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Natural Gas Technically Bullish

(November 21, 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 1,058.55 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

Last week, the 36th semi-annual edition of the top 500 list of the world's most powerful supercomputers was published at the 2010 International Supercomputing Conference in New Orleans, Louisiana.  Most notably, the top 500 list is still dominated by Intel-based systems (although many of the top-performing systems utilize IBM's “Blue Gene” processors), with AMD a distant second, and IBM third.  From a geopolitical standpoint, 54.8% of the top 500 supercomputers (by supercomputing power; note that the NSA – which houses some of the most powerful systems in the world – stopped reporting in 1998) are located in the US.  The biggest improvement came from China—jumping from 4.2% to 8.2% over the last 18 months.  Most significantly, China now houses the world's most powerful supercomputer, with a peak performance of 2.6 petaflops (although it mostly utilizes Intel CPUs and Nvidia GPUs).  Rounding out the top five are Germany, France, and Japan (each with 5.2%).  The UK, which ranked third just 18 months ago (with 8.8% of the world's supercomputing power), is now in 6th place, housing just 5.0% of the world's supercomputing power.

Aside from providing the most up-to-date supercomputing statistics, the semi-annual list also publishes the historical progress of global supercomputing power – as well as a reasonably accurate projection of what lies ahead.  Following is a log chart summarizing the progression of the top 500 list since its inception in 1993, along with a ten-year projection:

Today, a typical desktop with an Intel or AMD processor operates at 50 gigaflops (note that we are ignoring the GPU in our graphics processor from our calculations) – or the equivalent of an “entry-level” supercomputer on the top 500 list in 1999.  By early 2012, the power of a typical desktop should reach 100 gigaflops, or the equivalent of the most powerful supercomputer in the world in 1993.  On the highest end, IBM is on track to construct a Blue Gene/Q supercomputer with a targeted performance of 20 petaflops (or 20 million gigaflops) for the National Nuclear Security Administration in early 2012.  Code-named “Sequoia,” this supercomputer will possess half of the combined performance of all the supercomputers in the top 500 list as of today (see above chart) once it comes online (or the equivalent of 10 of today's most powerful supercomputer).

In other words, simulations that would take 10 years of computing hours for the most powerful supercomputer today will only take just one year once Sequoia comes online (roughly, since Linpack—the benchmark used to measure supercomputing performance—is not exactly representative of real-world supercomputing performance).  Tasks that take an immense amount of computing time today – such as weather forecasts, gene sequencing, airplane and automobile design, protein folding, etc. – will continue to be streamlined as newer and more efficient processors/software are designed.  By 2019, the top supercomputer should be able to reach a sustained performance of an exaflop (i.e. 1,000 petaflops).  IBM believes that such a system is needed to support the “Square Kilometre Array”—a radio telescope in development that will be able to survey the sky 10,000 times faster than ever before, and 50 times more sensitive than any current radio instrument—and will provide better answers to the origin and evolution of the universe.  The ongoing :democratization” of the supercomputing industry would also result in improvements in solar panel designs, better conductors, drugs that are more efficient, etc.  As long as global technology innovation isn't stifled, the outlook for global productivity growth – and by extension, global economic growth and standard of living improvements – will remain bright for years to come.  Should the quantum computer be commercialized in the expected five to ten-year timeframe, subscribers should get ready for the next major technological revolution (and secular bull market) by 2015 to 2020.  Make no mistake: The impact of the next technological revolution will dwarf that of the first and second industrial revolutions.

I now want to spend a little time on the topic of natural gas.  As reported by Baker Hughes, the number of natural gas drilling rigs dropped by 19 to 936 last week, and has fallen by a whopping 5% in the last 13 weeks.  More importantly, the total natural gas rig count has dropped by 42% from a peak of 1,606 in September 2008.  On the other hand, the U.S. natural gas storage level remains at a very high level—but given the depressed rig count and low natural gas prices, I would not be surprised if natural gas prices mount some kind of rally should the 2010/2011 weather is colder than expected.  To top it off, the technicals for natural gas looks pretty bullish, as exemplified by the following weekly chart of the December 2010 NYMEX contract:

As shown in the above chart (note the blue circles), natural gas prices have typically rallied whenever the faster MA (12-week) crossed above the slower MA (26-week)—as shown in the lower panel (which shows the Moving-Average-Convergence-Divergence technical indicator).  The 12-week crossed above the 26-week moving average for the December NYMEX contract late last week.  Given the approaching winter, depressed natural gas prices, and the monthly liquidity injections as a result of the Fed's QE2 policy, I expect natural gas prices to rally over the next several months.  One thing is for sure: subscribers should stop shorting UNG, for now (I know, this has been a rewarding trade).

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 November 19, 2010, the Dow Industrials rose 10.97 points, while the Dow Transports rose 66.61 points.  Last week's slight bounce seems to be a pause of an ongoing correction, as the market did not get very oversold in its most recent decline.  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) and the ongoing European sovereign debt/banking crisis, the market action should at least be range-bound (or correct) into the end of this year.  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 four-week moving average of these sentiment indicators increased from a reading of 19.1% to 20.4% for the week ending November 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 1998 to the present week:

The four-week MA decreased slightly from a reading of 20.4% to 19.7% last week. The prior week's reading of 20.4% was at its most overbought level since early November 2007—just a few weeks after the peak of the last bull market.  In addition, our liquidity indicators remain slightly bearish—and the potential for a “black swan” event in Europe remains high despite the latest Irish banking system bailout.  As a result, the action of the U.S. stock market will likely remain range-bound (or even correct) into the end of the year.  We will retain our 50% long position in our DJIA Timing System. 

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 119.6 to 122.4 last week, while the 50 DMA increased from 120.7 to 122.6.  Two weeks ago, the 20 DMA marginally declined below the 50 DMA and has since languished—suggesting that bullish sentiment may now be in a downtrend.  More importantly, given the bullishness in our other sentiment indicators as well as the challenging global liquidity conditions, probability suggests the market will likely be mired in a consolidation period into the end of the year.  We will remain 50% long in our DJIA Timing System.

Conclusion: Despite the structural challenges in the developed world (unprecedented government debt levels, aging of the baby boomers, etc.), the technological revolution steams ahead.  At some point in the next five to ten years, the world will reach a “tipping point” as the next major breakthrough materializes, whether it is the commercialization of the quantum computer, carbon nanotubes, or second-generation algae-based biofuels.  Whichever it is, that breakthrough will accelerate the commercialization of other significant technologies—thus ushering in the next technological revolution.  This will also be accompanied by the beginning of the next secular bull market.  In the meantime, I believe the U.S. stock market remains in a consolidation period or a correction—and that the only major bullish “play” for the next several weeks is U.S. natural gas.  I also believe that both the Euro and the Yen are now in confirmed downtrends (although the Euro should rally slightly with the “success” of the Irish bailout).  We are staying with our wait-and-see approach, and will remain 50% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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