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The Most Vulnerable Sectors

(July 22, 2007)

Note: I pulled up the front page of CNN earlier today and came across a Times Magazine article discussing the possibility of a military draft, for the umpteenth time.  For folks who are interested, Rod Powers at has written a great article dispelling any possibility of a military draft for the foreseeable future.

Dear Subscribers and Readers,

For those who would like to do some additional reading on the financial markets during this week, I urge you to read a couple of very well-written articles by GaveKal during April and May of this year.  In these articles, GaveKal reasserted why they were bullish on the world's stock markets, as well as the specific things that could derail their bullish views.  Keep in mind, however, that the equity markets have continued to rally since those commentaries were published – and so while their secular stories do not change, that does not mean you should now jump into the markets in full force.  For those who would like to read more of their research – I would highly recommend purchasing their book “The End Is Not Nigh” either on their website or on  Read this before you read the final book in the Harry Potter series!

Before we begin this commentary, I would like to let our subscribers know that we will be sending out a marketing piece sometime over the next week or so.  This marketing piece will contain an update of our MarketThoughts discussion forum, as well as one of our recent commentaries in PDF format.  This piece will go to both our current list of subscribers as well as those subscribers who were on our free mailing list prior to our transition to a subscription model (so for those who have been with us for a long time, you may actually get a duplicate email).  While we usually don't like to bother our subscribers on this, please forward this upcoming marketing piece to whoever you believe may be interested in subscribing to our commentaries.  As I have mentioned before, this is part of our effort in improving our services, as many of the global data vendors which I am currently evaluating involve substantial capital investments.  Because of this, we would love to recruit as many new subscribers as possible over the next few months!

Let us know begin our commentary by providing 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 July 22nd, we are still neutral in our DJIA Timing System (subscribers can review our historical signals 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, given that:

  1. Liquidity within the world's financial markets is continuing to decline.  Not only are the world's major central banks still on a tightening bias (China raised rates as late as last Friday and also slashed taxes on deposits in order to induce the public to leave their savings in their bank accounts) but both institutional investors and hedge funds are now cutting back their risks – as exemplified in the continuing “blowout” of subprime, CMBS, junk bond, and even emerging market spreads.

  2. Even as the Dow Industrials, the Dow Transports, and the S&P 500 made all-time highs last Thursday, the NYSE Common Stocks Only, the S&P 500, and the S&P 600 A/D lines all failed to surpass its all-time high – an all-time high that was made in early June, or more than seven weeks ago.

  3. The Yen carry trade is going to get more overstretched by the day, while the Swiss carry trade has most probably ended already.  In other words, the Yen carry trade is now definitely one of the primary pillars or liquidity in the world today – so that any reversal in the Yen to the upside will most probably cause dramatic problems not only for the world's financial markets, but in funding private takeovers and infrastructure deals as well.

By the beginning of August, a secondary pillar of liquidity will also be removed – as insiders are typically not allowed to sell any shares during the two weeks (before and after) surrounding the reporting of its earnings numbers.  Given that the flood of earnings reports is in the midst of peaking, this means starting in early to mid August, there is a strong likelihood that insider selling will flood the market, especially if the stock market continues to hold at current levels or rally into August.  Should the stock market rally further this week, there is a high probability that we will then initiate a short position in our DJIA Timing System – given what we had just discussed regarding the continuing deterioration of general market liquidity.

Let us now discuss the main subject of our commentary.  Over the last couple of weeks, several subscribers have asked us that – when/if we decide to go short via our DJIA Timing System – which sectors would we consider shorting if we have to choose.  Before we discuss this and our reasons (note that whatever we discuss below should not be construed as a recommendation), let us now do a recap of how the various sectors within the S&P 500 have done over the last five years.  Following is a table showing trailing performance for the Sector SPDRs of the S&P 500 over selected time periods in the last five years (note that performance highlighted in yellow means that the sector was one of the top four performing sectors during that selected time period).  Also, note I have used the iShares DJ US Telecom ETF to represent the telecom services sector since there was no comparable SPDR ETF for this sector):

Trailing Returns for Select Sector SPDRs as of July 20, 2007

As one can easily see (and to no one's surprise), the energy sector has been – by far – the best-performing sector within the S&P 500 over the last five years and across all of the selected time periods (except for the one-year trailing time period, even though it still ranked in the top three).  The next best performing sectors over the last five years were materials, telecom services, and utilities.  However, over the last three months and since the beginning of this year, a significant portion of the strength has shifted to technology and to industrials.

However, despite the tremendous rallies we have seen in the energy, materials, and utilities sectors over the last five years, they collectively still only make up 22% of the S&P 500 on a market cap basis (following chart is courtesy of Goldman Sachs):

Sector composition of the S&P 500 by equity capitalization, 1974-2007

For comparison purposes, the financials sector alone makes up 21% of the S&P 500.  Moreover, as a percentage of the S&P 500 market cap, the sectors that have shrunk over the last five years are health care and consumer staples.  This also comes as no surprise – as these two sectors are regarded as “defensive sectors” and are thus expected to under perform during a strong bull market – just like what we have been witnessing (and on a global basis) over the last five years.

Let us now look at the sector composition of the S&P 500 from another perspective.  That is, instead of breaking down the S&P 500 on a market cap basis, let us now break it down on a net income basis instead:

Net Income contribution by sector to the S&P 500, 1974-2007

Interestingly, as a percentage of market cap, the financials and energy sectors only make up 21% and 11%, respectively, even though the sectors contribute 28% and 15% of the S&P 500's total net income.  This is expected, as both sectors' earnings tend to be relatively cyclical in nature.  On the other hand, health care and information technology contribute significantly less on a net income basis, versus on a market cap basis.  Again, this is to be expected, as 1) health care stocks tend to either be growth stocks (biotechnology, etc.) or have high barriers to entry (big pharma), and 2) technology stocks tend to be growth tocks.  In other words, it makes sense for both the health care and technology sectors to possess higher P/Es.

One disparity that doesn't make too much sense, however, lies in the industrials sector.  Indeed, on a market cap basis, the industrials sector makes up 11% of the S&P 500, even though on a net income basis, it only contributes 10% to the overall index.  More importantly, the industrials sector – which consists of industries such as industrial conglomerates, aerospace & defense, transportation, construction and farm machinery, and industrial machinery – also tends to have relatively cyclical earnings.  Given this, it is difficult to see how the industrials sector could maintain a P/E that is higher than the P/E of the S&P 500 going forward.

Indeed, as illustrated by the below table (courtesy of Goldman Sachs), the industrials sector is now one of the most overvalued sectors within the S&P 500 – and given its cyclical nature, most probably THE most overvalued sector:

Current Valuation Metrics

Indeed, there are also significant cost pressures rising from two sides – those on the energy/materials side, and on the labor cost side.  With crude oil now at $75 a barrel – and with U.S. consumers seemingly tolerant of such high energy prices (summer travel is again expected to hit a record high this year) – there is a strong likelihood for oil prices to remain high over the next several months.  Moreover, there are now significant labor costs building both within India, and to a lesser extent, China.   Indeed, many Indian construction workers who have been working in Dubai are now being lured back home to work – not only because of the higher Indian Rupee but because of rising income levels at home as well.  Here in the US, the inevitable rise in the federal minimum wage laws will most probably have a “trickle up” effect, as real labor income growth since the beginning of this boom has been relatively tame.  Bottom line: Should higher energy or raw materials prices feed further into headline inflation, then the industrials sector could be finding itself being squeezed from two significant sides: higher energy/capital costs and higher labor costs as well.

At this point, based on what I am seeing so far, the industrials sector is most probably the best candidate to go short – should the market continue its rally during this week.  While the financials and consumer discretionary sectors should also continue to exhibit weakness going forward, the fact that these two sectors are not as overbought or overvalued suggest limited downside – unless 1) we experience a significant market meltdown, or 2) a full-blown consumer recession, which the US hasn't experienced since 1991.

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2005 to July 20, 2007) - For the week ending July 20, 2007, the Dow Industrials declined 56.17 points while the Dow Transports declined 10.06 points - breaking its two straight weeks of uptrend. While the declines of last week were relatively small, readers should keep in mind that the bulk of the decline came on Friday - when the DJIA declined 149.33 points and the DJTA declined 86.87 points, after both indices made all-time highs on Thursday. However, the Dow Utilities is still lagging badly, and given that the NYSE A/D line did not confirm the all-time highs in the many indices last Thursday, this author will most likely not get back in on the long side anytime soon. On the contrary, we will most probably initiate a short position in our DJIA Timing System should the DJIA rise above 14,000 again during this upcoming week.

For the week ending July 20, 2007, the Dow Industrials declined by 56.17 points while the Dow Transports declined 10.06 points – with both Dow indices making all-time highs last Thursday before taking a significant tumble on Friday.  While last Friday's decline has now rendered the stock market short-term oversold (the NYSE ARMS Index closed at 2.18 on Friday), time is now running out for the bulls – as so far, both the NYSE A/D line and the Dow Utilities have yet failed to close above their early June/late May all-time highs (the Dow Utilities is still 4.5% below its all-time high of 535.72 made on May 21st), and as liquidity should continue to wane for the foreseeable future.  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 again rally over 14,000 – assuming that both our liquidity and breadth indicators continue to deteriorate.  Should we decide to go short, we will inform our subscribers via a real-time “special alert” through email.

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 decreased slightly from last week's 24.7% to 23.9% for the week ending July 20, 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 July 20, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased slightly from 24.7% to 23.9%. Note that this reading has now been moving within a narrow range of 22.7% to 25.2% over the last 3 1/2 months. The $64 billion question now is: Which way will it resolve? Our stance on this, however, remains the same: Should the Dow Industrials rally above 14,000 in the upcoming week, then there is a strong likelihood that we will initiate a short position in our DJIA TIming System.

As mentioned on the above chart, the four-week MA has now moved in a very narrow range of 22.7% to 25.2% over the last 3 ½ months.  The $64 billion question now is: Which way will this resolve over the next few months?  Given that this reading has not been oversold since summer of last year, and given the tremendous rally we have seen since that time, my guess is that ultimately, this will resolve downward later this year – even if this indicator rises in the short-run.  As I mentioned last week, the perfect setup for an initiation of a 50% short position in our DJIA Timing System would be a further 3% to 5% in this reading – accompanied with a DJIA level of over 14,000 and a Barnes Index reading of over 70% (the Barnes Index is currently at 65.60).  Moreover, we do not plan to go long the stock market again until his reading has gotten to a more oversold level, such as what we experienced during the April 2005 (8.5%), the October 2005 (11.6%), and the June 2006 (1.7%) 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 few weeks in this indicator, and should this be accompanied a DJIA level of over 14,000, and a Barnes Index reading of over 70, then we will most 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:

ISE Sentiment vs. S&P 500 (November 1, 2002 to Present) - The 20 DMA of the ISE Sentiment (note that a significant number of historical readings in 2007 were revised by the ISE three weeks ago) hit a level of 150.7 last Friday, and is now at its most overbought level since the last week of May 2006. Meanwhile, the 50 DMA rose to a 5-month high reading of 140.9 last Tuesday, before stalling and finishing at 139.6 on Friday. Even though the absolute readings in these two moving averages are still relatively moderate - given the relentless run-up in both the 20 and 50 DMA since March, my guess is that the market will struggle throughout the summer and the Fall, especially as stock market liquidity tends to dissipate after the end of earnings report season (starting first week of August). More importantly, we will need to see a significantly more oversold reading in this indicator before we will go long in our DJIA Timing System yet again.

Over the last week, the 20-day moving average of the ISE Sentiment rose a further 3 points – from 147.7 to 150.7 – and is now at its most overbought reading since the last week of May 2006 (the ISE Sentiment Index closed at 152.9 on May 26, 2006).  Given the relentless rise of the 20-day moving average since early March, and given that this is now at its most optimistic reading since May 26, 2006, my guess is that the market will struggle throughout this Summer and Fall – starting in early August.  Should the ISE Sentiment Index continue to rise in the coming days, and should this be accompanied by a DJIA level of over 14,000, 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: Over the upcoming week, readers should continue to watch for signs of deteriorating liquidity and breadth in the stock market – while keeping an eye on both energy and metal prices, as well as rising labor costs across the world.  Should the Dow Industrials rally to over 14,000 again, and should there be more signs of a liquidity crunch in the financial markets, there is a good chance that we will initiate a short position in our DJIA Timing System.  Finally, should energy and metal prices turn higher in the upcoming week, then the industrials sector may actually be a good sector to short, although, like we have mentioned before, this should not be construed as a recommendation.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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