(January 13, 2008)

Note: As many of my subscribers may know, I am also a co-author of The Retirement Advisor, a monthly publication geared towards more conservative investors who do not want to time the markets and who are more interested in issues of asset allocation, retirement, savings vehicles (such as CDs), and mutual funds. For those who are interested, I want to offer our January 2008 issue as a sample. In this issue, aside from a summary of our portfolios' performance in 2007, we also discuss where one can get the highest CD rates, a sound withdrawal strategy from your retirement portfolios, as well as a summary of the various mutual fund families we discussed in 2007 (two of our recommended mutual funds were named Morningstar's "Fund of the Year" in their respective categories). Subscription information is outlined at the back of the newsletter as well as on our website.

Dear Subscribers,

As all of my subscribers should know, we made a very substantial change in our MarketThoughts.com DJIA Timing System last Wednesday morning, covering our 50% short position that we had initiated on October 4, 2007 at a DJIA print of 12,630 at a 1,326-point profit. At the same time, we initiated a 50% long position. Following is an update on our six most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 13,630, giving us a loss of 23.70 points as of Friday at the close.

Our decision to reverse our 50% short position and go 50% long was discussed in our Tuesday evening commentary. Aside from a severe oversold condition in the U.S. stock market, there were also numerous signs of capitulation, such as rumors of an inevitable bankruptcy in Countrywide Financial and a Tuesday afternoon decline that was exacerbated by AT&T announcement that implied a substantial economic slowdown. I also discussed (and as alluded to in our November 11, 2007 commentary) that should the S&P 500 decline to or below the 1,375 level, there was a good chance that the Federal Reserve will orchestrate an inter-meeting rate cut, a la the "Bernanke Put." While we did not get a surprise rate cut, we did witness many similar developments. For example, on Thursday, Fed Chairman Ben Bernanke issued a statement indicating that the Fed stood ready "to take substantive action" in order to prevent the economy from falling into a recession. Even William Poole - the St. Louis Fed President who is traditionally a hawk - recently came out with remarks that were uncharacteristically dovish. For Bernanke, this was a dramatic departure, as unlike Alan Greenspan, Bernanke has tended to make decisions by committee and consensus so far in his tenure as Fed Chairman. More importantly, this should also provide tremendous confidence to the markets going forward - as the markets have traditionally looked much more kindly on a leader/dictator (a la JP Morgan, Paul Volcker, and Greenspan) as opposed to a ruling committee on Fed policy during times of crises. Finally, talks of a Countrywide "bailout" started to become rampant on Thursday afternoon. By Friday morning, the deal was already sealed. In a "special alert" to subscribers on Thursday afternoon, I stated:

Today was an important today.

From Bernanke's statement today, we now know the "Bernanke Put" has a strike price of 1,375 on the S&P 500. This is the level which I have been discussing since early November, and is also a good support level which represents the bottom in early March 2007.

Secondly, not only will the Countrywide buyout (assuming it goes through) remove a substantial amount of "systematic risk" from the financial system, it will also remove a significant competitor for bank deposits (CFC and ETFC have been upping their deposit rates in order to remain liquid). This will lower rates on the short end of the curve immediately. Now, as the Fed again cuts rates, this will reliquify the entire system as the yield curve further normalizes.

I think the financials have, in general, bottomed out here, assuming the CFC transaction goes through.

There is now no doubt that the Federal Reserve is doing all it can - with the help of the private sector (the ones that still have cash, such as JPM and BAC) and sovereign wealth funds - to defend 1,375 on the S&P 500 and to actively remove as much "systematic risk" as it possibly can. For now, and assuming that the JP Morgan's acquisition of Washington Mutual goes through, it does look like that liquidity conditions are gradually loosening. This is being confirmed by the decline in the "TED spread," defined as the difference between the three-month LIBOR rate and the yield of the three-month Treasury bill, and is usually interpreted as the willingness of banks to lend to high-grade corporate borrowers or fellow banks. Following is a chart showing the TED spread (smoothed on a five-day basis) from January 1994 to the present:

Given that the TED spread was at a 20-year high as recently as three weeks ago (the highest since October 1987), and given the Countywide buyout and the impending Washington Mutual acquisition, there is a good chance that we have already seen the high in the TED spread for this cycle. Moreover, should the Fed cut by 50 basis points (or more) in the upcoming Fed meeting on January 30th, there is no doubt that this will ease back to below the 1.0% level. Assuming that the Washington Mutual acquisition goes through, and assuming that both Citigroup and Merrill Lynch is able to secure the necessary capital that the Wall Street Journal has advertised over the next couple of days, there is a good chance that we have already or will see a low in the financial sector during the upcoming week. For those that are already holding C or MER, the greatest risks (at least in the upcoming week anyway) will be dilutive in nature - as opposed to liquidity or even credit risks. Interestingly, despite a 246-point down day on the Dow Industrials last Friday, financial stocks actually closed positive for the day.

Speaking of liquidity, I also want to discuss stock market liquidity, or as we have mentioned before, our "cash on the sidelines" indicator. This indicator - the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 - had been particularly useful as a gauge of how oversold the US stock market really is - as well as how sustainable a current rally may be. I first got the idea of constructing this chart from Ned Davis Research - who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to January 2007 (updated with January 11th data for the month of January):

As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 23.41% - a level that has not been seen since the end of April 2003, and on par with the reading at the end of October 1990. While this ratio is not a great timing indicator, what it does show is the amount of "fuel" for a sustainable stock market rally going forward. Moreover, such a reading is very high on a historical basis and should be supportive for stock prices over the next 12 to 18 months. Even though the stock market can do anything over the short-run, my guess is that there is a maximum downside of only 5% from current levels - barring the failed acquisition of Washington Mutual or a less than 50 basis point rate cut from the Fed on January 30th. Moreover, the Fed will also need to address the dismal growth of the St. Louis Adjusted Monetary Base (the 10-week moving average of the St. Louis Adjusted Monetary Base is up a mere 1.6% over the last 12 months). However, unless we witness a collapse of the banking sector such as what we witnessed in the early 1980s (note that this ratio spiked quite dramatically from January 1981 to late 1982), chances are that stock prices will be higher 12 to 18 months from now.

Over in the Pacific area, we have also been witnessing a significant amount of capitulation in the form of a crashing Nikkei. In fact, since the Nikkei topped out on July 9, 2007, it has declined over 22% in the space of six months. As of Friday, the Nikkei closed at 14,110.79, its lowest level since November 15, 2005. Moreover, the Nikkei is now 16.12% below its 200-day moving average, as shown in the following daily chart (showing the Nikkei vs. its percentage deviation from its 200-day moving average from January 1995 to the present):

Based on this statistic, the Nikkei is now at its most oversold level since March 11, 2003. In addition, over the last 13 years, virtually all declines in the Nikkei (with the exception of the post-911 decline) have stopped when the Nikkei reached a level that is close to 20% below its 200-day moving average - recession or no recession. Given that more than 50% of stocks on the Tokyo Stock Exchange are now trading below book value, and given the severe Japanese underweighting of many international mutual funds here in the US, my guess is that the Nikkei is now in the midst of bottoming out. I continue to believe that Japanese small caps are approaching a significant buying point - and may come as early as this week.

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