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US Labor Market Update

(January 22, 2012)

Dear Subscribers and Readers,

Let's begin our commentary with a review of 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.

For 2012, I consumer deleveraging to slow down as US bank lending is finally looking up (see our recent mid-week commentary) and as the ECB continues to remove systemic risks off the table (with a potential QE policy down the road).  I expect the U.S. unemployment rate to decline significantly this year given the resilience of the US economy, record cash levels of U.S. companies (more than $2 trillion), and monetary easing by the vast majority of the world's central banks.  In addition, employee compensation as a percentage of U.S. GDP has just declined to a new 56-year low (as shown on the following chart)! There is only so much that US corporations can squeeze out of its workers; as such, I expect both employees' compensation and hiring to pick up significantly this year, especially given the increasing costs of outsourcing to India and China.

As shown on the above chart, U.S. employees' compensation as a percentage of U.S. GDP recently bottomed at 54.4%--the lowest level since 1Q 1955.  While total employees' compensation just surpassed its all-time peak three years ago, subscribers should note that much of the purchasing power has been eroded by inflation.  This is unprecedented (based on post WWII data).  With record low interest rates, a slowdown in U.S. household deleveraging, an anticipated increase in corporate capital spending and hiring, and global monetary easing (including a QE3 policy from the Fed; and potential QE from the ECB), I expect U.S. hiring (and salary increases) to pick up dramatically in 2012.  Another bright side to the recent recession is that many bright students in the natural sciences and engineering fields have chosen to get their PhDs and stay in their fields, instead of heading to Wall Street or law practice.  More monetary and talent research in the basic sciences and technology sectors will drive Schumpeterian growth yet further—starting with further advances in 3-D manufacturing, improvements in solar cell efficiency, and the potential commercialization of second-generation biofuels over the next two years.

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 in the following chart from July 2008 to the present:

For the week ending January 20, 2012, the Dow Industrials rose 298.42 points, while the Dow Transports rose 104.83 points.  Both the Dow Industrials and the Dow Transports enjoyed three consecutive up weeks and made fresh six-month highs—which is technically bullish. More important, the contagion risks from the European Sovereign Debt Crisis have diminished given the ECB's renewed commitment to reliquify the European banking system, the availability of the Fed's cheap US$ swap lines to the ECB, as well as the resilience of the US economy. Should the Fed implement a QE3 policy this week, it is likely that the Dow Industrials will surpass the 13,000 level decisively over the next several months. We remain bullish on US and US financial stocks, but given that we are dissolving the end of February, we will not make any more moves 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 16.4% to 19.7% for the week ending January 20, 2012.  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 2001 to the present:

Since hitting a multi-year low of -11.3% in early October, the four-week MA has surged by a whopping 31.0%. The four-week MA is now overbought in the short-run—as such, we would not be surprised if the market starts a correction, even if the Fed implements a QE3 policy this week. That said, it is still at a neutral level in the long-run  With the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines and the resilience of the US economy—we continue to look for a rally in US stocks and US financial stocks over the next several months.

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.  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:

Ever since breaking 100 in mid-December, the 20 DMA has been on an upward tear, and remains solidly above its 50 DMA. Such a breakout from a highly oversold condition is definitely bullish—all the more so since the risk of a Euro break-up scenario has diminished. However, the 20 DMA is now overbought on a short-term basis—hence, there's a good chance to market will correct over the next couple of weeks. Over the next several months, we remain bullish on US stocks and US financial stocks.

Conclusion: While there needs to be further pension, social security, and Medicaid reforms down the road, 2012 will likely be an upside surprise in terms of economic growth. More important, the fruits from global R&D—along with the US capitalist system—remain intact. Solar cell efficiency has continued to increase as predicted, while significant quantum computing advances were made in 2011. 3-D manufacturing should become even more pervasive this year. If anything, we are starting this year at a very low base (in terms of Employees' Compensation as a Percentage of GDP). As such, any significant uptick in GDP growth should lead to a disproportionately high amount of compensation growth and hiring this year. We should all remember that things move in cycles—especially the economy. No, the business cycle has not been eradicated. This means we will suffer the inevitable recession; but it also mean we get to enjoy the up cycles as well. I believe 2012 will be one such up, and enjoyable, year.

Signing off,

Henry To, CFA, CAIA

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