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The Permanent Income Hypothesis

(January 14, 2007)

Dear Subscribers and Readers,

It is said that the majority of New Year's Resolutions are not kept – which is not a surprise – as human nature tends to lack discipline and the patience/endurance to break out old, bad habits.  I have been guilty of this all too often, especially when it comes to trading the stock and financial markets.  That being said, I am going to commit myself this year to write commentaries that are more succinct (but which does not leave out any substance), as I know our subscribers are always pressed for time.

Many of you in the past have written asking us to devote more of our commentaries to individual stock picks or even manage a portfolio in real-time.  I have partially responded to these requests by bringing in Rick Konrad from Value Discipline – a former institutional portfolio manager for over 25 years and a brilliant analyst on many things besides the financial markets.  Along with our other regular guest commentator Bill Rempel, Rick has brought and will bring many more individual stock ideas for you to consider, along with a reasonable voice should this author ever get out of line!  In addition, one of my friends and I will be starting up an investment management partnership later this year.  It is mainly going to be an equity long-only fund – with various hedges in place should the general market or selective industries get too out of line.  I will be mostly responsible for the qualitative analysis, while my partner will be responsible for the quantitative and the forensic accounting analysis (the comparative advantage law works best when you have more than one person running a company or an investment partnership!).  Once our investment management business is fully in place, I will definitely have more individual stock ideas for you.

That being said, I do not intend to run a real-time investment portfolio on this website anytime soon.  My “specialty” has always been macro analysis – and I do not want to take away a significant chunk of my time away from macro analysis in order to run an investment portfolio.  I want our macro analysis to be one of the best out there – as many investors and traders have come to rely on us to time their stock market (and other financial instruments) purchases.  Macro analysis and global money flows are also my first love.  More importantly – and this may come as a surprise to some readers – I do not believe having a portfolio of stocks on our website will benefit our subscribers to any significant extent – as buying individual stocks only work if you have the knowledge, confidence, and patience for your purchases.  Buying based on a mere recommendation (even from Warren Buffett or Peter Lynch) will not work – as you will not have the conviction to hold them for the long-term.  And believe me, you will lose your conviction at the precise moment that you need them.  According to Morningstar, the total annualized return for the Legg Mason Value Trust Fund (run by the great manager, Bill Miller) was 12.14% as of December 31, 2006.  And yet, the investors return (what actual retail investors reaped from the fund) was a mere 9.30% annualized, as many investors timed themselves out of gains and chased performance.  Having a portfolio of stocks on our site will only work as long as subscribers know about each individual stock as well as we do or better yet, do their own independent analysis.  And while some subscribers will inevitably do that – based on past experience – most will not.  However, we will continue to give you stock ideas on companies that we think deserve more research.  From thereon, everything else will be up to you.

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 1,171.08 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,051.08 points

As of Sunday afternoon on January 14, 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 also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials.  Moreover – judging by what we saw at the Consumer Electronics Show in Las Vegas last week, there is a good chance we are now seeing a revival of Sony as a great global corporation (barring a global economic recession, the rest of this and the next decade will be known as the age of the emerging market consumer).  We also continued to be very bullish on good-quality and growth stocks in general.

In the short-run, the market is still vulnerable to some kind of correction – given that earnings season is going to ramp up this week.  That said, expectations are relatively low this quarter, so corporations may continue to surprise on the upside.  However, 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.  Speaking of corrections, there is a good chance that both the correction in crude oil and natural gas has already ended late last week.  Make no mistake, however, I still believe the pricing environment for energy and commodities in general will be tough this year – but for now, we have probably found a short-term bottom.   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 believe that both energy and commodity prices in general will struggle this year, I continue to be a secular energy bull – as long as there is no breakthrough in battery or solar energy in the next few years.

As many of you may know – Milton Friedman – who passed away last year at the age of 94 late last year, left behind many legacies.  One of them is his theory of “permanent income hypothesis” – which essentially states that consumers based their future consumption patterns on long-term income expectations, as opposed to current income.

Why is this important?  One of our premises for the continuation of the bull market in the United States and for the economy to reaccelerate early this year is our belief that the U.S. consumer is not close to being tapped out.  The perma-bears would claim that much of the “mortgage equity withdrawal” over the last few years went directly into consumption – but as I have discussed many times before, a significant chunk of the MEW actually went towards paying off (higher-yielding) debt, not consumption.  Another chunk of it went towards home improvements or starting businesses – both activities that could be classified as investments or capital spending (which is good for future economic growth).

The reduction in higher-yielding consumer debt is directly reflected in the consumer credit growth numbers over the last few years, as shown in the following chart:

Monthly Annualized Consumer Credit Growth (12-Month Smoothed)* (January 1989 to November 2006) - Both revolving and non-revolving consumer credit growth has been on a declining trend in the last four years - even as the U.S. emerged out of its latest recession in November 2001. In the latest month, the growth of the 12-month average of total consumer credit declined from 4.06% to 4.05% - the lowest growth since December 1993.

Look – the U.S. consumer is not that stupid.  Quite often, they may not be looking at the right places, but if they turn on the TV or open the newspapers and see all this talk about the “U.S. housing bubble,” then (according to Friedman's Theory of Permanent Income Hypothesis) they will appropriately plan their current spending patterns assuming the rise in home prices will not extend indefinitely into the future.  In other words, all this talk about the U.S. housing bubble over the last 12 to 18 months (and how this would bring about a consumer-induced recession) actually helped prevent one – as many U.S. consumers had already planned (by cutting back their spending or paying down debt earlier in the process) for such a recession in advance.

So Henry, what happened in 2001?  How did that recession come about?

The recession in 2001 was in fact preceded by a significant decline in capital spending – and in fact, the U.S. consumer never really retrenched (although they did suffer a significant slowdown).  Many U.S. large caps had no cash – and many companies that did have cash had to suffer huge write-offs because their customers had no means to pay or had no cash or credit to buy any more equipment.  In short, many U.S. companies stopped investing – not only because they did not have the means but also because there was such a huge overcapacity in the technology sector.  Today, the situation has been reversed – as U.S. corporations are sitting on huge amount of cash and as businesses and consumers start to demand better wireless and fiber optics technology.

To a certain extent, the slowdown in consumer spending in 2001 was partly due to the mistaken belief that the rise in stock prices in the late 1990s was permanent.  The March 2000 to September 2001 decline in stock prices shattered that belief – leaving a huge negative impact on U.S. consumer spending.  Today, the bursting of the U.S. housing bubble had no similar effect, as many U.S. consumers never believed that the rise in housing prices were permanent– thus retrenching in advance.  Milton Friedman saw this nearly 50 years ago.  On the other hand, many economists today are still surprised by the resiliency of U.S. consumer spending.  It is time to change your expectations, folks.

Based on my assertion that U.S. consumers are still not tapped out, and based on many of my commentaries over the last few months, I believe that 2007 will be a decent year for the U.S. stock market.  Sure, margin debt is now at a high not seen since March 2000, but as we have discussed before, the amount of margin debt outstanding has historically tend to make new highs in each successive cyclical bull market – even during the secular bear market of 1966 to 1974.  Moreover, as exemplified by the Barnes Index and the fact that S&P 500 earnings have been increasing at a quicker pace than the S&P 500, valuations are still relatively decent.  And finally, the U.S. stock market is not even close to exhaustion, given that U.S. retail investors have been shunning domestic equities for the last 12 months – and given the following chart (this is the first time we are showing this) showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to December 2006) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio suggests that the market is not near exhaustion - indicating that the bull market is not over yet.

I got the idea of constructing the above chart from Ned Davis Research – who had constructed a similar chart for a Barron's article a few months ago (his assertion was that we are also not close to a significant top in the stock market).  Make no mistake: The ratio between money market fund assets and the market cap of the S&P 500 is probably not a great timing indicator – but what it does show is the amount of “cushion” that we have in order to insure against a significant market decline.  While this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet.  Based on historical experience, this author will not be too concerned until this ratio hits a reading of 15% or below.  Assuming that the amount of money market funds remains the same going forward, the market cap of the S&P 500 has to rise a further 13% before we see such a ratio.  Based on the above study, we will remain 100% long in our DJIA Timing System.

Let us now quickly discuss crude oil.  As I mentioned in a previous paragraph, I believe the price of crude oil has made at least a short-term bottom last Thursday at the close.  First reason: The spot price of crude oil was extremely oversold on Thursday, as the spot price closed at a level that was 13.5% below its 50-day moving average, as shown on the following chart:

Daily Spot Crude Oil vs Percentage Deviation from its 50-Day Moving Average (March 1983 to Present) - 1) George Soros made a substantial amount of money by shorting crude oil in late 1985/early 1986. Crude declines from over $31 in November 85 to just $11 by March 86. 2) Iraq invades Kuwait. 3) Oil peaks at $28 in December 96. Asia and Emerging market crisis hits in 97. Oil bottoms at $11 in December 98. 4) Post *Gulf War 2* spike down - oil declines from $37 to $27 in just ten days. 5) On Thursday, the spot price of crude oil closed at $51.89, a 19-month low and 13.5% below its 50-day moving average. The $64 billion question is: How low is too low - given that we just experienced the biggest bull market in oil since the 1979 oil embargo? My guess: We just saw an important short-term low, but I believe crude oil should continue to experience a tough pricing environment in 2007.

With the U.S. economy continuing to surprise on the upside, I believe oil prices have made an important short-term bottom last Thursday.  Moreover, the most recent decline in the crude oil sport price was not confirmed by either the Dow Transports or the Oil Service HOLDRS (the OIH).  This is an important development, as the prices of these three indices have been rising in sync since the cyclical bull market in stocks began in October 2002.  Following is a daily chart showing the performance of the Dow Transports, the OIH, and the crude oil spot price from October 1, 2002 to the present:

Relative Performance of the Dow Transports vs. Oil Service HOLDRS vs. Crude Oil (October 1, 2002 to January 12, 2007) - Ever since the cyclical bear market bottomed in October 2002, the DJTA, the OIH, and crude oil have more or less moved in sync with one another. Note that, however, the recent drop in crude oil prices has not been confirmed by either the Dow Transports or the OIH - suggesting either that crude oil has made a significant bottom last week or that we are entering a deflationary boom - where supply issues are being trumped by technology advances.

Make no mistake – technological advances over the last few years have made many operators that were not profitable in the past (such as Canadian oil sands extraction or deepwater drilling) hugely profitable – but at a low of $51.89 a barrel last week, oil was starting to get close to its marginal cost of production – right in the midst of a strong global economy!  Unless some major region of the world (e.g. Western Europe, Japan, or China) experiences a recession in 2007, the price last Thursday was most probably pretty close to the bottom for 2007, give or take $5 a barrel (I don't believe oil will decline below $45 a barrel this year).  As I have mentioned before, I am still a secular bull on crude oil and natural gas, unless we manage to commercialize both solar energy and battery technology in a big way over the next few years.  

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 12, 2006) - For the week ending January 12th, the Dow Industrials rose 158 points while the Dow Transports rose 148 points. The Dow Industrials closed at a new all-time high for the week, while the Dow Transports closed at a new high not seen since December 5, 2006. While this latest rally was strong and broad-based in nature, my guess is that it will only be sustainble in nature should the Dow Transports close above its November 16th high of 4,881.57 in the next couple of weeks. For now, chances are that both indices will resume their up trend relatively soon - with the Dow Industrials continuing to make new all-time highs in the coming weeks and months.

For the week ending January 12, 2007, the Dow Industrials rose 158 points while the Dow Transports rose 148 points.  Both the Dow Industrials and the Dow Transports got “in gear” last week, but unless the Dow Transports breaks its November 16, 2006 closing high of 4,881.57 (it is still 121.30 points away from that high), the environment for the stock market will continue to remain tough.  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.  We also 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 28.5% for the week ending January 12, 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 12, 2007, the four-week MA of the combined Bulls-Bears% Differentials declined from 28.7% to 28.5%. 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 unchanged from last week 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 may 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 and is now once again consolidating at around the 140 level. The fact that the 50 DMA has caught up with the 20 DMA is definitely a well-needed *rest,* and given that the ISE sentiment is not that overbought, 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), after dipping slightly from mid November to mid December, has been, and is still consolidating in the 140 area.  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.  Bottom line: Most of the popular sentiment indicators that we are watching are still not signaling any exhaustion just yet.

Conclusion: Based on my assertion that the U.S. consumer is not close to tapping out, and based on the historically high cash levels on the balance sheets of U.S. corporations, I believe both the stock market and the U.S. economy will do well in 2007.  Not to mention the fact that U.S. private equity firms now have over $160 billion on their balance sheets, and buying power three or even four times of that amount.  Finally, the amount of money market fund assets is still relatively high at 17% of the market capitalization of the S&P 500 – suggesting that the stock market is nowhere near close to exhaustion just yet.  Again, I would not be overly concerned about the stock market until this ratio reaches 15% or below.

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.  Readers please stay tuned.

Signing off,

Henry To, CFA

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