made the case on why I believe the U.S. economy will outperform the Euro Zone economies over the next three to six months – with the most important reason being that the U.S. economy has historically lead the Euro Zone economies by approximately six months!  Given that there are no indications that this relationship has decoupled, there is a good chance that the Euro Zone is just now slowing down, as did the U.S. economy during the Summer and Fall of 2006.  This “slowing down” will further be exacerbated by the most recent rally in the Euro as well as the raising of the VAT in Germany and the raising of income taxes in Italy, both of which were effective beginning January 1, 2007.

And finally – over the long-run – I am still not too bullish on the Euro Zone in general, as structural reforms have not gone far enough and as the heterogeneous nature of the Euro Zone economies makes it difficult for the European Central Bank to administer a uniform monetary policy against the 13 different countries.  Going forward, however, the killer is going to be demographics (which is also going to be a huge issue in Japan going forward), as both birth and immigration rates have continued to remain low.  Moreover, education spending as a percentage of GDP in the Euro Zone is approximately half of that of the United States.  Going forward, this will be a significant tailwind for productivity gains as most of the gains in GDP in the future will come from “knowledge” sectors of the economy such as biotechnology, nanotechnology, and space technology.  The following OECD long-term economic projection of the Euro area and the United States illustrates this “problem” perfectly:

OECD long-term economic projection of the Euro area and the United States

Unless the Euro Zone implements tough structural reforms that the labor markets can live with (most likely, there will be a huge backlash even if legislation can be passed through), things will continue to get tougher for the Euro Zone going forward, as potential GDP growth in the Euro Zone is still currently one percentage point below that of the United States.  Going forward, this gap will continue to widen as population and productivity gains in the U.S. continue to outstrip that of the Euro Zone.

As for the Japanese Yen, I am currently neutral – as private savers in Japan have continued to diversify their investments globally – not only in fixed income but now in the real estate and equity markets as well.  This “structural” bearish tailwind for the Yen is offset by the fact that the Yen is now significantly undervalued to both the U.S. Dollar and especially the Euro on a purchasing power parity basis.

The Commodity Market

I still believe in the long-term bull market for both energy and commodities in general – but the run-up in commodity prices over the last several years has been extraordinary in nature and it is time for a breather.  Not only were prices very overbought in mid May 2006, valuations were also very historically stretched, as many commodities were trading at prices that were many times over the marginal cost of production (i.e. costs of production for the highest-cost producer in each of the commodities).  Historically, commodity prices have not been over the marginal cost of production for long periods of time, and this should continue to be the case going forward.

Given that both the European Central Bank and the Bank of Japan are still in tightening moods, the chances of a renewed bull in the commodity markets anytime soon are relatively low.  Moreover, the People's Bank of China (China's central bank) has continued to indicate that it will further tighten and raise reserve requirements in 2007 in order to curb excessive speculation and investments – a scenario which is also commodity bearish.  Finally, many commodities such as natural gas (which actually topped out in December 2005), crude oil, copper, and aluminum have significantly broken down – signaling that other commodities (such as secondary base metals and corn) may not be too far behind.  The breakdown of copper and aluminum prices vs. lead, tin, and nickel prices are illustrated by the following daily chart:

Daily Cash Prices of Selected Metals at the LME (January 1, 2003 = 100) (January 2003 to Present) - The spot prices of copper and aluminum have probably already topped out in May 2006, but it remains to be seen whether the prices of other base metals have further to run. Given the divergence of both copper and aluminum, however, chances are the prices of other base metals have topped out or are close to topping out.

However – if one really wants to buy commodities right now (for whatever reason, including for diversification purposes) – the only commodity I can recommend is natural gas.  Not only did natural gas top out many months before other commodities (in December 2005), but natural gas has also been severely sold and avoided by many hedge funds in recent months due to the collapse of the multi-strategy hedge fund Amaranth Advisors and the abnormally warm weather over the last couple of months.

Finally, the oil-to-natural gas price ratio ended at 10.87 at the end of December 2006 – representing a level (winter months only, as natural gas prices have historically been very seasonally) not seen since the end of February 2000., as illustrated by the following chart:

Oil to Natural Gas Spot Price Ratio - High, Average, and Low During the Winter Months* (1994 to 2006) - On the last trading day of 2006, the crude oil to natural gas spot price ratio reached 10.87 - a level not seen since the 11.27 level in at the end of February 2000.

Given that crude oil and natural gas has historically traded at a 6-to-1 ratio during the winter months, a ratio of 10.87 represents a significant divergence.  Coupled with a crude oil price that is now significantly oversold (at least in the short-run), buying natural gas drillers or producers seems to be a low-risk bet here – at least over the next couple of months.

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 January 5, 2006) - For the week ending January 5th, the Dow Industrials declined 65 points while the Dow Transports rose 52 points. For the first time since late June 2006, the Dow Industrials failed to confirm the upside rise in the Dow Transports. However, unless the Dow Transports (currently at 4,612.35) plunges below its most recent low made on December 22nd (at 4,510.50), chances are that both indices will resume their up trend relatively soon. For now, subscribers should hold off on making new purchases until at least earnings announcements are over.

For the week ending January 5, 2007, the Dow Industrials declined 65 points while the Dow Transports rose 52 points.  As mentioned on the above chart, the latest weekly action represents a divergence in that the Dow Industrials failed to confirm the Dow Transports on the upside.  However, unless the Dow Transports breaks below its most recent closing low of 4,510.50 made on December 22nd, chances are that both indices should resume their uptrend relatively soon.  For now, subscribers should hold off on making new purchases until at least earnings announcements are over.  For now, we continue to remain 100% long in our DJIA Timing System, as I believe that the market has still not made a significant top yet.  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 28.7% for the week ending January 5, 2007.  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 January 5, 2007, the four-week MA of the combined Bulls-Bears% Differentials rose from 27.6% to 28.7%. Even though sentiment has continued to get more optimistic - especially since the mid August bottom - it is still not close to the extremes we have witnessed at various points over the last few years. However, while the intermediate trend is still up, don't be surprised if we see a significant correction in the coming days given we have not experienced one in over five months.

As mentioned on the above chart, the four-week MA of this indicator has been rising consistently 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 0.92) 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, although the market should continue to at least consolidate or even correct 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 pulled back from mid November to mid December but is now on its way up north again (although it did decline slightly last week from 144.6 to 144.3). 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 in a consolidation phase.    Chances are that this will head up again relatively soon.  Meanwhile the 50-day moving average is also consolidating.  The latest pullback in both the 20-day and 50-day moving averages was definitely a well-needed rest for bullish sentiment – which is imperative in order for the rally to sustain itself.

Conclusion: As I stated in last weekend's commentary, 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).  The rear-view mirror analogy applies once again, as I believe many investors are too dollar-bearish and too commodity-bullish for 2007 – although in the short-run, energy stocks (especially natural gas drillers and producers) may offer a compelling buy.  I continue to be Euro bearish – as I believe the Euro Zone economy will surprisingly underperform both in the short-run and in the long-run.  For folks who do not feel comfortable with buying equities, I am recommending a purchase in U.S. short-dated bonds.

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 to 13,000 or so (on weak breadth) in the short-run.

Signing off,

Henry To, CFA

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