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October 11, 2006

Are Things Really Different This Time?
by Henry To

Dear Subscribers,

Important Announcement: This author has just published a book review on Stephen Drobny's "Inside the House of Money." This book is a must-read for any trader/investor alike. A great lesson in the psychology of trading successfully in the long-run as well as a great update on the world of "global macro" hedge fund investing as it is playing out in the world today.

Before we begin our commentary, let us first take care of some "laundry work." Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 - giving us a gain of 290 points. In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now 465.21 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 345.21 points in the black. Real-time "special alert" emails were sent to our subscribers informing them of these changes.

As of Sunday afternoon on October 8th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. We are also very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). The market action in large caps, retail, and technology has all been very favorable so far - and I expect it to remain favorable at least for the rest of this year. While investors have been worried about a lack of breadth in both the S&P 400 and the S&P 600 since the current rally began in mid August - that is to be expected, given that this market is now favoring large caps over mid and small caps. Moreover, the action of last Wednesday went a long way in improving the breadth of the market, as I will illustrate a bit more later in the commentary. For now, the so-called divergences are not a concern to me.

Let us now get on with our commentary. Investors who are fans of stock market history (IMHO, a comprehensive knowledge of stock market history over at least a 40-year cycle is essential to long-term success) should know that the four most expensive words in both the stock market and the financial markets are: "It's different this time." But as many participants in the financial markets found out to their dismay over the years (such as Long-Term Capital Management or George Soros), history cannot act as a complete guide either. For example, in an interview with "The Emerging Market Specialist" - Marko Dimitrijevic of Everest Capital - in the book "Inside the House of Money," the author discussed the nuisances of Mr. Dimitrijevic's Russian position just before its 1998 default and why it was unprecedented. I will now quote from the book:

Question: I understand that you liquidated your Russia position before the 1998 meltdown but then reentered just before they devalued and defaulted. What happened there?

Answer: We had invested successfully in Russian debt instruments for several years prior to 1998, including MinFin domestic dollar-denominated bonds of the Russian Republic, the former Soviet Vneshekonombank debt, and S- Account GKOs. By the spring of 1998, we were not completely out of Russian debt but we had reduced our position significantly. Then in July, when yields really started to rise, we thought it was a very good opportunity. We thought there was a decent probability that they would devalue, but in a controlled fashion ... What we didn't expect was a devaluation and a default at the same time. It doesn't make economic sense. It was the first time a country had devalued and defaulted at the same time, so it created a real panic. It was unprecedented that a government would do that, as you always got either one or the other.

In other words, Russia could have paid off their debts simply by printing rubles, as the debt was not dollar-denominated. Even Weimar Germany never defaulted on their own, local currency-denominated debt. The move by the Russians in the Fall of 1998 was simply unprecedented.

So Henry, what are you saying? Are you saying that things are "truly different this time" in the stock market? And perhaps that we are now in a bull market?

No, I am not saying we are now in a new bull market. I am also not saying "things are different this time." But then, not everything is the same either. For example, the latest rate hike cycle starting in June 2004 has been truly different, as I have discussed in previous commentaries. The fact that 1) it has been pre-emptive - similar to the 1994 to 1995 hiking cycle, and 2) all rate hikes have been very clearly communicated prior to the actual hike is truly unprecedented. Not only have we most likely achieve a mere "mid cycle slowdown" in the U.S. economy (as I have been discussing since the beginning of 2006) because of this pre-emptiveness - we have also not seen any major hedge fund blowups that have affected the major stock market indices. Case in point: We have not seen a 10% correction in the S&P 500 since early 2003.

At the same time, we know that the P/E ratio of the S&P 500 is still near historical highs at a level of approximately 18. That is, over the longer-term, stock market returns will still most likely be sub-par - especially relative to the returns during the 1980s and the 1990s. That is I do not believe we are now in a genuine multi-year bull market.

But Henry, aren't you 100% long now in your DJIA Timing System? Aren't you also bullish on U.S. large caps and U.S. "quality" growth stocks? What is your rationale on that?

As I have discussed many times before, the P/E ratio of the S&P 500 or any other "straight up" valuation indicator that attempts to measure how much the stock market is worth relative to its historical valuation is not a good timing indicator - at least over a period of 12 to 24 months anyway. This was apparent during the periods from late 1928 to late 1929, 1936 to 1937, 1945 to 1946, 1956 to 1957, 1963 to early 1966, 1968 to early 1969, mid 1971 to early 1973, early 1987 to Fall 1987, and finally 1992 to the present - the latter a period of over 14 years of "historical overvaluation!" Following is a monthly chart courtesy of Decisionpoint.com showing the historical P/E ratio of the S&P 500 from January 1925 to August 2006. Note that there has been many multi-month periods (as mentioned above) where the P/E ratio of the S&P 500 has hovered at or near the historical overvalued measurement of 20 or over:

Interestingly, today's P/E ratio of approximately 18 or so represents the most undervalued reading (okay, the undervalued label is stretching it a little bit but you know what I mean) since late 1995/early 1996 - suggesting a propensity for the market to move significantly higher (10% to 15%) over the next 12 to 18 months based on the elevated P/E ratio of the S&P 500 over the last 15 years or so.

However - and more importantly, the valuation of U.S. stocks relative to many other asset classes such as U.S. bonds, global real estate, global bonds, global equities, and commodities is now at its lowest level at least since the major bottom in October 1990. Unless the U.S. economy is heading into a deflationary bust (which is a low probability event as long as the Fed is finished with its series of rate hikes and as long as there is no major terrorist attack in the U.S. or Western Europe), the relative valuation of U.S. stocks as measured against other financial or even physical asset classes has always been a much better timing indicator (over the next 12 to 24 months) vs. historical valuation ratios such as the P/E ratio of the S&P 500. Moreover, as I have discussed many times before, U.S. equities are also very underowned and underloved - as evident by the Fed's Flow of Funds data on the balance sheets of U.S. households, mutual fund outflows out of domestic equities from May to August (the most since the four-month period ending October 2002), and the fact that there has not been much hedge fund speculation in U.S. equities in recent years. As for U.S. growth stocks, it is interesting to note that the famous "Value Line Ranking System" (a system based on buying good-quality, growth stocks and which has overperformed the marketing significantly since inception in 1965) has actually underperformed the market for the last consecutive five years - an occurrence which is totally unprecedented (again, never say never in the stock market). This and the relative valuation indicator suggests to me that U.S. large caps and U.S. growth stocks will most probably overperform most asset classes (including cash) for the rest of this year and even into Spring of 2007.

The fact that U.S. equities are underowned and underloved is also apparent in our most popular sentiment indicators - those being the American Association of Individual Investors (AAII) and the Investors Intelligence Surveys. I have not covered them on an individual basis since the beginning of this year (rather, these two indicators have been combined with the Market Vanes Bullish Consensus to come up with a combined indicator) so I want to provide a quick update. However, instead of providing the reader with weekly readings, I want to show both surveys on a 52-week moving average basis in order to smooth out any spikes or "seasonal effects" (along with giving the reader a longer-term perspective). Let's first start with the American Association of Individual Investors (AAII) Survey. During the latest week, the 52-week moving average of the Bulls-Bears% Differential declined from 7.0% to 6.4% - the lowest reading in three weeks. More importantly, the 52-week moving average of the AAII survey most recently bottomed at 6.1% in early August 2006 - which in turn represented the most oversold reading since June 2003.

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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