The Patent Index
(February 15, 2010)
Dear Subscribers and Readers,
I want to welcome readers who are subscribers of Mr. David Korn's BeingInvesting.com weekly e-newsletter. David writes a weekly newsletter that includes his summary and interpretation of Bob Brinker's Moneytalk, as well as his own model newsletter portfolio and discussion of all things related to personal finances. David has graciously asked me to be a guest columnist on his newsletter this weekend (and which I am honored to be). I have written for David's subscribers before – in fact, the first time I wrote for David was nearly five years ago. I'm glad to see that both Dave and our commentaries/subscribers are still going strong. One of my mottos has always been “Substance over form.” Sure, presentation and communication skills are important – but the only thing that really matters in the long run is the soundness of our advice and the honesty behind the delivery of the advice. We never try to generate readership by making outrageous “sky is falling on our heads” claims; nor do we pander to the public by claiming the ability to predict every little move in the market or engaging in revisionist history. Sure, the financial markets is a brutal world (that's why many folks cannot survive without doing the things they are doing), but we choose to let our results speak for themselves.
Before we begin our commentary and review our most recent signals in our DJIA Timing System, I would like to comment briefly on the latest technical action in the stock market.
There are many stock market myths out there, and one of those is the so-called “10% correction” that presumably occurs in nearly every bull market – typically corrections that cause many investors to panic and believe that an impending bear market is upon us (e.g. the 20% correction that occurred in Fall 1998). A closer inspection of the historical record, however, suggests that this is only a myth. For example, since the 1942 market bottom (just as the tide of World War II was turning), the Dow Industrials has gone through 16 bull markets. Only 9 of those bull markets have experienced corrections of 10% or more, and none of these 9 bull markets have experienced more than one such correction. In addition, 6 of these 9 corrections occurred at the later stage of a bull market – i.e. once retail investors have become more enthusiastic about buying stocks again and when professional investors are already looking for the exits. In other words, 10% corrections in bull market are actually relatively rare; especially in the early stages of a bull market (the current bull market is less than 12 months hold).
From peak to trough on a closing basis, the Dow Industrials has declined by 7.62%, and the S&P 500 by 8.13%. With many commentators, bloggers, and surveys now coming to an agreement that we're indeed in a correction phase (or worse yet, a new bear market), it may now be time to start thinking about positioning oneself on the long side, especially if one is a good stock picker. In addition, the stock market has successfully retested its recent lows twice now – once last Friday, and the other time the Friday before last. More importantly, there is little to no evidence suggesting that the cyclical bull market that began in early March 2009 has ended. While this correction may have more room to run, I believe the downside is limited. The most probable case – given the current technical and fundamental evidence – suggests an extended consolidation phase stretching out into March or April, or once the fiscal crises in Greece and Portugal have been (partially) resolved. This is my best guess using all available fundamental, technical, and sentiment indicators at this time.
Let us now 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 2,072.86 points as of yesterday at the close.
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 1,763.86 points as of yesterday 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.
I have received many emails asking how the U.S. stock market or U.S. economy could continue to grow given the overleveraged balance sheets of U.S. consumers and the governments of many “developed countries” (and I use this term loosely) around the world. My answer is: We do not live in a vacuum. While the U.S. consumer and U.S. government are still arguably overleveraged, companies in the S&P 500 are sitting on a combined $1.18 trillion of cash, a whopping $518 billion increase from a year earlier. Moreover, the traditional measure of U.S. personal savings (i.e. disposable income less personal outlays – which is a very misleading measure as I have discussed earlier) is averaging about $550 billion every year, equivalent to a 5% savings rate. More importantly – just as consumers in the developed world are starting to deleverage their balance sheets – countries in emerging markets are starting to see consumer spending pick up as disposable incomes increase. Given the lack of consumer leverage in countries such as China, India, Brazil, Indonesia, etc., the potential for consumer spending in emerging markets to “pick up the slack” isn't out of the question, especially as their currencies and productivity levels continue to rise. Sure, the next 2 to 3 years would still be a painful adjustment for many of those in the developed world (especially “marginal countries” such as the PIIGS, or those in the lower-to-middle class without college degrees), but as productivity levels in emerging market countries rise, and as Schumpeterian growth (i.e. productivity growth resulting from new technologies or new production processes) in the United States, Japan, and Western Europe reassert itself, robust U.S. economic and stock market growth should also return in due time. I have confidence in the resilience of the U.S. economy and much of its workers, as long as the capitalist system is allowed to work.
Indeed, just as they teach “Equity Valuation 101” in the CFA or MBA course materials, the idea of the “terminal value” almost always make up the bulk of a stock valuation. This terminal value isn't determined by what consumers or corporations are spending today, but rather on the long-term potential or outlook of a company, industry, or the global economy. That is why GDP numbers can be so misleading in revealing the long-term U.S. economic picture, not to mention its relationship with U.S. stock prices (also note that over 40% of the S&P 500's earnings now originate from overseas). In an almost perverse sort of way, this current consumer recession is good for the long-term health of the U.S. economy. It is cutting credit to the most marginal U.S. consumers (who are not exactly good at capital allocation or investment decisions – unless you can call big-screen TVs, sports cars, and oversized houses in Riverside County good investments). It is also forcing many good students to pursue advanced degrees in things they're good at or passionate about in lieu of a career in Wall Street or real estate development. The ripple effects are now also reining in sovereign countries that have overspent or overconsumed – sovereign states such as Dubai or Greece that have plowed significant amounts of borrowed money into “white elephant” projects or simply lavish lifestyles all at the expense of hard-working folks who unknowingly “invested” in these countries through their pension or sovereign wealth funds. This adjustment, while painful, will force many citizens in these countries to become more productive – and in turn, lead to a higher rate of global economic growth in the future.
It is difficult to measure the capacity for global economic growth, especially the factor that has the biggest impact – i.e. productivity growth. Sure, countries such as China, India, or Brazil can simply grow faster by adopting better (but existing) technologies or engaging in more efficient business practices or embracing the 21st century economy, but countries such as the United States or Japan could do little to speed up productivity growth. As I mentioned, while the U.S. experienced decent economic growth (as measured by GDP growth) during the 2004 to 2006 period, long-term economic growth most likely suffered during that time, as: 1) the country's best and brightest headed to Wall Street, 2) the marginal U.S. consumers mortgaged our children's futures to buy overpriced houses that they could not afford even in the best of times, and 3) science as a contribution to mankind's future prosperity was demonized not only by Hollywood, but by many of our political leaders. Thankfully, we could still find ways to measure future productivity growth objectively. One such measure is the number of U.S. patents granted.
Although I have to admit that it is a rather crude measure, I believe it makes sense to use this measure as: 1) intellectual property has become the dominant asset in many corporate balance sheets in the 21st century information economy, and 2) technology will continue to be the main driver of U.S. productivity, and hence economic growth. As cataloged by Ocean Tomo in their Ocean Tomo 300 Patent Index (which contains a diversified portfolio of 300 companies that own the most valuable patents relative to their book value), more than 80% of all corporate value in the S&P 500 in 1975 companies consists of tangible assets. Today, that is no longer the case, as tangible assets now only make up 25% of all corporate value. More glaringly – as a demonstration that intellectual property will be the main driver of 21st century economic growth – the OT300 actually outperformed the S&P 500 by more than 430 basis points annually over a ten-year period. Let us now look at U.S. patent activity (U.S. patents granted annually) from 1883 to 2008:
Note that it took about 60 years for patent grants to double (from 40,000 to 80,000 during the 1914 to 1974 period), but then it only took another 25 years for patents to double again (from 80,000 to 160,000 by 2000). In total, there have been over 7 million U.S. patents granted between 1883 and 2008. Moreover, despite the recession in 2008, U.S. and global patent grants show no signs of slowing down. With basic science funding now substantially improved, and with stem cell, cellulosic ethanol, and biofuels research now in full swing, probability suggests that U.S. patent grants will make a new high sometime in the next two to three years.
From a global standpoint, the picture is even more encouraging. While the number of patents granted in the U.S. has stagnated since 2001, the rest of the world has not let up. As shown in the following chart, the U.S. share of world patents has declined from over 30% to just 22% since 2001:
Interestingly, despite this decline, the U.S. share in 2008 is actually close to the average share over the last 125 years – suggesting that the U.S. is still busy innovating. With the best and brightest of this country going back to graduate school and moving into the labs – and with increased basic research funding – my sense is that the U.S. will retake some of this lost share over the next few years. In addition, there is still no shortage of venture capital – meaning that any promising technology will most likely be commercialized as long as there is a market for it (if there is no market, it would be created – just ask Apple , Yahoo!, and eBay). While the short-term picture still does not look good, the long-term picture for U.S. economic growth remains bright.
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 February 12, 2010, the Dow Industrials rose 86.91 points, while the Dow Transports rose 95.36 points. After declining four weeks in a row, both the Dow Industrials and the Dow Transports took a breather. With the U.S. stock market still at oversold levels in the short-run, I expect the “relief rally” to continue this week. Whether that turns into something more sustainable is still a big question mark, although 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 Greece, Dubai, Portugal, Ireland, and Spain). At the least, I expect the market to consolidate further – possibly going into March or even April. 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 a whopping 5.4% (after declining by 4.5% last week) - from a reading of 13.6% to 8.2% for the week ending February 12, 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:
After hitting a 26-month high three weeks ago, the four-week MA of the combined Bulls-Bears% Differential ratio has literally dived – and is now at its most oversold level since late November of last year. In particular, last week's decline of 5.4% was the largest such decline since mid July 2008 – suggesting that the market has probably made a short-term bottom. Whether the impending rally is sustainable is too soon to tell. My best guess is that the market has entered into a new consolidation phase (it takes time to work off the bullish sentiment) – one that could extend to March or even April. 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:
For the week ending February 12, 2010, the 20 DMA declined from 116.7 to 107.2, and is now at its most oversold level since late November 2008! This oversold condition not only confirms the much decreased bullish sentiment in the mainstream – but also confirms the bull's case at least in the short run. However, the 50 DMA still isn't in oversold territory. 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 – all suggests that the market will probably need to consolidate further before the bull market can resume.
Conclusion: The State of the Union and the global economy – as demonstrated by the number of patents granted and the availability of venture capital – remains strong. Going forward, it is essential to not only ensure that our kids are well-educated and encouraged to pursue the sciences/engineering, but that the global capitalist system is allowed to function. Capital must be protected; contracts must be honored; and the “corporate welfare” and personal welfare system must be selectively scaled back as society simply cannot afford them without class/generational warfare. At the same time, we must help those who are willing but not able, including bright and ambitious kids in many inner-city schools.
As for the stock market, the technical picture suggests that the “relief rally” that started last week will most likely continue. However, while I don't believe a Greek default is probably, the market will definitely remain jittery unless or until something concrete is done about the dismal fiscal situation in Greece. 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. In the meantime, she stock market remains in a consolidation phase that should likely last another 4 to 6 weeks. 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. There is 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.
Henry To, CFA