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MarketThoughts’ Roadmap for the Next Six Months

(April 20, 2008)

Note: The National Geographic has just done a great feature on China.  The following video featuring the rise of the Chinese middle class (courtesy of our poster rffrydr at our MarketThoughts discussion forum) is a must-see.

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 7 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 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 gain of 219.36 points as of last week at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 1,134.36 points as of last week at the close.

As of the close last Friday, both our latest buy signals in our DJIA Timing System are in the green.  Readers who are interested in the historical performance (as of March 31, 2008) of our DJIA Timing System can refer to our comments from a couple of weeks ago (The End of “Market Fundamentalism”).  Excluding dividends, our DJIA Timing System returned 13.76% over the last 12 months, beating the Dow Industrials return of -0.74%, and with lower volatility.  Again, our next update would be for the period ending June 30, 2008 – with a move to a semi-annual update schedule thereafter.

Before we go on and outline our thoughts for where the markets are heading in the next six months, I want to do some “house cleaning.”.  Specifically, in response to subscribers' assertion that demographics may not do much to alleviate the housing crisis (i.e. will the creation of an extra 150,000 households a year really make a difference, given that home sales are currently running at around 6 million a year?), subscribers should remember that one should always focus on available stock (inventory), as opposed to volume (or turnover in houses) as a sign of  potentially bottoming housing prices.  While volume had been a leading indicator of declining housing prices over the last six months, it is always existing and new housing inventory, general income levels, and demand that will have a bigger impact on housing prices going forward.  According to the IMF, new homes inventory is currently running at slightly less than 500,000 homes, as shown in the below chart:

Inventories of New Homes (1970 to January 2008)

If we include existing homes, total inventory for single-family homes in the U.S. is currently around 2.25 million, up from 2.2 million a year go and from 1.55 million a couple of years ago (source: Census.gov).  Giving that existing housing starts (see our mid-week commentary last week) are currently running around 500,000 to 600,000 (on an annualized basis) below the historical average, a 150,000 increase in annual demand for single-family homes suddenly does not seem so trivial.  More importantly – should the U.S. government's plan to grant tax credits to first-time homebuyers come to fruition, this could potentially push younger homebuyers (more of the Y-gens) into buying homes sooner rather than later.  As far as I know, no one has tried to model the effects of a $5,000 to $10,000 tax credit for first-time homebuyers (one reason is that there is no historical precedent for this) – but this could have a substantial impact on reducing existing housing inventories and cushioning housing prices over the next 12 months, especially given the dramatic increases in the housing affordability index over the last six months, as shown in the following chart from the IMF:

Housing Affordability (1970 to January 2008)

Again, I am not calling for the end of the housing correction just yet.  The purpose of my arguments in this commentary, as well as in our mid-week commentary last week, is merely to suggest that there are significant and countervailing forces to the current decline in U.S. housing prices – most of which should be taken seriously by the housing bears.  In the meantime, subscribers should keep an eye on the inevitable Option ARMS resets starting in mid 2009, but given that this is still 14 months away (and is a well-publicized fact), it is still too early to factor this into your general investment decisions, unless one is thinking of investing in companies that are holding these securities, such as Wachovia or Washington Mutual.  Another data point that needs tracking is global economic growth.  If global economic growth starts to falter – then some of our higher-priced markets that have gotten support from foreign buying, such as parts of Los Angeles and Manhattan, may start to weaken as well.

Let us now discuss our roadmap for the next six months.  First of all, here is my current perspective on the stubborn rise in LIBOR.  The latest rise in LIBOR last Friday occurred before the latest Bank of England's US$100 billion plans to reliquify the British banking system became news.  Aside from allowing banks to borrow from the Bank of England by swapping high-quality mortgages assets as collateral, this plan will also allow banks to post unsecured credit card debt as collateral.  The latter was unexpected, and should definitely alleviate the upward pressure on LIBOR.  Moreover, the Bank of England and the UK government – in return – is also asking banks to prop up their balance sheets.  Again, there is no lack of capital on the sidelines and certainly not in the government coffers or in institutions such as the IMF or sovereign wealth funds.  My sense is that the Bank of England announcement will come with a promise to do more should strains in the UK financial system fail to abate.  More importantly, investors have continued to show interest in taking significant stakes in banks (albeit at significant discounts as the latest $6 to $8 billion National City injection demonstrates), suggesting that LIBOR will definitely come down at some point.  In the unlikely scenario that the Pound Sterling come under attack, the Bank of England can always be backstopped by the IMF - which has a $300 billion balance sheet (if you mark to market their 100 million ounces of gold from $9 billion to $90 billion) and which is desperate to increase their loan portfolio and make themselves relevant again.  While this is not a good development for common stock shareholders in many of these institutions, this is definitely a good development for the global financial system as a whole and no doubt for the global economy as well.  Finally, according to Bank of America, the leveraged loan backlog sitting on banks' balance sheets has declined dramatically from approximately $240 billion last summer to just over $100 billion as of last week.  Assuming that Deutsche Bank goes through with its latest scheme to get rid of about $15 to $20 billion of LBO debt from its balance sheets, the total global leveraged loan backlog could easily decline to under $90 billion by the end of this month.  Sensing this, the leveraged loan market rallied substantially last week, and is no longer a significant drag on the financial and equity markets.

Second of all, I expect the rally in the S&P 500 to continue for the next several months, as the record amount of capital on the sidelines come back to the financial markets and as the effects of the “fiscal stimulus” kicks in.  With regards to the latter – despite the many surveys concluding that the majority of Americans will either invest/save their rebate checks or use them to pay down debts – subscribers should remember the adage that we should watch what we do, not what we say.  There is no question that many of us mean well, but the 2001 experience shows otherwise.  All of us would like to save, but we just do not have the discipline.  Similar to the 2001 “tax rebate” experience, my sense is that much of the fiscal stimulus would have already been spent on discretionary goods/services six months after the checks are mailed out, especially since we are already in a lower interest rate environment relative to when the tax rebates were mailed out during 2001.  Based on a recent study by the IMF (see page 73 of the IMF's latest World Economic Outlook) – a fiscal stimulus of this size, combined with monetary easing – is definitely significant in terms of its ability to assist GDP growth 3 to 12 months down the road.

In light of the soon-to-be-implemented fiscal stimulus and in light of its recent “rescue operations” of the U.S. financial system (and now with the last holdout, the Bank of England, following in its footsteps), my sense is that the Fed Funds rate will be close to its neutral rate (per the Taylor Rule) assuming that the Federal Reserve cuts the Fed Funds rate by 25 basis points to 2.0% at its April 30th meeting.  That is, there is a good chance that the Fed will shift to a more neutral position at its April 30th meeting – indicating that continued monetary easing is no longer a given going forward.

Should this come to pass (as of Friday, the Fed Funds futures contract was implying an 82% chance of a 25 bps cut and an 18 chance of not cut on April 30th), then there is a good chance that the U.S. dollar will find a firmer footing over the next several months.  More importantly, given the fact that many European banks have not been obliged to disclose their subprime losses as quickly as the U.S. banks, it is safe to assume that the majority of subprime losses that will be disclosed over the next 3 to 6 months will come from banks in the Euro Zone, as opposed to banks in the US.  Coupled with the weakening Euro Zone economy (which should put pressure on “second-round” inflationary pressures such as significant wage increases), there is a good chance that the ECB will start easing its overnight rates sometime in the second half of this year.  More importantly, given that the G-7 has threatened to intervene in the currency market should the Euro rise further against the US Dollar, my sense is that there is not much further upside in the Euro at current levels.  Should the Euro spike to $1.60 or so prior to the April 30th Fed meeting, then this author will not hesitate to go short the Euro against the US Dollar.

At this point, the greatest risk to the global economy and financial markets is the continuing rise in crude oil and food prices, as has been advertised in all major publications.  More worryingly, the latest rise in food prices has been exacerbated by flawed government policies across the world (such as higher export quotas, penalties, including life in prison, for food hoarding, food price controls, etc.) – even though we realize these are political steps that were necessary in many of these countries.  In the short-run, there is really nothing policymakers can do in order to help lower food prices (other than giving food aid to the most marginal population across the world), but in the longer-run, this should lead to better government policy (such as an opening up of the world's agricultural markets) and a greater incentive to utilize genetically-modified seeds to ensure better yields going forward.  For those subscribers who are looking to buy individual emerging market ETFs at some point, it is instructive to see which country would be most affected by the continuing rise in energy and food commodity prices, as shown in the following table courtesy of the IMF:

First-Round Impact of Commodity Price Changes on Trade Balance of Selected Countries, 2007

While the above table is merely a “rule of thumb,” it also reinforces my wariness on the Indian and Chinese stock markets.  Make no mistake, both the Chinese and Indian stock markets are still overvalued and are technically very weak.  Meanwhile, the liquidity in the Chinese stock market is still horrible, as Chinese IPOs have continued to hit the markets despite the latest weakness in Chinese and global equity prices, suggesting that we should see relative weakness in the Chinese equity markets for at least the next several months.  For those who want to have some kind of “Chinese equity theme” in their equity portfolios, I would suggest buying shares traded on the Hong Kong and Taiwanese stock exchanges instead.

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 April 18, 2008) - For the week ending April 18, 2008, the Dow Industrials rose 523.94 points while the Dow Transports rose 286.22 points. While the Dow Transports had already surpassed the February 1st closing high more than two weeks ago, the Dow Industrials hasn't done so until last Friday. In light of continuing bearish sentiment and the record amount of capital on the sidelines, this latest development is unequivocally bullish. Moreover, given the Dow Transports' role as a leading indicator since October 2002, the continuing strength (especially in light of record high oil prices) in the Dow Transports is doubly bullish for the market for the foreseeable future. This author continues to be bullish, based on three overriding ideas: 1) The fact that we have seen a capitulation low with the demise of Bear Stearns, backed-up by the once-in-a-cycle lows in our sentiment and technical indicators during late January and mid-March, 2) Our view that the Fed, Congress, and now the G-7 countries will continue to work together to resolve the liquidity crisis, and 3) The tremendous amount of capital sitting on the sidelines that will in all likelihood shift back to equities once the uncertainty has somewhat dissipated. Bottom line: I believe we have made an important intermediate-term bottom as of January 22, 2008 - and that we should the line of least resistance for the U.S. stock market is still up.

For the week ending April 18, 2008, the Dow Industrials rose 523.94 points while the Dow Transports rose 286.22 points.  With the latest rise in the two popular indices last week, both the Dow Industrials and the Dow Transports are now firmly above their February 1st closing highs.  Again, the Dow Transports remains the stronger index, as it is now more than 22% above its January closing low, and only 6.4% away from its all-time closing high.  Given the Dow Transports' role as a leading indicator of the broad market since October 2002, the strength in the Dow Transports is very encouraging, especially given record high crude oil prices last week.  Moreover, with the Bank of England finally getting more aggressive in reliquifying the UK financial system (the latest US$100 billion swap should be an indicator of further help and easing to come), and with further capital-raising within the global financial sector, it remains a dangerous time to stay short, especially given the unprecedented amount of global investment-ready capital sitting on the sidelines.  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 increased (for the third consecutive week) from last week's reading of -3.9% to -2.0% for the week ending April 18, 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 April 18, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios rose from -3.9% to -2.0% - the fourth consecutive weekly rise from an extremely oversold reading of -13.9% (which represented the most oversold level since late March 2003 and comparable with the late Sept/early October 2001 readings). With this turnaround, there is virtually no doubt that the market made a good bottom on January 22nd, with a successful retest on March 17th. I continue to believe that the line of least resistance for the stock market is still up for the next several months. We will stay 100% long in our DJIA Timing System.

Given the latest four-week rise in this sentiment indicator from a historically oversold condition (by far the most important reversal signal in the stock market is when this indicator reverses from a very oversold situation), there is now virtually no question that the broader market has already bottomed and that the line of least resistance is now up for the next several months.  Given the readings of this sentiment indicator, the positive divergences we previously mentioned at the time of the Bear Stearns collapse, the relative strength in the Dow Transports, the latest “bailout plan” from the Bank of Englanf, as well as an essential guarantee by the Fed for most of the U.S. financial system, 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, Congress, or the G-7 fail to do more to ease the wide spreads in the mortgage and the credit markets.

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.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators..  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) - After the historical four-week plunge of the 20 DMA ending mid March, the ISE Sentiment Index has bounced significantly over the last four weeks. In fact, the 20 DMA finally rose above the 50 DMA two weeks ago, the first time it has done so since December 31, 2007. Given that both the 20 DMA and the 50 DMA of the ISE Sentiment has most likely reversed from a historically oversold level, and given the piercing of the 50 DMA by the 20 DMA (again from a historically oversold level), chances are that the line of least resistance for the stock market is now up. Bottom line: The 20 DMA and the 50 DMA have reversed from historically oversold levels - levels that were even more oversold than mid October 2002 lows. We will stay 100% long in our DJIA TIming System.

With both the 20-day and 50-day moving averages of the ISE Sentiment Index reversing from their historically oversold readings – and given that the 20-day MA has now rose above its 50-day MA – probability suggests that the stock market has already bottomed and should continue to rally over the next several months.  Given this reversal from a historically oversold condition of the stock market, the Fed “backstopping” the majority of the U.S. financial sector, the approaching “fiscal stimulus” starting in early May, and the unprecedented amount of capital sitting on the sidelines, I continue to believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500, and am now expecting the Dow Industrials to rise above the 13,000 level by the end of April.  For now, we will stay with our 100% position in our DJIA Timing System, and will only scale back once the market becomes significantly overbought or if sentiment turns rampantly bullish again.

Conclusion: As has been well-advertised in our commentaries and in our discussion forum over the last few weeks, I continue to be bullish on the U.S. stock market, despite the fact that we are still in the midst of a larger deleveraging phase that is set to continue for the next 12 to 18 months.  Moreover, I expect limited downside in the U.S. Dollar relative to the Euro – as many of the European banks start to disclose more of their subprime losses and as the Euro Zone economy weakens – thus forcing the European Central Bank to start easing sometime in the second half of this year.  More importantly, the G-7 has also threatened to intervene in the currency market should the Euro rise further against the US Dollar.

We continue to be bullish on the U.S. stock market, given the reversal of our contrarian/sentiment indicators from historically oversold levels, the “fiscal stimulus” that is set to be implemented early next month, the beginning of a giant “bailout” of the British financial sector, and the immense amount of cash currently on the sidelines.  Again, I expect the Dow Industrials to close above the 13,000 level by the end of April, but will continue to be vigilant and inform our subscribers should we see a gathering storm that would impact the global equity markets, such as the current rise in food prices and global discontent among the world's poor.

Signing off,

Henry To, CFA

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