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“The Conundrum” in Reverse?

(October 14, 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 October 4, 2007 at 13,956, giving us a loss of 137.08 points as of Friday at the close.

As of Sunday evening on October 14th, we are 50% short in our DJIA Timing System (subscribers can review our historical signals at the following link).  In our “Special Alert” on the morning of October 4th, we briefly discussed our reasons for going 50% short in our DJIA Timing System.  I had briefly discussed them again in last weekend's commentary, and as a result, would not repeat them here, but as of Sunday evening, two of the three reasons are still valid.  The one reason that has been invalidated – the continuing strength in both the Shanghai and Hong Kong stock markets – has the least influence in our decision to go short in our DJIA Timing System.  In fact, one could even argue that a stronger Chinese and Hong Kong market would attract more capital away from the US market, as exemplified by a recent Morningstar article describing how many mutual fund managers with a domestic mandate are now trying to take advantage of the boom in Chinese shares by buying up shares on the local exchanges, Chinese ADRs or companies that do a great deal of business with the Chinese. 

For now, the most important reasons for us staying 50% short in our DJIA Timing System (and potentially going 100% short) remain technical in nature.  Moreover, given that most of the world's economies are now slowing down (as signaled by declining readings in our MarketThoughts Global Diffusion Index), and given the increasing bullish readings in our sentiment indicators this week, the overall case for a short position in our DJIA Timing System just became significantly greater.  Aside from the latest readings in our MGDI, another leading indicator of economic growth (container traffic within the Port of Los Angeles, which we discussed in last weekend's commentary), had also been signaling weaker economic growth going forward.  These readings are also being confirmed by the recent weakness in US railroad car loadings, as shown in the following chart courtesy of Reuters EcoWin:

United States, Railroad Traffic

Aside from total railroad car loadings in the US, I have also shown the rate of growth for the top four types of goods that are shipped on US railroads today, those being: coal, chemicals, grain, and motor vehicles & equipment.  Interestingly, even coal shipments – the one category that has had the strongest growth since early 2004 – is now seeing negative growth.  The only major category that is experiencing growth is chemicals (it is thus of no surprise that third quarter margins of all major chemical companies exceeded the consensus).  Given that railroad companies had been the strongest industry within the Dow Transports over the last 12 months, my guess is that we have seen the top in the Dow Transports in mid July – and at some point, this will put pressure on the Dow Industrials as well.

However, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last 7 weeks, there is a good chance that the Dow Industrials will 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.  Last week, I happened to drop by into an old camera store in South LA.  The owner of the store was a fellow in his late 50s who had been collecting older cameras since the mid 1970s.  Most of them were bought at estate sales.  Some of these cameras dated back to the 1870s, but the most amazing part was this: Modern photography technology had essentially remained unchanged ever since George Eastman pioneered the use of photographic film in the late 1880s.  35mm film, meanwhile, had been around since 1914.  Virtually all the older cameras were in fine working condition, which meant that with the right size film, and under the right conditions, we could have started taking and processing pictures with the older cameras that dated back to the late 19th century.  However, over 100 years after the arrival modern photography, digital cameras revolutionized the industry in only a decade.  The arrival of the first true digital camera came in 1990.  Kodak itself marketed a digital camera with a 1.3 mega pixel resolution for $13,000 in 1991.  Mega pixel digital cameras were generally not available for the consumer market until 1997, however, less than 10 years later, Nikon would announce a nearly complete exit out of the film market.  Moreover, it is estimated that over 90% of all cell phones manufactured today carries a digital camera.

To paraphrase Nassim Taleb in his excellent work “The Black Swan,” history, and especially technology, does not move in a linear or consistent way, but make unpredictable jumps.  Too often, most of us get comfortable with a way of life (or a certain technology) that has been the prevalent technology for at least over a generation, and are thus blindsided when it is replaced by something totally different, but more effective.  Fans of Joseph Schumpeter would label this phenomenon as “creative destruction.” 

Such phenomena can be constantly witnessed in the financial markets.  The collapse in liquidity of the CDO and asset-backed market is a prime example.  While most quants would call this a “six-sigma” event, it is anything but.  Of course, there are always true “100-year events' in the financial markets, such as the October 19, 1987 crash, the true rise of the emerging markets as a respectable investment class in recent years, and the Russian Default in 1998, the first time that a country has defaulted on debt that was denominated in its own currency.  Another similar event occurred manifested itself starting in June 2004 as the U.S. long Treasury yields failed to decline despite the beginning of Fed tightening.  This was the so-called “Conundrum.”  Quoting Alan Greenspan in his latest biography “The Age of Turbulence”:

I was perturbed because we had increased the federal funds rate, and not only had yields on ten-year treasury notes failed to rise, they'd actually declined.  It was a pattern we were accustomed to seeing only late in a credit-tightening cycle, when long-term interest rates began to fully reflect the lowered inflationary expectations that were the consequence of the Fed tightening.  Seeing yields decline at the beginning of a tightening cycle was extremely unusual … Unexplainable market episodes are something Fed policymakers have to deal with all the time.  On many an occasion I have been able to ferret out the causes of some peculiarity in market pricing after a month or two of watching the anomaly play out.  On other occasions, the aberration has remained mystery.  Price changes, of course, result from a shift in balance between supply and demand.  But analysts can observe only the price consequences of the shift.  Short of psychoanalyzing all market participants to determine what led them to act as they did, we may never be able to explain certain episodes.  The stock-market crash of October 1987 is one such instance.

… I did not come up with an explanation for the 2004 episode, and I decided that it must be another odd passing event not to be repeated.  I was mistaken.  In February and March of 2005, the anomaly cropped up again.  Reacting to continued Fed tightening, long-term rates began to rise, but just as in 2004, market forces came into play to render those increases short-lived.

What were those market forces?  They were surely global, because the declines in long-term interest rates during that period were at least as pronounced in major foreign financial markets as they were in the United States.  Globalization, of course, had been a prominent disinflationary force since the mid-1980s … With the new millennium, signs of it [disinflationary forces] became increasingly evident, even among development countries whose histories were rife with inflationary episodes.

But even though globalization had reduced long-term interest rates, in the summer of 2004 we had no reason to expect that a Fed tightening would not carry long-term rates up with it.  We anticipated that we would just be starting from a lower long-term rates than was customary in the past.  The unprecedented response to the Federal Reserve's monetary tightening that year suggested that in addition to globalization, profoundly important forces had developed whose full significance was only now emerging.  I was stumped.  I called the historically unprecedented state of affairs a “conundrum.”  My puzzlement was not assuaged b the numerous bottles of Conundrum-label wine arriving at my office.

I encourage readers to read “The Conundrum” chapter in Greenspan's biography in full.  Greenspan would go on to discuss the deflationary forces in the world's labor markets as a result of continued globalization, as well as the proportionally high savings rates of the developing countries.  Coupled with the lack of investments that had been made in the developed world over the last few years (as demonstrated by the large corporate cash flow that had been returned to shareholders), and thus it is no surprise that interest rates declined across the world.  However, Greenspan is definitely a realist, as discussed in the following excerpts from the same chapter:

… These data are consistent with the notion that this decade's decline in long-term interest rates, both nominal and read, is mainly the effect of geopolitical forces rather than that of the normal play of market forces.

If developing countries continue to grow at a rapid rate and financial networks expand to lend more readily to the increasing number of citizens with rising discretionary incomes, developing-country savings rates are bound to fall, at least back to 1980s and 1990s levels.  The inbred human desire to keep up with the Joneses is already manifest in the nascent consumer markets of the developing world.  Increases in consumption would tend to remove the downward pressure of excess savings on real interest rates.  But that would likely occur even if the rate of growth of developing country incomes should slow.  In all economies, spending rarely keeps up with unexpected surges in income; hence savings rates rise.  As income growth slows back to trend, savings rates tend to fall.

So, as erstwhile centrally planned workforces complete their transition to competitive markets, and as developing countries' increasingly sophisticated financial systems facilitate the inbred propensity toward higher consumption and less saving, inflation, inflation premiums, and interest rates will gradually lose their disinflation buffer of the past decade.

In a press release that we issued in April 2006, we discussed that the secular bull market in the US long bond was over, citing four major reasons: 1) The end of the quantitative easing policy in Japan, 2) The general lack of investment and the cash hoarding by US corporations were getting excessive and were not sustainable, 3) There was significant evidence of rapidly increasing labor costs in both China and India, and that wage concessions with US unions were in the final innings, 4) Unless crude oil spikes to nearly $100 a barrel over the next few years, the recycling of OPEC petrodollars would have a diminishing effect on bond prices across the world.

Here in, we continue to believe that interest rates bottomed out in mid 2003.  Aside from what Greenspan cited in his biography and what we cited in or April 2006 press release, another major reason for rising interest rates going forward is the unexpected rise in the U.S. budget deficit, which is projected to rise by more than 50% to $220 billion in the fiscal year that started this month.  Moreover, as countries like the UK, France, and Spain slow down from the end of their respective housing booms over the next 12 months, there is no doubt that their budget deficits would also rise going forward as well, especially given the out-of-control social welfare spending in the latter two countries.  Finally, as we mentioned in our mid-week commentary last week, Germany will not be immune to this either.  The fully reversal of “the Conundrum” has not occurred yet, but it will be by later this decade.  When the time comes, you definitely do not want to be invested in long-dated bonds.  As an aside, the defined benefits pension plan industry will also be decimated, as pension plan sponsors will have a huge incentive to terminate their pension plans once Treasury rates increase to the 6% to 7% area (resulting in huge cost savings to annuitize their plans).

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 12, 2007) - For the week ending October 12, 2007, the Dow Industrials rose 27.07 points while the Dow Transports actually declined 56.41 points, further stretching the underperformance of the Dow Transports vs. the Dow Industrials dating back to mid July. However, as can be seen on the chart, and as we have mentioned over the last 3 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 35% of the decline - leaving the index still more than 9% from its all-time high. 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 3 months is not a very good sign for the market.

For the week ending October 12, 2007, the Dow Industrials rose 27.07 points while the Dow Transports continued to underperform, declining 56.41 points for the week.  Again, 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 35% of its decline from July 19th.  More importantly, the Dow Transports is still more than 9% below its all-time high.   Given the weakness of the railroad loadings that we discussed above, and 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 535.72 on May 21, 2007.  That was nearly five months ago.  Last Friday, the Dow Utilities closed at 519.39 – a level that is still 3.0% 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 22.0% to 27.6% for the week ending October 12, 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 12, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 22.0% to 27.6%.  This reading is now at its most overbought since late February, or right before the 500-point decline in the Dow Industrials due to initial subprime concerns. Coupled with the relatively weak breadth and volume numbers coming out of the market recently, this author believes that there is a good chance we will revisit the mid August lows - despite the immensely oversold reading we witnessed five 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, and possibly moving to a fully (100%) short position should the Dow Industrials continue to rally in the coming days.

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 had mentioned in the last couple of commentaries (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 (it is now at its most overbought level since late February, right before the 500-point decline in the Dow Industrials due to initial subprime concern), 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 will stay with our 50% short position in our DJIA Timing System.  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 122.3 on Friday. However, the subsequent bounce since the mid August lows has been weak and narrow in scope, and more ominously, 20 DMA is no longer oversold, and is actually now at its highest level since August 1st. While the 50 DMA is still oversold - 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 7 weeks, the 20-day moving average of the ISE Sentiment rallied significantly – rising from 100.5 to 140.5 as of last Friday.  More importantly, the absolute level of the 20-day moving average is suggesting that retail sentiment is no longer bearish, and given this and the continued mediocre breadth and volume conditions in the market – my guess is that we will revisit the August lows at some point over the next 3 to 6 months.  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: Further evidence of a global economic slowdown continues to materialize.  Coupled with the many divergences that we are continuing to witness in the U.S. stock market, my guess is that both equity and commodity returns will most likely be mediocre at best.  As for long bond rates, we continue to believe that they collectively bottomed out in mid 2003, and that after the current global economic slowdown, worldwide rates will most likely make a new high for this decade.  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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