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Global Economy Now Slowing Down

(October 7, 2007)

Dear Subscribers and Readers,

Let us begin our commentary by first providing an update on our four 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.

4th signal entered: 50% short position last Thursday (October 4, 2007) at 13,956, giving us a loss of 110 points as of Friday at the close.

As of Sunday evening on October 7th, we are 50% short in our DJIA Timing System (subscribers can review our historical signals at the following link).  In our “Special Alert” last Thursday morning, we briefly discussed our reasons for going 50% short in our DJIA Timing System.  I will briefly recap them here:

  • Continuing divergences among the major U.S. stock market indices – with none of them confirming the new recent all-time highs in the mega and large cap indices such as the Dow Industrials, the S&P 500, and the Russell Top 200 Index.  Moreover, from a Dow Theory standpoint, we have continued to witness a significant amount of weakness in the Dow Transports since the rally off the mid-August lows.  Even within the S&P 500 Index, only the larger names are outperforming.  Case in point: Over the last three months, the total return (i.e. including dividends) of the S&P 500 Index is 2.03%.  However, on an equal weighted basis, the S&P 500 Index is actually down 2.19% over the last three months.

  • The two major stock markets in the world with the most relative strength in the last few months – the Shanghai Stock Exchange and the Hong Kong Stock Exchange (the latter exemplified by the Hang Seng Index) is now losing significant strength.  In fact, the latter index completed a huge one-day reversal in Wednesday's trading session.  Moreover, aside from what I had just discussed in this morning's commentary on the Hang Seng, the number of new highs in Hong Kong actually topped out in late May – and has been consistently decreasing since that time.  There is no question that the strongest stock markets in the world are now losing strength, and this will not bode well for the U.S. stock market going forward.

  • The recent strength in the U.S. Dollar – plus the fact that it is still significant oversold.  Given that as much as 50% of earnings in the Dow Jones Industrials come from foreigners, there is a good chance that there will be a squeeze in the profits of the Dow Industrials' components over the next couple of quarters – should the USD Index continue to rally.  This is significant, as any dollar rally against the Euro and the Yen will also mean a lower Chinese Renminbi – as the latter is pegged to a basket of the world's major currencies, including the USD.

Again, given the relatively weak rally (both in breadth and in volume) we have witnessed since the mid August lows, and given the non-confirmation of the rally by the major stock markets in Europe and in Japan, there is a good chance we could see a retest in the major indices before we see a sustainable bottom in the U.S. stock market.  Also, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last six weeks, there is a good chance that the Dow Industrials could continue to rise over the next couple of weeks, but we believe that any all-time highs will be short-lived. Should this occur, however, chances are that many other major market indices will not confirm this all-time high, such as the Dow Transports, the Dow Utilities, the S&P 400, the Russell 2000, the American Exchange Broker/Dealer, the Value Line Geometric, and the Philadelphia Semiconductor Indices.   Should the Dow Industrials make another all-time high – preferably in the 14,200 to 14,500 area, and should this be accompanied by continuing weak breadth and divergences among many market indices, then we will establish a 100% short position in our DJIA Timing System.  As always, whenever we change signals in our DJIA Timing System, we will inform all our subscribers via email as soon as we make the change.

Let us now begin our commentary.  Given that as much as 50% of profits within the Dow Industrials and the S&P 500 is derived from outside of the US, we would never have gone short within our DJIA Timing System if we had believed that profit growth from outside the US would “make up” for an earnings slowdown or decline within the US.  In a way, this was what happened in the US during the second quarter, as virtually 100% of year-over-year profit growth came from outside of the US, while domestic earnings remained stagnant.  The $64 billion quest now is: Given that US economic growth is set to continue to slow down over the next couple of quarters, will foreign earnings growth prove to be strong enough to offset any shortfall in earnings within the US?

Let us now try to answer this question by taking a look at the latest update of our “MarketThoughts Global Diffusion Index” (MGDI).  We first featured the MGDI in our May 30, 2005 commentary – with our last update coming in our September 9, 2007 commentary.  For our newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for the 25 countries in the Organization for Economic Co-operation and Development (OECD).  Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages.  More importantly, the MGDI has historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI on two occasions – first by incorporating the leading indicator for the Chinese economy, and second by dropping the one for Turkey.  The first revision is obvious; as China is now the fourth largest economy in the world and actually has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth this year is expected to surpass that of the US).  The second revision is less obvious.  While Turkey is by no means a small or marginal country, many of the readings over the last six months have been very unreliable – and so we have chosen to drop Turkey in our MGDI instead.  This is rather unfortunate, but it is better to omit certain data points than to incorporate unreliable data.  

Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the CRB Index and the YoY% change in the Dow Jones Industrial Average from March 1990 to August 2007 (the September 2007 reading will be updated and available on the OECD website in early November).  In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the CRB Index & the CRB Energy Index (March 1990 to August 2007) - The deviation of the change in the Dow Jones Industrials and the CRB Index from the annual and the rate of change (second derviative) in the MGDI suggests that the U.S. stock and commodity markets should at least take a further *breather* before resuming its rally. More importantly, this weakening in the MGDI suggests that global economic growth should continue to weaken over the next three to six months.

As we discussed in our February 25, 2007 commentary, “The strength of the MGDI is essential to keeping our U.S. economic slowdown scenario alive – as a slowing global economy in the midst of a U.S. economic slowdown can mean many negative feedback loops around the world's economies which could in turn induce a classic U.S. economic recession.”  Ominously, as the above graph suggests, global economic growth (OECD + China - Turkey) is now trending down – suggesting that the chances of a U.S. recession has just gotten a little bit higher (although we are still not looking for one at this stage).  More importantly for now, a slowing global economy has nearly always meant a decline in commodity prices, and to a lesser extent, equity prices.  Given that the consensus view is that commodities (and gold) will continue to rise going forward as the Fed cut rates, there is a now a good chance that the commodity markets could actually surprise us and turn down instead.

The deteriorating global economic growth is also being confirmed by the most recent weakness in base metal prices – a definite leading indicator of global economic growth given that much of the recent growth has been dependent on industrialization and infrastructure construction in countries like China, India, Brazil, Vietnam, United Arab Emirates – not to mention a real estate bubble in countries like the UK, Spain, France, Australia, and the US.   Following is a daily chart showing the spot prices of selected base metals with a base value of 100 on January 1, 2003:

Daily Cash Prices of Selected Metals at the LME (January 1, 2003 = 100) (January 2003 to Present) - The spot prices of copper and aluminum have probably already topped out in May 2006, while nickel probably topped out in May and tin in early August. The only base metal of consequence that is still making new highs is lead.  Given the divergence of virtually all other base metals, and given the continued weakness in silver, chances are that the up cycle in metals have topped out. In addition, this weakness in the base metals is also a good indication that global economic growth is now slowing down as well.

As mentioned on the above chart, copper and aluminum prices have most probably topped out in May 2006, while nickel made a significant top in May 2007 and tin in early August 2007.  The only metal of consequence (a metal that is not shown is zinc –  an essential ingredient of stainless steel – and which is down about a third from its November 2006 all-time highs) that is still making all-time highs is lead.  Given the divergence of all other base metals, and given the continued weakness in silver prices, chances are that:

1) The up cycle in metal prices in general have topped or is in the midst of topping out;

2) Global economic growth will at least slowdown over the next several quarters, as base metal prices have been a great leading indicator of the current global economic cycle.

While the bulls would claim that the new highs in the Baltic Dry Index is still signaling immense growth, subscribers should keep in mind that the Baltic Dry Index is merely a coincident indicator of the global economy at best – as it is just a representation of spot shipping rates of dry, raw materials.  That is, it is a representation of shipping rates for dry, raw materials that is being shipped right at this instant – raw materials that were bought as long as a few months ago, when prices were still high.  The recent decline in base metal prices suggests that the Baltic Dry Index will also start to reverse and decline over the next several months.  Moreover, a better leading indicator of global economic growth – container traffic within the Port of Los Angeles (the busiest port in the US) – is expected to be stagnant on a year-over-year basis for the rest of this year.  Given that much of the container traffic within the Port of Los Angeles is in the form of finished goods, this is a much better leading indicator of US (and to a lesser extent, global) economic growth than the Baltic Dry Index.

Moreover, not only has earnings estimates been declining in the US, but also in Europe and Japan as well.  The following chart (courtesy of Goldman Sachs) indicates that earnings estimate downgrades have been outpacing that of upgrades in Europe (ex UK), Japan and the US:

Earnings sentiment US, Europe and Japan have all seen a decline

In the meantime, the consensus in Europe is that earnings will continue to grow by more than 10% over the next 12 months (versus a 4% estimate from Goldman Sachs) – suggesting that there is still quite a bit of room for disappointment in Europe going forward.  Finally, given that profits growth in both Europe (ex UK) and Japan will most likely slow down going forward, there is a good chance that the earnings outlook for both the Dow Industrials and the S&P 500 will also come down substantially over the next several months as well.  Subscribers please stay tuned.

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 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2006 to October 5, 2007) - For the week ending October 5, 2007, the Dow Industrials rose 170.38 points while the Dow Transports rose an impressive 160.85 points. The big news of the week was the all-time highs made by the Dow Industrials on Monday. However, as can be seen on the chart, and as we have mentioned over the last 2 1/2 months, while the Dow Industrials has now retraced all of its decline since its July 19th top, the Dow Transports has continued to struggle - and has only able to retrace 42% of the decline - leaving the index still more than 8% from its all-time high. This latest action is further evidence of what we have been seeing for weeks now: that the Dow Transports continues to exhibit relative weakness versus the Dow Industrials. Note that the Dow Transports has nearly always been the stronger index over the last few years - as it has always led the Dow Industrials on the upside and had also risen more than the Dow Industrials during that period. As such, the relative weakness of the Dow Transports during the last 2 1/2 months is not a very good sign for the market.

For the week ending October 5, 2007, the Dow Industrials rose 170.38 points while the Dow Transports rose an impressive 160.85 points.  Also, as mentioned on the above chart, while the Dow Industrials has made fresh all-time highs since the decline from its July 19th top, the Dow Transports has continued to struggle, and has only been able to retrace just 42% of its decline from July 19th.  More importantly, the Dow Transports is still more than 8% below its all-time high.   Given that the Dow Transports has nearly always been the stronger index – as well as a leading indicator – ever since the cyclical bull market began in October 2002, subscribers should continue to be cautious.

Aside from a non-confirmation of the Dow Industrials by the Dow Transports, we are now also seeing a non-confirmation in the Dow Jones Utility Index.  Historically (aside from the early 2000 peak), the Dow Utilities has led the overall stock market by 3 to 12 months.  Over the last 25 years, a non-confirmation of the Dow Industrials and the Dow Transports has usually not been a good sign, as exemplified by the January 1984 top (the Dow Utilities topped out in November 1983), the August 1987 top (the Dow Utilities topped out in January 1987), the July 1990 top (the Dow Utilities topped out in December 1989), the February 1994 top (the Dow Utilities topped out in September 1993), and most recently, right before the May 10, 2006 to mid June 2006 correction, when the Dow Utilities made a significant top over 7 months prior – during early October 2005.  Note that the Dow Utilities has not made an all-time high since mid-May, when it closed at 533.54 on May 16, 2007.  That was nearly five months ago.  Last Friday, the Dow Utilities closed at 514.94 – a level that is still 3.5% from its all-time high.  Should the Dow Utilities continue to remain weak going forward, this would be another red flag for the stock market bulls.

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 15.1% to 22.0% for the week ending October 5, 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 October 5, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 15.1% to 22.0% - the largest weekly uptick since late November 2005. The important question now is: Did the reading of early September represent a bottom - both for the reading and for the stock market? Usually, an answer can be found by studying the health of the subsequent rally of a typical market correction. Given the most recent breadth and volume numbers coming out of the market, however, this author believes that we have not seen the bottom yet, and that there is a good chance we will revisit the mid August lows - despite the immensely oversold reading we witnessed four weeks ago. I also prefer to see this reading reach a more oversold levels than what we witnessed during mid August, as I did not see major capitulation during the mid August lows, and as such, we will continue to remain 50% short in our DJIA Timing System.

Note that at its most oversold level on September 7th, the four-week MA was at its most oversold level since the week ending June 30, 2006.   However – given the weakening breadth of the U.S. stock market, the inevitable slowdown of the U.S. economy due to the lingering concerns over subprime resets and Alt-A loans, and the weakening global leading indicators that we mentioned in our in the beginning of this commentary (in particular, the weakening signals coming out from the Euro Zone, the UK, and Japan), I am still inclined to think that the U.S. stock market will retest its mid-August lows before embarking on a more sustainable path upwards.  Now that the above indicator has spiked up substantially, and given that this and the all-time highs in the Dow Industrials has not been accompanied a corresponding confirmation in breadth and in other major indices, we have chosen to initiate a 50% short position in our DJIA Timing System last Thursday morning.  Should the Dow Industrials rise to the 14,200 to 14,500 area over the next few days, readers should not be surprised if we choose to shift to a fully (100%) 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 May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting a 14-month high of 152.9 in late July, the 20 DMA of the ISE Sentiment fell to an extremely oversold level of 99.9 on August 28th, which, along with the late March lows, was the most oversold level since November 4, 2002. Meanwhile, the 50 DMA rose to a 5-month high reading of 140.9 on July 19th, before finishing at 117.4 on Friday. However, the subsequent bounce since the mid August lows has been weak and narrow in scope, and while the 20 DMA remains semi-oversold, it has risen quite a bit over the last 6 weeks, and is actually now at its highest level since early August. At this point - while the 50 DMA is now at a very oversold level - this author believes that the 20 DMA (and thus the the stock market) will spike down again before we can claim *capitulation,* and so we will continue to remain 50% short in our DJIA Timing System for the time being.

Over the last six weeks, the 20-day moving average of the ISE Sentiment rallied significantly – rising from 100.5 to 130.0 as of last Friday.  Indeed, while the absolute level of the 20-day moving average is suggesting that retail sentiment is still semi-bearish (and thus neutral to bullish from a contrarian standpoint), the surge in the 20 DMA over the last six weeks – despite the mediocre breadth and volume conditions in the market – suggests that the bottom is still not here just yet.  Moreover, should the 20-day moving average and the Dow Industrials continue to rally over the next several trading days, and should this be confirmed by our other sentiment indicators, relatively weak breadth, and lack of confirmation in other major market indices (such as the Dow Transports, the Dow Utilities, the American Exchange Broker/Dealer Index, the Russell 2000, and so forth), then there is a good chance that we will go fully (100%) short position in our DJIA Timing System.

Conclusion: Aside from the “sea change” that we discussed last week on institutional behavior – as investment money started shifting from small caps to large caps, and from value to growth stocks, there is another underlying theme that is equally, if not more, important: The gradual slowing down of not only US economic growth, but also global economic growth as well, especially within the Euro Zone and Japan.  This global economic slowdown is being confirmed by our MGDI, the topping out of base metal prices, as well as the latest economic forecasts from the ECRI and the UCLA Anderson Forecast.  At the same time, earnings estimates are now being ratcheted down – not only in the US but also within the Euro Zone and Japan as well.  Going forward, both equity and commodity returns will most likely be mediocre at best.

For now, we will also continue to remain 50% short in our DJIA Timing System – but as we mentioned in this commentary, given the right circumstances, we will shift to a fully (100%) short position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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