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A Note on Demographics and the Yen

(October 31, 2010)

Dear Subscribers and Readers,

Let us now begin our commentary with a review of the 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 973.40 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

One of the many secular, global macroeconomic topics we have covered at has been future demographic trends—not just in the U.S. but all over the world.  For example, the aging of the baby boomers would not only have a broad societal impact on the U.S. but in much of the “developed world,” namely Western Europe, Japan, and even China.  We first raised this issue (and its investment implications) in our August 29, 2004 commentary (“Three Important Questions—Economic Survival in the 21st Century”), then again in our August 11, 2005 (“Demographics do Matter”), November 19, 2006 (“Random Thoughts on Life, Trend Changes, and Demographics”), and December 14, 2008 (“Demography is Destiny”) commentaries.  In those commentaries, we mainly discussed the inevitable fiscal and pension/healthcare shortfalls as more baby boomers retire, as well as the “expanding middle class” in many emerging market countries, such as Brazil, China, India, Indonesia, and Vietnam.  What is little discussed is the demographic shift in the “younger echelons” of U.S. society—that is, the shift in age distribution among America's youth, as evident in the chart below (courtesy of Goldman Sachs):

As evident in the above chart, the “under-18” group is dominated by kids in the 0 to 4 age range, or what is generally labeled “Generation Z.”  Over the next five years, the number of childbirths is expected to grow by 1% a year (up from an average 0.5% from 2000 to 2010).  In five years' time, the number of children that are aged 9 or under (Generation Z) will far surpass those at age 10 to 18.  By 2020, the age 0 to 9 cohort is expected to grow by 7% to 44.3 million, up from a 4% to 5% growth over the past decade.  This means youth sales in the U.S. will heavily skew towards those catering to Generation Z, including companies catering to pediatric nutrition, baby products, toy sales, etc.  Note that 70% of toy sales are directed to the age 0 to 9 age range.

Now, a quick word on the Japanese Yen.  We last discussed the Yen in our September 16, 2010 (“Ad Hoc Comments on the Yen”) and September 5, 2010 (“Why the Yen Could Rise Further”) commentaries.  The Yen has since gotten more overbought and continued to push new highs.  In fact, Friday's close of 124.39 (i.e. one Yen = $0.012439) is only marginally lower than its all-time high set in April 1995.  The Yen is now 9.88% above its 200-day moving average, as shown in the following chart:

Interestingly, this is what it has come down to—the Yen is on the verge of making an all-time high against the US$ in the face of a Republican win in the House ( is pricing in a 90% chance of the Republicans taking the House) and a lower-than-expected QE2 policy from the Fed.  With the new Congress set on a tighter fiscal policy, no one could have predicted such as move in the Yen just a few months ago.  Amazingly enough, the Yen is also making new highs in the face of an ongoing intervention threat by the Bank of Japan.  No doubt, capital repatriation and short covering by hedge funds are powerful forces.  I am going on a limb here—but should the Yen spike further after the conclusion of the mid-term election and the FOMC meeting, it may be a good time to short some Yen.

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 October 29, 2010, the Dow Industrials declined 14.16 points, while the Dow Transports declined 0.68 points.  Last week's decline broke the three-week winning streak of both the Dow Industrials and the Dow Transports, although both Dow indices are still on the verge of breaking their cyclical bull market highs.  Note that the market is still very overbought on a short-term basis and are still exhibiting negative divergences.  Combined with the lack of bullish signals stemming from our global liquidity indicators (and the fact that the market has already discounted the Fed's QE2 policy), the market action could remain range-bound (or even correct) into Thanksgiving or even Christmas.  For now, we will remain 50% long 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 16.1% to 18.6% for the week ending October 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 1998 to the present week:

The four-week MA increased from a reading of 16.1% to 18.6% last week, and is now at its most overbought level since the first week of May.  In addition, our liquidity indicators are no longer bullish, especially since if the Fed disappoints with the size of its “QE2 policy” this week.  We will retain our 50% long position in our DJIA Timing System, for now.  In the meantime, the action of the U.S. stock market will likely remain range-bound (or even correct) into Thanksgiving or even Christmas.

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 decreased from 125.3 to 121.3 last week, while the 50 DMA increased from 114.1 to 116.4.  There is no real news to report—the 20 DMA has been above its 50 DMA for seven straight weeks, suggesting that ISE Sentiment remains in an uptrend.  While this is normally a bullish signal, subscribers should keep in mind that the market has nonetheless remained range-bound for the last five months.  Moreover, our liquidity indicators are no longer bullish and combined with the short-term negative divergences—this suggests the market will likely be mired in a consolidation period into Thanksgiving or even Christmas.  We will remain 50% long in our DJIA Timing System.

Conclusion: Given the profound power of demographic shifts and the baby boomers since the end of World War II, the investment implications of these shifts should not be underestimated.  In addition—while everyone is focused on the aging of the baby boomers and the “rising middle class” in emerging market countries—subscribers should not forget that America's youth still represents a powerful force, as this portion of the population drives a significant amount of household decisions and spending.  More important, the “Generation Z' cohort will dominate the under age-18 group several years from now—and thus would continue to drive product sales in this area.  Finally, the Yen may take a breather here, given its overbought condition and the possibility of a disappointment from the Federal Reserve's QE2 program on November 3rdGiven that the market has been range-bound over the last five months, and combined with the challenging liquidity conditions, probability suggests that the market will likely correct or consolidate further into Thanksgiving or even Christmas.  We are staying with our wait-and-see approach, and remain 50% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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