Identifying Short and Long Term Trends for 2009 - Part II
(January 4, 2009)
Dear Subscribers and Readers,
I hope all our subscribers had a great New Year's. As I mentioned in Part I of our two-part “Identifying Short and Long Term Trends for 2009” commentaries, I anticipate working harder than ever this year to bring you the most original thoughts and investment ideas. I also want to thank you for having continued confidence in us as we chart towards an era of great uncertainty – an uncertainty that will bring both danger and opportunities – over the next 12 to 18 months. Please also continue to send in your best ideas and thoughts, or post and discuss them in our discussion forum. After all, you – our subscribers – and the network that you have created since the inception of Marketthoughts.com, are definitely our most treasured and valuable asset. Many original ideas and investment opportunities over the last few years have indeed come from our subscriber base.
Before we begin our commentary and review the most recent signals in our DJIA Timing System, I want to recommend two business books to our subscribers. The first book, “The Goal” is a classic work (first published in 1984) that discusses the “Theory of Constraints” within a manufacturing system – and how to go about thinking about and solving them. This book is a straightforward and entertaining read – it also provides a good insight (to the lay reader) into how the Japanese manufacturers could become so much more efficient than American manufacturers starting in the 1970s. The second book, “Category Killers” was published in 2005 and provides a very good summary of how the U.S. retail industry developed in the 20th century – from department stores to the appearance of the “category killers” (big-box retailers that dominate their industries, such as Best Buy in electronics, Barnes & Nobles in books, and Home Depot in home improvement) to how they may evolve in the future (as well as their future threats). It is a must-read for any subscriber who has bought or is thinking of buying a retail stock.
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 3,137.31 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 2,828.31 points as of Friday at the close.
I will provide an update of our one-, two-, three-year, and since inception-annualized returns of our DJIA Timing System in our next weekend commentary. In the meantime – and since we are on the subject of the retail industry – I want to devote a few paragraphs to the various industries I have been studying up on over the last few weeks. The first industry, not surprisingly, is retail. Over the long run, it is tough for retailers to make outsized economic profits, given the industry's fragmented nature and its relatively undifferentiated products. To a significant extent, many retailers have been cushioned by above-trend increases in consumer spending and favorable demographics since the end of World War II (note the rise of Toys R Us could not have succeeded to such an extent if it hadn't been for the baby boomers). With the most recent plunge in the stock market and housing prices, many American consumers will no longer look to these asset classes as their “savior” for a comfortable retirement. While many baby boomers will choose to work longer (which will benefit the economy and society as a whole), they will also strive to rebuild their savings. As a result, there is no doubt that the American consumer will cut back on his discretionary spending. This cutback in spending will be amplified in 2009 as banks and credit card companies cut back on their consumer lending. Many retailers will struggle to survive as their debt payments come due in 2009 and 2010.
In the intermediate and long run (over the next five to ten years), this will be healthy for the U.S. economy, as the U.S. cannot indefinitely run a current account deficit that is 6% to 7% of GDP without jeopardizing the long-term health of the country. The ongoing (and upcoming) shakeout will also be beneficial for the remaining competitors as their competition are wiped out – and as the surplus in retail space will compress retail rents possibly for as many as the next five years (a record amount of retail real estate will be completed in 2009 even as many retailers are going out of business). We are already seeing some evidence of this – with the recent liquidation of Linens & Things, Mervyn's, Sharper Image, 155 Circuit City stores, various Borders Books stores, and Steve & Barry's. 2009 will no doubt be a year of more retail liquidations, as discretionary spending declines and as the availability of DIP financing for retailers grinds to a halt. In the case of Circuit City, I expect the entire chain to liquidate sometime in 2009. The most direct and biggest beneficiaries from the recent liquidations would be Bed Bath & Beyond, Best Buy, and Barnes & Noble.
Of course, no discussion of the retail industry is complete without a discussion on demographics. For example, the Gap's “Forth & Towne” concept – a retail store catering to over-35-year-old women – was launched based solely on the projected growth of this particular demographic group, as well as its spending power on apparel. While the concept did not do well, it was more of an execution and marketing blunder, rather than a strategic one. As this fastcompany.com article discusses, it wasn't because Gap was wrong in predicting that women aged 35 years or older was a growing group with lots of spending power (and the will to spend on apparel), it was because they did not want to identify themselves as being in that age group the moment they walk into a retail store. Interestingly, the major department stores such as J.C. Penney, Macy's, and Kohl's – despite decades of relative decline against discounters and specialty retail stores – are now benefiting from this trend. As the baby boomers and the general population continue to age, there is most probably room for traditional department stores to gain back some retail market share, unless specialty retail stores such as The Gap, Limited, and Footlocker are willing to devote significant sections of their stores to selling apparel & footwear to baby boomers (which I seriously doubt).
According to the Department of Commerce, the percentage of the U.S. population in the “age 55 and over” group will rise to 27.0% by 2015, from 23.8% today. By 2025, this percentage is expected to rise to just over 30%. As the baby boomers age, they bring with them a tremendous amount of wealth and an appetite for “new senior lifestyles” that specialize in “experiences,” such as going on cruises and living in upscale semi-retirement communities – not to mention a tremendous amount of spending on health care – presumably spending that will allow them to maintain their current lifestyles. With Carnival and Royal Caribbean Cruises having an effective duopoly on the U.S. cruise market, and with the inevitable (continued) rise on cruise spending, subscribers may want to take a look at both companies in the near future. Interestingly, neither company have particularly impressive ROEs (according to Yahoo Finance, their ROEs are 11.9% and 9.4%, respectively), even with their concentrated market shares and the demographic tailwind. Unless these companies start to get their act together (which they will have to given the inevitable slowdown in the cruise industry in 2009), then it may still be too early to invest in either company.
Another demographic trend worth discussing (as it pertains to the retail industry) is the “coming of age” of the Y-Gens (the offsprings of the baby boomers) – as they advance in their careers, get married, buy houses, have kids, etc. As recent as two years ago, teen retailer American Eagle (AEO) ranked as one of the best-performing stocks over the last decade – appreciating by a whooping 7,884% for the ten-year period ending December 31, 2006. Other teen retailers, such as Abercrombie & Fitch and Urban Outfitters also performed very well. Two important factors that contributed to this outperformance were related to the Y-Gens. In 1991, the first Y-Gen turned 13. That soon turned into a deluge as the rest of the Y-Gens became teenagers. Not only did they become a great market for teen apparel, they also swamped our schools, malls, and by the late 1990s, the internet as well. More importantly – and for the first time in history – many of these teenagers were empowered by their wealthy Boomer parents to purchase clothes for themselves. Instead of flocking to discounters such as Wal-Mart or Target or traditional department retail stores, these newly-empowered teens chose to shop at stores that specifically catered to teens, namely American Eagle, Abercrombie & Fitch, and others. Unfortunately, this tailwind for teen apparel retailers is about to disappear as the majority of Y-Gens are no longer teenagers. In fact, according to the Department of Commerce, the percentage of the U.S. population in the age 15 to age 19 group is expected to decline to 6.3% by 2015, from 7.2% today. Even on an absolute basis, the number of teens in the age 15 to 19 cohort is expected to decline, from 21.7 million to only 20.2 million by 2015. Suddenly, the potential for further growth in the teen apparel market just got significantly smaller.
China in 2009
In our August 10, 2008 commentary (“An Upcoming Chinese Slowdown?”), I discussed the high probability of a slowdown in the Chinese economy, given the slowdown in the OECD countries as well as the immense tightening by the People's Bank of China and the fiscal authorities (e.g. clamping down on real estate lending and speculation). At the time, I mentioned that Chinese economy growth would most likely slow down to the 7% to 9% range later in the year and into 2009. This view wasn't too popular at the time, but since the global stock market crash in late September to early October, this “slowdown view” has gathered significant momentum, with some analysts now publicly calling for only 5% GDP growth for China in 2009. With the Chinese manufacturing sector declining for the fifth month in a row (even though the December reading did beat expectations), the bears are now coming out with full force.
In light of the significant decline in the global economy since early October – and combined with an inevitable recession in much of Europe – I am now revising my Chinese GDP growth range for next year to a range of 6% to 8%. While this revision may sound conservative to the bears, it is still a relatively big deal, as the Chinese economy has been consistently growing in a range of 9% to 12% over the last six years. Moreover, with the significant decline in its import prices (such as crude oil, copper, iron ore, etc.) China can most probably maintain a relatively “healthy” trade surplus, despite its recent and projected decline in the value and volume of its exports. More significantly, China is still a relatively underdeveloped country. Based on potential productivity gains alone stemming from technology transfers and a more educated workforce, the Chinese baseline economic growth rate is probably at around 5%. With the People's Bank of China now dramatically easing – and with its central government now committed to a significant growth stimulus – this author has a hard time envisioning Chinese economic growth in 2009 to be anywhere south of 6%. True, there is still significant overcapacity in many of its domestic sectors (e.g. China has 570 million tons of steel production capacity but there is only around 400 million tons of demand) – but this excess capacity does not have to be eradicated all in one go. With the Chinese government committed to an infrastructure and social spending plan, much of this excess capacity could be “worked off” over a period of two to three years, as opposed to 2009. I expect Chinese GDP growth to be relatively week in the first half of 2009 – with an acceleration in the second half to bring total 2009 GDP growth to the 6% to 8% range.
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:
For the week ending January 2, 2008, the Dow Industrials rose 519.14 points while the Dow Transports rose 280.83 points. With both Dow indices rising above their December 8th resistance levels (despite last week's low volume), the bulls' case just got stronger. The next resistance levels are now their November 4th closing levels – which are 9,625.58 and 4,071.81, respectively. With tax-loss selling and hedge fund liquidation now over, with the rescue of the Big Three automakers (and GMAC) and with the Federal Reserve and the Bank of Japan both adopting a “quantitative easing” policy, global liquidation pressures have most probably peaked. I also continue to believe that the vast majority of the world's central banks would do everything in their power to stem the liquidation pressures in the financial markets. Even the European Central Bank has turned slightly more dovish this past weekend. I am now looking for a 25 to 50 basis point cut from the European Central Bank on January 15th. Just a week ago, I was expecting a pause from the ECB. 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 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 increased from -14.6% to -12.9% for the week ending January 2, 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:
With the four-week moving average of our popular sentiment indicators having (convincingly) reversed from a historically oversold condition, chances are that the stock market will continue to rally for the foreseeable future, as the stock market has typically performed well when this sentiment indicator reverses direction from an extremely oversold condition. Moreover, the ten-week MA (not shown) is also now in an uptrend, after hitting an extremely oversold condition just four weeks ago – thus providing more “fuel” of for a further rise in the stock market before we could see a significant correction. Again, given the end of tax-loss selling and hedge fund liquidation, a rescue package provided for the Big Three automakers and GMAC, 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 we are in the midst of the biggest buying opportunity of our generation. 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:
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 for an upcoming or a continuation of a rally. With both the 20 DMA and the 50 DMA rallying above their “resistance levels” dating back to January 2008, there is a good chance that bullish sentiment (and thus the stock market) has further room to run before the stock market correct in a major way. As I have mentioned before, 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: While I believe U.S. equities are a “buy” in general, subscribers will need to be very selective if buying individual stocks, given the ongoing deleveraging phase and the projected shift in demographics and industry dynamics over the next 7 to 10 years. While I believe the strong “category killers” – such as Best Buy, Bed Bath & Beyond, and Barnes & Noble – will ultimately benefit from the ongoing deleveraging of the retail industry, subscribers will generally need to be very careful with buying “yesterday's winners,” such as those in the teen apparel industry, for example. At some point, the U.S. cruise industry will be a strong buy, but not until either Carnival or Royal Caribbean Cruises raise their ROEs from their current levels. As for China, there is still significant excess capacity in many of its sectors, but I expect the shedding of this excess capacity to occur over a period of two to three years, as opposed to being concentrated in 2009. As a result, I expect Chinese GDP growth to be somewhere in the range of 6% to 8% in 2009.
Going into 2009, I expect global liquidation pressures to ease further, although there are still further “shoes to drop” – primarily in Central & Eastern Europe, and in the commercial real estate market. More importantly, the compelling valuations in the US equity market are still too difficult to ignore. For those with a long-term timeframe, this represents the greatest buying opportunity of our generation. I am still 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. We will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA