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As Long as the Sun Shines

(August 3, 2008)

Dear Subscribers and Readers,

Let us begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 845.68 points as of Friday at the close.

7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 536.68 points as of Friday at the close.

In a recent article on solar energy on the McKinsey Quarterly, the authors Peter Lorenz, Dickon Pinner, and Thomas Seitz asserts that a new era of solar energy is upon us.  More specifically, based on past and current advances in our harness of solar power (20% reduction in costs for every doubling of global installed capacity), solar power is projected to hit “grid parity” in as little as a three to seven years in high solar power penetration and high electric costs areas such as Italy, California, Southwestern United States, Japan, and Spain.  By 2020, McKinsey predicts that we should witness solar “grid parity” in more areas such as Denmark, Netherlands, Germany, Australia, and even New York State, as shown in the following exhibit courtesy of the McKinsey Global Institute:

The growing competitiveness of solar power

Moreover, McKinsey discloses that their forecasts are based on an extrapolation of the current trend in technological improvements of solar cell designs and materials, but does not account for any potential radical breakthrough nor the emergence of a dominant technology (at this time, three technologies – silicon wafer-based, thin-film photovoltaics, and concentrated solar thermal power – are competing for leadership).  However, given the sheer amount of venture capital funds pouring into the solar power and other “clean tech” sectors ($3.2 billion in 2007 and more than $4 billion projected for 2008), chances are that the deflationary forces in this and other clean tech sectors could be much more ferocious in the next three to five years than we have ever anticipated.  Should Congress lift the off-shore drilling bans in various key States, then the deflationary forces in the energy sector could further accelerate, as both traditional and alternative fuel sources compete for market share over the next few years (lifting the off-shore drilling ban would also “encourage” countries such as Mexico, Iran, and Venezuela to invest more into their oil industries in order to regain market share).  At this point, I believe the technologies underlying solar power, wind power, and cellulosic ethanol have gathered too much momentum to be easily displaced by fossil fuels, even if crude oil decline back to $75 a barrel or natural gas declines back to $7.50/MMBtu.

Finally, I believe McKinsey – in projecting that global solar power capacity will grow from 10 gig watts to 200 to 400 gig watts (or 30 to 35% annually) in 2020 –  is relatively pessimistic.  Note that an installed capacity of 200 to 400 giga watts in 2020 will only make up 1.5% to 3.0% of total global power capacity.  Should solar power production reach “grid parity” in three to five years, my sense is that installed capacity will literally explode on the upside as it rides along the technology “S-curve” – similar to the installation of railroad capacity in the 1850s, the adoption of automobiles and radio in the 1920s, television in the 1950s, and of course, the internet in the 1990s.  As installed capacity continues to increase, costs will also continue to decline – thus putting a further deflationary force in fossil fuel prices, food prices, etc.  The development and commercialization of alternative energy sources is a major reason why I am still bullish on the US (and Japan) over the long run.

The MarketThoughts Global Overbought/Oversold Model

Now that we are past the end of July, let's review the latest oversold conditions of the global, regional, and country-specific equity markets by consulting our Global Overbought/Oversold model.  Under normal circumstances, we utilize our monthly Global Overbought/Oversold Model as cues to either go long in a substantial way or cut back on long positions (overbought indicators are notoriously bad timing indicators), and this is what we are going to do in this instance.  This model was first discussed in our August 2, 2007 commentary.  As we mentioned in that commentary, the inner workings of this global overbought/oversold “model” are rather simplistic.  For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages.  Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998.  This way, we are comparing apples to apples and can control for country or region-specific volatility.  We also added the CRB Total Return Index since our August 2, 2007 commentary.  Following is our Global Overbought/Oversold Model as of the end of July 31, 2008 (note that this does not take into account Friday's action):

Global Overbought/Oversold Model as of July 31, 2008

In last month's update of our Global Overbought/Oversold Model, we observed that aside from equity markets in Latin America, Emerging Europe, and the Middle East, the vast majority of the world's equity markets were oversold (below the 15th percentile, or approximately one standard deviation below the average – these cells are highlighted in yellow).  Specifically, both Belgium and Ireland were oversold on all timeframes (3, 6, 12, 24, and 36 months), while  India, with a 0% percentile ranking over the last 3, 6, and 12 months, was extremely oversold in the short run.  Canada and Norway, however, were still doing well in light of stubbornly high crude oil and natural gas prices.  Meanwhile, the United States was oversold on both a 12 and 24-month timeframe for the first time since this bull market began in October 2002. 

Since that time, the United States has remained oversold on both a 12- and 24-month timeframe.  Should the U.S. broad market end the month of August lower by 1% to 2%, then the U.S. stock market will also be oversold on a 36-month timeframe as well – the first time it will do so since this bull market began in October 2002.  More importantly, the decline in oil and general commodity prices have also generated selling in many markets in Latin America and the Middle East (as well as Canada and Norway) – leading to a broader oversold condition in the world's equity markets compared to the end of June.  Finally, both the MSCI World and the MSCI All Country World indices are now oversold on a 3-, 6-, and 12-month timeframe, versus only an oversold condition on a 3-month timeframe at the end of June.  While the US and global stock market can still retest its mid July lows in the short-run, my sense is that the stock market has already hit an intermediate bottom and should at least embark on a six to eight-week rally 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 July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2006 to August 1, 2008) - For the week ending August 1st, both the Dow Industrials and the Dow Transports continued to consolidate after the significant rally coming off the July 15th bottom - with the Dow Industrials declining 44.37 points while the Dow Transports declined 9.85 points. Given oil's lack of ability to rally off of *bullish news* (e.g. hawkish statements from Israel) and given that natural prices have also confirmed on the downside, there is a very good chance the market will continue its rally over the next two to three months. Moreover, the Dow Transports has continued to be very resilient as it is only 9% away from its all-time high (vs. 20% for the Dow Industrials). Given that the Dow Transports has led the broad market since October 2002, I expect the Dow Industrials to have bottomed already and to embark on a significant rally over the next two to three months. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending August 1, 2008, the Dow Industrials declined 44.37 points while the Dow Transports declined 9.85 points.  Listening to the mainstream media last week would make you think that the market and US economy was entering an “Armageddon” scenario, even though the stock market was only down marginally (the Russell 2000 actually rose 0.8% last week) as the latest weekly decline seems more like an extension of a consolidation phase coming off the significant rally off the July 15th bottom.  Also, the Dow Transports is still holding up very well, as it is only 9% away from its all-time high (versus 20% for the Dow Industrials).  In addition, given the recent deleveraging by the airlines (and thus newfound pricing power) and the continuing bottlenecks in the US transportation infrastructure, I expect the Dow Transports to remain resilient, especially as the technical action of crude oil prices has remained very weak, despite hawkish comments from Israel last week.  Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I expect both the Dow Industrials and US stocks to embark on a sustainable rally over the next six to eight weeks.  For now, we will remain 100% long in our DJIA Timing System – and will only seek to pare back our position if the market becomes more overbought or if our sentiment indicators become overly bullish again.

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 slightly from last week's historically oversold reading of -22.7% to a -21.2% for the week ending August 1, 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 August 1, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios increased slightly from -22.7% to -21.2% - representing the first uptick in this sentiment indicator in 10 weeks. Again, this set of readings over the last three weeks represent the most oversold readings since March 2003 (at the exact start of a major four-year bull run). Moreover, the ten-week MA (not shown) is now at its most oversold level since mid April 2003. For now, we will remain 100% long in our DJIA Timing System - and will only look to reduce our position should this sentiment and other technical indicators rise to more overbought levels sometime later this year.

Last week's reading of -22.7% put this indicator at its most oversold level since July 2002, surpassing even the historically oversold reading ending March 14, 2003 – which happened to be at the beginning of the stock market's major four-year bull run.  Moreover, the latest reading puts the ten-week moving average at -12.5% (not shown) – an oversold level which we haven't witnessed since mid April 2003.  Combined with the oversold condition in the global stock market, decent global valuations, the recent decline in energy prices, the sheer amount of investable capital sitting on the sidelines, the record amount of short interest, and the backstopping of the GSEs by the Feds, this reading should be good for at least a six to eight-week bounce in the US stock market.  For now, I am very comfortable with our 100% long in our DJIA Timing System, and will only pare back our position should the stock market or should our sentiment indicators get overbought once again.

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) - The 20 DMA of the ISE Sentiment Index has been consolildating near current levels over the last two months since its dramatic two-month rise off the mid March lows. More importantly, this two-month consolidation has worked off most of its short-term overbought conditions (note that the 50 DMA just made a ten-week low) , and is sufficient to provide *fuel* for a sustainable stock market rally going forward, especially since current readings are still oversold relative to those over the last five years. Bottom line: The 20 DMA and the 50 DMA - even though they have reversed from historically oversold levels - are now sufficiently oversold for the market to embark on a sustainable rally.

While the ISE Sentiment Index has bounced substantially since its mid March lows, my sense is that both the 20 DMA and the 50 DMA of the ISE Sentiment Index have now worked off most of their short-term overbought conditions (in fact, the 50 DMA just made a ten-week low).  More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years.  Given this, the probability for much further downside is minimal, and is thus conducive to a sustainable rally over the next six to eight weeks.

Conclusion: I continue to be bullish on the long-term prospects of both the US and Japanese stock markets, as long as the venture capital/private equity fund-raising environment remains healthy and as long as US entrepreneurship remains alive and well.  Given recent technological advances in the production of solar panels, battery technologies, wind power, and cellulosic ethanol, there is a good chance we could reach “grid parity” in major parts of California, Texas, and Florida in as little as three to five years.  Combined with the removal of offshore production bans in key areas, this could have a huge deflationary force on energy prices by 2010 to 2011 as the rest of the world either: 1) adopt similar technologies (think Japan, Spain, Italy, Australia, and Germany), or 2) finally invest in more oil production facilities in order to regain their pieces of the global energy pie (think Iran, Venezuela, and Mexico).   In a world where future growth is hugely dependent on a breakthrough in new technologies, the Federal Reserve should maintain borrowing rates as low as feasible in order to stimulate further investments in the “clean tech” and life sciences sectors.  Should corporate bond yield spreads continue to rise in the coming days, don't be surprised if the Treasury, with its newfound powers vested by Congress, intervene in the bond markets by buying up agency MBS on the open market.  This would not only bring down mortgage rates for most new homebuyers, it would also help bring general credit spreads down as technical/liquidation selling is absorbed by the US Treasury. 

I also believe that Japanese equity prices bottomed in mid-March.  Given global inflationary pressures as well as the reflationary and releveraging trends in Japan, I continue to expect the Japanese equity market to exhibit relative strength against a global equity portfolio over the next 12 to 18 months.  For now, we will stay with our 100% long position in our DJIA Timing System, and will only seek to pare back our long position once the stock market gets overbought again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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