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January 24, 2008

Capitulation this Week?
by Henry To

(January 20, 2008)

Dear Subscribers,

No doubt this week has been difficult for many of you. Believe me; the decline of last week had been tremendously frustrating for me as well. Aside from doing some research this weekend, I also spent a lot of time working out and running - and of course, some time relaxing and hanging out with my fiancé as well. More specifically, despite making a 1,326-point profit on our 50% short position that we had initiated in our MarketThoughts.com DJIA Timing System on October 4, 2007 when we decided to cover our position on January 9th, we had also gone 50% long immaturely at the same time at a DJIA print of 12,630. Subsequently, we watched the Dow Industrials decline day after day - taking out one oversold level after another. However, as I have mentioned in my many commentaries, "ad hoc" emails, and posts in our discussion forum over the last 5 to 7 trading days, our technical indicators - such as the NYSE ARMS, new highs vs. new lows on both the NYSE and the NASDAQ Composite, the % of stocks below their 200-EMAs on both the NYSE and the NASDAQ, a Barnes Index reading below zero, etc, are now showing oversold levels not witnessed since the significant bottoms during October 1990, Fall 1998, September 2001, and October 2002. All these bottoms have been a great time to buy - with half of these bottoms marking the beginning of a multi-year bull market in US stocks.

Of course, there are also other factors telling me that we are not in a "full-blown" bear market just yet, but before I go on and discuss those factors, let us first update you 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 12,630, giving us a loss of 507.00 points as of Friday at the close.

Now that we have gotten this out of the way, so Henry, what are some of the other factors indicating that we are not in a "full-blown" bear market? After all, didn't the US (along with the UK, Australia, and a large chunk of the Euro Zone) just experience a once-in-a-generation housing bubble, as well as a bubble in structured finance? Shouldn't we wait on the sidelines for now until all the "excesses" have been cleansed out?

The answer to the last question, in general, is "yes." But as I have mentioned before, investment and commercial banks alike have already written down much of their questionable assets based on various structured finance indices (such as the ABX) that were not even available five years ago. More importantly, these indices are now reflecting a significantly more dire situation than where either US residential real estate or housing prices are right now. Could these derivative indices be right? Sure, but should we witness any improvement in either these indices or simply a less pessimistic outcome in the US housing market over the next few months, then we could see some upside surprises in next quarter's round of earnings reports. My main point is this: Because of the structure of the financial markets today, US investment and commercial banks are now writing down assets much quicker than in the last US housing downturn - especially during the S&L crisis in the early 1990s - such that all the "excesses" are now being cleaned out at a tremendous rate, and even better for us, they may have even overshoot on the downside.

As for the reasons why I don't believe we are in a full-blown bear market just yet, there are many reasons - so I would only list out some of them here, in no particular order:

First of all, unlike the late 1990s technology bubble, the current bubble did not originate in the stock market - but rather, in the US residential housing market that was further aided by financial engineering and a loose monetary policy during 2003 to 2004. Because of this, much of the retail speculation had focused on US housing, or more specifically, housing in California, Florida, Nevada, and Arizona. To the extent there was retail speculation in the US stock market, it had centered on shares of homebuilding and mortgage companies. In my humble opinion, the bubble in mortgage companies, and to a lesser extent, homebuilding companies, had already burst a long time ago and is close to being fully wounded down. Because of this lack of retail speculation in the US stock market in recent years, valuations, in particular in the consumer discretionary, technology, health care, and consumer staples sectors, have never really gotten out of hand, unlike during the late 1990s bull market.
While one could argue that many companies in the financial sector had over-inflated earnings due to the structured finance boom in recent years, subscribers should remember that any "crisis" that originates out of the financial sector - unlike the capital overspending and the aftermath in the technology sector during 2000 to 2002 - is usually easy to fix. Whether the crisis was the S&L crisis during the early 1990s, the Russian/LTCM crises in 1998, or the current crisis in subprime - the easiest strategy has always been to inflate, inflate, and inflate. Make no mistake: The Fed will continue to ease aggressively going forward. It will also do everything in its power to make sure LIBOR stays at the Fed Funds rate. From a fiscal standpoint, we have already seen what the Bush Administration and Congress is willing to do to prop up consumer spending this year. Moreover, they have committed to agreeing on a solution by the State of the Union address on January 28th. Not only that, the FDIC Chairman has publicly declared that if a market solution isn't enough to solve the subprime problem, the government will step in. This is akin to the Federal government printing money and using it to soak up on the excess Cisco routers and Intel processors during the 2001 to 2002 debacle unwinding of the technology bubble. Sure, many mediocre companies will still fail - but the overall stock market and the stronger companies will be propped up or "bailed out."
The change in investors' sentiment had been very dramatic since the beginning of the year. Right before New Year's (and when we had already been short for nearly three months), everything was still "hunky dory" according to stock market analysts and economists alike - and now after a dismal unemployment number and a breakdown in the chart patterns, most if not all market analysts are now calling for a US recession and the end of the October 2002 to October 2007 bull market. Given that the majority of these analysts and economists had not anticipated the current market decline last year, it doesn't make too much sense in betting on them now.
As for basing your equity allocation based on "chart patterns" alone - I want to ask my subscribers this: Would you bet your life on a chart pattern, and if not, why would you bet your retirement portfolio on a chart pattern? If one can call the beginning of a major bull or bear market simply by looking at moving average cross-overs, then there would be no market. 20 years ago, this would have been a useful endeavor - given that this kind of data was not easily available. Nowadays - with a few simple mouse clicks, anyone can bring up a chart of the S&P 500, along with every technical tool one can dream of, for free. That is not to say that this author doesn't look at charts. However - to me - trading or making decisions based on chart patterns is only useful on the condition that: 1) Not many other analysts are observing the same patterns at the same time, and 2) The chart pattern is being confirmed by my other indicators, especially from a valuation and sentiment standpoint. On both counts, the bearish case based on the current S&P chart pattern (and to a lesser extent, the bearish implications of the Nikkei chart pattern) does not pass much muster.

Moreover, subscribers should keep in mind that the "cash on the sidelines" is now approaching a level that has marked major bottoms in the past. As mentioned in the Wall Street Journal over the weekend (and according to Morningstar), the cash levels of domestic equity mutual funds (mutual funds that have a general mandate to invest exclusively in US stocks) were at an average of 7.3% of assets as of December 31, 2007 - the highest year-end number since December 31, 2000. Moreover, many of these funds (such as American Funds Fundamental Investors and Fidelity Magellan) have tried to "goose up" their returns over the last couple of years by "diversifying" into foreign stocks, even though their general mandate is to invest solely in domestic stocks. In other words, not only are domestic equity mutual funds now heavily in cash, they are also underweight U.S. equities. Barring a 1929 or a 1987 style panic out of the equity markets, domestic equity mutual funds not only have enough funds for redeeming investors, but also a substantial cash cushion to buy more domestic stocks should the market continue to decline.

Outside of mutual funds, there is another "cash on the sidelines" indicator that I want to discuss. This indicator is one that I showed in last weekend's commentary, but which now I want to update. 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 18th 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 24.62% - a level that has not been seen since March 2003, and is now at a high level than where it was at the end of October 1990. While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now extremely high on a historical basis and should be supportive for stock prices not only for over the next few years, but over the next few months as well. Even though the stock market can do anything over the short-run, my guess is that investors will capitulate this week - meaning we should get a good buying opportunity this week that will allow us to shift from a 50% long to a 100% long in our DJIA Timing System.

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.