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Identifying Short and Long Term Trends for 2010 - Part II

(January 2, 2011)

Dear Subscribers and Readers,

Happy New Year!  We will update the performance of our DJIA Timing System in next weekend's commentary.  Before we dig deeper into Part II of our 2011 outlook, let us review our 13 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;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

Based on the MSCI market indices, the best performing developed market (by country, and in USD, gross terms) in 2010 is Sweden (+31.3%), followed by Denmark (+29.8%), and Hong Kong (+19.7%).  Not surprisingly, Greece was the worst performing “developed” market in 2010 with a performance of -46.36%, followed by Spain (-25.4%), and Ireland (-19.7%).  Meanwhile, the best performing emerging market in 2010 is Thailand (+56.3%), followed by Peru (+53.4%), Chile (+44.8%).  Colombia is worth a mention too as it powers 43.4% higher—taking its 10-year annualized return to a whopping +44.0% (i.e. a $1,000 investment made in Columbia 10 years ago would be worth $38,207 today)!  The worst performing emerging market is Hungary (-9.6%), followed by the Czech Republic (-1.7%), and China (+4.8%; yes, the Chinese stock market didn't go anywhere last year).  Among the rest of the BRICs, Brazil returned 6.8%, Russia 19.4%, and India 21.0%.

In last weekend's commentary, I asserted that the U.S. economy would perform better in 2011 (vs. a 2010 GDP estimate of 2.8%); and that any surprises are likely to the upside.  Interestingly, official 2011 GDP growth estimates are all over the map.  Estimates range from just 2.2% to as high as 4.0%, with consensus estimates at around 3.0%.  My personal estimate is for 2011 U.S. GDP growth to range from 3.0% to 4.0%, based on a slowdown in U.S. household deleveraging (the households' financial obligation ratio is now at its lowest level since 1Q 1995), a pickup in hiring and capital expenditures (U.S. corporations have a record $1.9 trillion on its collective balance sheet), and a normalization in European and Japanese GDP growth in the latter half of the year.  One example where increased capital expenditures are justified: Intel has just unveiled its next-generation mobile processor, Sandy Bridge.  With a CPU performance 50% to 100% faster and an integrated GPU more than double the speed of previous high-end mobile processors, Intel has not just raised the bar—2011 will be the logical year for IT professionals to upgrade their companies' laptop line-ups, especially given the lack of capital spending growth in 2009 and 2010.

In Part II of last year's outlook, we entertained Jim Chanos' and Pivot Capital's bearish views on China—i.e. their views that China was in the midst of a credit/capital spending bubble whose bursting was “imminent.”  In fact, Jim Chanos was so confident that he stated that the “Chinese capital spending bubble” would burst in the first half of 2010.  At the time, while we entertained the thought of a capital spending or credit bubble, we stated “However, while Chinese capital spending is no doubt unprecedented, subscribers must remember that China essentially had no choice in both 2008 and 2009, as global economic growth slumped – leading to a decline in global demand and exports.  I would argue that the Chinese had no other choice but to ramp on capital spending last year.  In addition – given the slump in wages and the price of construction materials last year – I would argue that it was actually a good strategy as long as the funds are efficiently and well spent.”  To the extent that Chinese capital spending remains relatively efficient (which is not difficult in a developing country), we argued that there's no cause for alarm.  Over the course of 2010, the Chinese government has made more efforts to increase overall economic efficiency (such as forcing the closure of smaller plants and smelters).  The latest move involved dividend reform for state-owned enterprises where the SOEs are now required to maintain a higher dividend payout ratio (from 10% to 15%)—making it more difficult for SOEs to blindly reinvest their earnings.

To maintain a “harmonious society,” the Chinese government will further hike interest rates in order to curb commodity inflation and real estate speculation in 2011.  It also instituted quotas on automobile sales in Beijing (car sales in Beijing are projected to decline 60% to 70% this year), to curb traffic congestion, and other cities, such as Shanghai, may follow.  China is also becoming a leader in battery and solar technologies—as the Chinese leadership understands that its current growth trajectory is unsustainable should it rely mostly on fossil fuels.  Going forward, China needs to find ways to boost domestic consumption to maintain its target 8% to 10% GDP growth, as well has move further high up the “value chain” so it could boost its exports.  With a GDP per capita of just US$3,700, there are still plenty of potential productivity gains, although the short-term path could be bumpy.  I do not expect China to pose any kind of systemic or downside risk to U.S. economic growth in 2011.

Rather, the potential downside risk will come from the lack of political will to construct a permanent solution to the European sovereign debt crisis.  My sense is that the market will push policy makers for a more comprehensive solution early this year (hence that's why I'm looking for a correction to start soon)—and once they are pushed, EU policymakers will come up with a better solution.  Failing that, the crisis could spread to other countries, namely Spain, Italy, or even Japan.  The latter is an interesting case—as it is also on a precarious path similar to that of most Western European countries (high debt load, negligible economic growth, and horrible demographics).  Based on current exchange rates, Japanese GDP is around 400 trillion Yen.  Its sovereign debt load is about 200% GDP, or 800 trillion Yen.  In 2011, Japan is expected to borrow a net 44 trillion Yen, or 11% of GDP!  Already 15.4 trillion Yen (or 16.7% of the budget) goes towards interest payments—and interest rates in Japan are already as low as they can be!  In addition, Japanese banks hold a substantial amount of JGBs.  Should an ongoing crisis in Europe cause a renewed loss of confidence in sovereign debt, than Japanese yields could also spike.  No matter what happens in 2011, the Japanese debt situation is untenable; even though Japanese savers have 1,200 trillion Yen stashed away (the Japanese will start consuming their savings as baby boomers retire).

Another potential risk to our U.S. economic growth scenario is another potential spike in oil prices.  We will cover this in next weekend's commentary.

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 December 31, 2010, the Dow Industrials rose a mere 4.02 points, while the Dow Transports rose 27.83 points.  Clearly, the Dow Industrials (and the S&P 500) is losing momentum.  Combined with the overbought condition (the Dow Industrials has risen five weeks in a row), and with the global liquidity environment still challenged, I expect an imminent correction in the stock market. For now, we will remain completely neutral in our DJIA Timing System, although the cyclical bull market that began in early March 2009 remains intact.

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 21.1% to 23.5% for the week ending December 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 increased for the fifth consecutive week from a reading of 24.9% to 27.4%—and is now at its most overbought level since late October 2007 (right at the peak of the last bull market).  In addition, the ten-week MA (not shown) rose for the 17th consecutive week to 23.0%, and is at its highest level since late July 2007.  Combined with our bearish liquidity indicators—and with the potential for a “black swan” event in Europe—I expect the U.S. stock market to correct starting very soon..  We will retain our neutral 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 again declined slightly from 143.1 to 140.6.  Nonetheless, the ISE Sentiment Index remains at a heavily overbought level—in fact, at the peak last week, 20 DMA rose to its highest level since mid-July 2007.  Meanwhile, the 50 DMA decreased slightly from 130.4 to 129.7.  With both the 20 DMA and 50 DMA at highly overbought levels (relative to their readings over the last three years), and combined with the bullishness in our other sentiment indicators as well as challenging global liquidity conditions, we believe a market correction is imminent.  We will remain neutral in our DJIA Timing System.

Conclusion: While the global economic scenario is more “benign” today than it was last year, there is still cause for concern.  Specifically, the European sovereign debt crisis may continue to morph and “infect” other countries—even Japan.  Should Japan run into trouble (my sense is that this will ultimately happen anyway; although not in 2011), there is really no practical bailout solution, given its sovereign debt load of approximately US$10 trillion.  I expect EU policymakers to come up with a more comprehensive solution to stop the bleeding in Western Europe they are pushed by the market.  Again, it is difficult to see how the PIIGS countries could “grow out of their problems” given their low structural growth and given their horrible demographic situations (and generous pension systems).  We remain neutral in our DJIA Timing System and will take a wait-and-see approach until the market becomes oversold again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA


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