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Fundamentals and Technicals Improving

(April 2, 2009)

Dear Subscribers and Readers,

It is good to be back – my three-day break from the financial markets was enjoyable and was a much-needed timeout!  Sometimes, it is important to stand back and to reflect deeply on current events and what they mean from a big picture perspective.  Otherwise, it is very easy to get lost in the day-to-day volatility, the rumors, and the half-truths.  Again, I want to thank every one of you for your patience and your support during these trying times.  During the three-day break from the markets, I managed to sneak in some reading on the “father” of the so-called “Keynesian Economics” – i.e. John Maynard Keynes.  For anyone that has an interest on the philosophical developments of economics and politics during the Victorian era and up to the end of World War II – as well as Keynes' philosophical and intellectual evolution – I highly recommend the abridged version of Robert Skidelsky's biography on Keynes.  Skidelsky also recently penned an article on the current economic crisis (and implications) on the Prospect Magazine – which is also a must-read. 

I would also like to take this opportunity to remind our subscribers of our forum.  This discussion forum has been in place since the beginnings of our website – and is truly a friendly (we have many moderators working around the clock to make sure of that) interactive forum which has fostered both original thinking and commentary topics in the past.  Myself, and a couple of other notable posters (such as rffrydr, nodoodahs, and diesel) also post there during market hours and on very up-to-date topics.  For those that would like to get a “daily fix” of some our thoughts, look no further than our discussion forum.

Over the last few days, there have been tons of bad news for the market, including Obama's new inclination to let General Motors and Chrysler to file for bankruptcy, the banks' assertion that March was a horrible month, the ever-declining housing prices, and the ongoing bickering prior to the all-important G-20 meeting – and yet, the world's stock markets have taken all this in stride.  As I am typing this, the Nikki is up by more than 300 points, while the S&P 500 overnight futures are up more than 10 points.  The ECRI Weekly Leading Index, as we have covered over the last couple of weeks, is starting to stabilize.  With the stock market's appreciation and the further expansion of the Fed's balance sheet over the last two weeks, chances are that the ECRI Weekly Leading Index has already bottomed.  This suggests that GDP growth would most likely be positive again by the third quarter of this year, and that unemployment would most probably peak at 9% to 10% by Thanksgiving or Christmas of this year.  With entire industries and many business models (especially those that depended on leverage or short-term funding in the money markets) having been destroyed, it will take at least several more years for the US economy to truly recover, but the new businesses (presumably those based on scientific or technological innovations) that arise from these ashes would be more sustainable (and would add more to our collective happiness) than ever.  The idea of “Creative Destruction,” as coined by Joseph Schumpeter many years ago, will be a prominent feature of the US economy for the next several years.

In the meantime – as we have discussed since early March – stock market technicals have grown stronger and should be supportive for a continuation of the rally over the next several months.  For example, the Dow Jones US Home Construction Index (an industry that has led the broad market since 2006) just made a higher low earlier last month, while its relative strength against the S&P 500 is now near its highest level in over six months, as seen in the following chart courtesy of

Dow Jones US Home Construction Index ($DJUSHB) - The DJ US Home Construction Index made a higher low early last month, while its relative strength against the S&P 500 is now close its highest level in over six months!

The above chart suggests that the US Home Construction industry may be bottoming.  Since the US Home Construction index has led the stock market since 2006, such a development would not only be bullish for the stock market, but for the US economy as well.  In addition, the Dow Jones US Durable Housing Products Index (as seen in the following weekly chart, again courtesy of is now seeing experiencing some relative strength, even though its relative strength line is still bumping up against its 20-week EMA. 

Dow Jones US Durable Household Products Index ($DJUSHD)

The DJ US Durable Household Products Index is definitely an index that needs tracking, as it has also been a leading indicator of the S&P 500 in the latest bear market (in fact, consumer durables is a component of the Conference Board's monthly leading indicator).  While this index does not yet suggest we are out of the woods, its tremendous bounce over the last few weeks is definitely encouraging.  Assuming its relative strength line against the S&P 500 breaks through its 20-week EMA, the broad market will most likely continue to rally for at least the next several months.

In terms of sentiment and liquidity, things are also now looking up for the US equity markets.  For example, the amount of cash held by equity mutual funds rose from 5.8% to 5.9% of total assets during February (as shown in the following monthly chart).  Most notably, the level of cash held by equity mutual funds as a percentage of total assets is now at its highest level since eight years ago!

Monthly Equity Mutual Fund Cash Levels (January 1996 to February 2009) - Cash levels at equity mutual funds spiked to 5.9% at the end of February- its highest level since February 2001!

Finally, the deleveraging within the stock market – as exemplified by the amount of margin debt outstanding – is most probably getting “long in the tooth,” as margin debt outstanding decline again in February.  Margin debt outstanding has declined by 52% since its peak in July 2007, and is now at its lowest level since October 2004:

Wilshire 5000 Vs. Margin Debt Outstanding(January 1997 to February 2009) - 1) * Ratio = Margin debt divided by Wilshire 5000 divided by 10 2) Total margin debt decreased $4.8 billion during February to $199.7 billion, from $204.4 billion at the end of January. Margin debt outstanding has decreased by a whooping $177.4 billion in the 12 months ending February. This immense rate of margin debt liquidation is unprecedented. Even during the 2000 to 2002 bear market, margin debt outstanding never declined so quickly. From its peak in July 2007, the amount of margin debt outstanding has now declined by 52%, and is now at its lowest level since October 2004.

The above developments – combined with the strong upside breadth and volume over the last few weeks – suggests that the US stock market has most probably bottomed.  More importantly, the current fundamentals and technicals suggest the current rally should last for several more months, at the very least.  The ongoing expansion of the Fed's balance sheet – combined with more fiscal stimulus down the road – also suggests the US “real” economy should bottom in the next several months, with the level of unemployment probably peaking by Thanksgiving or Christmas of this year.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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