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Bearish on Retail

(November 15, 2009)

Dear Subscribers and Readers,

Note: As we all (at least on like to say, "Demography is destiny."  As China ascends on the world stage, its "Achilles' Heel" is its deteriorating demographics and the relative lack of formal education among its older workers.  At the same time, the US is not immune from this trend, as the aging of the baby boomers promises to swamp our Social Security and Medicare systems, with higher taxes an inevitability.  What do our subscribers think?  Please sound off by posting on our "Demographics" thread on our discussion forum!

Dear Subscribers and Readers,

Let us begin 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 1,901.53 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 1,592.53 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.

As the US consumer continues to deleverage his extended balance sheet (assisted by the lack of credit from banks, credit card companies, and the ABS markets), many companies in the retail, specialty retail, restaurant, and leisure (most notably the casino operators) industries will struggle over the next few years.  We have beaten this topic to death already, but the longer-term (the next three to five years) troubles in these industries cannot be overstated.  In our June 7, 2009 commentary ("Victims of Their Own Successes"), we had this to say about the casino operator industry, and broadly, other US industries that have relied on quantitative marketing strategies and increasing consumer leverage over the last 25 years:

What is less obvious is that the US casino operator industry (in particular the large ones on the Strip) is a victim of its own success.  In a now-famous Harvard Business Review article published in 2003, the CEO of Harrah's Entertainment, Gary Loveman, discussed how Harrah's has been able to boost the most loyal clientele in the industry, resulting in 16 straight quarters of same-store revenue growth and the most profitable casinos in the industry through customer-data mining and innovative marketing strategies.  A summary of the article is as follows: “Harrah's Entertainment CEO and former Harvard Business School Professor Gary Loveman explains how his company has trumped its competitors by mining customer data, running experiments using customer information, and using the findings to develop and implement marketing strategies that keep customers coming back for more. Harrah's identified its best customers--who were not typical high rollers--and taught them to respond to the casino's marketing efforts in a way that added to their individual value. The company's customer preference data were collected through its Total Rewards incentive program; in addition, it used decision-science-based analytical tools and database marketing. This deep data mining has succeeded because Harrah's has simultaneously maintained its focus on satisfying its customers. Loveman outlines the specific strategies and employee-performance measures that Harrah's uses to nurture customer loyalty across its 26 casinos.”

Similar customer data-mining and marketing strategies were adopted by other casino operators – not just on the Strip but also by Atlantic City and some tribal casinos as well.  Unfortunately – especially with the advent of computer tracking technology, the use of modern-day quantitative marketing strategies, and the immense hiring of marketing MBAs in recent years – casino operators were too successful, resulting in a severe oversaturation of the domestic gaming market.  This “victim of its own success” phenomenon was clear across many US industries, including the casual dining, auto, consumer electronics, specialty retail, mortgage, and the home improvement industries.  Such a spending binge was further fueled by the structural decrease in borrowing rates (accompanied by an increase in credit availability) from 1980 to 2006.  Who could've thought that Alfred Sloan's innovative strategy of annual model changes (a strategy designed to increase aspirational spending to get folks to buy more cars) – combined with late 20th century financial innovation – would ultimately lead to the crash of the domestic auto industry, and the demise of GM and Chrysler?

As has been evident for many years, the US auto industry (especially the relationship between the companies and the unions) was in need for a fundamental reboot.  That it took a “liberal” like Obama to ultimately break the UAW isn't a surprise (much like Nixon's 1972 visit to China).  What is less obvious – from both an investing and social standpoint – is that a “fundamental reboot” of the spending behavior of US consumers would also mean dramatic changes in the various industries as described above.  In general, one does not want to be investing or working in the US retail, mortgage, restaurant, auto, and casino industries, as these industries have already reached saturation point and should experience below-GDP growth (or an outright shrinkage) in the next decade or two.  Moreover, many of these industries are also saturated on the “supply side” with skilled workers and MBAs who will be competing ferociously as their industries shrink going forward.  For the MBAs that are just graduating – take heed!  For those with an international background or international experience, I would highly suggest migrating to Asia in order to take advantage of the next consumer-spending boom, as we briefly discussed in our weekend commentary two weeks ago.  Working in a growing industry that isn't “top heavy” from a labor standpoint is the best career move anyone could make.  Conversely, working in a declining industry that is “top-heavy” with workers with many years of experience could result in a lifetime of agony – unless one could find a special niche in said industries.

Since the early March 2009 bottom, the best-performing stocks have been those with the greatest balance sheet and operating leverage, as well as those that depend on rising consumer leverage, such as retail stocks.  While the longer-term fundamentals for these industries remain bearish, there was no denying that at their November 2008/March 2009 bottoms, many of these stocks were selling at ridiculously low valuations.  In addition, this kind of stocks typically rally the most coming out of a serious bear market, so it was not a total surprise.  The following weekly chart (courtesy of, which shows both the absolute value of the S&P Retail Index and its relative strength to the S&P 500 from July 2004 to the present) indicates that the relative strength of the S&P Retail Index to the S&P 500 actually bottomed in July 2009, and has been trending upward since that time:

S&P Retail Index ($RLX) - The spike in the relative strength of the S&P Retail Index to the S&P 500 in early August took it to its highest level since July 2005!

However - while the S&P Retail Index made another rally high last Friday - its relative strength to the S&P 500 actually made its last high in early August.  In fact, the spike in relative strength in early August took it to its highest level since July 2005.  With many retailers still struggling to improve their top-line revenue growth (much of the improvement in profitability has come from cost-cutting), and with the momentum of the retailers now rolling over, I expect retailing stocks to struggle come 2010, or perhaps as early as December as the Thanksgiving and Christmas Shopping season disappoint.

The macroeconomic picture also does not bode well for the relative performance of retailing stocks.  For example, the production gap (the difference between personal consumption expenditure and industrial production) peaked in the second quarter of 2009.  On a three-month lag basis, the relationship between the production gap and the subsequent relative performance of retailing stocks has been significant, with an R-squared of 64% since 2000.  As the consumer expenditure picture should remain challenged going into 2010 (and with emerging markets and thus, our export markets, expected to recover), the production gap should continue to shrink going into 2010.  As shown in the following chart (courtesy of Goldman Sachs), such a trend does not bode well for the relative performance of retailing stocks vs. the S&P 500.

Production Gap vs. relative RLX YoY (1995-2010E)

Of course, this does not mean that retailing stocks will decline on an absolute basis.  Rather, I expect retailing stocks to substantially underperform most other sectors going forward.  At some point, I expect to make a trade based on this view by shorting the S&P Retailing Index ETF (XRT) and going long the S&P 500 ETF (SPY) in our MarketThoughts Opportunistic Investor Portfolio.  Coincident with this trade, I also expect to take off our long exposure in Best Buy (BBY) and Carnival Cruises (CCL) in our MarketThoughts Opportunistic Investor Portfolio.  Note that relative strength is also starting to shift from small cap to large cap stocks.  Buying a large cap index like the S&P 500 and shorting an all-cap index like the S&P Retailing Index would give us more positive exposure should this trend continue into 2010.

Following is an update of the performance of our Opportunistic Investor Portfolio:

The Opportunistic Portfolio
(As of November 13, 2009)
Security Description Sector Date
BBY Best Buy Common Stock Consumer Discretionary 11/14/2008 21.70 41.88     93.0%
CCL Carnival Common Stock Consumer Discretionary 1/16/2009 21.11 32.21     52.6%
DXHO US Dollar Index March 2010 Futures FOREX 10/27/2009 76.58 75.75     -1.1%


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 January 2007 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 2007 to November 13, 2009) - For the week ending November 13, 2009, the Dow Industrials rose 247.05 points, while the Dow Transports rose 108.10 points . While the Dow Industrials has now clearly made a new rally high, both the Dow Transports and other major indices such as the NASDAQ Composite are still lagging. Combined with the recent low volume, this *non-confirmation* suggests that the market would have a tough time rising further going into Thanksgiving. In addition, there are still some fundamental issues to deal with in commercial real estate and investors will likely remain jittery about the sector for months to come. For now, however, we will maintain our 100% long position in our DJIA Timing System, as we don't believe the cyclical bull trend that began in early March this year has ended yet.

For the week ending November 13, 2009, the Dow Industrials climbed 247.05 points, while the Dow Transports rose 108.10 points.  While the Dow Industrials continues to make new highs, the Dow Transports is still 2% below its rally high made in mid October (although there is strong evidence suggesting that the Dow Industrials is starting to become a leading index - which the Dow Transports has been since the bottom of the last bear market in October 2002).  Combined with the drop-off in volume over the last two weeks, probability suggests that the latest rally may be short-lived.  In addition, given the vulnerability of the European banking system and US commercial real estate market (at the very least, these two sectors still need to raise a substantial portion of capital from the equity markets), I continue to expect the US stock market to be mired in a consolidation phase going into Thanksgiving and the end of the year.  For now, probability suggests that the cyclical bull that began in early March remains intact.  We will thus maintain our 100% 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 decreased from a reading of 7.1% to 5.9% for the week ending November 13, 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 November 13, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 7.1% to 5.9%. This reading has now declined three weeks in a row, as is in fact at its lowest level since mid September. That said, it is still overbought relative to its readings over the last two years. While the strong upside breadth in the stock market since early March suggests the intermediate uptrend remains intact, many signs are pointing towards at least a consolidation period in the stock market, including the decline in volume over the last few weeks and the relentless rise in this sentiment indicator since March. For now, however, we will maintain our 100% long position in our DJIA Timing System.

While this reading has declined from its 17-month high of 11.2% made three weeks ago, it is still a little overbought in the short-run.  In addition, its relentless rise from early March to the present suggests that individual investors have gotten too bullish, too quickly.  While there is still enough “fuel” for a longer-term rally (the “cash on the sidelines” indicator, while not shown in this commentary, also confirms this), probability suggests that the stock market will need to consolidate before the rally can continue.  Moreover, while the “Bernanke Put” is still alive, the Federal Reserve has already indicated it will end its “credit easing” policy at the end of 1Q 2010 – thus constraining liquidity creation and support for the financial markets.  For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March remains intact.

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) - The 20 DMA decreased from 130.8 to 127.6 last week. While the 20 DMA has become more oversold, it is stil far from a very oversold level, and has in fact declined below the 50 DMA (suggesting that it may now be in a downtrend). The most recent action of this indicator and other sentiment indicators suggests the market will have a very hard time rally further as we head into Thanksgiving and the end of the year. There are also other fundamental issues that need to be dealt with - including the shakiness of the European banking system and the US commercial real estate market. For now, however, we will remain 100% long in our DJIA Timing System.

For the week ending November 13th,  the 20 DMA decreased from 130.8 to 127.6, while the 50 DMA increased from 126.2 to 128.3.  While the 20 DMA is now more oversold, it is still very far from an oversold level that would imply a much further advance in the stock market indices going forward.  Moreover,, the 20 DMA is now in fact below the 50 DMA - suggesting that bullish sentiment is in a downtrend.  This does not bode well for the stock market in the short-run.  Given the slowing liquidity creation by the Fed, and the ongoing vulnerability of the European banking system and the US commercial real estate market, the most likely scenario would be for the market to enter into a long period of consolidation till at least Thanksgiving and possibly into the end of the year.

Conclusion: We are bearish on the relative performance of retail stocks vs. the S&P 500 for many reasons, including: 1) The ongoing deleveraging of US consumers' balance sheets for the foreseeable future, 2) The overbought conditions in retail stocks, 3) The relatively high valuations in retail stocks, as well as negligible top-line revenue growth among many retailers over the last 12 months, and 4) The deteriorating demographics in the US.  The lifecycle of the US consumer has shown that consumer spending typically peak at age 55 or so, and that after that, discretionary spending tend to focus more on "services" as opposed to "products."  At some point, we will initiate a short position on the XRT (S&P Retail ETF) and a concurrent long position in the S&P 500 in the MarketThoughts Opportunistic Investor Portfolio in order to take advantage of a potential peak in the relative strength of retail stocks vs. the S&P 500.  The timing will most likely depend on investors' reactions to the first post-Thanksgiving Holiday sale.  Please stay tuned.

As for the stock market – while many indicators suggest a long consolidation period into at least Thanksgiving  – probability suggests that the cyclical bull market that began in early March is still intact.  For us to turn very bearish on the market again (i.e. for us to enter into a short position in our DJIA Timing System just like we did in October 2007), many things would need to line up, including a potential fiscal policy mistake (i.e. higher taxes), economic policy mistake (i.e. major protectionist threats), or a monetary policy mistake (such as the failure of the ECB to assist the Euro Zone's banking system in raising capital).  Moreover, while we no longer believe European banks pose a global systemic risk, there is no denying that European banks still need to raise $200 to $300 billion of capital in order to resume its “normal state” of lending going forward.   In addition, the ongoing decline in US commercial real estate prices continues to pose a global systemic risk, and is something that we will continue to track for the foreseeable future.  For now, our short-term belief is that the US stock market will be mired in a consolidation phase into Thanksgiving and possibly to the end of the year.  Subscribers please stay tuned.

Signing off,

Henry To, CFA


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