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Look for a 50 Basis Point Cut on January 30th

(January 24, 2008)

Dear Subscribers and Readers,

I want to begin this mid-week commentary by providing an update on our 7 most recent signals in our DJIA Timing System, given that we had just instituted a new signal on Tuesday morning, when we shifted from a 50% long position to a 100% long position:

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 on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 359.83 points as of Wednesday at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 555.17 points as of Wednesday at the close.

With the 600-point reversal in the Dow Industrials yesterday, the two long positions that we had initiated over the last couple of weeks are now collectively in the green.  As I had alluded to in our discussion forum yesterday morning, I was looking for more “after shocks” to the recent market decline.  Even as the Dow Industrials declined 500 points on Tuesday morning and 300 points on Wednesday morning, the decline was “lacking teeth,” given the following:

  1. Soon after the NYSE opened on Tuesday morning, the NYSE ARMS Index (the TRIN) hit a level of nearly 5.0.  Immediately afterwards, it declined to the 1.0 level.  In other words, we were at the edge of the abyss, but we quickly about 15 minutes after the market opened.  From then on, the TRIN never flashed a “crash reading” for the rest of the day.

  2. Similarly, the VIX peaked shortly after the market opened on Tuesday.  It spiked to a lower high on Wednesday morning but calmed down substantially soon afterwards.

  3. Downside breadth was substantial during Tuesday morning but quickly dissipated throughout the day.  In particular, many of the retail names that Rick Konrad had discussed in his guest commentary last Thursday were actually in hugely positive territory (e.g. AEO closed up 10.8%, and BBBY closed up 8.2%).  From a Dow Theory standpoint, the Dow Transports also edged into positive territory sometime during the morning.

As I discussed in our most recent weekend commentary, I was looking for the market to capitulate this week.  More specifically, I stated that should the Dow Industrials gap down on Tuesday morning, I would most likely shift from a 50% long to a 100% long position within our DJIA Timing System as early as Tuesday.  With the Fed's 75 basis point behind our backs on Tuesday morning, we decided it was time to go long.  While we acknowledged that Tuesday's selling could have turned uglier, the fact that the market was declining even with a 75 basis point rate cut showed that someone or some group of investors were being forced to sell – and that, after the initial washout, a solid bottom would emerge.  With the benefit of hindsight, it now looks like one of the biggest “forced sellers” was Société Générale, as it had been forced to unwind a substantial amount of equity index derivatives.  The total loss was almost €5 billion.  Assuming SoGen had taken a 10% loss, the total long position of the trade would have been a staggeing €50 billion, or approximately $72.5 billion.  Such an outflow would have been equivalent to the sum of all U.S. mutual fund outflows during the “capitulation” months of September 2001 and July 2002.  A forced seller – especially one of this size – usually just take what price it can get, and usually takes bottom prices.  Anyone who bought stocks on Tuesday morning or during Monday on the European stock exchanges was essentially providing liquidity (or “omega” in Myron Scholes' terms) to the financial markets.  Such trades – as Warren Buffett, JP Morgan, and Jesse Livermore can attest to – usually result in substantial profits.

The question now on everyone's mind is: Did this result in a significant bottom, allowing for a resumption of the bull market that began in October 2002/March 2003, or is this going to be merely a bounce, ultimately leading to lower lows ahead?  As Bill Rempel discussed last night, this will depend on the equity index or the asset class you are discussing.  For the purpose of this discussion, we will refer to the major U.S. stock market indices such as the S&P 500, Dow Industrials, and the NASDAQ Composite.  However, as I have discussed in our recent commentaries, I continue to be overweight the U.S. equity markets– especially selected companies within the consumer discretionary and financial sectors, and Japanese small caps.  I am also bullish on Taiwan, as I believe technology – and semiconductors in particular – will outperform most stock market indices during 2008.

In order to answer this question, we will resort to another question: What if we are now in a new bear market – one that could be as ferocious as the 2000 to 2002 bear market in technology and large cap growth shares?  First of all, trendlines and moving-average crossovers aside, I believe it is still too early to conclude that we are in a new cyclical bear market.  I spoke about this at length in last weekend's commentary.  After the 75 basis point cut by the Fed on Tuesday morning, I am now more resolved than ever, as – with that cut (along with the pending Countrywide acquisition)– most of the commercial banks' yield curves are now substantially normalized.  Moreover, as discussed by a Barron's article last Saturday, it seems like the demise of the bond insurers had been grossly exaggerated.  With the New York Insurance Department assuring the markets of “providing stability” to the bond insurers yesterday afternoon, there is no doubt that the market has calmed down and made a capitulation bottom, for now.  Make no mistake: The 75 basis point rate cut, combined with New York's intervention, suggests that if a private solution fails to materialize, the government will step in and provide a solution, essentially socializing the losses in order to prevent, as PIMCO's Paul McCulley likes to put it, a “Minsky Moment.”   With the promise of a substantial fiscal stimulus now in full swing, there is no question that the “Bernanke Put” and the “Fiscal Put” is also truly alive and well.

However, even if we are in a new cyclical bear market, the conditions as of Tuesday afternoon and Wednesday morning were very oversold, even relative to market declines such as during October 1987, Fall 1998, September 2001, and October 2002.  In particular, I mentioned that by some measures, the S&P 500 consumer discretionary and financials indices were at the most oversold level since October 1990 – or during the last consumer-driven recession, and right in the middle of the fallout from the S&L crisis.  As for the NASDAQ Composite, subscribers should note that the 21-day moving average of the high-low differential ratio just touched -8.63% - an oversold reading not seen since November 11, 1987, when it touched a low of -8.80%.  Following is a chart showing the NASDAQ Composite vs. the 21-day MA of the high-low differential ratio from January 1978 to the present:

21-Day Moving Average of the NASDAQ High-Low Differential Ratio vs. the NASDAQ Comp (January 1978 to Present) - The 21 DMA of the NASDAQ Comp High-Low Differential Ratio just touched a reading of -8.63%, the lowest reading since November 11, 1987, when it touched a record low of -8.80%.

Should the NASDAQ Composite continue to exhibit weakness over the couple of days, there is no doubt that this reading would break its record low of -8.80%.  As a matter of fact, the daily reading of the NASDAQ Composite high-low differential ratio touched a reading of nearly -30% at the close on Tuesday – its most oversold reading in the history of the NASDAQ!  The last time the NASDAQ Composite had a similarly oversold reading (its second most oversold reading, when it touched -25.08% on September 28, 1981), the index would go on to rally nearly 11% over the next month.

Given that the Fed Funds futures has now priced in a 50 basis point ease on January 30th, the U.S. stock market could very well make a new low should the Fed surprise with a lesser cut, similar to the reaction to the “disappointing” 25 basis point ease on December 11, 2007.  The question is: Will the Fed cooperate with the market and ease by 50 bps next Wednesday?  My answer to that is “Yes.”  First of all, despite the surprise (at least to some folks) 75 bps rate cut on Tuesday, the U.S. Dollar Index failed to tank, even as the ECB and the Bank of England continued to reiterate that they will not follow in the Fed's path.  Moreover, since the 75 bps cut, the long-end of the Treasury yield curve has continued to decline, signaling: 1) no signs of inflation or capital flight, and 2) that more investors are pricing in the chances of a recession, despite the Fed's move.  In addition, the TED Spread (the difference between 3-month LIBOR and 3-month Treasury bill yields) is still at an elevated level of 1.13% - up from 1.11% as of last Friday.  In fact, as shown in the following chart, the five-day moving average of the TED Spread actually rose to 1.09% as of the close yesterday, compared to a reading of 0.96% last Friday.

5-Day Simple Moving Average of the TED Spread (January 1997 to Present) - The TED spread hit a 20-year high in mid December, but has since declined back to the 1.09% level. Should the Fed ease by 50 basis points on January 30th, there is no doubt this will ease back to below the 1.0% level, which is where the Fed likes it and where it has been over the long-run. The inevitable decline in the TED spread not only suggests that liquidity issues are now gone, but most probably that we have already witnessed a significant low in the U.S. stock market.

As mentioned in the above chart, given where the TED spread is today versus its historical averages, it makes perfect sense for the Fed to again ease the Fed Funds rate – which would (hopefully) lead to a lower LIBOR going forward.  Should the Fed fail to cut by 50 bps next Wednesday, it will be seen as an overly restrictive move, especially if the TED spread remains consistently above 1.0%.

Meanwhile, the latest monthly reading of the ECRI's Future Inflation Gauge just touched a 31-month low on January 4th.  In its press release, ECRI stated: “U.S. inflation pressures reached a 31 month-low in December due mostly todisinflationary moves in measures of commodity prices, loans, jobs and interest rates, a report said on Friday, paving the way to further interest rate cuts by the U.S. Federal Reserve.”  Given the most recent decline in oil prices, Japanese exports, other commodities, as well as the Baltic Dry Index, I also believe that the Fed has more room to cut rates next week – even if the cut is as large as 50 basis points.

I will now like to leave our readers with one last chart, courtesy of the Bank Credit Analyst:  In the following chart, the BCA asserts that a recession has already been priced into “risky assets” – such as corporate bonds, equities (especially small caps), and even the Fed Funds futures, which is now pricing in a 2% Fed Funds rate by next January – a level that is consistent with a mild recession in the U.S.  Should the U.S. fail to enter a recession sometime this year, then both equities and corporate bonds (especially high-yields) will probably soar going forward.

Bank Credit Analyst

Signing off,

Henry To, CFA

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