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Putting Things into Perspective

(January 27, 2008)

Dear Subscribers and Readers,

I realize that the events over the last few weeks have been very difficult and frustrating for many of our subscribers.  This has been by far the most difficult market for retail investors since we started writing regularly in August 2004.  In a way, this has been a test for us as well.  So far, I would argue that we have passed our test admirably, as our 7 most recent signals in our DJIA Timing System can attest to:

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 422.83 points as of Friday at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 492.17 points as of Friday at the close.

While our two latest signals are just barely in the green, we are glad that we were able to go 50% short in early October at a DJIA print of 13,956 – and to close out that position in early January for a gain of 1,326 points.  For those who like to avoid shorting/hedging as an investment or trading strategy, you would have also avoided the general volatility and gut-wrenching feelings that most investors experienced over the last few months if you had stayed in cash.  More importantly – having avoided the dramatic decline over the last few months – this would've put you in a great psychological position/advantage in going long early last week.  Even had the stock market declined another 10%, you would have still been better off than most investors.  Unless you believe the U.S. is entering a severe recession (I have discussed why this is a low probability event in our last few commentaries), chances are your portfolio would outperform bonds/treasury bills by a significant margin over the next several years.

To recap: The purpose of MarketThoughts.com had always been to empower investors – to “democratize” finance and to help our readers maximize gains during a bull market and to protect assets during unfavorable market climates.  We do not profess to be innovators when it comes to doing market or economic research.  Rather, we read and aggregate a huge/diverse amount of original research and subsequently come up with our own views on where the financial markets and certain asset classes are heading.  We also help provide insights into the factors that will affect the stock market and individual stocks – focusing on both fundamentals and technicals of the current stock/financial markets, as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.  So far, I believe we have satisfied these goals.

I believe it is at times like these where you would have to trust us.  Sure, I believe I have already provided enough evidence suggesting that the U.S. stock market (in particular consumer discretionary and financials shares) had already discounted a mild U.S. recession at the beginning of last week.  Moreover, I do not believe a U.S. recession, even a mild one, is inevitable at this point.  I also do not believe for one second that you should place your financial trust into the analysts or newsletter writers who: 1) missed the top in either mid July or early October, stayed long through the first week of January, and are only urging investors to get out now, or 2) were too early, warning of an inevitable peak in the markets as early as 2006, and have only been “vindicated” over the last few months.  This also applies to economic forecasters – the economists who have been optimistic all along and who have just been recently revising their economic forecasts are simply too late, and should be ignored.  In terms of economic forecasts, subscribers should only pay attention to four leading outfits/indicators: 1) The ECRI Weekly Leading Index (“WLI”).  The ECRI has been one of the most accurate economic forecasters over the last 20 years.  Moreover, as the name of their indicator implies, the beauty of their U.S. economic leading indicator is that it is updated on a weekly basis, 2) The Conference Board's monthly leading indicators, 3) The OECD leading indicators – this is slightly delayed but aside from a U.S. economic leading indicator, the OECD also provides leading indicator readings (using a consistent methodology) for over 30 major economies around the world, and 4) The UCLA Anderson Forecast, which is released on a quarterly basis, but is again, one of the most accurate economic forecasters over the last 20 years.  In particular, the ECRI Weekly Leading Index (of which I am a subscriber) had been weakening since late August 2007.  In late November, it started to dive dramatically – implying a dramatically weakening U.S. economy 6 to 12 months out, or sometime in late May 2008 and onwards.  Amazingly, no one (and certainly not the mainstream media) paid heed to their advice until it was too late.

At this time, none of these four leading services/indicators are predicting a U.S. economic recession just yet.  In particular, the ECRI, in their “special supplement” last Friday, stated that there was still a window of opportunity for policy makers to fend off a recession, as long as any stimulus (either from the Fed or Congress) is done quickly and efficiently.  Moreover, one of the most crucial factors that have typically led a classic U.S. recession – high inventory levels – is conspicuously missing from the current cycle.  More importantly, not only had the U.S. inventory-to-sales ratio failed to rise over the last few months (which was the case immediately prior to the March 2001 to September 2001 recession), but had actually declined to a new low as of the end of November 2007:

U.S. Inventory-to-Sales Ratio for all Businesses (Seasonally Adjusted) (January 1998 to November 2007) - The I-S ratio actually declined to a new low of 1.24 during November 2007 - owning to suprising economic strength during 3Q 2007 and prevalent pessimism of the US economy over the last six months. More importantly, the I-S ratio is significantly lower than where it was in the beginning of the March to September 2001 recession, when it reached a level of 1.42 immediately preceding the recession.

The “inventory cycle” has historically driven the U.S. into past recessions.  That is, manufacturers have historically tended to be too optimistic even as demand starts to slow down – subsequently prompting a severe cutback in production and layoffs to work off excess inventories.  This was also the case immediately prior to the March to September 2001 recession, as inventories had started to mount since the beginning of 2000.  In the current cycle, however, this had not been the case.  In fact – owning to surprising economic strength in the third quarter of last year, as well as continuing pessimism among manufacturers and retailers alike during the second half of 2007 – inventory levels (as indicated by the inventory-to-sales ratio) actually declined to a record low as of the end of November 2007.  Combined with a very weak U.S. dollar this time around (by comparison, the U.S. dollar had been very strong going into the March to September 2001 recession), there is a very strong chance that the U.S. could avoid a recession by using any excess production to “export its way out” of a recession.

So what now?  As I discussed in our mid-week commentary, financial assets (especially consumer discretionary and financial shares) are now pricing in a mild U.S. recession.  Also, I believe the Fed will ease by 50 basis points on Wednesday.  As discussed in our mid-week commentary, the markets is still “screaming” for a 50 basis point ease. Not only is the Fed Funds futures market projecting for a 50 basis point ease, but the still-elevated levels of the “TED Spread” (the difference between three-month LIBOR and three-month Treasury yields) still suggests for such a significant easing, as shown in the below chart:

5-Day Simple Moving Average of the TED Spread (January 1998 to Present) - The TED spread hit a 20-year high in mid December - and has managed to decline back to the 1.05% level on the back of the recent easing and liquidity injections by the Fed. Despite the recent 75 bps ease by the Fed, the 5-day MA of the TED spread remains at a relatively high level of 1.13% - suggesting that the Fed should again ease this Wednesday. 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. This inevitable decline in the TED spread not only suggests that liquidity issues are now gone, but that we have already witnessed a significant low in the U.S. stock market.

Despite the 75 basis point easing by the Fed early last Tuesday, the 5-day moving average of the TED spread still remains at an elevated level of 1.13% (actually up from 0.96% from the Friday prior to the easing).  Given that the TED usually trades below the 100 basis point level (and more often below the 50 basis point level) during “normal market conditions,” there is no doubt that the Fed would ease by 50 basis points this Wednesday (keep in mind that the next schedule meeting after January 30th isn't until March 18th)  – which should, hopefully, bring an end to the current panic in the global financial markets.

Moreover, inflationary pressures are also starting to decline to a level (per the latest Future Inflation Gauge readings from the ECRI) that is conducive to a 50 basis point easing.  As we discussed in our December 9, 2007 commentary (“Global Economic Growth Continues to Disappoint”), the latest readings of our MarketThoughts Global Diffusion Index (“MGDI”) is also confirming the inevitable decline of not only global economic activity, but also general commodity and energy prices as well.  Such a trend can already be witnessed in the recent trend of base metal prices, as shown in the below chart:

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 most probably already topped out in May 2006, while nickel probably topped out in May 2007. The only base metals of consequence that have still been making new highs over the last four months are lead and tin, but even lead has declined significantly over the last two months. Given the divergence of the base metals, and given the continuing weakness in our MGDI, 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 inflation pressures are declining as well.

Moreover – according to the latest “Global Oil Report” from PIRA Energy Group, should the U.S. experience a mild recession over the next six months, U.S. inventory levels of crude oil by the end of the second quarter should be at a level close to the high-end of its five-year range – even if OPEC decides to implement a one million barrel per day output cut at its April 1st meeting.  Their base forecasts are now calling for an $85 WTI oil price by April, and $75 by this summer.  No matter what happens going forward, the current crude oil price of $90 a barrel is likely to decline over the next six months – thus putting less pressure on inflation and potentially boosting consumer spending outside of gasoline and other petroleum products.  Finally, given the latest unemployment readings and the flexibility of the U.S. labor markets, this author currently does not see any “second-round” inflationary effects emulating from the labor markets – unlike what is currently transpiring in the Euro Zone (and over which the ECB is so worried about).

Assuming that: 1) the Fed ease by 50 basis points this Wednesday, 2) the fiscal stimulus is enacted by Congress and put into place by May, and 3) the GSE conforming limits are raised in California and Florida by the end of next month, there is a good chance that the U.S. economy will avoid a recession.  Even if the U.S. does experience a mild recession sometime this year, I believe the downside in stock market prices is limited at current levels (my guess is that we will see a bottom in the Dow Industrials at approximately the 11,500 level should we experience a mild recession).  In the meantime, subscribers should continue to expect more “tremors” in the stock market going forward, as “weak hands” who were going to sell last Tuesday deferred their selling in light of the 75 basis point cut in the discount and Fed Funds rates.  However, I continue to believe that the “capitulation bottom” of last Tuesday will hold going forward.

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 January 25, 2008) - For the week ending January 25, 2008, the Dow Industrials rose 107.87 points while the Dow Transports rose a whooping 295.12 points, or more than 7%. The recent strength of the Dow Transports, coming off from only a 7-point decline during the week prior (when the Dow Industrials declined more than 500 points) - is very reassuring from a Dow Theory standpoint, as the Dow Transports had been a major leading index of this bull market since October 2002. Once again, this author is now bullish on the major US market indices, based on two overriding ideas: 1) The fact that we have seen a capitulation* in the US financials and consumer discretionary sectors, as well as in the European markets where we saw a liquidation of a $72 billion position early last week, and 2) Our view that the Fed will continue to ease going forward, starting with a 50 bps cut in the Fed Funds rate this Wednesday. Bottom line: Subscribers should continue to be cautious, but I believe we have at least made an important intermediate-term bottom as of early last week.

For the week ending January 25, 2008, the Dow Industrials rose 107.87 points while the Dow Transports rose an astronomical 295.12 points, or more than 7%.  The strength of the Dow Transports over the last two weeks is very telling (especially in light of high oil prices), as the Dow Transports has been the leading index since this cyclical bull market began in October 2002.  Coupled with the severe oversold condition in the U.S. and global stock markets early last week, there is a very good chance that we have already seen a bottom early last week, even though retail investors should continue to be jittery over the next several weeks.  For now, we will stay 100% long in our DJIA Timing System.

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 from last week's -0.4% to -6.1% for the week ending January 25, 2008.   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 January 25, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios embarked on another major decline - declining from -0.4% to -6.1%, and is now below its five-year *trading range.* Specifically, this reading is now at an oversold level not witnessed since early April 2003. Moreover, the 10-week MA (not shown) is now at 2.5% - representing the most oversold reading since May 2003. Given the postive divergenc in the Dow Transports we witnessed in the last couple of weeks, along with the SoGen liquidation of its $72 bilion position in the European markets, I expect the market to have bottomed out last week and to enjoy a substantial rally over the next several months. At this point, we will stay 100% long in our DJIA Timing System.

With the reading at -6.1%, the four-week MA is now extremely oversold, and has surpassed the hugely oversold readings that we got during June 2006, and is now approaching the readings we witnessed during March 2003.  Given this and other factors we have previously discussed, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should the Fed ease by less than 50 basis points next Wednesday.

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 3-month high of 143.4 on October 15th, the 20 DMA of the ISE Sentiment has declined to the 103.2 level, an oversold level not seen since August 30, 2007.  More importantly, both the 20 DMA and the 50 DMA are now severely oversold, and are consistent with levels achieved during various market bottoms over the last 18 months. Should the 50 DMA decline another point over the next few days, then the 50 DMA would be at a low not seen since November 2002. I continue to believe that there is little downside here. For now, we will stay 100% long in our DJIA TIming System.

With the 20-day moving average of the ISE Sentiment Index declining to 103.2 and the 50-day moving average to 111.8 in the latest week, the ISE Sentiment Index is now extremely oversold and has “sold off” to a level that is consistent with various market bottoms over the last 18 months, and are now close to declining to levels not seen since November 2002.  Given the capitulation bottom that we saw last Tuesday, and given the oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, I believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500.  Again, this assumes that the Fed will ease by 50 basis points this Wednesday.  For now, we will stay with our 100% position in our DJIA Timing System.

Conclusion: As we mentioned in last weekend's commentary, the only true advantage that most of you have is your investment horizon and in adopting a long-term view, since most of you do not need to report quarterly numbers to your investors and so have no pressure to outperform in the short-run.  If you sell out now, you will not only lose that only advantage, but would also fall prey to the mainstream media as well.  This is how most investors lose money and/or underperform the S&P 500 over the long-run.  Put another way, you cannot expect to outperform cash or bonds unless you put up with the additional risk or volatility – but if you can stay with your stocks through “thick and thin” then you (assuming you're diversified) should be richly rewarded for it over the long-run.  Since 1978, there have only been five down years in the S&P 500, with those being 1981, 1990, 2000, 2001, and 2002.  During three of those five years (1981, 1990, and 2000), the S&P 500 was down less than the 2008 YTD total return of -9.61%.  Unless you are betting that this is “the big one” (which I am definitely not, unless the Federal Reserve or the Administration makes some major policy mistakes), then chances are that the S&P 500 will end 2008 higher than where we are today.

For now, we will stay with our 100% long position in our DJIA Timing System.  I also continue to be bullish on U.S. consumer discretionary and certain financial shares (please see Rick Konrad's latest guest commentary for some suggestions on the consumer discretionary/retail side).  We will only look to par down our positions should the Fed or Administration make some major policy mistakes (such as not easing by 50 basis points this Wednesday or failing to get the fiscal stimulus through Congress in time) or should the rescue of the “monoline” bond insurers fail to work.  In terms of overseas markets, I am bullish on Japanese small caps (and most Japanese companies with a domestic focus) as well as Taiwanese shares.  Given the tremendous valuations (not to mention its hugely oversold condition) we are now seeing in the Japanese stock market, I think it is now time to start nibbling on Japanese equities.

Signing off,

Henry To, CFA

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