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Valuations and Technicals Still Look Bullish

(April 12, 2009)

Dear Subscribers and Readers,

Let us begin our commentary by reviewing our 8 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 4,088.62 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 3,779.62 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a gain of 833.38 points as of Friday at the close.

As a former pension consultant for many Fortune 1000 firms, and as someone who believes that demographics will play a profound role in both the US economy and politics over the next two decades, one of the many trends I regularly track is the demise of defined benefit (DB) pension plans at many Fortune 1000 firms.  Starting with the first private DB plan created by American Express in 1875, the number of US DB plans grew steadily into the late 20th century.  This concept of retirement security – where the company would provide a “defined amount” of monthly benefits after retirement – even withstood the Great Depression (although some employers had to terminate their plans during that time).  As wage controls set in during World War II, the popularity of DB plans grew again as employers enacted indirect wage increases through the provision of a DB plan or a promised increase in retirement benefits.  With the passage of ERISA in 1974, Congress solidified the legitimacy of these plans by protecting employees' rights to their benefits and setting minimum standards for employee participation and benefits.  The Act also created the Pension Benefit Guaranty Corp. (PBGC) – which is essentially an insurance scheme for these plans (with annual contributions made by plan sponsors).  While the number of DB plans (and those covered under them) continued to grow during the 1980s, the popularity of these plans were starting to decrease – as the onerous costs (both direct and indirect) of sponsoring a DB plan increased dramatically after the passage of ERISA in 1974.  According to the PBGC, the number of DB plans peaked at 114,000 in 1985.  Today, there are only 38,000 DB plans, due mostly to the termination of DB plans with 100 or fewer participants (given the complexity and costs of administering these plans).

In recent years, the trend has been a move by many Fortune 1000 companies to either terminate or freeze their DB plans, as the two-decade “asset tailwind” provided by the bull market in equities drew to a close in the year 2000.  Prior to 2000, many plan sponsors had fully-funded DB plans for many years – and since the cost of administering these plans mainly came from pension assets, company executives did not regard them as cost centers in general.  On the contrary, many CEOs and CFOs were able to book the asset gains in their DB pension plans as part of earnings during the equity bull market (e.g. nearly one-third of IBM's earnings in the late 1990s came from asset gains in its DB plan, even though pension assets are legally separate from company assets).  With the crash in the financial markets last year, and with the increased volatility in both interest rates and asset prices, many CEOs and CFOs are no doubt taking another hard look to see if they could trim costs by either terminating or freezing their companies' DB plans.  Anheuser Busch is the latest company to do so – setting a target freeze date of January 1, 2012 on its $1.8 billion DB plan for salaried employees.

Perhaps one of the most profound social and economic issues over the next two decades is the impending aging/retirement of the baby boomers – especially as “social safety nets” such as DB plans go away.  Once regarded as one major leg of the “three-legged stool” to support our retirement (the other two being personal savings and social security benefits), the termination of DB plans since 1985 will have a tremendous, and adverse impact on many baby boomers as they struggle to retire over the next two decades.  Its heir apparent, the defined contribution plan (such as 401(k) and 403(b) plans) has been grossly inadequate (baby boomers simply have not been disciplined enough to contribute sufficient amounts to their DC plans) – made all the more so given last year's crash in the financial markets.  As for personal savings, many baby boomers have little, even though baby boomers are by far the wealthiest demographic cohort in the US today.  Don't get me wrong – many baby boomers are still very well off, but given the distribution of wealth and income levels today, many baby boomers will also have a difficult time trying to retire.  Predictably, these same baby boomers who have saved little will also struggle to stay employed going forward, as these are typically folks who have little skills to offer in the 21st century knowledge economy.  Continuing on with our theme from last weekend's commentary, I believe this impending “social problem” will result in more government intervention and spending in many parts of our economy/society over the next two decades.

Another theme that I regularly track – given my education and experience – is the state of the US money management industry.  As I discussed in our March 22, 2009 commentary (“Levered Beta Plays Are No More”), the concept of “alpha” is difficult to grasp and even more difficult to achieve in today's markets.  In fact, many value managers who were able to outperform the equity markets since the end of World War II were simply those who engaged in “levered beta” or “exotic beta” strategies – nothing more.  While I expect levered beta strategies to continue their bounce over the next three to nine months, I expect them to underperform starting in 2010, as the US and most of the developed world continues to rebuild their balance sheets.  On the other hand, I expect technology and healthcare stocks to outperform, and for active managers to continue to move into “exotic beta” strategies (to try to extract alpha) including private equity, private real estate, foreign small caps, and emerging market bonds.  This period will be a tremendously difficult period for US active equity managers, unless one has a good informational advantage within the technology or healthcare sectors.  In today's environment of free earnings transcripts on the internet, lightning fast access of company's 10-Ks and analyst presentations, easy availability of sell-side reports, the growing number of financial MBAs, and the Fair Disclosure Act, we are now on a much more level playing field.  More importantly, especially for those who are still seeking employment in the investment management industry, the number of employees at many major money management companies actually hit a record high in 2007 (right before the financial crisis) as shown in the following chart (courtesy of P&I Online):

Number of Employees by Year

Since the end of 2007, there have been numerous announced layoffs in many money management firms.  For example, BlackRock has announced layoffs totaling to 8.9% of its workforce, Fidelity 2.9%, Janus 9%, Legg Mason 8%, MFS 5.0%, Putnam 12.3%, State Street 6.0%, Wellington 10.0%, and Western Asset Management 10.0%.  Even Harvard Management Company – the entity responsible for investing Harvard's sizable endowment, laid off 25% of its workforce.  Note that after the technology bull market peaked in 2000, many of these companies retrenched for the next three years.  While these companies did hire more employees on a net basis in 2004, they really did not start hiring aggressively again until 2006 (once the Dow Industrials rose above its previous bull market high of 11,723.00).  My sense is that many traditional asset management firms have been “shell shocked” by the Crash of 2008, and thus most likely won't start hiring aggressively again until we are again close to bull market highs (my sense is a DJIA print of above 13,000).  In addition, with the long-short equity hedge fund industry still in the midst of consolidation (and layoffs), folks who are looking for full-time jobs in the asset management industry may have a hard time find them not just this year, but in 2010 as well.

I now want to comment briefly on the equity market's valuations and technicals.  As we discussed in our March 8, 2009 commentary (“Illiquidity Still Killing the Market”), we estimated that the price-to-book ratio sunk to a new 26-year low at the bottom in March.  Ned Davis Research has confirmed this, as shown in this chart.  At the bottom in early March, the price-to-book ratio of the S&P 500 sank to a value of only 1.2, or half the average of the last 31 years.  Moreover, the P/B ratio of the S&P 500 has not been close to that level since the beginning of the huge 1980s to 1990s bull market in late 1982, when the P/B ratio bottomed at around 1.0.

The perma-bears – looking at this from a “glass half empty” perspective will claim that the P/B ratio will need to retest its July 1982 low before the bull market can start renew again.  They may be right, but they should also remember that the P/B ratio of the S&P 500 is overstated relative to its lows in the early 1980s, as neither technology or biotechnology R&D spending (the biotechnology industry was not born until the late 1980s) is capitalized and treated as an asset on the balance sheet.  For example, Amgen and Gilead Sciences – two of the better performing stocks on the S&P 500 over the last 18 months, have P/B ratios of 2.46 and 10.38, respectively.  Even Microsoft, a mature cash cow in the software industry, has P/B ratio of 4.95.  Assuming (conservatively) that 15% of the S&P 500 are made up of such companies that did not exist in their current forms in the early 1980s, I estimate the P/B ratio of the S&P 500 to be approximately 1.05 on a R&D adjusted basis at the bottom in early March, or its lowest level since the beginning of the greatest bull market in history in late 1982.  In addition, analysts are still projecting the S&P 500's earnings to be in the range of $35 to $50 a share this year, suggesting that the S&P 500's book value will continue to grow this year.  Based on the price-to-book ratio of the S&P 500, the core earnings power of the S&P 500's components, the fact that the government and bondholders have been taking losses for common shareholders in companies such as AIG and the GSEs (as pointed out by Jeremy Siegel, who argued that the S&P 500's 2008 earnings are actually $79.40 when using his proposed weighting method), and the range of liquidity schemes implemented by the Federal Reserve and Bank of England, there is no doubt that stocks represented a great buying opportunity in early March.

Since early March, the Dow Industrials have rallied 23%, the Dow Transports 39%, the NADAQ Composite 30%, the S&P 500 27%, and the Russell 2000 36%.  While valuations are not as attractive as those were in early March, subscribers should note that both upside breadth and volume have been very impressive the early March bottom – suggesting that there is genuine institutional demand for stocks.  Moreover, this has been accompanied by a genuine improvement in the fundamentals of the financial system and liquidity – as signaled by the rally in bank stocks, the decline in the VIX, the upturn in the ECRI Weekly Leading Index, and the quantitative easing policies implemented by the Federal Reserve, the Bank of Japan, the Bank of England, and the Swiss National Bank (and soon the Bank of Canada and potentially the European Central Bank).  In a latest technical piece on the website, founder Carl Swenlin asserts that with the S&P 500's 20-day EMA closing above its 50-day EMA last Thursday, the S&P 500 is now on a “medium term” buy signal.

In addition, the number of 52-week highs vs. the number of 52-week lows has experienced three “high lows” since October of last year.  This means that while the broad market indices were making new lows in March, many other stocks were not confirming on the downside.  As a matter of fact, the number of common stocks on the NYSE making new 52-week lows during the March decline shrunk to half that of the October decline of last year – suggesting that the decline and selling pressure was running out of steam, as shown in the following chart (courtesy of

NYSE Common Stock Only New Highs and New Lows - The 10 DMA of the NYSE CSO High-Low Differential is about to turn positive – for the first time since late May of last year. Given the three *higher lows* experienced in this indicator since October of last year, such a development would be very bullish for the market.

More encouragingly for the bulls, the 10-day moving average of new highs vs. new lows is actually about to move to positive territory for the first time since May 2008.  Should this occur, this will be immensely bullish for the stock market for at least the next several months.  Note that we are also seeing a similar picture on the NASDAQ Composite.  As a matter of fact, the 10 DMA of the new highs vs. new lows on the NASDAQ Composite hasn't been in positive territory since October 2007!  Based on this indicator, the NASDAQ Composite has been in a bear market for 18 consecutive months – with no significant bear market rallies during that time period.  Such an oversold condition hasn't occurred in NASDAQ's history going back to the 1970s – not even during the 2000 to 2002 bear market in technology stocks.  Finally, with many institutional investors (such as pension funds, endowments, and foundations) now underweight equities, there will continue to be some institutional rebalancing back towards equities over the next several months.  For now, we remain bullish on the US stock market, and thus will remain 125% long in our DJIA Timing System.

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 2006 to April 9, 2009) - For the week ending April 9th, the Dow Industrials rose 65.79 points, while the Dow Transports rose 10.67 points. Both Dow indices have now risen five weeks in a row - and more importantly, are now on the verge of breaking above their recent resistance levels. So far, the strength of this rally has been strong, as both upside breadth and volume have been the most impressive since the bear market started in late 2007. More importantly, the Dow Transports managed to hold above its March 2003 low of 1,942 in early March (if the March 2003 low did not hold, we will most probably experience a far greater-than-expected global recession).  In addition, until the financial system is working again and until the US housing market stabilizes, the Obama administration will continue to find ways to revive the financial markets. The current rally looks sustainble - but whether it will be sustainable in the weeks ahead will depend on investors' reactions to 2Q earnings. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending April 9, 2009, the Dow Industrials rose 65.79 points while the Dow Transports rose 10.67 points.  The two Dow indices have now risen five weeks in a row – and more importantly, are about to break above their recent resistance levels.  Given the strong upside breadth and volume over the last five weeks, the many positive divergences we have discussed, the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system, I expect the current rally to continue for the next several months.  Should there be any further need for capital after the results of the banks' “stress tests,” I expect the US Treasury to stand by the terms of its February 10th “Financial Stability” plan, and with the Feds now providing support for the TALF and the PPIP, I also see a significant increase in bank lending and an eventual reopening of the securitization markets.  Because of this, we will maintain our 125% long position 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 a reading of -15.5% to –11.5% for the week ending April 9, 2009.   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 April 9, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -15.5% to -11.5%. Meanwhile, its ten-week MA (not shown) has also reversed from a historcal oversold reading of -18.9% two weeks ago (lowest since August 2002!) to -17.9% - suggesting that sentiment has reversed from its very bearish readings. Subscribers should note that any reversal from historically oversold readings is usually a precursor to a significant rally. We will remain 125% long in our DJIA Timing System, and are now looking for a continuation of the rally over the next several months.

With the four-week moving average rising over 15% in the last four weeks, there is no doubt that this sentiment indicator has now reversed to the upside from a historically oversold level.  Historically, the best time to buy equities is when this sentiment indicator reverses from a very oversold level – and no doubt this is one of those times.  Given this development there is a very good chance the market will continue to rally.  With the world's governments committed to reliquifying the global financial system, and coupled with the inevitable rebalancing into equities by institutional investors, my sense is that the market could sustain its rally over the next several weeks to several months.  We will remain 125% long in our DJIA Timing System, for now.

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 its most recent peak on March 24th, the 20 DMA has been consolidating in the 131- to 137 range - indicating that this sentiment indicator is working off its short-term overbought conditions. While the 20 DMA has become overbought relative to its readings over the last two years, it is still oversold relative to its longer term readings. Moreover, the 20 DMA is now trading authoritatively above the 50 DMA - signaling that the market is still biased towards the upside. Now that we have received concrete details on the TALF and PPIP, we should see a continuation of the rally over the next several months.

Since its most recent peak on March 24th, the 20 DMA has consolidated in the 131 to 137 range over the last few weeks.  While this sentiment indicator is at a level that is overbought relative to its readings over the last two years, its consolidation over the last few weeks has allowed it work off some of its short-term overbought conditions.  More importantly, the 20 DMA is still trading authoritatively above its 50 DMA – suggesting that both bullish sentiment and the stock market are still biased towards the upside.  As a result, the ISE Sentiment reading is also supportive for a sustainable rally in the stock market over the next several weeks to several months.

Conclusion: As US and global demographics shift in profound ways over the next two decades, we should expect radical shifts in government priorities and a sustained increase in government regulation and spending, especially given the withdrawal of the private sector in providing a stable income and/or healthcare benefits for employees in retirement.  As we have discussed many times before, the current defined contribution structure and the rise of the 401(k) and 403(b) plans as a popular retirement savings vehicle is nowhere near sufficient in providing retirement security for our aging baby boomers.  Long regarded as a major component of retirement security, the demise of the defined benefit plan has created a void in many boomers' retirement plans – and unless the private sector comes up with a well-engineered “solution” in the next few years, the lack of a social safety net for many baby boomers after they retire will result in firm governmental action sometime in the next decade.  This is a trend that we will continue to track going forward.

As we mentioned a few weeks ago, I expect levered beta strategies to outperform for the rest of this year as global policy makers go “all out” to cushion or stop the deleveraging in the financial markets.  Consequently, I expect financial stocks, consumer discretionary stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis for the next several months.  Starting in 2010, however, this trend should shift, as consumers and corporations around the world start to rebuild their balance sheets once again.  Whatever future growth we achieve will need to come mostly from Schumpeterian growth, while true alpha would mostly be extracted from “exotic beta” strategies such as microcap stocks, foreign small cap stocks, private equity, and private real estate strategies.  As the US Treasury and the Fed continue to find ways to reliquify the asset-backed markets and our financial institutions (through the Fed's stress tests), I expect CDS spreads to narrow and for the structured finance indices to start their recovery.  Such a scenario would not only benefit the asset-backed markets, but the stock and bond markets as well (especially the balance sheets of major financial institutions).  With the darkest sentiment in decades and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System on February 24th.  We will sell this additional 25% long position once the market rally starts to lose steam.  For those with a long-term timeframe, the stock market still represents a good buy.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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