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What Is Not Sustainable Cannot be Sustained

(January 31, 2010)

Dear Subscribers and Readers,

Before we begin our commentary, 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 2,104.67 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 1,795.67 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.

It is always easier for countries in distress to take the painful medicine now than to suffer the consequences at a later point in time.  Case in point: After years of government corruption and “living it up” by borrowing to the hilt to fund consumption (interestingly, Greeks actually work on average more than Americans, although that is skewed by the disparity of the number of part-time workers), Greece is finally forced by the markets to “clean house.”   To paraphrase “Reminiscences of a Stock Operator”: The market is a stern paymaster; he is always on the job and never loses the pay envelope that is coming to you. 

In actuality, having the capitalistic system force a solution is preferable than a classic Soviet-style cover-up.  For in the end, a Soviet-style cover-up always ends in much more dire straits – riots and starvation on the mild side and full-fledged (bloody) revolution on the extreme side (e.g. the collapse of the dynastic system in China in 1912 or the collapse of the Soviet Union in 1991).  George Soros was the best thing that ever happened to Great Britain in the early 1990s and it now looks like Greece will have to take its own dose of medication.  Ultimately, a transparent market is in everybody's interest (except for those speculators who make money by pouncing on the macro inefficiencies) – especially since politicians can (generally) never be relied upon to advance the long-term economic interests of their constituents (also, the bigger the issue, the more ideology comes into play, thus limiting policy makers to implement the most efficient/fair solutions).

As the subject of this commentary states, what is not sustainable cannot be sustained.  Until Greece comes up with a satisfactory fiscal solution, the risk of a general capital flight from Greek government bonds will continue to increase.  In many ways, this is a new kind of crisis, as Greece cannot simply devalue its currency to entice new investors or to improve on its trade balance (although the trade balance usually takes a long time to adjust given the long-term nature of business/trade contracts).  More importantly, it is difficult to envision the Greek government or its citizens to seriously reform the system unless the country comes very close to or actually experience a systemic collapse.  In many ways, the Greek trade unions, the farmers, and many of its politicians and citizens are still in denial.

As of last Friday, the spread between Greek 10-year governments bonds to that of Germany stood at nearly 400 basis points – easily surpassing the level at the height of the financial crisis in late 2008/early 2009 (when it stood at just about 300 basis points).  Out of the PIIGS countries (the original PIGS countries, including Ireland), Greece is by far being hit the most.  The country with the second highest spread is Portugal, whose 10-year government bond closed at approximately 120 basis points over that of Germany.  Spain, another country on the periphery, saw its 10-year government bond closed at just under 100 basis points over that of Germany last Friday.

Let us now review the fundamental macro economic backdrop of these countries.  The following chart (courtesy of Goldman Sachs) shows the “twin deficits” (fiscal and current account) of the PIIGS countries for the last four quarters:

Twin deficits in the periphery

Interestingly, Greece's current account deficit has actually improved since its peak in late 2008 (not shown) as Greek citizens increased its savings as a response to the financial crisis.  Unfortunately, this is not close to being sufficient, as the current account deficit over the last four quarters is still near a whopping 12% of GDP.  More ominously, the fiscal budget has continued to deteriorate.  If Greece had not been in the Euro Zone, the “conventional” solution would have involved a combination of a current devaluation, a cut in fiscal spending, and likely an IMF rescue.  As it currently stands, the Greek government really has limited options.  Over the next 11 months, the Greek government still needs about €25 billion to fund its fiscal deficit – and if the EU doesn't step in, chances are that the Greek government would be paying substantially higher rates.  Should the Greek government decide to drastically cut fiscal spending, this could have various “knock-on” effects that could reverberate throughout the entire economy, resulting in a further decrease in tax revenues.

More ominously for Greek citizens and those in the other PIIGS countries, the standard of living (as measured by unit labor costs) has risen sharply over the last decade.  With the Euro still at an elevated level, and with the current account/trade deficits now in the midst of reversing (the PIIGS countries have not been competitive for many years now), there is no doubt that real unit labor costs will have to come down over the next decade:

Unit labour costs have risen sharply in the periphery

The inevitable decline in the standard of living across the PIIGS countries will be a source of much societal conflict in these countries over the next five to ten years, especially as baby boomers retire and draw down their pensions.  The youth of these countries, in particular, will face the most difficult challenge since World War II, as the combination of high taxes (much of which will be transfer payments to the elderly and the unemployed), lack of 21st century jobs, and disastrously high real estate prices will limit their place and advancement in the world.  Similar to Russia, there's a good chance of a “brain chain” as the youth of these countries (especially those who are the most talented, entrepreneurial and aggressive) flee for countries with lower taxes, or those societies who place a higher value on economic or career achievements.  The United States is a likely candidate, along with other countries that value talent irrespective of one's origins or ethnicity (China would not be in this picture).  All in all – this author fails to see how Greece or the PIIGS countries can solve this dilemma without huge sacrifices – all of which will involve a decrease in standard of living and their place in the 21st century world.

As for the U.S. stock market: While the stock market is now very oversold in the short run, technical and sentiment indicators suggest that it is still trading at a neutral to overbought level in the intermediate term.  As we have mentioned, while part of the decline could be attributed to the Obama administration's assault on the financial industry, there was no doubt that the market was due for (and very vulnerable to) a short-term correction.  The stock market's rally since early March 2009 was more of a “relief rally” as it reacted to the easy monetary and fiscal conditions that global policy makers provided – and which helped avoid a collapse of the modern financial system.  Over the last few months – starting with the near-collapse of the Dubai economy – the market has started to differentiate among the stronger and weaker economies and corporate entities.  Unfortunately for the bulls – given the lack of a resolution in Greece, as well as the lack of an oversold condition in our technical and sentiment indicators – probability suggests that the correction isn't over yet (especially given the lack of a serious correction since early March of last year).  For now, we will just take it one day at a time, but I believe this correction could last another four to six weeks, and with a bottom in the 9,500 to 9,800 range for the Dow Industrials.  For now, however, we will remain 100% long in our DJIA Timing System, as we believe that the cyclical bull trend that began in early March 2009 is still intact.

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 1, 2007 to January 29, 2010) - For the week ending January 29, 2010, the Dow Industrials declined 105.65 points, while the Dow Transports declined 109.60 points. The long dreaded correction finally came two weeks ago - and given the lack of a substantial correction since the bull market began in March last year, chances are that this correction will be deeper and longer in duration (six to eight weeks, with strong support in the DJIA 9,500 to 9,800 range). We should experience some kind of reprieve this week, as the markets are now very oversold in the short term (the intermediate term indicators are still at neutral to overbought). However, given the tremendous amount of liquidity being created, decent momentum, and decent valuations - the cyclical bull trend that began in early March remains intact. The troubles in Spain, Greece, and Dubai will continue to cast a deflation cloud for the rest of the world, but the major effects should be limited to commodities and certain cyclical companies. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending January 29, 2010, the Dow Industrials declined 105.65 points, while the Dow Transports declined 109.60 points.  While we did not expect such a deep correction so quickly, we had maintained that the U.S. stock market was vulnerable to a short-term correction given the overbought conditions coming into this correction.  With the U.S. stock market now at a very oversold condition in the short-run, I expect it to stage some kind of relief rally this week – but most likely, such a rally will not be sustainable.  Given the lack of a serious correction since early March of last year, I expect this current correction to be deeper and longer than all the corrections since that time, especially given the heightening policy risk and the ongoing concerns over the economies of Spain, Greece, and Dubai.  However, given the strong momentum from the early March 2009 lows – and combined with decent valuations, strong liquidity, and strong upside breadth – there is no question that the cyclical bull market is intact.  In the meantime, we 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 20.0% to 18.1% for the week ending January 29, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending January 29, 2010, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 20.0% to 18.1%. Despite the decline last week, this sentiment indicator is still close to its November 2007 levels and thus remains very overbought relative to its readings over the last two years. As we mentioned two weeks ago: *While the strong upside breadth since March 2009 suggests the intermediate uptrend remains intact, the relentless rise in this sentiment indicator since March suggests the market is now vulnerable to a short-term correction.* The correction is now on - and chances are that this sentiment indicator will be significantly lower before the correction finishes playing out. For now, however, we will maintain our 100% long position in our DJIA Timing System.

After hitting a 26-month high last week, the four-week MA of the combined Bulls-Bears% Differential ratio pulled back slightly.  However, it remains very overbought (not just relative to its readings over the last two years, but over the last decade as well).  In addition, its relentless rise from early March suggests that individual investors have gotten too bullish, too quickly.  The overbought condition of this sentiment indicator suggests that the current correction isn't over yet, and most probably won't be over until another four to six weeks from now.  However, given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a decent rally starting in late spring and summer of 2010, and probability suggests that we will end 2010 with a new cyclical bull market high.  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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - After touching a fresh 6-month high of 137.6 on December 1st, the 20 DMA has traded in a range of 126 to 135; however, it actually penetrated below that range last week, hitting a reading of 120.4, and settling at 123.8. It remains overbought relative to its readings over the last two years. Combined with the high bullish sentiment in our other sentiment indicators, my sense is that market is still stuck in a correction/consolidation period. For now, however, we will remain 100% long in our DJIA Timing System.

For the week ending January 29, 2010, the 20 DMA declined from 126.7 to 123.8 – finally penetrating below its two-month trading range of 126 to 135.   While the latest decline suggests this reading is becoming more oversold, subscribers should keep mind that it is still overbought relative to its readings over the last two years.  More importantly, the vast majority of our other technical and sentiment indicators are still not in oversold territory on an intermediate term basis – suggesting that the current correction has more room to run (although we should experience some kind of “relief rally” this week).   In addition, the macroeconomic backdrop - specifically the heightened policy risk, the ongoing troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market - is suggestive of a further correction in the stock market.

Conclusion: The fiscal/financial crisis in Greece remains unresolved.  Given the rigidity of its financial system and the lack of its central bank to devalue and print money, it will be difficult for Greece to resolve its current situation without an EU or IMF-led bailout.  More importantly – given the immense “twin deficits” in the PIIGS countries – there is no doubt that the standard of living in these countries will at least decline on a relative basis over the next five to ten years.  Should onerous taxes or the lack of opportunities result in a “brain drain” to other countries, the recovery will be much tougher, especially giving the aging demographics and lack of innovative/entrepreneurial spirit in said countries.

The stock market remains in a corrective phase.  Given the overbought conditions coming into the correction and the lack of a serious correction since early March of last year, probability suggests that the correction will be deeper and last longer than all prior corrections since March of last year.  I expect this correction to last another four to six weeks, with strong support for the Dow Industrials in the 9,500 to 9,800 range.  However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market – and thus we remain 100% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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