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August 03, 2006

A Buying Point is Near
by Henry To

Dear Subscribers,

Well, it has been six weeks since the beginning of my leave-of-absence from my full-time day job. I am glad to say that I will be again back in full swing starting tomorrow (I am just addicted to work) - with the same company (Buck Consultants) but beginning my new job as an investment consultant here in Los Angeles. Besides the crazy traffic and the sky-high rents, there is a lot to like about this city - including the weather, the diversity, creativity, and the openness of the "locals" (they say virtually everyone in LA is an outsider) to new ideas and innovations. You can feel that change is the air, and both Los Angeles and California is at the forefront. Case in point: Most of the recent venture capital funds specializing in the alternative energy sector was raised in the West Coast, as opposed to Houston or Texas, the so-called "energy capital" of the United States and even the world.

Speaking of getting settled in, we bought and assembled several pieces of furniture from IKEA a few days ago. Once in awhile, I would not mind assembling furniture or doing "handy things" around the home, but things got slightly complicated for my significant other and myself when we found a faulty part in one of the drawers we were assembling. I called the local IKEA early this morning and was put on hold for more than 20 minutes - and still no customer representative answered the phone. As mentioned by this author and on our discussion forum, American consumers are getting squeezed on both ends by employers who are cutting down costs - on one end as employees who are getting laid off or mediocre raises and on the other end as consumers who are losing customer service and who are finding their personal calls being directed to India or other foreign countries. Given today's environment, any Fortune 1000 company who is providing just a little but more customized or personal service is rising above the crowd - companies such as UPS, FedEx, Dell, etc. Make no mistake: Today's population is on the "quest for voice" and for individualism - as exemplified by the surge in popularity in websites such as MySpace.com, and Youtube.com. In the book, "The Support Economy," authors Dr. Shoshana Zuboff and Dr. James Maxmin discusses a new kind of capitalism that is emerging - a kind of capitalism that is based more on "psychological self-determination" where each one of us want to seek our own individual meanings - which will in turn transform our economy from an economy based on services to that of one which is based on "deep support." The days of mass consumerism and "managerial capitalism" are over, the authors contend - and with it, the companies that chooses not to listen to this "growing chasm" between today's consumers and corporations. The book "The Support Economy" is a must-read for not only consumers but for corporate CEOs as well.

Our 100% long position in our DJIA Timing System was stopped out at its average entry point at a DJIA print of 10,805 on July 14th. As mentioned in our commentary from the weekend before last, this author was looking for a way to get back into the market on the long side - as I had believed we were now entering a quick "capitulation phase" in the stock market due to the violence that was going on in the Middle East and the wide scale dumping of equities by both individual and institutional investors. Based on my commentaries and postings over the last couple of weeks or so, we went 50% long in our DJIA Timing System at a DJIA print of 10,770 on the afternoon of July 18th - which was communicated to our subscribers by a real-time email. We are definitely now in capitulation phase. In our latest mid-week update, I stated that while the market may not have reached bottom yet, I had believed that we were definitely in "capitulation phase."  As a result, it was time to start looking for a bottom and for certain stocks to buy. As of Sunday evening, this author wants to shift from a 50% to a 100% long in our DJIA Timing System. Given that the market ran away from us on the upside last Friday, this author will have no choice but to wait for a correction in the Dow Industrials before going fully long. Again, this author will communicate to our subscribers via a real-time email once we decide to go 100% long in our DJIA Timing System.

I understand that many of our subscribers are concerned about the state of our economy and financial markets - including concerns such as the Israeli conflict, the popping of the housing bubble, high oil prices, an inverted yield curve - all amid a rising interest rate environment in many parts of the world, including China and India. I will cover some of these issues in our upcoming mid-week commentary (Bill Rempel is taking the month off from doing a guest commentary), but readers should keep this in mind: A significant chunk of retail investors here in the U.S. have already capitulated from the stock market over the last 12 months - as exemplified by mutual fund outflows and the most bearish sentiment from both the AAII and the Investors Intelligence Surveys since October 2002. At the same time, corporations are using much of their excess cash to buy back their own shares - and private equity transactions and cash acquisitions of corporations are at an all-time high. There are also no signs of letting up, as corporations and private equity investors alike are sitting on a huge chunk of change. Moreover, the U.S. domestic large caps as an asset class have been one of the biggest underperformers around the world since October 2002 and are now at very reasonable valuations. In a global tightening liquidity environment, U.S. large caps tend to overperform. Moreover, as I have mentioned before, the latest Israeli-Hezbollah conflict in Lebanon should serve to remind Middle Eastern investors the risk of investing in their own domestic markets - making the U.S. equity markets attractive to Middle Eastern investors again for the first time since the events of September 11th. Finally, the speculators have all been driven away from real estate and most probably commodities alike. What is the next asset class ripe for speculation? Could it be the U.S. large caps? Obviously, this author does not have all the answers, but as a long-term hold (at least over the next five years), U.S. large caps are now a near no-brainer.

In this weekend commentary, this author wants to make a couple of suggestions on what sectors to buy, based on classic "oversold" conditions and based on the current revival in large caps. As this author has mentioned many times before, I now believe the U.S. large caps will set to overperform. The Bank Credit Analyst has also recently taken up this concept in their July 24th daily commentary. Quoting the Bank Credit Analyst: "Small cap stocks have surged into overshoot territory over the past few years, fueled by a steady diet of easy money and rapid economic growth. In fact, relative performance has reached an extreme, two standard deviations above its 20-year trend. While markets can stay overbought for a prolonged period, the conditions supporting small cap outperformance have begun to fade: liquidity is draining from the financial system at the same time the main engines of growth are slowing, namely the U.S. consumer and Chinese investment growth. These forces have helped set in motion an upturn in financial market volatility and act as the catalyst to return to large cap leadership." Following is the relevant chart from the Bank Credit Analyst showing the trend of the S&P 600 to Wilshire 5000 ratio plus and minus two standard deviations from 1983 to the present:

As recently as mid-May, the S&P 600 to Wilshire 5000 ratio was not only at a cyclical high, but at a potential secular high as well. Again, tightening global liquidity and a rise in risk premiums in international equity markets (due to the Israel-Hezbollah conflict) should both serve to provide a trigger for U.S. large cap outperformance going forward.

As for which sectors to potentially buy, I bet many of the technical analysts on our subscription list will balk when I mention two of the sectors that I like at the moment. They are - in no particular order - semiconductors and retailers. Fundamentally, the semiconductor shares are now trading near historical lows on a price-to-book and a price-to-earnings basis. Moreover, while semiconductor sales have slowed down somewhat this year, they are still projected to grow 10% year-over-year for the rest of this year. Starting in 2007, semiconductor sale growth should again recover, given the release of Windows Vista and given the depressed amount of capital spending by U.S. corporations over the last couple of years. The pessimism over semiconductors is evident when one sees at the relative strength of the Philadelphia Semiconductor Index (the SOX) vs. the S&P 500, as shown by the following weekly chart:

As mentioned on the above chart, the relative strength of the SOX vs. the S&P 500 had just dipped below the troughs of February 2003 and August 2004 - hitting a low not seen since October 2002. Retail investor pessimism in the semiconductor shares is further confirmed by the amount of assets held by the Rydex Electronics fund (which is as close to a semiconductor fund as you can get), as shown by the following chart courtesy of Decisionpoint.com:

Given that the semis 1) are now trading near historically low valuations, 2) have paid down a significant amount of debt since 2000, 3) have been shunned by both retail and institutional investors, and 4) should again be in high demand after the release of Windows Vista in January 2007, my guess is that we are now at or close to a buying point in the semiconductor shares. As far as individual names are concerned, this author would suggest buying the cashflow-rich, large-cap shares in the semiconductor industry. As an interesting aside: The last significant trough in the relative strength of the semiconductors in August 2004 also preceded a huge multi-month rally in the NASDAQ Composite.

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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