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Demography is Destiny

(December 14, 2008)

Dear Subscribers and Readers,

Let us now 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 3,542.32 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 3,233.32 points as of Friday at the close.

Nearly 200 years ago, Auguste Comte – a French philosopher and the founder of “positivism” branch of philosophy – coined the phrase “Demography is destiny.”  Indeed, true to his positivist roots, the future demographics (say, 20 to 30 years from now) of a general population set is easily predictable, as birth/death rates tend to remain relatively stable for a developed society over a 20-year period, and as the majority of the population 20 years from now has already been born today.  Demographics affect nearly every aspect of our lives – from the spike in college environment over the last ten years (as the “echo boomers” come of age), to the popularity of Corona beer in the US, and to the recent extraordinary increases in healthcare spending.  Many things – including violent crime rates, college enrollment, consumer spending patterns, healthcare spending, and home purchases – can reasonably be projected from current demographic trends (although I would not go as far as to claim that one could predict the future level of the stock market based on demographic trends).

As I discussed in our June 24, 2004 commentary (“Aging Demographics – The Other Super Secular Trend”), one unavoidable and highly impactful trend to watch in the next 10 to 20 years is the aging of the baby boomers – not just in the US but in other countries as well – in particular Western European countries, Japan, and even China.  I highly recommend subscribers to go back and read that commentary if you are not familiar with this trend.  Staying on this same topic – Richard Jackson and Neil Howe, sponsored by the Center for Strategic & International Studies' Global Aging Initiative, recently published a report entitled: ‘The Graying of the Great Powers: Demography and Geopolitics in the 21st Century.”  The major findings of the report are published in this 18-page document.  I highly recommend our readers to read the major findings in its entirety, but since most of you would probably prefer some lighter reading during Christmas, I will summarize the more interesting findings in the following bullet points:

  • The “graying” of the global population will not be uniform across all regions.  For example, today's oldest countries – mostly concentrated in Europe – is also expected to experience the most aging given low birth dates.  Today's youngest countries, such as those in sub-Saharan Africa will experience the least aging.  As a result, we should witness more “divergence” in average age and population across the world over the next 20 to 40 years.  A significant number of countries will also see outright declines in population.  In fact, Germany and Japan, barring a drastic change in their immigration polices, have already seen their populations peaked.   Following is a table from the report showing which countries will see their populations peak from now to 2050:

Countries projected to have declining populations, by period of the decline's onset

  • As covered here before, the aging and the outright decline of the general population in various countries will have great social and economic implications.  As the relative and absolute size of the workforce shrinks, the ability to support retirees is hindered.  With the way that most retirement systems are constructed in the developed world today, such a development is not sustainable – either retirees will need to take dramatic cuts in their retirement payments (or else the younger population will migrate to countries where taxes are less onerous) or they will have to work longer.  The more popular choice seems to be the latter (at least in the US), as the advent of the knowledge economy has made educated baby boomers much more “valuable” than they have ever been – especially when compared to an industrial society that involved back-breaking labor.  Unless there is a significant technological break-through (such as the widespread adoption of robotic technology in our everyday lives), many countries would also experience a structural decline in their GDP levels at some point in the future.

  • Make no mistake: The influence of the “developed world” will continue to decline over the next 20 to 40 years.  During the Industrial Revolution and into the 1920s, the population of the developed world grew at a faster pace than the rest of the world's population.  By 1930, the developed world's share of the world population increased to 25%, up from 17% in 1820.  By 2005, its share has shrunk to just 13%, and is projected to decline to a mere 10% by 2050.  Similarly, the developed world's share of global GDP will decline from 54% in 2005 to 31% by 2050.  Interestingly, the U.S. share of the developed world's GDP is expected to increase – as the US birth rate and immigration policy will allow the US population to continue to grow going forward.  According to the report's findings, as recently as the early 1980s, US and Western Europe's GDPs were roughly the same (with each making up 37% of the developed world's GDP).  By 2050, US GDP is expected to rise to 54%, versus Western European GDP of a mere 23%.  Such a position will put the US in its most dominant position (relative to the rest of the developed world) since the immediate aftermath of World War II.  Barring a change in today's geopolitical structure, the US will again be a dominant force relative to her traditional allies – not because we want to but because we need to.  Talks over the last ten years of a new “United States of Europe” challenging the dominance of the US in the world's economy and geopolitics is not merely premature, but a hallucination.

The Impact of Demographics on the Biotech Industry

The aging of the US and global population is also a structural tailwind for the biotech industry.  According to the U.S. Census Bureau, people aged 60 or older in the U.S. accounted for nearly 50% of overall drug spending (including sales of biologics) in 2007.  Concurrent with the aging of the “baby boomers,” the number of U.S. residents aged 60 or over will increase 50% by 2020, rising from 17% to 20% of the population.  A recent article in Health Affairs (penned by economists from the National Health Statistics Group) projects national prescription drugs spending to increase 100% over the next ten years.  Demographic trends in foreign markets also look favorable.  For example, 21% of Europe's population was aged 60 or over in 2006, a figure that is projected to rise to 26% in 2020 and 29% by 2030.  Even in Japan – where population growth is negative – the number of people aged 60 or over is expected to rise 27%, from 34 million in 2005 to 43 million in 2010.  Finally, while patients in developed countries have been the primary customers, sales growth in emerging markets such as China, India, and Brazil have outpaced those in developed countries in recent years, rising from 13% of the global market in 2001 to 17% in 2007.  According to the IMS, pharmaceutical sales in emerging markets should rise to over 20% of the global market by 2020.

As life expectancy increases and as developing countries adopt “western lifestyles,” cancer will become the number one killer in the world by 2010.  By 2020, global cancer rates should double from 10 to 20 million new cases a year.  Similarly, the incidence of chronic diseases will increase.  Unlike the pharmaceutical pipeline, the biotech pipeline remains strong.  According to IMS Health, US and global pharmaceutical sales (including biologics sales) in 2007 were $287 billion and $754 billion, respectively.  Of these, US and global biologics sales in 2007 were $42 billion and $75 billion, respectively.  While the growth of global biologics sales declined from 18.2% in 2006 to “only” 12.5% in 2007, it is still double the 6.5% growth enjoyed by the global pharmaceutical market in 2007.  Global biologics sales growth is expected to continue to outperform.  According to BioPharma Insight, biologics now account for 42% of all preclinical candidates and 26% of FDA submissions, versus 26% and 18% in 2005, respectively.  While an increase in responsibilities and the uproar over the Vioxx scandal have caused the FDA to be much more cautious in approving new drugs in recent years, the pace of drug approvals has increased in 2008.  Moreover, the Obama administration has promised to increase FDA funding – which should in effect speed up the approval process going forward.  As if today, the biotech industry is one of the few remaining domestic industries that could be classified as a true “growth industry” as many industries that have previously experienced strong growth (such as the lodging & gaming, and the casual dining industries) have become saturated.

In the meantime, I expect the Big Three automakers to be “bailed out” by the Bush administration sometime this week.  The situation is still in flux – but I expect at the very least a short-term loan that would provide sufficient reprieve for both General Motors and Chrysler to last through February of next year (until the Obama administration had sufficient time to evaluate the situation).  Again, assuming the Big Three automakers are bailed out, neither the Federal Reserve nor the US government is impotent in reversing the most violent decline in the US economy since the beginning of the Great Depression.  A severe recession (unemployment rate ultimately peaking at over 10%) at this point is still not inevitable, although we are coming dangerously close.  With the global reflation effort still in full swing, I expect the Federal Reserve to cut rates for the last time this Tuesday and for them to move to a “quantitative easing” policy – where the Federal Reserve will attempt to directly reliquify the economy by further bringing down LIBOR rates and possibly GSE mortgage spreads.  A more drastic policy would be for the Treasury, in conjunction with the Federal Reserve, to bring down credit spreads by buying private label MBS, CMBS, other asset-backed securities, and possibly corporate bonds, but I do not see them implementing this policy at this stage.  With the wide variety of tools available to global policy makers – and given their willingness to use these tools – I expect the global reflation effort to succeed (at least in the developed economies, and other major countries such as China, Brazil, and India) sometime in 2009.

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 March 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (March 1, 2003 to December 12, 2008) - For the week ending December 12th, the Dow Industrials declined 5.74 points, while the Dow Transports declined 187.89 points. For now, it looks like that global liquidation pressures are easing, given the Federal Reserve's backstop for Citigroup and given the promised bailout package for the Big Three automakers by the Bush administration. In addition, the Fed is scheduled to again cut rates again this Tuesday - possibly for the last time - and shift to a *quantitative easing* strategy. Over the longer-run, however, we will continue to be vigilant, given ongoing deleveraging in central and eastern Europe, along with deleveraging in the weakest companies in the US economy, such as newspaper publishers, certain retail stores, and highly indebted energy companies. However, with the immense amount of capitulation and very compelling valuations across the world - I believe we are now experiencing one of the greatest buying opportunities of our generation. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending December 12, 2008, the Dow Industrials declined 5.74 points while the Dow Transports declined 187.89 points.  With the Federal Reserve's backstop for Citigroup and the inevitable bailout of the Big Three automakers, global liquidation pressures should ease this upcoming week.  Moreover, I expect the Federal Reserve to cut rates for the final time this Tuesday and to move to a “quantitative easing” policy.  While there are still landmines in various emerging market countries (such as Russia and most of central and eastern Europe) and individual stock investments, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis, given the most compelling valuations in the US equity market in decades and the emerging innovative/Schumpeterian growth forces that will inevitably be unleashed in the next 5 to 15 years.  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 slightly from -18.2% to -18.6% for the week ending December 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 December 12, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from -18.2% to -18.6%. The latest decline in bullish sentiment suggests that investors are still getting more bearish again, although subscribers should note that the four-week moving average is now again at near historically oversold territory. Moreover, the 10-week MA (not shown) hit its most oversold level since early September 2002 last week, and has since reversed to the upside. While sentiment can indeed get darker, my sense is that global liquidation/deflationary pressures are now abating - suggesting that selling pressure has or will peak soon. For now, we will remain 100% long in our DJIA Timing System.

With the four-week moving average of our popular sentiment indicators declining to -18.6%, this indicator has again declined to near a historically oversold (the 10-week MA “sold off” to its most oversold level since early September 2002 last week, and has now reversed to the upside).  Again, given the inevitable rescue package for the Big Three automakers, and combined with the compelling global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, I believe this is the buying opportunity of our generation, even though we could possibly retest our most recent lows at some point in the next couple of months.  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) - Since hitting its recent lows in mid October, both the 20 DMA and the 50 DMA of the ISE Sentiment Index have reversed to the upside (with the 20 DMA crossing above the 50 DMA in late November) - suggesting that the up trend in bullish sentiment is still infact. More importantly, relative to levels over the last five years, both the 20 and the 50 DMAs are still at very oversold levels, signaling that sentiment has a good chance of reversing to the bullish side over the next few weeks. Given the immense liquidation in the global stock market in the last three months - combined with unprecedented public policy action all over the world - my sense is that the US stock market is in the midst of stablizing.

Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early to mid October, both the 20 DMA and the 50 DMA have reversed convincingly to the upside.  Historically, a reversal of the ISE Sentiment index from an immensely oversold level has been the most powerful indicator of an upcoming rally.  Combined with the oversold level in our other sentiment indicators, extreme valuations and oversold levels in the equity markets, as well as an unprecedented global bailout package (note the Irish government just committed a 10 billion Euro bailout to its banking industry today), and assuming that the G-20 countries commit to more easing policies going forward, I believe the stock market is now presenting itself as a once-in-a-generation buying opportunity.  As long as one is under the age of 60 and is in a reasonable state of health, then one should be buying US equities aggressively with one's long-term savings.

Conclusion: Demography is destiny.  The emerging demographics trends over the next 20 to 40 years will put the developed world on a “collision course” with many profound issues of the 21st century – such as the outright decline in population in various countries, the declining economic and geopolitical influence of Western Europe, and the inevitable increase in healthcare spending as the baby boomers near retirement age.  While further breakthroughs in the biotech, medical device, and pharmaceutical industries should help relive the burden of aging for the baby boomers (or even bring down healthcare costs), there is no doubt that the relative importance of Western Europe will continue to wane over the next 20 to 40 years, assuming no dramatic changes to its immigration policy. 

Going into Christmas, I expect ongoing liquidation pressures stemming from tax loss selling and hedge fund redemptions to be relatively benign, given the inevitable bailout of the Big Three automakers and the willingness of global policymakers to continue to ease monetary policy and to provide fiscal stimulus.  More importantly, the compelling valuations in the US equity market are now too much to ignore.  For those with a long-term timeframe, this represents the greatest buying opportunity of our generation.  I also continue to be constructive on US, Japanese, and Chinese equity prices in the longer-run, as the world starts to focus on sustainable, Schumpeterian Growth vs. Ricardian Growth over the next few years.  Over the intermediate term, I am still bullish on gold miners – specifically, the GDX.  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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