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February 22, 2007

A Potential Short in the Midst of a Bull Market?
by Henry To

Dear Subscribers,

I hope all our subscribers have had a good weekend. The market certainly did - with the Dow Industrials rising 1.5% and the S&P 500 1.2% for the week. More importantly, all three Dow indices (the Dow Industrials, the Dow Transports, and the Dow Utilities) all made all-time highs last Wednesday - the first such occurrence since March 17, 1998. Excluding a similar signal in 1929 and the signal on March 17, 1998 (the reasoning behind this omission is discussed in this following post in our discussion forum), such a signal has often been a precursor for more stock market gains ahead.

Despite the continued and recent strength in the stock market, two of the weakest sectors within the stock market have been the semiconductor industry and the subprime lenders. The semiconductor industry has always been a very cyclical industry, and the best time to buy semiconductor stocks (in general) has always been during times of high inventories and predictions of "doom & gloom." Moreover, I expect the adoption of Microsoft Vista to accelerate sometime later this year with the release of "Service Pack 1." Coupled with the commercialization of the "solid state hard drive" for ultra-mobile PCs and high-end laptops, I expect the demand for semiconductors to soar and for inventories to tighten later this year. As for subprime lenders, it is definitely too early to say the industry has bottomed. Sure, there has been a shakeout among the smaller subprime lenders as their credit lines were cut - but readers should keep in mind that this has occurred while both the U.S. and global economies are still awashed in liquidity. Therefore, don't expect the Federal Reserve to come in and save these lenders (by cutting rates), unless there is a high probability the subprime lending industry would pose a risk to our financial system. If anything, it now looks like that the major central banks are still continuing to tighten, as exemplified by the recent messages coming out from both the European Central Bank and the Bank of Japan. At this point, however, I do not believe there will be any "spillover effects" from the troubles in the subprime industry. That being said, I will continue to monitor developments in this industry and report back if my assessment changes.

Before we continue with the rest of our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,382.57 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,262.57 points

Given the recent upside surprises in both the Euro Zone and Japan - not to mention the continued strength in the Nordic countries and in the majority of emerging markets around the world, chances are good that the U.S. stock market will continue to strengthen in the weeks and months ahead. As of Sunday afternoon on February 18, 2007, 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 (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel (Intel is now close to two generations ahead of AMD), GE, and American Express. We are also bullish on Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been overblown. We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials. We also continued to be very bullish on good-quality and growth stocks in general. In terms of individual countries, we continue to be bullish on both the Taiwanese stock market and the Taiwanese dollar.

Our view that growth stocks should outperform value stocks going forward is also shared by the Bank Credit Analyst. In a daily commentary last week, the BCA stated: "Generally, soft economic landings have led to a shift in investor preference toward growth. One reason is that as fear of recession and profit contraction ebbs, confidence in the durability of a long run economic expansion starts to build momentum. Under these conditions, analyst long-term (5-year) earnings forecasts have had a tendency to be ratcheted higher. In fact, a re-rating phase has already begun, as long-term profit forecasts have started to grind higher. Keep in mind that the last two major re-ratings in long-term forecasts have occurred well after both profit margins and profit growth had peaked, implying that an increase at the current phase of the business cycle would be well within historical norms. Inevitably, increased conviction in the long-run outlook has led to growth stocks to outperform value, and we expect a replay to unfold."

Following is a chart courtesy of the Bank Credit Analyst showing the ratio of the performance of the S&P 500 Growth Index and the S&P 500 Value Index over the last 20 years:

As shown on the above chart, value stocks in general have outperformed growth stocks over the last seven years. In fact, relative performance of growth vs. value is now at its lowest since late 1994 (the last time the U.S. economy had a successful "soft landing), suggesting that it is only a matter of time before growth stocks outperform value stocks. As stated by the above commentary from the Bank Credit Analyst, that time is probably now upon us.

But Henry, what could provide the "fuel" for a further upside in the stock market, especially a stock market that is conducive for a "re-rating" of growth stocks? Isn't the bull market that began in October 2002 now "long in the tooth?"

I would attempt to answer the latter question first. Yes, the bull market that began in October 2002 is now maturing. But so was the market in early 1995 when it was emerging out of its "soft landing" in 1994, as the bull market that was to extend into early 1998 really began in October 1990. As the above chart showed, the bull market in growth vs. value began in late 1994 - and it was not to end until early 2000. While I am definitely not looking for a similar rise in growth stocks in the current cycle, I would not be surprised if growth stocks outperformed value stocks by a total of 20% to 30% over the next few years.

Moreover, in previous commentaries, I had discussed that based on our indicators such as 1) the amount of money market funds vs. the S&P 500 market cap, 2) equity and equity mutual fund holdings as a percentage of total household assets, 3) mutual fund inflows/outflows data per AMGdata.com, 4) short interest outstanding on the NYSE and the NASDAQ, 5) relative valuations of U.S. equities vs. U.S. bonds, international stocks, real estate, and commodities, and so forth - this current bull market in U.S. stocks is still not close to a top just yet. The potential long-term bullishness inherent in these indicators is also being confirmed 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 our October 8, 2006 commentary (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). In essence, the readings of these two surveys suggest that the premise that there are "too many bulls out there" is a false premise. Let us 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 increased from 4.9% to 5.2%. While this reading is the highest reading since early December of last year, it is more important to note that this only represents a small bounce from a low of 4.3% achieved during late December/early January - a low which had represented the most oversold reading since June 2003. Following is the 52-week MA of the AAII survey vs. the weekly closes of the Dow Industrials from July 1988 to the present:

As mentioned on the above chart, the 52-week MA of the AAII Bulls-Bears% Differential most recently hit a low not seen since June 2003. Moreover - excluding the spike lower in the latter parts of 2002 and early parts of 2003, the 52-week MA of the AAII Bulls-Bears% Differential is at its most oversold level since March 1995 - and we know what happened afterwards.

As for the 52-week MA of the Investors Intelligence Bulls-Bears% Differential - it is definitely not as oversold as the AAII survey on a historical basis - but please note that during early October of last year, it hit a low not seen since July 2003, as illustrated by the following weekly chart:

While the 52-week MA of the Investors Intelligence Bulls-Bears% Differential has since bounced to a level of 18.9%, subscribers should keep in mind that this is only a relatively minor bounce - and in fact, if we exclude the readings over the last few months, the latest reading of the 52-week MA still represents the most oversold reading since August 2003. Again, while the Investors Intelligence Survey isn't as oversold as the 52-week MA of the AAII survey, the fact that it is now giving us a reading which is still oversold is definitely encouraging for the bulls and for our "growth stock scenario" going forward. The "conjecture" by the permabears suggesting that "there are too many bulls out there" just does not hold water.

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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