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Building a Better Mousetrap

(March 28, 2010)

Dear Subscribers and Readers,

Before we begin, I want to follow up on our last weekend's commentary regarding Iran's energy infrastructure.  As we mentioned, Iran's “Achilles' heel,” is its antiquated/deficient energy infrastructure – more specifically, its refining capacity shortage, including a substantial shortage in light fuels (gasoline) refining capacity.  Increasing its refining capacity would not only eliminate this “weakest link,” but also provide Iran tremendous bargaining power under threats of economic sanctions or even war (this would also increase the government's hold on power).  Obviously, Iran realizes this – as it plans to build an additional 1.5 million barrel/day in refining capacity over the next 3 to 5 years.   Since building refining capacity is much easier than finding new sources of recoverable oil – over the next five years, I thus expect Iran to increase its oil refining capacity by a substantial amount.

For the United States, the $64 billion question is: Can Washington afford an Iranian power that is completely energy independent – an Iranian power that also possesses the world's second largest natural gas reserves (at over 1,000 trillion cubic feet) – especially as it pursues and builds out its nuclear infrastructure?  The consensus among the U.S. military, as well as geopolitical analysts, suggest the answer is a “definite no.”  In fact, Stratfor recently asserted that the biggest short-term threat from the White House standpoint is Iran's pursuit of nuclear technology.  Should Iran continue to pursue and build out its nuclear infrastructure, I believe an Israeli or U.S. led airstrike against its nuclear infrastructure would be imminent (this would likely trigger a spike in crude oil prices and a decline in global equities).

Let us begin our commentary with a review of 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 1,321.64 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 1,012.64 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.

In light of the highly overbought conditions in the stock market, strongly bullish sentiment indicators, and the negative divergences that are now emerging in the U.S. stock market (e.g. relatively weak upside breadth and upside volume that has accompanied the recent rally), I anticipate the stock market to at least experience a short-term correction starting this week or next week.  While I believe the cyclical bull market that began on March 9, 2009 remains intact, there also exists strong fundamental forces that could trigger a larger-than-expected correction global equities, including the weakness in the European banking system (which could arguably be systemic in nature), a tightening People's Bank of China, the ongoing price declines in the U.S. commercial real estate market, and geopolitical risks such as a potential nuclear Iran.  Make no mistake: These forces have been in place for a while, but it is only in recent times when investors have started to ignore these bearish forces – continuing to bid up equity prices. In the short-run, the stock market is now highly vulnerable to a correction.  Because of this elevated risk, we are now seriously thinking of paring back our 100% long position in our DJIA Timing System to a 50% long position should the U.S. stock market rally further this week.  Should we choose to do so, we will (as always) send you a “Special Alert” real-time email informing you of our shift.

Let us know get into the gist of our commentary.  In a capitalist society, political power, or any power derived from other people or the masses, is fleeting.  On the contrary, the power to create – whether it is a new product or a new production method – is the greatest power of all.  For the vast majority of business owners, capitalists, artists, or even salaried workers, this statement/assertion is a very important one to grasp.  To capture an increasing market share of one's industry, or to capture the imagination of the masses, one always needs to build a “better mousetrap.”  This mousetrap may be an improvement of a current product or a totally original product, but the message is clear: Creativity, as well as the ability to follow through on your creation (through commercialization and marketing), is the greatest power of all in today's global capitalist society.  The so-called “second-handers” – whether they are MBAs with no original thoughts, “value investors” that simply focus on straight-up valuation methods, politicians who do not get anything done, or bloggers who simply pander to the public – do not add much value to global society and ultimately will not capture much success, whether it is in the form of real power or capital.

This is the reason why I always value original thought, especially given my time constraints.  To invest successfully, this is of the utmost importance, as all unoriginal thoughts tend to be discounted by the market very quickly.  Last Wednesday, I attended the UCLA Anderson Forecast's quarterly breakfast (we last discussed the UCLA Anderson Forecast in our June 21, 2009 commentary).  While the UCLA Anderson Forecast has an enviable record in calling business cycle turning points, many economists have struck a black mark against them as the Forecast famously failed to call the beginning of the last recession in early 2008.  Professor Ed Leamer (Director of the Forecast) attributed this to flawed BLS employment growth data.  Note that the BLS employment growth data is not real-time or even actual data.  Rather, it is based on surveys and is subject to significant revisions.  In early 2008, the BLS employment data did not suggest a recession was at-hand  However, the growth data was revised down earlier this year – which means that the data was suggesting a recession after all (if only the Forecast had been able to use it).

As a response to the lack of real-time and accurate data, the Forecast, in a partnership with Ceridian, has created an alternative index that has been more accurate as a leading indicator of the U.S. economy.  Among other services, Ceridian provides credit and debit cards, including fuel cards and employer pay cards, and processes card transactions for various industries in the U.S., including the transportation industry (see the following link for the company's background).  The underlying data of the Ceridian-UCLA Pulse of Commerce Index is derived from credit card swipes for the purchase of diesel fuel at over 7,000 truck stops all over the country. Per the Forecast, “The interstates that crisscross America are the arteries along which flow the products that are the lifeblood of the economy.  If the goods do not move, the economy turns comatose.  Rather than measuring the pulse at a couple of locations, like the wrist and the neck, Ceridian has, in effect, installed sensors at truck stops all over the United States that measure the flow through this arterial system…

The Pulse of Commerce Index is based on real transactions, observed instantaneously, with rich geographic detail.  By tracking the volume and location of fuel being purchased, the Pulse of Commerce Index closely monitors the over-the-road movement of produce, raw materials, goods-in-process and finished goods to U.S. factories, retailers and consumers.  Working with economists at the UCLA Anderson School of Management and Charles River Associates, Ceridian releases the index monthly for the national overall and for the nine Census regions, but the geographic detail of the data offer vast opportunities for studying details of local economies.”

Obviously, the PCI has its limitations.  For example, if retailers decide to shift more of their goods transported from trucks to railways due to increased freeway congestion, then diesel purchases will decline.  Similarly, an increase in the fuel efficiency of the general vehicle fleet will also have a detrimental impact on the accuracy of the PCI.  That said, the PCI has three major attractive features: 1) the data collected is real-time – in theory, the PCI can be (and is) updated on a daily basis, 2) the data is accurate in that it measures actual transactions, as opposed to survey data as collected by the BLS or other government organizations, and 3) the data is very granular in nature.   For example, the Federal Reserve's Census region data is quite spotty.  The PCI can add a lot of value in terms of being a leading indicator of economic growth in the nine individual Census regions.  In fact, the various regional Federal Reserve banks have already engaged in discussions with Professor Ed Leamer in utilizing the PCI as part of their Beige Book reports (which are published 8 times a year).

As shown in the following graph, the PCI would have been instrumental in calling the last recession, as the index turned down in late 2007 –signaling that a recession was at hand.  More importantly, the PCI (similar to the readings of the ECRI Weekly Leading Index) is indicating that 2% to 3% real GDP growth remains on track for the second half of this year.  The launch of the Ceridian-UCLA Pulse of Commerce Index is one of the most exciting launches (in the world of U.S. leading economic indicators) since the launch of the ECRI Weekly Leading Index.  Going forward, I intend to track this data at least on a monthly basis:

Ceridian-UCLA Pulse of Commerce Index

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 March 26, 2010) - After making concurrent bull market highs the week before last, the rally has stalled somewhat - for the week ending March 26, 2010, the Dow Industrials rose 108.38 points, while the Dow Transports actually declined 33.82 points. This non-confirmation by the Dow Transports - in light of the highly overbought conditions - suggests that the U.S. stock market is now highly vulnerable to a short-term correction. Moreover, there are still lingering troubles in the European banking system, the U.S. commercial real estate market, as well as a tightening Chinese central bank. However, given the decent momentum and valuations in the U.S. stock market - the cyclical bull trend that began in early March 2009 remains intact. Should the U.S. stock market rally early this week, we will likely shift to a 50% long position in our DJIA Timing System from our current 100% long position.

For the week ending March 26, 2010, the Dow Industrials rose 108.38 points, while the Dow Transports actually declined 33.82 points – after having risen for six consecutive weeks.  The latest non-confirmation of the Dow Industrials by the Dow Transports on the upside (per the Dow Theory) – in light of highly overbought conditions – suggests that the U.S. stock market is now highly vulnerable to at least a short-term correction.  While the Greek fiscal crisis has now died down, I still expect the global equity markets to consolidate further, given the highly overbought conditions as well as lingering concerns about Greece's (and other peripheral countries in the Euro Zone) austerity plans, the troubles in the European Banking System, as well as the tightening policy by the People's Bank of China.  My guess is that any upcoming consolidation will last from 2 to 6 weeks.  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.  We remain our 100% long position in our DJIA Timing System, but we would not hesitate shifting to just a 50% long position for risk-control purposes should the market rally further this week.

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 rose from a reading of 13.3% to 13.8% for the week ending March 26, 2010.  Over the last five weeks, this reading has made a stunning advance – rising 8.9 percentage points from just 4.9%.   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 March 26, 2010, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of 13.3% to 13.8% - its most overbought reading since late January. The latest rise in bullish sentiment suggests that the rally is again vulnerable to a short-term correction, especially given the overbought nature of the market. For now, we will maintain our 100% long position in our DJIA Timing System, but will not hesitate shifting to a 50% long position should teh market rally further early this week.

After rising from 4.9% to 13.8% over the last five weeks, this reading is now again approaching overbought levels.  Because of this rise in bullish sentiment, I expect the market to consolidate further (it takes time to work off the bullish sentiment) – one that could extend to late April or even early May.   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, although we will likely cut down our long position to 50% for risk-control purposes should the U.S. stock market rally further this week.

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 declining to its lowest level since late November 2008 just four weeks ago, the 20 DMA has turned up dramatically, and is no longer at an oversold level. Moreover, the 50 DMA is also in the midst of turning up. While this latest move suggests that the bull market remains intact (sentiment reversing from an oversold level is always a bullish sign for the stock market), it does not preclude the market from experiencing a short-term correction. For now, we will remain 100% long in our DJIA Timing System, but will likely shift to a 50% long position should the market rally further this week.

For the week ending March 26, 2010, the 20 DMA rose from 120.5 to 126.1.  Over the last four weeks, the 20 DMA has literally skyrocketed – rising from just 107.4 (its most oversold level since November 2008) to 126.1.  Given the bounce over the last four weeks, the 20 DMA is no longer at an oversold level.  While the latest reversals in both the 20 DMA and the 50 DMA are a bullish sign in the longer-run, I still expect the market to correct over the next few weeks, given the overbought nature of the U.S. stock market.  Again, we will not hesitate shifting from our 100% long position to just a 50% long position in our DJIA Timing System in order to control for risk.

Conclusion: The key to success in the global capitalist world is clear: Be creative; try to beat your competition by always creating a “better mousetrap.”  Seasoned quantitative and growth investment managers would know what I am talking about, as well as those working in the information technology, biotechnology, or defense industries (of course, this list isn't meant to be exhaustive).  With the creation of the Ceridian-UCLA Pulse of Commerce Index, the UCLA Anderson Forecast has taken the art of economic prognostication to a whole new level.  Not since the creation of the Dow Jones Industrials and the Dow Jones Rails Indices by Charles Dow has there been a complete, reliable, and real-time economic leading indicator such as the Ceridian-UCLA Pulse of Commerce Index (merely counting the number of ships into the ports of Los Angeles, Long Beach, Houston, etc., does not count).  I will keep track of this indicator on an ongoing basis and report on any significant developments.

As for the U.S. stock market, I continue to expect a short-term correction given the overbought conditions in the global stock market.  Even though the Greek fiscal crisis is over for now, the overbought conditions and the lack of a serious correction since early March 2009 provides a good backdrop for a correction, especially given the lack of bearish sentiment out there.  Should the market experience a deep correction, subscribers should note that there is strong support for the Dow Industrials in the 9,500 to 9,800 range (note that I do not expect any upcoming correction to fall that much).  However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market,  We currently remain 100% long in our DJIA Timing System, but will not hesitate to shift to a 50% long position to control for risk should the market rally further this week.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

 

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