The Times They Are a-Changin
(June 24, 2007)
Dear Subscribers and Readers,
Before we begin our commentary, following is an update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As of Sunday evening on June 24th, we are neutral in our DJIA Timing System (subscribers who want to go back and review our historical signals can do so at the following link). While it would have worked out well if we had continue to hold our long position since May 8th, we decided to exit our position at that time since there were many signs – including most of our valuation, sentiment, and liquidity indicators – that the rally was getting tired. We continue to stand by this position. However, we currently do not plan to go short in our DJIA Timing System – not even in the midst of the latest Bear Stearns hedge fund crisis – at least not until/unless the Dow Industrials manage to rally to the 13,800 to 14,200 area. At that time, we will reconsider. Again, while equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S. equities are now at its most expensive level since May 2006, despite the correction we witnessed the week before last. Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th.
Now, let us continue.
Change is in the air. For the majority of the population, the turning point of a society or the stock market is only clear in retrospect, but those who have been paying close attention can often sense it – although curiously, these same folks usually do not react until someone else has. Why is that? The big reason is just human nature, as 1) human beings tend to extrapolate the recent past into the indefinite future, and 2) human beings don't usually want to stand out from the crowd, and preferring to follow and only opine on a view until someone else.
This curious observation has manifested itself over and over again in the financial markets. From the 1906 San Francisco Earthquake, to the declaration of war by Austria-Hungary on July 28, 1914 (which ushered in World War I), to the international debt crisis of 1982, to the 1997 Asian Crisis, to the 1998 Russian/LTCM crises and to the 2000 peaking of the technology bubble, Wall Street usually does not immediately react. That is why peaks in the stock and financial markets usually come relatively slowly – but there are now signs that the market will have a relatively tough summer this year. What might those signs be?
As everyone and his neighbor should know by now, the subprime problem is not going away anytime soon – as exemplified by the collapse of two Bear Stearns hedge funds that invest mainly in CDOs last week. Even if Bear Stearns managed to “paper over” its problems with a $3.2 billion bailout, that by no way means its problems have been solved, as both Wall Street and the general population now know that the CDOs that many hedge funds and investment banks are holding are actually worth less than half of what they are now generally recognized. Essentially, this has now turned into a game of musical chairs – but with no chairs. To further compound the problem, the majority of central banks in the world today is still in the midst of tightening – and even at this point, the Federal Reserve has gone on record and stated that it is concerned about inflationary pressures more than anything else, despite the fact that it is also keeping a close eye on the Bear Stearns situation. Finally, given Merrill's response to Bear's bailout plan last week, it is also evident that many Wall Street banks are now significantly pulling back from crediting liquidity within the financial markets and from taking on significant risks. This is exemplified by the fact that many Wall Street banks are now hiring bankers and lawyers that specialize in buying or dealing with distressed debt. In other words, the vultures are already circling above their preys – and my guess is that Wall Street is now significantly pulling back because they don't want to become preys themselves.
For the first time since the Japanese boom of the late 1980s, Wall Street is now dependent on Asia (and to a lesser extent, the Middle East) as their main source of liquidity. Indeed – even as yields across Europe and the US were rising over the last four weeks, yields in much of Asia remained relatively stable. Moreover, the Hang Seng Index actually rose nearly 5% last week, despite a 2% decline in the S&P 500. Many other Asian markets also rose – with Thailand rising nearly 4%, Taiwan, India, and Malaysia over 2%, and Singapore approximately 1%. Going forward, these Asian countries should continue to be a significant provider of liquidity to the US and Europe, especially given that China is now in the midst of relaxing its capital controls on its domestic citizens from investing in overseas markets. In the meantime, as far as we can identify, the main Asian provider of liquidity in the US and European financial markets is the Japanese – or more specifically, Japanese institutional and retail investors who are currently trying to benefit from the Yen carry trade.
We have discussed the concept of the Yen carry trade extensively over the last few months, so I will not repeat them here (please see our free archives for our past discussions on the Yen carry trade, along with a whole variety of different topics). Suffice it to say, the Yen carry trade has continued to expand since our last discussion in our June 10th commentary (“Market Not Close to a Bottom”). In that commentary, I stated that one reliable indicator of these “animal spirits” is the strength of the Yen carry trade.- and that given the weakness of the Yen vs. the major currencies in the world today, there is no doubt that risk aversion among hedge funds and retail investors alike remains relatively low. Following is a chart showing the performance of the Yen against the Euro, Pound Sterling, the Australian Dollar, and the Canadian dollar from January 2, 2007 to last Friday:
The last time we showed this chart to our subscribers (in our June 10th commentary), only the Australian Dollar was at a new high vs. the Yen. However, since that commentary, the Canadian Dollar, the Euro, and the Pound Sterling have turned around significantly and embarked on further new highs. As a matter of fact, both the Euro and the Pound Sterling closed at a new high vs. the Yen last week – with the Canadian Dollar not too far behind. The lack of risk aversion is especially apparently when one compares the recent action of the Yen to action during late February and early March – when the Yen rose anywhere from 6% to 8% against these same currencies during that period. Given this weakness in the Yen, there is no doubt that both the US and the European markets are now hugely dependent on Japanese institutional and retail investors for marginal liquidity – and that any turnaround by either the Japanese or Chinese/Taiwanese/Korean/Singapore investors could wreck havoc on global equity prices.
In the meantime, we probably haven't seen the bottom in the Japanese Yen just yet – as Japanese retail investors are now preparing to invest their semi-annual bonuses out of Japan en masse over the next few weeks. Furthermore, given the light volume surrounding the July 4th holidays, there is no telling what the market may do. In the meantime, I would not be surprised if the markets retest its all-time highs over the next few weeks – or even surpass them. Should that happen on light volume, and should that be accompanied by a Barnes Index reading of over 70 and/or a non-confirmation by the Dow Transports, then we will most probably initiate a short position in our DJIA Timing System.
However, for the majority of the population, the most dangerous forces they will face in their lifetimes will not be the liquidity-constrained financial markets over the next six months. Nor will it be homegrown or foreign terrorism. In an older commentary that I penned on August 29, 2004 (“Economic Survival in the 21st Century – the Three Key Questions to Ask”), I stated that there were three important issues that U.S. investors and citizens alike will face over the coming years – those being 1) the combination of a U.S. aging population and globalization, 2) an era of significantly more expensive energy prices (at the time I wrote that article, crude oil was trading “only” at $45 a barrel), and 3) figuring out what type of investor you truly are, as I had believed at the time that the stock market will continue to remain a tough place to invest in for the foreseeable future. In many ways, these three issues are just the most recent manifestations of significant changes that are going on across the world today. As stated in the beginning of this commentary, “the times they are a-changin.”
Since I penned that commentary on August 29, 2004, these three issues have served to be my “talking points” whenever I had wanted to “light a fire” under our subscribers (or ask our subscribers to light a fire under their next of kin) and whenever we had wanted to do some fear mongering! Not anymore. While these three issues will continue to remain important talking points going forward, I now want to add a fourth issue – with that issue being technology.
Indeed, ever since the beginning of the demise of the technology bubble in early 2000, it had seemed that promise after promise that were made during the height of the technology boom were either not kept or were too optimistic. Whatever happened to the 3-G networks that were to span across the US? Or how about all those Global Crossing fiber optical cables that remained unlit after all these years? Whatever happened to the Iridium or Globalstar business models? Craig Venter was at the top of the biotech (and arguably, the one person that was closest to playing God, with the possible exception of Bill Gates) industry in 2000 – as his company, Celera, had just finished sequencing modeling the Human Genome (his own genome, as it turned out). All throughout the project, we were consistently being reminded that many gene-related diseases will be effectively eradicated soon after the first genome has been sequenced, as for the first time in history, we would literally have a “blue print” for human life. As it turned out, modeling the human genome was only the first step. While the costs of modeling a human genome has plunged from the initial costs of $3 billion to only $1 million today (that's right, James Watson's genome was sequenced within three months and only cost $1 million), there are still many things we do not understand about our origins and how our genes really work.
Going back further, if we measure aircraft and spacecraft advances by speeds achieved or by distance covered, the human race literally stopped advancing with the demise of the SR-71 blackbird program in 1989 (or in the commercial area, by the demise of the Concorde program) and the abandonment of the moon with the last manned lunar mission in December 1972. While President Bush's vow to go back to the moon is admirable, it certainly isn't inspiring kids anywhere to be “rocket scientists” – as it is certainly not that appealing to be setting foot on an area that a bunch of astronauts on the Apollo missions have already set foot on more than 35 years ago. No – in terms of being engaged in something intellectually stimulating and/or being a pioneer, starting up a hedge fund to trade credit or catastrophic derivatives is infinitely more attractive for a U.S. student that has both a high IQ and a high EQ.
All this, however, is about to change. This is not a bold statement by any means – it is a conclusion I am reasonably sure of given the many things I have been witnessing over the last 12 to 24 months. On June 21, 2004, SpaceShipOne became the first privately-funded human spaceflight. Funded by billionaire Paul Allen, it won the honor by flying “100 kilometers in altitude twice in a two-week period with the equivalent of three people on board, with no more than ten percent of the non-fuel weight of the spacecraft replaced between flights.” As I am typing this, Scaled Composites, the developer of the SpaceShipOne spacecraft – in conjunction with Richard Branson's Virgin Galatic spaceliner, is developing SpaceShipTwo – which is designed to be a suborbital spacecraft with a speed of 2,500 mph (or 4,000 km/h) and should fly significantly higher than SpaceShipOne – with a range between 100 to 200 miles. It will also have three times the capacity of SpaceShipOne. Test flight begins in late 2007, and if all goes well, the service will be open to paying passengers by late 2009 – with the first spacecraft to be named, appropriately, Virgin Space Ship Enterprise (in honor of Star Stek's USS Entreprise).
While the first landing on the moon by Neil Armstrong was symbolic in nature, it merely represented a political coup for the United States. The successful launch of SpaceShipOne is something different. It is on an entirely different realm – and it is sad that it wasn't on the front page of newspapers for days after that (contrast that with the fact that Paris Hilton will be paid US$1 million for her first post-jail interview – but then, that is only human nature). No, the successful launch of SpaceShipOne is akin to the first successful commercial development of the steam engine, the Wright Brothers 1903 flight from Kitty Hawk, the development of the first digital computer (ENIAC) in 1946, the development of the first market index fund by Wells Fargo in 1973, and the creation of the modern internet, the World Wide Web, in 1991. Assuming that private interest continues in space suborbital flights (and soon after that, orbital flights) continues to grow, I have no doubt in my mind that the costs of space travel will plunge going forward. While this is definitely good news for the private sector and for the general population alike, this is definitely bad news for NASA. This is not entirely surprising, especially given that the only time NASA has been on the spotlight recently has been because of the “Astronaut Love Triangle Scandal.” Need we say more?
But I digress. The successful launch of SpaceShipOne is just one recent manifestation of recent technological advances – advances which have been promised for years but which never arrived. Granted, many very highly intelligent and passionate folks have been working behind the scene for years and years on this – so this did not occur overnight (again, we've paying too much attention to “other things” over the last seven years). What is making the space tourism industry come true (along with virtual reality worlds such as Second Life, and social networks such as Facebook, file-sharing sites such as Youtube) is the rapid pace of technological advances over the last few years. Consider this:
1) As I have alluded to in our discussion forum, the fastest supercomputer today is a 280.6 teraflop IBM Blue Gene machine based in Lawrence Livermore National Laboratory. It achieved that status in March 2005 and is still the fastest supercomputer today. However, by early 2008, the next generation of the IBM Blue Gene series is expected to be commercialized and is going to be four times as fast – easily surpassing one petaflop in speed. Moreover, as I am typing this, the Japanese government has commissioned Hitachi, Fujistu, and NEC to develop a 10 petaflop machine by March 2009. Sometime early next year, Nvidia is expected to release its first “supercomputer on a desktop” processor – slated to be half a teraflop in speed. For comparison purposes, the new laptop which I am currently typing this in (it is a 2ghz Intel Centrino Duo processor with a 667 mhz front side bus) has a speed of approximately 10 gigaflops – or with only 2% of the speed of the Nvidia GPU (obviously, this is not an apple-to-apple comparison since my Intel laptop is designed to run on a different platform and to run different applications than the Nvidia GPU, but for certain tasks, the Nvidia will definitely be many times as fast as Intel processors are today). Here is the kicker: Consensus is that an entire automobile can be designed on a 10 petaflop computer virtually – i.e. without the use of physical models. Some real-world testing will need to be done of course, but that will only be minimal. Assuming a 10 petaflop computer can be designed in two years time by either the Japanese or by IBM or Cray, this will most probably be commercially viable for any of the automakers to purchase a few years after that (e.g. GM purchased a 9 teraflop supercomputer back in 2004). That is, by 2012 or 2013, automobile development costs will come down drastically – and while this will definitely be good for consumers, there will be losers – such as the troop of design engineers that are being employed by the major automakers today or even some of the automakers themselves as the industry continues to consolidate. By 2015 or 2016, the whole automobile industry may come into question, as design teams at much smaller companies will now have the capability to design custom-made cars – and then deliver it over a virtual world like Second Life over a fiber optic or next-generation WiMax system. From thereon, all you need to do is to do then email a copy of that design to your local manufacturing facility – where a computer-operated 3-D printer will be able to “print out” your new automobile in 24 hours.
2) The Human Genome Project took over a decade to complete and approximately US$3 billion in funds. For comparison purposes, James Watson's genome was sequenced in two months and only costs $1 million. Assuming that cost declines to remain on this historical path (there is no reason to expect it won't, given the advances made both in hardware and software in recent years), it will only cost $1,000 to sequence your gene in ten years time – and instead of two months, it will most probably only take one day, with a few of those hours used for interpretation time by a doctor based in Vietnam or India. By 2020, sequencing your gene and doing full-body 3-D scans will be part of your annual checkup – and instead of having to wait at your local medical center for the results, this same Vietnamese or Indian doctor will be calling you at home after dinner to discuss your results.
3) Assuming electricity costs originating from fossils fuels stay the same going forward, electricity costs originating from solar power are expected to decline below that of fossil fuels sometime in 2015. Given that most daily commutes are below 35 miles today, the majority of automobiles around the world could solely be run on a battery power on a daily basis. Moreover, the range of 35 miles is expected to increase going forward, given the inevitable advances in battery technology. In other words, fossil fuels will no longer be needed except for long-haul automobile travel or jet flights – since solar power should be sufficient in creating the electricity that is needed for everything else (assuming the storage technology is there). Failing that, there could be other sources of power – such as non-corn ethanol, nuclear power, or producing hydrogen via solar power (again, assuming the storage technology is available). Failing all these, however, the continual development of supercomputing technology should also allow us to dig deeper and further for fossil fuels than ever before. In other words, while I was somewhat pessimistic about cheap energy supplies in our August 29, 2004 commentary (and rightly so, since oil was trading at $45 a barrel at the time), I am not as pessimistic now. As a matter of fact, I believe that solar power and other sources of energy will usher in a new era of cheap energy. However, should California experience a net set of brownouts or another spike in natural gas prices over the next couple of years, then I will expect this trend to accelerate going forward. That is, instead of aiming for a “crossing point” sometime in the year 2015, this could occur as early as 2013 or even 2012.
4) As the demand for bandwidth continue to exponentially increase going forward (John Chambers predicts that worldwide demand for bandwidth will increase over 300% annually over the next few years!), service providers will satisfy this demand by building faster and more bandwidth capable networks. For example, Sprint has been heavily investing in its WiMax network that is scheduled to go live in April of next year, while Verizon has just recently signed up its one millioneth customer for its Fios fiber optic network – with download speeds reaching up to 30 mbps. By the end of 2008, the Sprint WiMax technology is expected to have a potential reach of nearly 100 million people in the US. Times are definitely a-changin.
Cheap processing and virtually unlimited processing power. Same goes for bandwidth, and for power – not just power for your servers or your computers but power for your automobile and your homes as well. Of course, none of this is any use if we are not healthy, correct? With the expected advances in medical technology going forward (which is not going to be only focused on prevention, but on effective and efficient disease and virus eradication as well), the playing field will be much more level than it has been ever before. Today, that is giving us MIT Opensource education – where a middle class Chinese and/or Indian could access online lectures from one of the best educational institutions in the world today. It is also allowing mass outsourcing and offshoring – along with efficient overseas manufacturing and even designing. Tomorrow, it will be the mass offshoring of biotech and medical research. A couple of years from now, it will be the dawn of the semantic web – where searches will be much better customized and much more efficient. Given the advances in computing power, there will be no need to spend hours planning your trip or getting your secretary to plan your latest business schedule – your laptop or ultra-mobile device will be able to do all that for you in a few years time. Virtual worlds such as Second Life will be significant economic forces of their own – and instead of keeping track of the traditional M-2 or M-3 numbers, we will also need to start keeping track of money supply numbers in these virtual worlds as well, not to mention economic statistics of countries such as China, India, Indonesia, Vietnam, and South Korea. A few years from now, the data that you see on this site will be completely different to what you're seeing today. This is going to be one of the most exciting times in human history, but on the flip side, there will be a whole new wave of Americans that will be rendered unemployable, not because of globalization itself but mostly because of significant advances in technology. By 2020, the final phase of globalization will be complete, as many folks will now be able to afford sub-orbital flights – rendering a trip from New York to London to less than two hours and from Hong Kong to Los Angeles in less than four hours.
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 January 2005 to the present:
For the week ending June 22, 2007, both the Dow Industrials and the Dow Transports declined – with the former declining 279.22 points and the latter declining 68.76 points. Note that this latest decline definitely was not surprising, given the weak attempt of the stock market to recover to its all-time highs during the week before last. Moreover, the latest close last Friday represented the lowest weakly close for the Dow Industrials since May 11th, and for the Dow Transports, April 13th. More ominously, this latest decline is being confirmed in a big way by the Dow Utilities, as the Dow Utilities index closed on Friday at its lowest level since March 19th (note that the Dow Utilities would have been even weaker if it wasn't for the support coming from the impending buyout of TXU Energy by KKR and TPG). For now, we will continue to maintain our completely neutral position in our DJIA Timing System and will probably initiate a 50% short position in our DJIA Timing System should the Dow Industrials hit the 13,800 to 14,200 area in the coming weeks – unless the Barnes Index (please see last weekend's commentary for a review of the Barnes Index) stays below the 70 level (it is currently at 64.40, declining from 65.60 during the week) or unless liquidity around the world starts to improve. For now, it is too early to expect both liquidity and breadth conditions to improve.
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 slightly from last week's 22.8% to 23.5% for the week ending June 22, 2007, despite the weakness prevalent in the stock market last week. 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:
While the latest reading of 23.5% is definitely not at an overbought level, readers should keep in mind that it is nowhere near oversold either. Given that this reading also did not get very oversold during the late February to mid March decline, this author is thus very hesitant to buy stocks again until this reading has gotten to a more oversold level, such as what we experienced during the April 2005, the October 2005, and the June 2006 bottoms. For now, we will remain neutral in our DJIA Timing System, but should we witness some kind of spike (in the 3% to 5% range) over the next couple of weeks in this indicator, and should this be accompanied by a DJIA level of 13,800 to 14,200 and a Barnes Index reading of over 70, then we will probably initiate a short 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:
While the 20-day moving average of the ISE Sentiment (at a current reading of 130.8) is still not close to overbought levels, its rally from 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) to 137.8 as of June 4th was definitely getting long in the tooth – and as such, a correction was definitely due. Even though the 20-day MA has since declined to 130.8 as of last Friday, this reading is still somewhat elevated – and therefore, my best guess is that the market will continue to struggle throughout this summer. More ominously, the 20-day MA of the ISE Sentiment has declined below its 50-day MA (after a false signal on June 12th), suggesting that the ISE Sentiment Index is now in a downtrend. However, should this experience some kind of spike in the coming days, and should this be accompanied by a DJIA reading in the range of 13,800 to 14,200 and a Barnes Index reading of over 70, then we will most likely initiate a short position in our DJIA Timing System. The bottom line is that unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.
Conclusion: Make no mistake, times are definitely “a-changin.” As we continue to make this exciting journal ahead, my main message is this: For the majority of U.S. investors or U.S. workers, the main threat is not the demise of the U.S. stock market, but the demise of one's skill sets in relation to the global economy, as well as the demise of one's profession – whether that is being replaced by lower-cost workers or by technology that has finally come into fruition after all these years. While the continued advances in general and medical technology will bring significant benefits to the global population, there will definitely be bumps along the way. Obviously, I would not want any of our subscribers to be one of those “bumps,” so I urge you to please stay tuned, as always.
Henry To, CFA