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2006 4Q Flow of Funds Update

(March 11, 2007)

Dear Subscribers and Readers,

Before we begin our commentary, I would first like to thank David Korn – fellow newsletter author of “The Retirement Advisor” and author of the site – for inviting me as a guest commentator in his market newsletter this week.  David has asked me to write a little tidbit on the “Yen Carry Trade” for his subscribers.  Also, I have asked David for a “return favor” next week – as I will be out for business in Chicago from Sunday morning to Monday evening, and therefore would not have time to write a full commentary.  Look for a copy of David's newsletter in your email inbox next weekend.

For those that are near retirement or who are retired, David Korn, Kirk Lindstrom, and I have also published a monthly financial newsletter catered to folks in this age group, should you be interested.  This set of newsletters is more focused on long-term portfolio management issues as well as other financial management or planning issues.  Our third issue has just been published.  For those would like a sample copy, you can download our inaugural copy at no cost at the following link.

Let us now 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 891.32 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 771.32 points

I hope everyone has had a nice week.  For those who had been wishing for a reprieve from the volatility and the gyrations in the financial markets, you definitely got your wish last week, as – coming off another 90% downside day on Monday, the stock market recovered and experienced a 90% upside day on Tuesday.  Not only that, but the world's stock markets and currency markets recovered as well, as the Yen sold off and as gold recovered from its abrupt slide over the last few weeks.

More encouragingly, there were no hedge fund “blowups” during the latest crisis – despite the intensity in selling on February 27th (the NYSE ARMS Index closed at 15.77 that day – the highest reading since the 30.76 reading on September 26, 1955 – the Monday after President Eisenhower's weekend heart attack).  Moreover, there were only six prior instances of an ARMS reading above 15 since January 1940 – with one of them coming during the Fall of France, two of them during 1943 (when it seemed like the Allies were losing World War II), and two more during 1946 when the 1942 to 1946 cyclical bull market was in the midst of topping out.  For comparison purposes, the NYSE ARMS Index hit a level of 14.07 during Black Monday, on October 19, 1987.

Following is a chart showing the ten-day moving average of the NYSE ARMS Index from January 1949 to the present:

10-Day Moving Average of the NYSE ARMS Index (January 1949 to Present) - 1) Eisenhower heart attack and aftermath 2) 1987 crash and aftermath... 3) The darkest days of the 1997 Asian Crisis... 4) The bursting of the tech bubble and aftermath... 5) The darkest days of the 1973 to 1974 bear market... 6) The crash that ended the *-tronics* boom in 1962 7) The panic selling on February 27, 2007 and aftermath...

As one can see from the above chart, the selling that we endured on the U.S. stock market during February 27th and the following four days was one of the most intense in history.  Not only was this apparent in the U.S. stock market, but all around the world as well as the major global market indices plunged.  At the height of the selling, money managers in Asia were remarking that they have not experienced this kind of selling intensity since the height of the Asia Crisis in October 1997.

Again – more encouragingly – there were no significant hedge fund blowups.  Nor were there any significant “forced sellers” or derivative problems as far as we could tell.  The cause of the February 27th plunge in stock prices is still unknown, but what is clear is the following:

  1. As I have mentioned before (see our “MarketThoughts' Road Map for the Next 12 to 24 Months” post in our discussion forum), many hedge funds over the last six months had capitulated" and just tried to ride either the MSCI World Index and the S&P 500 in order to goose up their returns. In other words, they were really increasing their “betas” and disguising them as “alphas.” They had to - since many "absolute return strategies" were not working out. Spreads were at all-time lows. The carry trade was getting very dangerous, as the Yen were at all-time lows against the Euro and against the dollar on a purchasing power parity basis. The huge increase in exposure to both the S&P 500 and to the MSCI World index by hedge funds over the last six months has been well-documented by Goldman, Lehman, and GaveKal.  Given the “trigger-happy” condition of many hedge funds, a quick correction in the S&P 500 and other global market indices was inevitable sooner or later.

  2. In both the short-term and the intermediate term, both the world's stock markets and the Yen carry trade were getting stretched.  Again, a correction was to come sooner or later.

  3. Finally, many “bad news of the day” events were coming to the forefront – bad news such as the problems in the subprime industry, the volatility in the Chinese stock market, a continuing slowdown of the U.S. economy, and so forth.

Make no mistake: I am not trying to downplay the events over the last two weeks, but so far, this author has not seen any classic signs of an impending top in the U.S. stock market – or any other major stock market across the Atlantic or Pacific, for that matter.  Sure, the troubles in the subprime industry is a warning that “trees don't grow to the sky” – but typical cyclical bull markets have survived harsher blows before – ranging from the San Francisco Earthquake of 1906, the Korean War, the 1994 collapse of the bond market, the 1997 Asian Crisis, and so forth.  As a matter of fact, the recent “shot across the bow” presents a good warning to both investors and hedge funds about risk taking and management – and should actually serve to lengthen the duration of the cyclical bull market rather than shorten it.

As for the Yen carry trade, readers should be reminded here that the structural underpinnings of the Yen carry trade remains sound.  That is, the biggest participant of the Yen carry trade remains the Japanese retail investor – as he or she continues to seek out investment opportunities around the world, given the lack of investment opportunities in his/her home country.  Make no mistake: The financial liberalization of the Japanese economy is only just starting.  One of the consequences (which we are already witnessing) is that both Japanese institutional and retail investors have continued to adopt a more global mandate in their investments.  From a recent Bloomberg article:

Japanese mutual funds have boosted purchases of overseas assets to about 40 percent of the total from about 8 percent in 2002, according to Investment Trust Association data. Japanese mutual funds now have about $244 billion of assets denominated in foreign currencies, including $98 billion in the U.S. dollar.

There may be more outflows because Japanese households keep 51 percent of their savings in cash or bank accounts, compared with 13 percent for savers in the U.S., said Brian Garvey, senior currency strategist with State Street Global Markets in Boston, one of the world's largest custodians of investor assets with $11.9 trillion.

Finally, with over $2 trillion in the Japanese Postal savings accounts – there is still a lot of funds waiting to be invested.  Ever since the Japanese real estate and stock market bubble collapsed in 1990, “capital conservation” has been the game – but with the first uptick in real estate prices in Japan last year, and with the Chinese government also adopting a more global asset allocation strategy going forward, one can most probably bet that the Japanese isn't far behind as well.  After a hiatus of over 15 years, a more risk-seeking Japanese populace will fundamentally change the meaning of global investing – weakening the Yen further in the process.

I now want to use the rest of the commentary to discuss the latest 4Q 2006 “Flow of Funds” data as published by the Federal Reserve – and what this may entail for the U.S. economy and the U.S. stock market.  Let us first discuss the balance sheet of U.S. households – starting with a chart showing the absolute amount of net worth of U.S. households vs. their asset-to-liability ratio from 1Q 1952 to 4Q 2006:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 4Q 2006) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.18 today... 5) Household net worth rose 7.4% on a year-over-year basis to an all-time high of $55.6 trillion. 6) The *dip* in net worth caused by the October 1987 stock market crash.

As mentioned on the above chart, total U.S. household net worth rose another 7.4% on a year-over-year basis to an all-time high of $55.6 trillion as of the end 2006.  While this latest appreciation has not been as brisk as the average appreciation from the third quarter of 2003 and onwards (it has averaged nearly 10% since 3Q 2003), it is still very respectable – especially given the slowdown in the U.S. housing market and the slower-than-expected GDP growth of 2.2% during the fourth quarter of 2006.  More importantly, this latest appreciation was accompanied by a rise in the asset-to-liability ratio from 5.16 to 5.18 – as the growth of home mortgage debt slowed to 8.9% in 2006, down from a 13.8% rate in 2005.  However small it may be, this latest decline in the leverage of households' balance sheets is definitely a welcome sign.  Note, however, that the secular decline in the asset-to-liability ratio of U.S. households remains intact.

Unless we experience an across-the-board decline in U.S. home prices and unless gasoline rises to $4 a gallon, the secular story of the U.S. consumer remains intact for now.  Moreover, the following chart (showing the amount of equities and mutual funds held by U.S. households as a percentage of their total and financial assets) is telling us that the cyclical bull market in the U.S. is nowhere close to exhaustion just yet:

Equities and Mutual Funds as a Percentage of Total Household Assets (1Q 1952 to 4Q 2006) - 1) As a percentage of total household assets, equities *only* make up 15.16% - slightly below its 54-year average of 15.22%. Probability suggests that the cyclical bull market still has further to rally until *exhaustion* sets in. 2) As a percentage of total financial assets owned by households, equities *only* make up 24.80% - slightly above its 54-year average of 23.64% and is actually still at a level slightly lower than the average over the last three years.

While the stock market can and will do anything in the short-run (and sometimes even the intermediate term as well), the history of the stock market suggests that a cyclical bull market will only die on “exhaustion.”  That is, it will not end until all the marginal buyers are exhausted – whether these marginal buyers are your “widows and orphans,” your shoeshine boys, or whoever that has no place in being in the stock market in the first place.  Among the classic indicators of potential exhaustion are valuations, the amount of margin debt outstanding, and of course, the amount of equities or mutual funds held by U.S. households as a percentage of their total and financial assets (note that while sentiment is a great bottom indicator, it has never really worked as a “topping” indicator).  Given that the amount of equities held by households (as a percentage of their total and financial assets) is only at its 54-year average – there is still a lot of potential for further accumulation of U.S. and international stocks by U.S. households.  The U.S. cyclical bull market lives on…

In last week's commentary and our other prior commentaries, we discussed that unlike the May to July 2006 decline (when bond yields rose), the February 27th decline (with bond yields declining) may have been discounting a deflationary bust instead.  In a deflationary bust scenario, all bets are off.  Oversold indicators will get much more oversold, and many companies and hedge funds will go bust before it is all over.  However, the deflationary bust scenario is very suspect – as 1) the ECRI Weekly Leading Index is still rising at a healthy rate, 2) Corporate cash levels remain historically high and 3) Foreign reserves held by the world's central banks are at very high levels – unlike the situation prior to the 1997 Asia Crisis and the 1998 Russia and Brazilian Crises.  Moreover, if we were really moving towards a deflationary bust or a “hard landing scenario,” corporate Baa spreads would now be blowing out.  So far, however, this hasn't been the case – as evident by the following monthly chart showing Baa spreads relative to ten-year U.S. Treasuries from January 1996 to March 2007 (with the latest March data taking into account the spread on last Thursday's close):

Yield Spreads of Moody's Baa Bonds over the Ten-Year U.S. Treasuries (January 1996 to March 2007) - 1) The yield spread of the Moody's Baa bonds over the 10-year Treasuries is still at a relatively benign reading of 1.67% as of the close last Friday - which is only slightly higher than the 1.66% reading at the end of 2006. More importantly, Baa bond yields have actually declined four basis points since the end of 2006 (and a whopping 60 basis points since the end of June 2006) - evidence which supports the continuation of this cyclical bull market. 2) Spreads got to as high as 3.79% in October 2002 - right at the bottom of the last cyclical bear market!

In last weekend's commentary, we discussed that the spread between 10-year Treasuries and Moody's Baa bonds was a mere 1.62%.  Over the last week, this has increased by five basis points.  However, what does not change from last week is this: A spread of 1.67% is still only slightly higher than the 1.66% reading at the end of 2006, and actually lower than the 1.69% reading at the end of October of last year.  Moreover, Moody's Baa bond yields have actually declined four basis points since the end of 2006 (along with a whopping 60 basis points since the end of June 2006) – suggesting that equity prices remain relatively undervalued and that a deflationary bust/hard landing scenario is not in the offing.  For now, we will remain 100% long in our DJIA Timing System – and whether we will trim this position in the days or weeks ahead will continue to depend on the current strength of this rally.

Let us now 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 March 9, 2007) - Over the last week, both the Dow Industrials and the Dow Transports enjoyed a nice rebound from the huge declines during the week before last - with the former rising 162.22 points and the latter rising 48.13 points. Moreover, the internals of the market were healthy (with the exception of the rout in the subprime lenders) - as evident by the Lowry's 90% upside day last Tuesday. For now, probability still suggests that the intermediate term trend remains up, but as always, we will continue to reevaluate our signals in the upcoming days. For now, we will remain 100% long in our DJIA Timing System as we currently believe this is only a hiccup within the context of an ongoing cyclical bull market.

For the week ending March 9, 2007, the Dow Industrials rallied 162.22 points while the Dow Transports rallied 48.13 points.  While the amount of point gains in the two popular Dow indices was not that impressive – readers should keep in mind that the internals of the market (with the exception of Monday) were very healthy indeed, as the 90% downside day on Monday was followed by a 90% upside day on Tuesday.  Moreover, the internals of the stock market continued to improve for the rest of week.  For now, we believe that the intermediate term trend of the U.S. stock market remains up.  Finally, given that all three of the Dow indices made simultaneous all-time highs as late three weeks ago, and given that the A/D line of the major stock market indices remains relatively healthy, this author will have to witness more deterioration of both breadth and other technical indicators before calling for a more substantial decline.  For now, we remain 100% long in our DJIA Timing System – and will continue to do so unless evidence suggests that we should trim down our position.

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 declined from last week's 28.8% to 24.0% for the week ending March 9, 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 March 9, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased from 28.8% to 24.0%, representing the most pessimistic reading since the week ending October 20th of last year. However, this reading still remains elevated on a historical basis. And while the readings over the next couple of weeks should serve to bring this indicator to a more oversold status, I doubt we should see similar readings to what we witnessed in either October 2005 or June of last year - so investors should not indiscriminately buy just yet. For now, however, the intermediate term trend remains up.

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.  As of last Friday, the four-week MA declined from a 12-month high of 31.0% two weeks ago to 24.0% - a level that is still relatively overbought given the most recent declines in the stock market.  While we should see more oversold readings in the coming weeks, I doubt we would see the kind of oversold readings that we witnessed during either October 2005 or June 2006.  In other words, investors should not indiscriminately buy – as any upcoming rally would most probably be more selective than what we have witnessed from June 2006 to February 2007.

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) - The 20 DMA of the ISE Sentiment plunged a whopping 12.2 points in the latest week - the biggest decline since the week ending June 9, 2006. Interestingly, the 20 DMA is now more than 22 points below the level on June 13, 2006 - when the S&P 500 made its bottom last year (at 1,223.68) - while its absolute reading of 105.9 is now at its most oversold since October 2, 2006. The continued decline in the ISE Sentiment index reflects pervasive pessimism among retail investors - especially given the heavy retail put buying on the major subprime lenders late last week.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment plunged a whopping 12.2 points in the latest week – representing the biggest decline since the week ending June 13, 2006.   While the indices can certainly decline to test last week's lows, the pessimistic readings coming out of the ISE Sentiment Index suggests pervasive pessimistic sentiment – signaling that the market is definitely a “buy” basis the Dow Industrials or the S&P 500.

Conclusion: Given the oversold situation created by the February 27th decline and its aftermath, and given the latest Flow of Funds data and the relatively bearish sentiment on U.S. stocks, this author is convinced that the cyclical bull market has yet to run its course.  Whether the decline of February 27th will turn into something more serious is still up in the air – but given the stock market's recovery from last Tuesday and onwards, probability suggests that both the short-term and the intermediate term trend remains up, for now.  Should market internals or valuations deteriorate substantially over the next couple of weeks, we will definitely trim down on our 100% long position in our DJIA Timing System – but as of Sunday evening, we will remain 100% long.  We also continue to be long-term bullish on U.S. equities in general, especially U.S. large caps and large cap growth stocks.

We also believe that the deterioration of the subprime industry will not “spill over” into the rest of the U.S. economy.  We will continue to reevaluate our position in our DJIA Timing System, and will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System in the upcoming weeks (this will depend on new information such as technicals, liquidity, mutual fund inflows/outflows, sentiment, and so forth).

Signing off,

Henry To, CFA

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