Identifying Short and Long Term Trends for 2010 - Part II
(January 10, 2010)
Dear Subscribers and Readers,
We will update the performance our DJIA Timing System (as of year-end 2010) in this week's mid-week commentary (which will be penned by our guest commentator, Rick Konrad of Value Discipline). Before we dig deeper into Part II of our 2010 outlook and the Chinese equity market, its economy, and its potential impact on the global financial markets, let us first review 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 1,553.81 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 1,244.81 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 I discussed in our email sent to our subscribers last Wednesday, I spent parts of last Thursday and Friday in Omaha, Nebraska as part of a trip organized by the two student investment funds at the UCLA Anderson School of Management to meet Warren Buffett. Buffett hosts several of these meetings for business school students each year as part of his mission to educate the nation's next generation of “business leaders” through instilling a sense of community involvement, business ethics, and providing career advice. Buffett was gracious enough to host us for a two-hour Q&A session, treat us for a lunch, and take individual pictures at the end. Notwithstanding the -25 degree Fahrenheit wind chill in Nebraska, I was excited to be there and thoroughly enjoyed the experience. Following are some of Buffett's notes that I think you will find of interest:
Warren Buffett on the prospects of the BRIC countries
During the Q&A session, one student from Brazil ask whether a bubble is developing in any of the BRIC countries. Buffett does not think so – but he caveats this by stating that he does not try to predict how a certain business or economy will do in just two to five years, but over a much longer timeframe. Buffett asserts that these countries all have a powerful force propelling their economies – a force they did not have as recent as just a decade ago. The U.S. economic system has had a history of allowing human beings to meet their full productive potential, and Buffett believes that these countries are now adopting similar economic systems and rules. While the economic growth of the BRIC countries will periodically be interrupted by recessions and dislocations, the overall machinery is definitely moving and it is very difficult to call the short-term swings to the downside.
Henry's note: We're going to comment on China later in this commentary – but in general – I agree with Buffett. Calling bubbles, and subsequently avoiding them/shorting them, and buying back near or at the bottom is an immensely difficult endeavor for not only retail investors, but for investment professionals as well. After all, how many of them got out of equities in late 2007, and how many of them called the bottom in March 2009? By definition, most investors cannot make such moves. The only real advantage for retail investors is to pick their spots or hold for the long-run – two very logical strategies which the majority of investment professionals cannot do (due to the pressure of making quarterly performance numbers or to “closet index” their benchmarks).
Warren Buffett on innovation and entrepreneurship in the U.S.
One student asked if the recent decline in venture capital funding worries Buffett, as the U.S. was built on a history of innovation and technological growth. Buffett counters that getting ideas funded today is a cinch, especially when compared to 50 years ago. Obviously, the American spirit of innovation may be different, but it still exists. More importantly, the U.S. political and economic system has pushed people to do the things they are good at, e.g. Steve Jobs, Larry Page and Sergey Brin, etc.
Henry's note: I fully agree with Buffett here. While Buffett is primarily about investing in businesses that possess stable and consistent cash flows with a very long-term horizon, this does not mean that Americans in general are not bitten with the innovative bug or investing in businesses with questionable prospects but with significant potential (venture capital and angel investing falls into this category). Buffett and at least 99% of Americans benefit indirectly from such innovation and speculative funding.
Warren Buffett on finding the industry or businesses with the most future growth
One student asked which industries will likely experience the most growth in the next 20 years. Buffett answered that he is not too concerned with individual industry growth, as: 1) No one really foresaw the internet's transformation on the world in 1995, and even if they had, they could not have foreseen the tools or businesses that ultimately became successful. For example, during a day-long meeting with Bill Gates, Steve Ballmer, and Charlie Munger in 1995 about the potential of the internet, not one of them could foresaw how the internet could transform GEICO's business. At the time, GEICO made over 140,000 insurance quotes a day over the phone. Obviously, internet quoting would be a game-changer, but Buffett did not realize this until a few years later.
Buffett also commented that the growth of new industries and adoption of new technologies has accelerated over the last century. For example, 40 years after Alexander Graham Bell developed the telephone in 1878, it still costs on average about a week's wages to make a three-minute phone call from New York to San Francisco. The commercialization of refrigerators, especially in households, took decades. In addition, figuring out where the money is – even if one can predict future industry growth – is a whole different animal. Buffett points out that few businesses have actually made money due to the commercialization of the internet. On the other hand, buying businesses such as Coke and Gillette (those with consistent and stable growth) have been very easy to figure out. It is not sufficient to figure out the things that are important but unknowable or things that are unimportant but knowable. Rather, one must need to figure things that are both important and knowable.
Henry's note: I cannot agree more with Buffett's view, especially pertaining to the minimal impact on one's investment performance from forecasting future growth for new industries or businesses.
Warren Buffett on the most important lessons learned from Benjamin Graham
Buffett has discussed this numerous times before, but it probably doesn't hurt to reiterate this. Buffett believes the most important lessons he learned from Ben Graham could all be distilled in Chapter 8 (which discusses the way to look and analyze the overall market – in this chapter, Graham also brings in the concept of the schizophrenic “Mr. Market”) and Chapter 20 (which introduces the “margin of safety” concept) of “The Intelligent Investor”. Buffett's entire investment framework – in terms of thinking about stocks as individual businesses – is based on these two chapters. Buffett has also been inspired by Graham in many ways. For example, Buffett believes in buying simple businesses (those that take less than ten minutes to understand) and things that are very certain. One counter-example is GM. Buffett asserts that he can spend a year looking at GM and its products and still would not understand the competitive landscape of the auto industry.
Buffett reiterates that investors must need to realize that the market is offering you things, not instructing you. One must use the market's quotes to one's advantage, and ignore the market most of the time.
Let us now discuss the prospects for the Chinese economy and equity market in 2010. On one end, folks such as Warren Buffett, Jim Rogers, GaveKal, and Goldman are still bullish on China for the long-term and do not yet see a bubble developing (although to be fair to Buffett, he is not too concerned about short-term market gyrations). On the other end, folks such as Jim Chanos (short-seller famous for making a bundle on shorting Enron) and Pivot Capital now view the “popping of the Chinese credit/capital spending bubble” as imminent, that is, sometime in 2010 or even the first half of 2010. As Pivot Capital points out, the numbers are now getting very scary, as shown in the following charts:
The above charts show the extent of capital spending in China from 1981 to 2009, relative to other capital spending booms in the 20th century (post World War II Germany and Japan, for example). In other words, Chinese economic growth, especially during 2009, was more or less totally dependent on capital spending growth. However, while Chinese capital spending is no doubt unprecedented, subscribers must remember that China essentially had no choice in both 2008 and 2009, as global economic growth slumped – leading to a decline in global demand and exports. I would argue that the Chinese had no other choice but to ramp on capital spending last year. In addition – given the slump in wages and the price of construction materials last year – I would argue that it was actually a good strategy as long as the funds are efficiently and well spent.
What's more alarming is the fact that Chinese capital spending may now be losing its efficacy. For example, as pointed out by Pivot Capital, China currently produces 500 million tons of steel (more than the combined production of the U.S., European Union, Japan, and Russia), with an overall capacity of 660 million tons. 60 million tons more of steel capacity are under construction. More shockingly, the per capita production of steel in China is about equal to the EU average and higher than the US average! Within the cement industry, China is now consuming as much as Spain and Ireland on a per capita basis – two countries which have recently gone through a housing and general real estate bubble:
As far as China's transportation infrastructure is concerned, Pivot Capital points out that while the U.S. has 4.2 million kilometers (2.6 million miles) of paved roads (with 80,000 kilometers or 50,000 miles of expressways), China already has 2.7 million kilometers of paved roads, of which 60,000 kilometers are expressways. At the same time, the U.S. has more than five times the number of vehicles in China (250 million versus 43 million). The only part of China's transportation infrastructure which needs further (and substantial) investments is arguably its railway and airport systems. In the meantime, Pivot Capital would argue that China's existing roads, steel, and cement capacity (among many other things) are adequate, for now. More importantly, any further expansion in these areas would simply lead to waste and substantial overcapacity down the road.
Going forward, China will need to find ways to boost domestic consumption in order to maintain its target 8% to 10% GDP growth, as well has move further high up the “value chain” so it could boost its exports (e.g. China just displaced Germany as the world's number one biggest exporter). With a GDP per capita of just US$3,000, there is still plenty of potential productivity gains, although the short-term path could be bumpy. More importantly, valuations of Chinese equities are not too extreme, as shown by the following chart, courtesy of Goldman Sachs:
On a macro basis, I expect the momentum in Chinese economic growth (and any secondary and multiplier effects on commodities, etc.) to continue through 1Q 2010, if not 2Q 2010. With much of its transportation infrastructure and manufacturing capacity now pushing its natural limits, I expect profit margins in many of these industries to be slashed in the second half of 2010 and 2011. Combined with higher-than-average commodity inventories, I expect commodity prices to make a major peak sometime in 2Q 2010 or the second half of 2010. For now, I merely expect a slowdown in Chinese economic growth in 2H 2010 and 2011 – not a major dislocation. This should also benefit the U.S. Dollar Index, and indirectly, U.S. consumer discretionary spending in 2H 2010 as the U.S. Dollar strengthens and commodity prices and Chinese wages decline.
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:
For the week ending January 8, 2010, the Dow Industrials rose 190.14 points, while the Dow Transports rose 122.63 points. Both the Dow Industrials and the Dow Transports made new cyclical bull market highs late last week, with the Dow Industrials finally closing above its 10,230 to 10,600 trading range that had been in place for the last two-and-a-half months. Given the strong momentum – and combined with decent valuations, strong liquidity, and strong upside breadth – there is no question that the cyclical bull market that began in early March is intact. However, given the still overbought condition of the US stock market, as well as the ongoing concerns about the economies of Spain, Greece, and Dubai, I expect the US stock market to consolidate further into the end of January (such a consolidation period would also be healthy for the market in the longer-run). We 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 increased from a reading of 16.6% to 17.7% for the week ending January 8, 2010. 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:
The four-week MA of the combined Bulls-Bears% Differential ratios just hit a new 25-month high and remains very overbought relative to its readings over the last two years. In addition, its relentless rise from early March suggests that individual investors have gotten too bullish, too quickly (although the actual evidence – such as the lack of equity mutual fund inflows, says otherwise). Given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a decent rally in 2010, but probability suggests that the stock market is still stuck in a consolidation period that should last until the end of January. For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March 2009 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:
For the week ending January 8th, the 20 DMA rose from 126.3 to 132.8, after hitting a fresh 6-month high of 137.6 on December 1st. As mentioned on the above chart, the 20 DMA has since settled lower, although it remains overbought relative to its readings over the last two years. Combined with the overbought readings in our other sentiment indicators, probability suggests that the market will consolidate further until at least the end of January. In addition, the macroeconomic backdrop - specifically the ongoing troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market - is also suggestive of a further consolidation period for the stock market.
Conclusion: Overall, our two-day trip to Omaha, Nebraska was well worth it, despite the subzero temperatures! We got a chance to not only see Buffett in person, but also a reiteration of his investment philosophy as well as some current views on the BRICs, and the innovative/entrepreneurial spirit of the United States. As for China, there is no doubt that certain areas – such as manufacturing capacity and infrastructure spending – are now in red-hot territory, although its longer-term outlook remains positive. We are now looking for a slowdown in the Chinese economy in 2H 2010, and possibly well into 2011 if economic growth in the rest of the world does not pick up by then. This will have a bearish impact on commodity prices sometime in 2Q 2010, or 2H 2010. Sometime in the 2012 to 2013 timeframe, I expect U.S. (and the rest of the developed world's) economic growth to accelerate again – once U.S. households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth.
As for the US stock market, our short-term belief is that the US stock market will be mired in a consolidation phase into the end of January. Should the US stock market experience a correction, there will be significant support at the DJIA 9,750 level. However, we remain bearish on the retail industry (as discussed in our commentary over a month ago), as well as the major US casino operators. Subscribers please stay tuned.
Henry To, CFA