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Energy Complex a Short-Term Buy?

(September 14, 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 750.01 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 441.01 points as of Friday at the close.

As I am typing this, the S&P 500 futures are down 40 points while the NASDAQ 100 futures are down 43 points on news that Lehman Brothers is preparing to file for bankruptcy, as Bank of America and Barclays pulled out of the bidding process for the company.  Over the last several hours, I have been fielding subscribers' questions on whether this is now time to go to cash and avoid risky assets altogether.  More specifically, are we looking at a 1,000-point decline in the Dow and are we on our way to breaking the mid July lows?

The answer is only in the affirmative if you believe the Lehman bankruptcy is the first step to something bigger, such as the collapse of AIG or Merrill Lynch.  At this point, it is not obvious to us that this will happen - given AIG's capital raising/restructuring efforts going on right now and given Bank of America's interest in acquiring Merrill (WSJ just reported that Bank of America has agreed to acquire Merrill Lynch for $29 a share, or 70% above its Friday closing price).  More importantly, the world's biggest banks have created a $70 billion lending pool targeted for troubled financial companies, while the US Treasury and the Federal Reserve have just announced an expansion of the Fed's lending program to encompass more asset classes (including equities) as collateral for Federal Reserve loans.  As we all know, during "liquidation mode," anything can happen.  But if both AIG can resolve its liquidity crisis by Monday morning, and if the Fed adopts an easing bias on Tuesday (if not cut the Fed Funds rate outright), then we are probably much closer to the end of the crisis than any Wall Street analyst would care to admit.

I recognized I erred in my comments regarding the GSEs a couple of weeks ago, as I had anticipated that the systematic bleeding would stop there.  But at this point, careful analysis still suggests we're closer to the end that most would admit.  For example, when it became apparent that Drexel Burnham Lambert would file for bankruptcy on February 12, 1990, the Dow Industrials declined 1.2% that day.  While the stock market would drift down another 2% over the next ten days, the Dow Industrials would rally 5% over the next six months from the close on February 12th.  Similarly, when Enron filed for bankruptcy on November 28, 2001, it was accompanied by a 1.6% decline in the Dow Industrials.  Six months later, the Dow Industrials was up by 3%, while the maximum drawdown from the November 28, 2001 close during those six months was only 0.2%.  The recurring theme here is obvious: If Lehman represents the last major financial firm to fail (the lower lows in July/October 2002 were due more to the liquidation of over-indebted technology/telecom companies more than anything else), then based on history, we should see more than a respite in the current downtrend, as this will significantly reduce the ongoing systematic risks that the financial markets have been pricing in over the last couple of weeks.

With the demise of Lehman Brothers and Bank of America's potential acquisition of Merrill Lynch, this now leaves only two “bulge bracket” firms in the United States: Goldman Sachs and Morgan Stanley.  Goldman Sachs aside (since they actually used the “subprime bullet” to their advantage), subscribers should note that Morgan Stanley is report earnings this Wednesday morning. Depending on what happens tomorrow, we could see this pushed forward to Tuesday or even Monday afternoon.   More importantly, despite taking write-downs in both 1Q and 2Q, Morgan Stanley still managed to report positive earnings due to its diversified revenue streams.  On top of that, its current net exposure to subprime mortgage-related securities now only totals $300 million. Goldman Sachs expects Morgan Stanley to report 85 cents a share for the current quarter, while the average consensus estimate of sell-side analysts puts it at 77 cents a share.  Unless Morgan Stanley announces a loss on Wednesday morning, it does not look like the current crisis will spread to either Morgan Stanley or Goldman Sachs.  While the current “liquidation mode” in the financial markets could very well take us to the mid July lows, I do not anticipate a substantial breaking of those lows, assuming the Federal Reserve adopts an easing bias (or outright cut) this Tuesday.  For now, the best thing for the global financial markets is still an aggressive easing campaign by the European Central Bank and the Bank of England (based on my estimates, the European Central Bank's base rate should be at least 150 basis points lower based on the Taylor Rule and based on the timeline of the ECB's easing campaign during 2000 to 2002). 

Aside from Merrill Lynch, AIG, and Washington Mutual, the only other US company that could cause a systematic meltdown is General Motors.  With Congress now contemplating a $25 billion direct loan to the US automakers (at a rate of 5%), however, this is now off the table (House Speaker Nancy Pelosi has indicated that she will make this a priority).  Interestingly, while shareholders and employees of investment banks have been demonized by the press, GM, Ford, and Chrysler shareholders and employees will be bailed out by the Federal Government. Going forward, look for more of these deals in other "strategic" industries (not to mention another fiscal stimulus once the new President comes into power), as private lending continues to be curtailed, or unavailable altogether.  There is also a good chance that the auto loans bill will pass before Congress adjourns in early October.  Regardless, any direct loans by the government at rates that are substantially below the market rates will also be very bullish for both financial market and economic liquidity.

With the global financial markets in “liquidation mode” over the last several weeks, everything has literally been hit (as we discussed in our last mid-week commentary) – unlike the sell-offs during mid March and mid July when only financial and consumer discretionary companies were “called into question.”  On a month-to-date basis, only the S&P 500 consumer discretionary and consumer staples indexes are in positive territory (out of the ten broad sectors within the S&P 500).  On a year-to-date basis, only the S&P 500 consumer staples index is in positive territory.  Interestingly, even as most analysts and commentators are bemoaning the “death of the US consumer,” the S&P 500 consumer discretionary index is only down 5.89% on a year-to-date basis, far better than the -13.44% return logged by the S&P 500 Total Return Index (which includes dividends).  Energy – which has been doing so well earlier this year – is down 6.80% on a month-to-date basis (worst performance out of the ten broad sectors) and down 14.06% on a year-to-date basis.  On a related basis, the price of crude oil (WTI) is now trading at below $100 a barrel as I am typing this, after hitting as high as $147 a barrel in July.  Over the very short-run, the price of crude oil is now very oversold, as shown in the following daily chart of crude oil (along with their 50 and 200-day rates of change) courtesy of

Oil - Light Crude - Continuous Contract (EOD) ($WTIC) - 1) With the decline of crude oil to below $100 a barrel in pre-market trading, the price of crude oil is now more than 20% below its 50-day moving average – a very oversold level in the short-run any way you look at it. 2) The 50-day range of change in crude oil prices is (as of Friday's close) at a historically oversold reading of -29.48%.  The only other comparable reading occurred in the fourth quarter of 2001 – right in the aftermath of the terrorist attacks on the World Trade Center.

As mentioned on the above chart, judging by where the price of crude oil is from its 50-day moving average, as well as its rate of change over the last 50 trading days, the price of crude oil is now historically oversold – hitting levels not seen since the fourth quarter of 2001, when gasoline consumption dramatically slowed down in the aftermath of the World Trade Center terrorist attacks.  Moreover, as I am typing this, WTI oil futures is down another $2 a barrel in pre-market trading – most probably as a result of “liquidation fears” in light of the Lehman bankruptcy filing and the near-end of “hurricane season” here in the United States (the hurricane season ends in about a week).  Should crude oil continue to sell off over the next few days, adventurous traders may seriously want to think about taking a position on the long side.

Meanwhile, this extremely oversold condition in the price of crude oil is also being confirmed by an extremely oversold condition in the XLE, the Energy Select ETF.  Following is a chart courtesy of showing the percentage of stocks within the XLE over their 200-day, 50-day, and 20-day exponential moving averages over the last three years:

Percent of Energy (XLE) Stocks Above Their 20/50/200-EMA (3-Yr)

As can be seen in the above chart, none of the stocks within the XLE is above their 200-day exponential moving averages.  While the XLE had bounced slightly in Friday's trading session, both the XLE and the XLE's components would surely sell off again in tomorrow's trading session.  The latest decline in crude oil, energy stocks, and “energy countries” around the world is further evident in the Russian stock market, which we illustrated in our most recent mid-week commentary.  At some point, Russian equities should be good for a trade on the long side as well – as Russian equities are now trading at extremely low valuations (even with a crude oil price at $90 a barrel, Russia's P/E is still at an extremely attractive multiple of 5.3, while earnings growth for 2009 is estimated to decline by only 2%).

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 September 12, 2008) - For the week ending September 12th, the Dow Industrials rose 201.03 points (breaking its four-week losing streak) while the Dow Transports rose 185.26 points on the heels of the GSEs' bailout. The lack of a more impressive rally in the global equity market in light of the GSE bailout signals that the global financial markets are still in liquidation mode - which became more obvious as the week passed by as investors dumped shares of Lehman Brothers, citing disappointment in the company's *turnaround plans.* Whether the market can embark on a sustainable rally will depend on whether Lehman's assets can be liquidated in the open markets in an orderly fashion. The bright spot is that while the Dow Industrials is still exhibiting relative weakness, the Dow Transports is hanging in there, and is only 7.6% away from its all-time high (vs. 19.4% for the Dow Industrials).  Given that the Dow Transports has led the broad market since October 2002, and given the technical downtrend in oil prices (WTI crude is now below $100 a barrel as I am typing this), I expect both the broad market and the Dow Industrials to have bottomed mid July, even though the financial markets are still in liquidation mode. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending September 12, 2008, the Dow Industrials rose 201.03 points while the Dow Transports rose 185.26 points, on the hells of the bailout of the GSEs.  Since the bailout, 30-year mortgage rates have declined by a whooping 40 basis points, helping to bring down further housing affordability across the nation.  How the upcoming week's action plays out will depend on how Lehman's assets are liquidated.  As we currently understand, Lehman is only filing for Chapter 11 bankruptcy at the holding company level.  That means the broker/dealer operation will still be operating on Monday's trading.  That is, a downright liquidation of risky assets across the company and across the entire financial sector is now inevitable – all the more so given the expansion of the Fed's loan facilities and the establishment of a $70 billion for troubled financial institutions by the largest banks in the world.  This also assumes AIG can find some kind of funding facility by Monday morning.  In the meantime, from a Dow Theory perspective, the Dow Transports is still holding up relatively well.  Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I do not believe the Dow Industrials will substantially break below its July lows even though the market is still currently in “liquidation mode.”  For now, we will remain 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 -8.3% to -11.1% for the week ending September 12, 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 September 12, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios declined from -8.3% to -11.1%. While this reversal is slightly disappointing in terms of sentiment (sentiment tends to move with the direction of the stock market unless it is hugely overoptimistic or overpessimistic), subscribers should note that this indicator is once again moving towards a hugely oversold level. Moreover, the ten-week MA (not shown) - now at -14.8% - is also just 2% away from its historically oversold level in mid March 2003. While we should see more selling this week, my sense is that the stock market will not break substantially below the mid July lows. For now, we will remain 100% long in our DJIA Timing System.

While the latest reversal of the four-week moving average is slightly disappointing (historically, this sentiment indicator has moved in the same direction in the markets, and is only useful as a contrarian indicator during oversold/overbought conditions), subscribers should keep in mind that a reading of -11.1% is still very oversold under normal circumstances.  Moreover, this indicator is again rapidly approaching historically oversold conditions, with the 10-week moving average (not shown) not at -14.8%, or only two percentage points above its mid-March 2003 lows.  Combined with the oversold conditions in the global stock market, decent global valuations, the sheer amount of investable capital sitting on the sidelines, and the record amount of short interest, this reading should be good for a sustainable rally in US and global equities once the current liquidation phase is over.  For now, we will remain 100% long 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.  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 a consolidation period of almost three months (a consolidation that worked off most of its short-term overbought conditions resulting from the two-month rise off the March lows) , the 20 DMA of the ISE Sentiment Index has finally broken out on the upside and decisively rose above the 50 DMA. Since then, however, the *rally* in the 20 DMA has stalled - and is in danger of crossing back below the 50 DMA. Regardless, relative to levels over the last five years, both the 20 and the 50 DMAs are still at oversold levels, signaling that sentiment is much closer to a bottom than a top. While the stock market could test its mid July lows, I do not anticipate a substantial break below those lows.

While the ISE Sentiment Index has bounced substantially since its mid March lows and has since stalled, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are still at oversold levels that are synonymous with a tradable bottom in the stock market.  While we should see both the 20 DMA and the 50 DMA sell off to more oversold levels this week, my sense is that we should not see a substantial breaking of the mid July lows in the stock market should we get there.  As indicated by the ISE Sentiment Index and other indicators, we are much closer to a market bottom than most analysts would care to admit at this point.

Conclusion: With the demise of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America, there now remain only two “bulge bracket” firms in the United States: Goldman Sachs and Morgan Stanley.  As mentioned in the above paragraphs, I do not see either institution going the route of Lehman or Merrill.  For now, the goal of the Federal Reserve and the US Treasury is to continue to minimize systematic risk.  Moreover, I would not be surprised to see the Federal Reserve adopt an easing bias (or even cut outright) in Tuesday's meeting – as the global financial markets continue to deleverage and as deflationary pressures mount.  I also believe that any liquidation of Lehman's businesses and positions will be “orderly.”  The big variable is now AIG.  Assuming that AIG is able to obtain funding (approximately $20 billion to $30 billion, by some estimates) by Monday morning, then this will go a long way towards soothing the global financial markets.  Going forward, I expect the US Treasury, the Federal Reserve, and the new Presidential Administration to maintain an active, interventionist stance, as ever since the end of World War II, both the US government and the Federal Reserve have favored the capitalists (especially those with business debts) and risk-takers over the risk-averse such as those who stuff their money under their mattresses.  I see no reason to change this policy now or in the future.

While I am still very constructive on US and Japanese equity prices in the longer-run, there is no doubt that we are still in a “liquidation phase.”  During a “liquidation phase,” anything can happen, although I continue to believe that the stock market won't substantially break below its July lows should we approach those levels.  In the meantime, the bailout of the GSEs has resulted in a 40 basis-point decline in the 30-year mortgage rate over the last week – something that is constructive for US housing prices over next several quarters.  I also believe UK financial stocks may be good for a trade on the long side, in light of the more “dovish” views as expressed by the UK government over the last couple of weeks.  Within US stocks, I still like the healthcare sector, the asset managers, and the exchanges.  I also believe that the energy sector is rapidly approaching a tradable bounce.  For now, we will stay with our 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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