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Defense Spending at Crossroads

(April 19, 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 4,040.67 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 3,731.67 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 881.33 points as of Friday at the close.

On April 6, Secretary of Defense Robert Gates detailed a rebalancing of priorities for the upcoming defense budget.  While defense spending in the 2010 budget will rise $20 billion from the 2009 budget many analysts now believe defense spending will decline in the next decade, as spending on mandatory programs such as Medicare, Social Security, and interest payments on the national debt take priority over defense programs.  Many of these projections were made before the peak of the current financial crisis – suggesting that defense spending will most likely be cut further, given the Obama administration's current fiscal stimulus programs, including infrastructure spending and middle class tax cuts.  In addition, the Obama administration has made clear that it intends to place priority on other issues, such as the economy, healthcare, and energy.  On the geopolitics front, it has focused on rebuilding relationships instead (most recently with Cuba, Iran, and many countries in Latin America).  I believe the stock prices of many aerospace & defense companies will struggle over the next few years, despite some decent valuations in the sector.

According to many analysts and the Council on Foreign Relations, the 2010 budget is too far along the planning stages to endure any immediate cuts – suggesting that the $20 billion year-over-year projected increase in the 2010 budget is safe.  That said, there is no doubt that the Pentagon has its eyes on scaling back many programs that deal with “traditional, strategy, and conventional conflict” over programs slated for what Gates describes as “irregular warfare,” such as improving the Pentagon's cyberspace capabilities (increasing the number of cyber experts it can train from 80 students to 250 students a year starting in 2011) increasing R&D to improve our capability to defense against long-range rogue missile threats, and increasing investments in our air force for programs such as Unmanned Aerial Vehicles and electronic warfare capabilities.  In terms of its “conventional program,” Gates proposals would include cutting the $67 billion F-22 Raptor program from the air force's target of 381 to 187 planes, halting the $27 billion DDG-1000 destroyer program, and terminating the $26 billion transformational satellite program, among others.

For now, the defense budget is protected, as the Obama administration seeks to increase the number of troops and replacing worn out equipment costing tens of billions of dollars.  But the US spent nearly $700 billion on defense in 2008.  Including supplemental appropriations for the wars in Iraq and Afghanistan, defense spending in 2008 was approximately $800 billion – equating to 27% of the federal budget, or 5.8% of GDP.  On both measurements, such spending would be at the highest level since the Regan defense buildup in the late 1980s, and is more than tripled the defense spending of the vast majority of developed countries (such as Canada, Germany, New Zealand, Italy, Spain, etc.).  From fiscal 2001 to today, US defense spending has approximately doubled, as shown in the following exhibit (courtesy of the Department of Defense and Goldman Sachs):

FY08 the actual peak in total DoD spend

Make no mistake: The Obama administration has is on record with respect to its five top priorities.  Those are: 1) the economy, 2) energy, 3) healthcare, 4) tax cuts for the middle class, and 5) education.  Given Obama's withdrawal timetable in Iraq (by 2011), and given the administration's actions so far in Latin America and the Middle East, defense spending would most likely be a priority for this administration going forward.  While cutting defense spending will be a very politically heated (and contested) issue, both parties must recognize that defense spending has to give, due to the increasing amount of commitments from mandatory programs such as Social Security, Medicare, and increased infrastructure spending.  In addition, many within the administration and the Pentagon have gone on record stating that a defense budget in the realm of about 4% of GDP (or $560 billion) is sufficient in maintaining our defense capabilities.  This suggests that is room for a $120 billion cut in defense spending going forward.

Finally, the growth in defense spending – just like everything else – has seen its share of cycles since the end of World War II (as shown in the following exhibit courtesy of the Department of Defense and Goldman Sachs):

Historical Defense investment account growth

Over the last 50 years, the change in defense spending has undergone three long upturns and two long downturns – each lasting approximately a decade.  Given that defense spending has already increased 12 years in a row (which encompasses the 2009 budget), one has to question here whether defense spending will hold up over the next decade, especially given the ongoing headwinds (increase in mandatory social welfare spending, other priorities such as energy independence, the economy, etc.).  For investors who are thinking of buying aerospace & defense stocks for “defensive” purposes, I highly suggest you look elsewhere.

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 17, 2009) - For the week ending April 17th, the Dow Industrials rose 47.95 points, while the Dow Transports rose 105.88 points. Both Dow indices have now risen six 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, although this strength has subsidied a little bit in the last couple of weeks. 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 and to the banks' *stress tests* that will be published in early May. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending April 17, 2009, the Dow Industrials rose 47.95 points while the Dow Transports rose 105.88 points.  The two Dow indices have now risen six weeks in a row – and more importantly, are about to break above their recent resistance levels.  Although both upside breadth and upside volume have dissipated in the last two weeks, this weakening is most probably due to investors' reaction to the short-term overbought conditions of the market.  On the contrary, the fact that the market has held up relatively well despite the short-term overbought conditions suggests that the rally still has further to go.  I expect the broad market indices to rally further in the next several months, given the amount of liquidity on the sidelines, the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system, and the ongoing efforts of global monetary authorities to reliquify the world's financial markets.  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 -11.5% to –8.7% for the week ending April 17, 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 17, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -11.5% to -8.7%. Meanwhile, its ten-week MA (not shown) has also reversed from a historcal oversold reading of -18.9% three weeks ago (lowest since August 2002!) to -16.6% - 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 18% in the last five 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.  Moreover, the current four-week MA reading of -8.7% is still far from an overbought reading.  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 50 DMA has now caught up to the 20 DMA - suggesting that this sentiment indicator has now worked off its ST overbought conditions. 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 several 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 several weeks has allowed it work off its short-term overbought conditions.  With this indicator still far from historically overbought levels, the ISE Sentiment reading is still supportive for a rally in the stock market over the next several weeks to several months.

Conclusion: While the amount of US defense spending will depend very much on 21st century politics, history, budget constraints, and the current administration's priorities suggest that the growth of defense spending will be curtailed after 2010.  Moreover, an increasing portion of defense spending will shift to what Gates has termed “irregular warfare” – such as cyber warfare, unmanned aerial vehicles, and high-tech robotics.  In addition, there is a general belief among many in the administration and the population that more important domestic investments need to be made – particularly on energy independence (which will reduce the need to project our power to the Middle East), healthcare, and education.  At this stage, there is a general belief that without a stronger domestic economy and infrastructure, we simply cannot sustain the current level in defense spending.  While a sustained decline in defense spending is not guaranteed, we simply cannot recommend any aerospace & defense stocks for now, given the tremendous headline risk going forward.

In terms of the general stock market, I continue to 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.  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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