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A Six-Month Review of our DJIA Timing System

(July 12, 2009)

Dear Subscribers and Readers,

Before we begin our commentary on the alternative energy sector, I want to update our DJIA Timing System's performance to June 30, 2009, and review our 9 most recent signals.  Note that subscribers who want to independently calculate our historical performance could do so by tallying up all our signals going back to the inception (August 18, 2004) of our system (we have sent our subscribers real-time emails whenever there is a new signal).  Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to June 30, 2009:

DJIA Timing System Performance Statistics

To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way.  We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500 or the Russell 1000), since most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market.  In addition, the Dow Industrials has a rich history and has been computed since 1896, while the S&P 500 was only created in 1957 (although it has been retroactively constructed back to 1926).

Looking at our most recent performance and performance since inception, it is clear that most of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and our subsequent shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we closed out on January 9, 2008).  While we have stayed on the long side for the most part since mid January 2008, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance.  Looking at the last six months, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided over 3% in outperformance, although that resulted in slightly higher volatility (since we were 125% long).

There is no way around this.  Our track record so far is definitely not “marketing material,” but while we are not happy with our performance over the last 12 months, subscribers should note that we are still ahead of the Dow Industrials by nearly 10% on an annualized basis over the last two years, or since the beginning of the credit crisis.  In addition, on a total return basis, we are ahead of the Dow Industrials by more than 13% since the inception of our DJIA Timing System on August 18, 2004, returning -3.07% vs. -16.23% for the Dow Industrials (on a price-only basis).  Our goal is to beat the stock market with less risk over the long run, and so far, we have done that.  Today, we remain 100% long in our DJIA Timing System. 

Subscribers should remember that:

  1. It is the major movements that count.  Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;

  2. Capital preservation during times of excesses is the key to outperforming the stock market over the long run.  That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back sometime in the next few years.  I am not going to change my mind on this until/unless I see 1) a major policy mistake from the Fed or the European Central Bank, 2) the potential emergence of an inflationary spiral, 3) a major policy mistake from the Obama administration, such as protectionist policies or higher taxes, 4) extreme overvaluations in the U.S. stock market, or 5) the potential emergence of a major regional war, especially in the Middle East.  At this point, I do not see much threat to the stock market on any of these five counts (versus late 2008, when valuations were overly high and when the Fed was reluctant to cut rates), although Iran definitely remains on our watch list.

Also note that our (annualized daily) volatility levels continue to be lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods.  For now, we believe that the stock market made a solid bottom in early March, and thus we will most likely remain 100% long in our DJIA Timing System for the time being.  Should the DJIA decline back to the 6,900 to 7,500 area over the next few weeks (which is possible if investors react badly to the 2Q earnings reports and 3Q projections), there is a good chance we will go 125% long in our DJIA Timing System again.  We will next update the performance of our DJIA Timing System at December 31, 2009.

Let us now continue our commentary by reviewing our 9 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 4,025.48 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 3,716.48 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.

In our last weekend's commentary, we stated that while we continue to express our doubts on the commitment of the world's central banks to reflate the economy and the spending power of global consumers in the short-run, we are still very much bullish on the long-term innovative capacity of the US and global economy.  Specifically, the innovation and the progression in the global supercomputing industry remain on track.  Quoting our last weekend's commentary: “Tasks that take an immense amount of computing time today – such as weather forecasts, gene sequencing, airplane and automobile design, protein folding, etc. – will continue to be streamlined as newer and more efficient processors/software are designed.  While my optimism is relatively guarded, futurist Ray Kurzweil asserted that a supercomputer with 10 petaflops of computing power would be capable of simulating the basic functions of a human brain (with a supercomputer 1000 times as power for full human brain neural simulation).  Such a democratization of the supercomputing industry would also result in improvements in solar panel designs, better conductors, drugs that are more efficient, etc.  As long as global technology innovation isn't stifled, the outlook for global productivity growth – and by extension, global economic growth and standard of living improvements – will remain bright for years to come.

Just like almost every innovation and productivity-enhancer in the modern economy, the availability of cheap power is the lifeblood of the supercomputing industry.  In fact, the bulk of the costs (both the purchase and the operational costs) of a top-notch supercomputer today lie in the cost of electricity – both to power the supercomputer and to cool down its components to prevent overheating.  While recent discovery of natural gas shale fields (such as the Haynesville Shale, which is estimated to hold approximately 10 years worth of domestic natural gas reserves) should be sufficient to power today's economy, the global hunger of cheap energy and power will grow for years or decades to come.  According to the Goldman Sachs Global Market Institute, China consumed only 1/3 of the total energy that the US consumed in 2000.  By 2006, China's appetite for energy had already risen to 2/3 of total US energy consumption, although on a per capita basis, Chinese annual consumption was only 56.2 million BTU, versus US annual consumption of 334.6 million BTU per capita.  By next year, Chinese energy consumption will be 15% of total world energy consumption, and by 2020, total Chinese energy consumption is expected to exceed total US energy consumption.

In order to satisfy this global hunger for energy – and to limit the growth of carbon emissions – a viable alternative energy industry will need to be developed.  Today, China's main source of energy still comes from coal.  In fact, the number of coal power plants in China now exceeds those in the US, UK, and India combined.  Moreover, China is still building two large coal-fired power plants every week.

Thankfully (or not surprisingly), the Chinese government has become more concerned with the destructive effects of being the world's largest CO2 emitter – and from a geopolitical standpoint, its dependence on foreign oil imports to maintain its blistering growth rate.  At this point, 17% of China's electricity and 7% of its total energy needs come from renewable resources (its primary source of alternative energy is hydropower).  China's goal is to generate 20% of the country's electricity and 16% of its energy from renewable resources by 2020.

The following exhibit, courtesy of Goldman Sachs, the Department of Energy, and the Energy Information Administration, shows the BRIC countries' total installed hydroelectric and other renewable energy capacity over the next couple of decades:

Total hydroelectricity and other renewable installed capacity in the BRICs countries

China's installed wind capacity doubled in 2008 to 12,210 MW, while China is now the world's largest producer of photovoltaic cells.  Moreover, China has vowed to become a world leader in electric car development.  In a bid to reduce its energy intensity (i.e. energy consumed to produce a dollar of GDP), China has already set a goal to become the world leader in hybrid and electric vehicles over the next three years.  Most notably, all the R&D is now being financed by the Chinese government (hence the reason why it was so important for the US government to directly support the efforts of Tesla).

Of course, the US isn't resting on its laurels.  In 2008, clean tech drew the most amount of venture capital out of all investment categories.  While private investments in clean tech dropped to $13 billion in 1Q 2009, this is most likely a temporary phenomenon.  The following exhibit (courtesy of Goldman Sachs and New Energy Finance) shows the amount of private investments in clean tech (on a quarterly basis) from 2004 to 1Q 2009:

Global new private investment in clean enegry quarterly - Recent decline likely to be an aberration

Since the vast majority of private, venture capital activity occurs in the US, the above amounts (global new private investment in clean tech) are mostly US-centric.  In addition, from a public policy standpoint, the US government has committed $13 billion to modernize the power grid and $20 billion in tax incentives over the next 10 years to developing renewable power resources.  Furthermore, the Department of Energy initiated a loan guarantee program to underwrite up to $60 billion for renewable projects to be commenced by September 30, 2011, and recently announced that $800 million will be made available to accelerate biofuel research and to fund large biorefinery demonstration projects – with a goal of developing and commercializing cellulosic ethanol.  Without government funding, there is no way (despite the amount of venture capital funding in clean tech) that the US could compete with China, especially in the currently difficult fund-raising environment for any new venture project.

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 July 10, 2009) - For the week ending July 10th, the Dow Industrials declined 178.35 points, while the Dow Transports declined 54.48 points. From the March 9th bottom till now, the Dow Industrials and Dow Transports are up 24% and 45%, respectively, despite the swoon since early June. The short-term outlook for the market remains tited towards the down side, as the lack of central bank liquidity creation (the failure of the Bank of England to raise its asset purchase limit to 150 billion pounds is the latest disappointment), the vulnerability of the the European banking system, and the deterioration of the commercial real estate market hang over the horizon. Moreover, our short-term technical indicators are still not in oversold territory. However, we will maintain our 100% long position in our DJIA Timing System, as we believe that we will eventually make new highs by the end of this year.

For the week ending July 10, 2009, the Dow Industrials declined 178.35 points while the Dow Transports declined 54.48 points.  With the two Dow indices having risen 24% and 45%, respectively, from their early March lows, and with the ongoing liquidity and systemic risks (the latest threat is a potential bankruptcy filing by CIT – which probably doesn't pose a systemic risk but which could conceivably drive the national unemployment rate to 11% or higher if allowed to fail), our decision to reduce our risk exposure by paring back our 125% long position to a 100% long position in our DJIA Timing System on the morning of June 8, 2009 was a good decision, in retrospect.  With the world's central banks continuing to cut back on liquidity creation, and with the uncertainty surrounding the 2nd earnings reports, the direction of the stock market remains down, for now.  With most of our short-term technical indicators are not at oversold levels just yet (although the 10-day MA of the NYSE ARMS Index just hit an oversold level of 1.50), we will continue to remain cautious.  However, should the DJIA decline to the 6,900 to 7,500 area over the next couple of weeks (most likely as a reaction to 2nd earnings reports), then there is a good chance we will again go 125% long in our DJIA Timing System in order to pick up a few percentage points of outperformance.

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 from a reading of 2.3% to -6.1% for the week ending July 10, 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 July 10, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of -2.3% to -6.1% -its third consecutive down week since peaking at 1.0% three weeks ago. While this reading is oversold on a historical basis (although this is definitely not the case during bear markets), subscribers should note that it has been on a relentless uptrend since early March. As a result, in order to control for risk, we decided to par back our 125% long position to 100% long in our DJIA Timing System on the morning of June 8th. For now, we will remain 100% long in our DJIA Timing System.

After peaking at 1.0% three weeks ago, the 4-week MA has now declined three weeks in a row – to -6.1%.  While the 4-week MA is at an oversold level relative to its readings over the last 12 years, subscribers should note that it has increased very quickly since the early March lows.  Combined with the liquidity headwinds (including the potential failure of CIT Group), the systemic risks stemming from Central & Eastern Europe, and potential jitters from 2nd quarter earnings reports, I expect the stock market correction to continue for the next couple of weeks.   While I believe the world's central banks are still committed to reflating the global financial system should the financial markets exhibit another bout of weakness, the “Bernanke Put,” as we discussed last week, has disappeared for now.  For now, we will remain 100% long in our DJIA Timing System – although there is a good chance we would shift back to a 125% long position should the Dow Industrials trades down to the 6,900 to 7,500 level.

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) - With the latest decline to 116.7, the 20 DMA is now at its most oversold level since early February 2009. From a contrarian standpoint, this is a positive for the stock market, but there are some short-term but significant obstacles that the market needs to deal with - including 2nd quarter earnings and projections, the systemic risks emanating from the European banking system, and the recent lack of central bank liquidity creation. Because of these ST obstacles, we have decided to reduce our 125% long position to just a 100% long position in our DJIA Timing System on the morning of June 8th in order to control for risk.

With the latest decline to 116.7, the 20 DMA is now at its most oversold level since early February 2009.  With this downward spike, this indicator is no longer at an overbought level.  From a contrarian standpoint, this is bullish for the stock market (although note that a reading of 116.7 is still far above where this reading was back in the March 2008 or November 2008 lows).  Despite this, there are still some short-term but significant obstacles that the market needs to deal with.  Unless this reading (along with the 50 DMA) decline to a more oversold level, probability suggests that the market should continue to correct over the next couple of weeks.

Conclusion: With the Obama Administration and the Chinese government now realizing that the key to long-term, sustainable growth is to develop a viable alternative energy sector, the race is now on for world leadership in many of these areas (on a more immediate basis, the development of more efficient hybrid and all-electric vehicles) between the US and China.  This is the modern “Space Race” – and I am confident that this would result in greater availability of energy and technologies that are significantly more energy-efficient over the next few years.  However, while US and global productivity growth remains bright in the long run, there are still many short-term headwinds that the stock market needs to deal with.  This includes the Bank of England's reluctance to raise its asset purchase limit from 125 to 150 billion pounds last week.  At its current rate of asset purchases (6 to 7 billion pounds a week), the Bank of England will hit its 125 billion pound limit in just two weeks. 

In addition, the Chinese government and the People's Bank of China are now pulling back from its loose monetary policy enacted over the last 8 months.  Combined with the troubles at CIT Group, and with a possible financial dislocation emanating from Central & Eastern Europe, I expect a further correction in the global equity markets in the short-run.  That said, I still expect the global equity markets to rise later this year, as global central banks will no doubt return to a more accommodative mode if equity and commodity markets experience a weak summer.  2010 will be trickier, as consumers and corporations around the world will continue to rebuild their balance sheets.  On a country-specific basis, I expect most of Asia and Brazil to continue to outperform (with a focus on domestic-orientated stocks).  While this is still too early to say, I expect the next US bull market to be driven by technology and biotechnology stocks.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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