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The New Frontiers of Global Investing

(April 15, 2007)

Dear Subscribers and Readers,

According to a recent Associated Press article, the Indian IT industry is once again experiencing growing pains, as the country is quickly running out of qualified workers to fill the necessary jobs in the IT industry.  Sure, Indian schools currently graduate as many as 400,000 engineers every year, but according to experts such as Mohandas Pai, human resources chief for Infosys Technologies, only about 100,000 or so are ready to join the IT workforce.  Quoting James Friedman, an analyst at Susquehanna Financial Group that has studied the issue: “"When we first started covering the industry, in 2000, there were maybe 50,000 jobs and 500,000 applicants. Now there are perhaps 180,000 annual openings, but only between 100,000 and 200,000 qualified candidates.”  In order to combat this shortage, many companies in India (such as Infosys and IBM) are building “finishing schools” or programs to help Indian graduate brush up their jobs skills – and while they are having initial successes, things are getting more uncertain as time goes on.  For this year, the Indian IT industry will most probably hold up – but if the Indian IT labor pool does not see an improvement as early as next year, we could potentially see skyrocketing wages and a shift towards other overseas markets, such as the Philippines, Ireland, and so forth.

At the same time, however, this is no time to be resting on your laurels.  Because while the cost of operating call centers and software companies may be rising in India, this is not the case just yet for “front-office work” such as investment banking, drugs development, aircraft design, and so forth.  For example, Cisco has now mandated that as many as 20% of its “top talent” should be located in India within five years.  IBM has shrunk its U.S. workforce by 31,000 since 1992 and increased its Indian workforce from 0 to 52,000 during the same time period.  Meanwhile, 600 of Citigroup's stock analysts were hired in India.  For folks that have PhD or MBA aspirations at a top 50 school, this is now the time to get one.

Before we begin our 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 1,227.13 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,107.13 points

In our mid-week commentary, I discussed the highlights of the IMF's latest Global Financial Stability Report – namely, what the IMF sees in terms of short to intermediate term risks (these were all covered in Chapter 1 of the document), such as the deteriorating conditions in the U.S. housing market, the increasing leverage and complacency in the global LBO industry, global “imbalances” such as the U.S. current account deficit and the Yen carry trade, and so forth.  What I did not discuss, however, was the potential risks in the emerging markets countries as seen by the IMF.  Make no mistake: Emerging market countries as a whole have increased their shares of their global pie over the last five years – and any “hiccup” in those countries will also have a significant impact on the U.S. and other developing countries as well – whether it is in decreased sales of Fortune 500 companies, investor losses, or just an increase in the general aversion of risk.  Fortunately for the bulls, the risks – as evaluated by the IMF – in emerging market countries as a whole have “broadly declined” since the release of the last Global Financial Stability report last September.  Quoting the IMF:

[This view is] supported by the benign global economic outlook, improved macroeconomic performance, and improving sovereign debt profiles. Investor flows to EMs have increased and demand has broadened, not just for external debt, but for local-currency denominated assets … The positive global outlook, including generally high levels of commodity prices in recent years, continues to provide a supportive backdrop for emerging markets and should allow for continued export-led growth. In addition, EM vulnerabilities have broadly continued to decline.

The decline in these “vulnerabilities” can be witnessed in the following graph showing: 1) the decrease in gross public debt since 2002, 2) the increase in reserve cover since records have been kept, and 3) the improvement in the fiscal balance (as a percentage of GDP) since 2002:

Indicators of External Vulnerability in Emerging Markets

Moreover, with the exception of countries such as Ecuador, Thailand, and Venezuela, government and local central bank policies have generally been constructive on improving the credibility of emerging market countries.  This was evident in countries such as Turkey, South Africa, and Hungary.  Quoting the IMF report:

Policy credibility continued to recover in Turkey following the central bank's sharp tightening of monetary policy in June and July 2006, and efforts to improve policy communications. In South Africa, the Reserve Bank's steady tightening of monetary policy helped consolidate market stability. In Hungary, market perceptions that fiscal policy was becoming increasingly credible helped restore investor confidence, leading to record levels of nonresident holdings of forint-denominated assets in late 2006.

More importantly – unlike investors' reactions and perceptions during the 1990s and into the Argentine Crisis of 2002, much of the negative reactions have been confined to the countries concerned (such as Thailand).  This was not surprising, as EM sovereigns aggressively retired external debt in 2006 – and sovereign external debt flows, including coupon payments, are expected to be negative during 2007.  Together, this resulted in a further rise in EM credit ratings to just slightly below BB+, representing a one-notch increase since the end of 2004.   Finally, sovereign credit rating upgrades by Moody's and S&P outpaced downgrades in 2006 for the 5th year in a row, with 38 upgrades vs. only two downgrades.  The improvement in EM credit quality is illustrated in the following chart from the IMF report:

Emerging Market Credit Quality Index

Not everything is perfect, however.  The purpose of the “Global Financial Stability” publication is to illustrate potential systematic risks – so the IMF will go to any lengths to “dig up” any potential trouble spots.  Again, quoting the IMF:

However, as investors move further out along the risk spectrum, such [foreign] flows pose new challenges for policymakers, requiring concomitant advances in financial market development and regulation. Two recent developments highlight the need for these advances. First, a rapid expansion of corporate debt issuance in emerging Europe, led by domestic banks, is contributing to rapidly expanding credit in some countries. Second, as investors seek out “new frontiers” in EMs, recent inflows into local government securities of some countries in sub-Saharan Africa have exposed those markets to risks of reversal.

In discussing the rapid corporate debt issuance in emerging Europe, the IMF specifically brings up the examples of Kazakhstan and Russia, where corporate bond issuance (mainly from banks) is supporting rapid growth in loans to the private sector.  Moreover, the majority of these loans are only BB rated – and both capital adequacy in these two countries are either low or declining.  Another issue is that the majority of these loans are not denominated in the local currency – thus increasing foreign currency exposure (remain when many Thai companies found out that they were up to their eyeballs in debt simply because the Thai Baht crashed in the midst of the Asian Crisis in 1997?).  However, much of these risks may be offset by the continuing economic growth in these two respective countries and generally low leverage ratios.  Given that banks account for a significant proportion of this new EM corporate debt issuance, the IMF is currently mainly concerned with the adequacy of bank regulation and supervision in these countries.

Meanwhile, the second concern of the IMF is most probably not “systematic” in nature from a global standpoint, but it is definitely of concern to those countries that can be classified as the “new frontiers” – or in other words, many of the countries that are currently booming in sub-Saharan Africa, with the exception of South Africa.  This is the main topic of our commentary today (yes, finally).

Ever since the proposal of the “Multilateral Debt Relief Initiative” in June 2006 by the G-8 countries, investors have come to recognize that many of the countries who initially qualify for this relief (March 2007) will receive significant one-time boosts to both fiscal and political stability.  Indeed, two countries that initially qualified – Zambia and Ghana – have also benefited hugely from high commodity prices.  Combined with the fact that many of these markets remain uncorrelated with the more liquid emerging markets, there is no doubt that they have now become very attractive places to invest.  As stated in the IMF report:

Portfolio investors have become increasingly active, especially in local currency debt markets, led by dedicated EM hedge funds and institutional investors. A trading volume survey by the Emerging Market Traders Association (EMTA) shows sub-Saharan debt trading volume reached $12.7 billion in 2006, nearly double the volume in 2005 … Meanwhile, the ability of foreign investors to access the region's markets has improved as an increasing number of the region's assets can now be settled via Euroclear, lowering transaction costs. Prior to 2006, only the South African rand among sub-Saharan African currencies was a settlement currency within Euroclear. In 2006, seven additional sub-Saharan currencies were added.

There are caveats to this benign backdrop, however, as the relatively small size of these “new frontier” markets make them very sensitive to foreign inflows and outflows.  The IMF report cites Zambia as a typical example.  Since the IMF report can tell this story better than I can, I will quote them directly again:

The experience of Zambia between late 2005 and end-2006 provides a case study on the impact that foreign investor entry and subsequent exit can have on small local markets. Zambia had achieved the completion point under the Heavily Indebted Poor Countries Initiative in April 2005, and was poised to benefit from the G-8's post-Gleneagles Summit commitment to enhance poverty reduction resource flows to Africa. In addition, as a copper exporter, the dramatic rise in that metal's price—up 173 percent from end-2004 to its peak in May 2006—had strengthened prospects for Zambia's macroeconomic performance. Against this favorable economic backdrop, foreign investor interest in local Zambian markets rose. High nominal interest rates (18 percent in September 2005) and prospects of gains from currency appreciation drew in foreign investors, despite very limited market liquidity and the undeveloped state of local markets. Foreign inflows into local Zambian government securities markets increased from almost nothing to a sizable share of the domestic market. By the second quarter of 2006, nonresidents held 15 percent of the outstanding stock of bonds and 23 percent of the treasury bill market. The influx of foreign inflows accentuated the appreciation pressure on the Zambian currency. The kwacha rose by 44 percent from the second half of 2005 to the first quarter of 2006, significantly more than other commodity exporting countries. At the same time, inflows into local government securities brought with them a pronounced drop in nominal yields, accompanied by a decline in inflation. The one-year yield fell to 7 percent by late May 2006, while inflation declined about 10 percentage points to 8.6 percent year-on-year. However, amid growing political uncertainty ahead of the September 28, 2006 elections and a fall in copper prices, foreign investors retreated from local markets. This retreat added significantly to pressure on the local currency and interest rate markets. Between end-May and end-September, the kwacha depreciated by 16 percent against the dollar, compared with a decline in copper prices of 4 percent. Foreign investors' share of the outstanding stock of treasury bills declined from 24 to 19 percent during this period. By year-end, the one-year yield had moved back above 9 percent, reflecting, in part, the impact of foreign investors' exit from local markets.

Despite this volatility, however, the economic backdrop for countries like Zambia remains favorable, especially as the global economy continues to grow broadly.  This is exemplified by the fact that foreign investors continue to hold a substantial amount of the country's total debt, as shown by the following chart:

Zambia: Foreign Ownership of Outstanding Debt (In billions of kwacha)

While the amount of foreign holdings has declined slightly since the beginning of 2006, they definitely remain very high by historical standards.  Over the longer-run, the challenges for countries like Zambia will be to make sure that its local economy and financial liberalization is keeping pace with the growth in foreign portfolio flows.  This is no small feat.  However, to a certain extent, Nigeria has been doing quite well and can serve as a role model, as its local pension sector has been rapidly developing over the last few years and is now a consistent provider of liquidity in Nigeria's secondary markets.

From the latest IMF Global Financial Stability report, one important thing that we can take away from this is that the “Emerging Markets” are now finally in the midst of emerging – something that has very much eluded these markets since the end of World War II, despite consistent optimism among many investors.  Meanwhile, the “new emerging markets” in the 21st century will most probably be countries like Nigeria, Ghana, and Zambia – and to a lesser extent countries in Central and Eastern Europe such as Hungary, Estonia, Poland, Turkey, and Ukraine.  In the meantime, countries like China, India, and Brazil will be the engines of global economic growth going forward, while countries like the United States, Japan, UK, and Germany will be the countries that are responsible for continuing innovations in terms of technology, the financial sector, corporate management, and so forth.  For many institutional and retail investors, emerging markets in the classic sense is no longer off limits – while for those in America, Japan, or Western Europe who have grown accustomed to a middle class lifestyle, it is again time to be paranoid – although this is something I have mentioned on and off in our commentaries over the last few years.

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 April 13, 2007) - 1) Over the last week, both the Dow Industrials and the Dow Transports continued their recoveries from the late February to early March swoons - with the former rising 51.93 points and the latter rising 117.94 points. The Dow Industrials is now a mere 20 points below its February 26 close, while the Dow Transports less than two points below. Moreover, the internals of the market and most of the world's stock markets continued to remain healthy. For now, probability suggests that the intermediate term trend remains up, but whether the internals will continue to hold up as we power near the all-time highs remains questionable, especially as we move towards the *seasonally weak* six months of the year. For now, we will remain 100% long in our DJIA Timing System, although we will continue to keep watch.

For the week ending April 13, 2007, the Dow Industrials rose 51.93 points while the Dow Transports rose 117.94 points, as the two popular Dow indices strived to take out its pre February 27 highs.  Given that quarterly contributions for calendar-year DB pension plans are due tomorrow, there is a good chance that liquidity for the stock market will remain supportive for the rest of this month.  More importantly, the combination of this and the continued strength in the internals of the stock market (as the A/D lines of the NYSE Common Stocks only Index continue to make all-time highs last week) suggest that we have not seen the top of the stock market just yet – and chances are that we will mount an assault on the all-time highs over the next couple of weeks.  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 increased from last week's 19.9% to 22.7% for the week ending April 13, 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 April 13, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 19.9% to 22.7%. While the latest bounce suggests that the trend of increasingly pessimistic readings has reversed, the fact that this reading did not bounce from a more oversold level suggests that any upcoming rally probably won't be too spectacular. For now, the intermediate term trend remains up - although we may consider trimming down our bullish position if this spikes higher over the coming few weeks.

While the four-week MA of this indicator hit its most pessimistic reading since September 8th of last year on March 23rd, (and is now rebounding) the fact that it isn't bouncing from a more oversold level suggests that any upcoming rally will probably not be too spectacular, there is a very good chance that we will see an all-time high in the Dow Industrials (most probably over 13,000) and possibly an assault by the S&P 500 to the 1,500 level.  Given that April tends to be a strong month for the stock market (especially since required quarterly contributions for calendar year-based DB pension plans are due April 16th), my guess is that the stock market should continue to have an upward bias over the next couple of weeks.  Should this rally be accompanied by a spike in readings in the Market Vane, the AAII, and the Investors Intelligence Surveys., however, this author will probably become more cautious and trim down our 100% long position in our DJIA Timing System.

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:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA of the ISE Sentiment bottomed at a reading of 98.5 on March 21st (representing the lowest reading since the 97.6 reading on October 30, 2002) and has since bounced back to a reading of 117.3 as of last Friday. Meanwhile, the 50 DMA is still playing *catch-up* - declining from 114.1 to 112.4 during the latest week. Note that the 20 DMA has now risen above the 50 DMA. Given the hugely oversold readings of the ISE Sentiment Index during late March, we should continue to see the stock market sustain its rally over the coming months - although this isn't currently confirming the average of the Market Vane, AAII, and Investors Intelligence surveys.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment dropped to a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) and has since bounced back to a reading of 117.3 last Friday.  In the meantime, the 50 DMA is playing “catch up”, declining from 114.1 to 112.4 – a low not seen since October 18, 2006.  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.  However, not everything is perfect at this point – as I am still wary that the average of the AAII, the Investors Intelligence, and the Market Vane surveys did not confirm when the ISE Sentiment became oversold in the latest late February to early March decline.  For now, however, a rising bullish sentiment coming out of an oversold to semi-oversold condition is usually very bullish – and thus we will continue to hold our 100% long position in our DJIA Timing System until we see more divergences within the global or the U.S. stock market.

Conclusion: As we move towards a more integrated global financial market, the term “emerging markets” no longer apply to the emerging market countries of old – those such as China, India, Brazil, Malaysia, Mexico, and so forth.  Rather, the “new frontier” is now in sub-Saharan countries such as Nigeria, Ghana, and Zambia – and to a lesser extent, Central and Eastern European countries such as Poland, Hungary, Estonia, and so forth.  In terms of risks in the emerging market countries, there aren't really much to speak of currently – unless 1) banking reforms and monitoring start to break down within the EM countries, or 2) global commodity prices crash.  As of today, I do not see any of those two happening – as global liquidity remains rampant and as the Yen carry trade remains very much alive (although the Yen is again becoming hugely oversold relative to the Euro).

As for the U.S. stock market, we will continue to remain 100% invested in our DJIA Timing System, as current liquidity levels, valuations, technicals, and breadth suggest that the cyclical bull market still has further to run.   Should market internals or valuations deteriorate substantially over the next couple of weeks, however, 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 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.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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