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The Implications of Quantum Computing and 2010 2Q Flow of Funds Update

(September 19, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 12 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;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

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;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; giving us a gain of 462.85 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

The recent piece on the commercialization of quantum computing is the most meaningful Financial Times article in a long time.  It is definitely a must-read.  I've kept track of this topic for the last few years.  Quantum computing wasn't supposed to be a reality for at least another 10, if not 20 years.  The conclusion that quantum computers could be commercialized and be more powerful than conventional computers in just five years (as published in the journal Science)—and the FT's pick-up of this story—came as a shock.  This will have profound implications for the world.  Assuming that we each have a soul--and that a soul cannot possess a machine (meaning that a machine can never achieve free will)—quantum computers should come as close to artificial intelligence (A.I. but with the added benefit of unimaginable raw computing performance) as we could ever achieve.

This represents a paradigm shift in the computing world that would permeate across all aspects of the global economy and society.  Quantum computing would directly lead to the development of a customized medicine/drug industry and new nanomaterials (including superconducting materials). Declining manufacturing costs, combined with the advent of 3-D printing, means that domestic manufacturing would be revived (and China would be screwed unless the country moves up the "value chain")--but there would be no significant job creation at the domestic manufacturing level because everything would be automated.  Much "smarter" robots capable of more customized tasks would also be developed.  Cellulosic ethanol would be a reality given the sheer amount of computing performance available to develop new compounds.

Capital and intellectual capital will win—yet again (as they always would in a capitalist system).  The "global labor arbitrage" remains.  Unions will be decimated as nearly all unskilled jobs would be automated--eventually to include car washers, janitors, construction workers (already 3-D printers are capable of "printing" houses), etc.  The computing industry as we know it will change forever.  New programming for quantum computers would need to be developed, but quantum computing would render the skills of the current crop of computer scientists obsolete.  Closer to home, quant investment strategies would have to be "reinvented" to take advantage of quantum computing capabilities.  A pure (i.e. non-corporate activist) fundamental stock picker would need to possess very, very good intuition and a great grasp of global macroeconomics to outperform a quant strategy utilizing quantum-computing algorithms--at least in developed market investing.  Fundamental stock pickers may still have an advantage in emerging/frontier markets—but only if they have access to inside information.

This may sound far-fetched but as we all know, capitalist economies have always be characterized by spurts of Schumpeterian growth.  I.e. Technological innovations which appears out of nowhere but gets adopted very quickly—including the canals, the mechanical reaper, the railroad industry, electricity, the oil and steel industry, the automobile industry, the adoption of radios and television sets, plastics, and the adoption of the PC and internet.  When I first accessed the World Wide Web in late 1994, the number of websites could be counted in the hundreds.  Today, there are over 250 million websites.  Capitalism is characterized by waves of sudden, rapid, and immense changes.  Get ready for another wave in the next 5 to 10 years.  I, for one, am really looking forward to it!

Let us now discuss the 2Q 2010 Flow of Funds update published by the Federal Reserve last Thursday.  The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year.  Data is available for most statistics since 1952.  Since the inception of, one of the main themes we have tracked through the Flow of Funds information has been the concept of overleveraged U.S. households, as well as the inevitable deleveraging as a result of the financial/housing crisis and the subsequent decline in household credit growth..  In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio (using the Fed's Flow of Funds data as of 1Q 2009) hit a new post WWII low, and that despite the rally in asset prices during the second quarter, it will take at least several years before U.S. households will finish rebuilding their balance sheets.

Since then, the state of U.S. households' balance sheets has improved – with U.S. household net worth rising by $4.70 trillion over the last five quarters (despite a $1.52 trillion decline during 2Q 2010).  As of the end of 2Q 2010, U.S. households net worth stood at $53.5 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.45 to 4.85 over the last five quarters.  As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth have a long hill to climb ($12.25 trillion) before it reaches its prior peak levels, even assuming U.S. housing prices have already bottomed.  Note that the absolute net worth scale on the right is a log scale:


Based on the above chart, U.S. households will likely deleverage their balance sheets for at least a couple of more years.  Interestingly, U.S. households' liabilities have only declined by $653 billion from its peak.  This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as U.S. commercial bank and consumer credit has grown by a minimal amount over the last five quarters.  So why did US households' liabilities only decrease by $653 billion from its peak?  The likely answer is that many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices).  While this bodes well for the balance sheets of the US largest banks (whose portfolio are mostly in residential mortgage securities), it also means that the true deleveraging (and home foreclosures) is not yet over.  That is, actual mortgage defaults will most likely stay elevated over the next 12 months, despite a relatively low national housing-price-to-disposable-income ratio, a near all-time low in mortgage rates, and an improving employment picture.

Indeed, as we have already mentioned, the sector that still need to deleverage over the next decade is U.S. housing.  The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 2Q 2010.  While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:

For every percentage growth in assets that U.S. households accumulated over the last 58 years, U.S. households incurred 3.54 times as much in mortgage debt, while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.)  was “just” 2.12 times as much.  Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen LCD TVs (readers should not forget that some of these have also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging would have to occur in the U.S. mortgage market.  While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the next decade and thus provide a “cushion” to the U.S. housing market, U.S. housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or to relocate to smaller or cheaper living areas.  I expect most U.S. regional housing markets to underperform other asset classes for the next 10 to 15 years (although assisted living properties should outperform).

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2007 to the present:

For the week ending September 17, 2010, the Dow Industrials rose 145.08 points, while the Dow Transports rose 32.48 points.  Both the Dow Industrials and the Dow Transports are safely above their 200-day moving averages, and sitting just below their early August highs.  While the technical condition remains solid, subscribers should be concerned about “whipsaw risk,” as the market has been really volatile and “indecisive” over the last couple of months.  Combined with the  lack of bullish signals from our global liquidity indicators and the lingering default risks for Greek sovereign debt, the market action should thus remain tough going into the September 21st FOMC meeting, it not into October.  We will remain 50% long in our DJIA Timing System, and should eventually shift to a 100% long position depending on the market action and fundamentals in the coming weeks.

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 -6.8% to -2.8% for the week ending September 17, 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 1998 to the present week:

The four-week MA finally reversed after declining three weeks in a row (and hitting its most oversold level since late July).  More importantly, while this sentiment indicator is relatively oversold, our liquidity indicators are not yet flashing bullish signals.  We will thus wait for a more oversold reading before shifting to a 100% long position in our DJIA Timing System, and would do so only once our liquidity indicators improve.  In the meantime, the action of the U.S. stock market will likely remain tough into October.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  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:

The 20 DMA increased from 101.0 to 110.3 last week, while the 50 DMA increased from 104.8 to 107.6.  The 20 DMA rose above its 50 DMA last week.  While this is normally a bullish signal, I would not read too much into this, as both this sentiment indicator and the markets have been subject to whipsaw over the last several weeks.  Moreover, since our liquidity indicators are not supportive of the bullish case, the market will likely be mired in a consolidation period into October.  We will thus only shift to a 100% long position once liquidity conditions improve or if the stock market becomes more oversold.

Conclusion: Aside from the ongoing deleveraging “theme” in the developed markets over the next couple of years, another important trend to track—and which would ultimately drive Schumpeterian growth—is the development and commercialization of new technologies.  As long as the capitalist system is allowed to work, the waves of “creative destruction,” driven by Schumpeterian growth, are actually the norm rather than the exception.  Within this context, the commercialization of a quantum computer isn't too far-fetched.  What is surprising is the projected timeline of five years, as I have not expected the commercialization of a quantum computer for at least 10, if not 20 more years.  Just like other major technologies since the dawn of the Industrial Revolution, I expect the advent of quantum computing to change the underlying fabric of the global economy and society, including the investment management industry.

As for the stock market, we remain on a wait-and-see approach in terms of our DJIA Timing System given the challenging liquidity conditions.  Until our global liquidity indicators improve or until the U.S. stock market becomes more oversold, we will stay with our 50% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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