A New Era?

By: Henry To | Mon, Aug 8, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. Since July 14th - even while some of the other major indices have enjoyed nice gains - the Dow Industrials has actually slightly declined, thus giving us slight gains in our DJIA Timing System. We will continue to remain 25% short in our DJIA Timing System - as the DJIA has definitely been and still continues to be the weaker index. Again, since tops are inherently difficult to call, I am giving this market the benefit of the doubt - and if no significant selling pressure develops in the next five to ten trading days, we may actually cover our 25% short position and go completely neutral in our DJIA Timing System. We will not switch to a 50% short position in our DJIA Timing System unless I see more evidence of a significant top (such as more negative divergences, more insider selling and more IPOs and secondary offerings, etc.)

Important note: I apologize for the confusion of our title in our July 24th commentary. Our title did suggest that we were anticipating switching to a 50% short position in our DJIA Timing System during the week of July 24th. However, whenever there is a new signal in our DJIA Timing System, we have always sent a "special alert" email to our subscribers as well as recorded it in our "Special Alerts" section of our discussion forum - neither of which we did during that week. As a matter of fact,, I had made a couple of posts in our discussion forum discussing that I was getting hesitant during the early parts of that week - as well as emailed an "Ad Hoc" update on Thursday evening stating: "Anyway, as our subscribers know - in our commentary last weekend - we were anticipating to switch from a 25% short position in our DJIA Timing System to a 50% short position sometime this week. I apologize for "jumping the gun," but as I mentioned in our discussion from on Wednesday night, I believed by that time that there was a good possibility that the market will make one more "push" to the upside and thus we may not switch to a 50% short position until next week or the week after. The action of Thursday has further confirmed my views at this point." In our commentary last weekend, we also discussed the reasoning behind why we did not switch from a 25% short position to a 50% short position in our DJIA Timing System during the week of the 24th. Again, I apologize for the confusion. This definitely will not happen again (ironically, if we had indeed switched to a 50% short position, we will be in a more profitable situation than we are currently!).

An update on our transition to a subscription model: Right now, our target date for the switch to a subscription model is October 1st. We will be offering a free one-month trial period to all our current subscribers and to new subscribers (in essence, our target for getting paid is really November 1st) going forward. My partner, Rex, and I are still trying to hammer out our final subscription schedule - but our current intention is to offer an introductory discount price of $39 for the first six months of your subscription (excluding your first-month trial subscription). Thereafter, the price of an annual subscription will be $99 a year - with appropriate price changes for a monthly or a six-month subscription if you choose to go that route. Since Rex and I have limited resources, we will only accept payments via Paypal. Moreover, our current archives will be available free of charge (with a one-month delay for new commentaries) as well as the ability to post and read messages in our discussion forum. I cannot guarantee, however, that access to our archives and our discussion forum won't be restricted to only paying members sometime in the future.

Let's now get on with our commentary. Readers who took a glance at the title may be thinking that I have gone out of my mind. After all, didn't investors who believed in the last "new era" suffered greatly (and mortally for some) when the technology bubble crashed beginning five years ago? Of course they did - but while stories were exaggerated upon (with an excess of funds to boot) that does not preclude the fact that we were in such a new era. The fall of the Berlin Wall, the economic liberalization of India, and the advent of the internet all combined to "flatten" the world (as put forward by Mr. Thomas Friedman), and in the process, opened up new markets and opportunities (and displaced old ones). This is still happening as we speak. After all, there is no way we could have started such an economic advisory website and enjoyed such a blistering expansion just a mere ten years ago. I am very grateful and honored to be able to write to all of you and to communicate my deepest thoughts and concerns regarding the world economy and financial markets.

With this "flattening" of the world, the economic changes that will be experienced by Americans, Western and Eastern Europeans, the Chinese, the Japanese, and Indians alike going forward will accelerate. Historically, great change usually only benefit the minority, and unless our education systems adept to these changes or unless we become more self-reliant and take responsibility for our own destinies, there is no reason to believe that "this time will be different." In the past few weeks, we witnessed a currency regime change when the Chinese revalued their currency and announced an intention to continue to diversify into other currencies (other than the U.S. dollar) and we also witnessed crude oil again surpassing $60 a barrel - with apparently minimal impact on the U.S. consumer! And don't forget the ever-declining rates on the long end of the U.S. Treasuries, along with the VIX "conundrum" that has plagued traders over the last 18 months (for readers who are interested, please check out our latest thread on the VIX in our discussion forum). When it comes to the world economy and financial markets, the word "surprise" seems to be the norm rather than the exception.

Like I have mentioned before, the 21st century will be increasingly about self-reliance and self-responsibility. I sincerely believe that this is where we come in - to alert our readers of great changes ahead (quicker than most out there) and to help our readers dissect potential problems and to help solve them. In our special report, "Three Important Questions - Economic Survival in the 21st Century" (which was published nearly a year ago), I discussed three issues that should be of the utmost concern for our subscribers, namely demographics, the end of cheap energy, and the need to know your own investing psyche and to be able to make independent investing decisions in order to make money over the long-run. Over the last 12 months or so, I have discussed these three topics extensively - with the exception of demographics (namely the aging population of the developed world), even though the subject of demographics is definitely as important as the latter two topics, if not more important.

I will discuss the possibly implications of aging demographics in more detail on Thursday's commentary - but the main gist is this: This is a topic which has been one of the most widely discussed but also one which has been largely ignored by the masses - even by members of Congress as well as company managers. The "threat" of an aging worldwide population is real, particularly in Western Europe and Japan (please see the following thread on our discussion forum for a brief summary and implications of the situation in Japan). For the blind optimists who disregard the secular bearish implications of the Dow Theory, all I can say is: "Demographics matters." I am reminded of Winston Churchill's writing in the first volume "The Gathering Storm" of his work on World War II. Commenting on the aftermath of World War II, Winston Churchill had this to say about the French people: "But the future [despite the fact that Germany had lost the war] was heavy with foreboding. The population of France was less than two-thirds that of Germany. The French population was stationary, while the Germans grew. In a decade or less the annual flood of German youth reaching the military age must be double that of France. Germany had fought nearly the whole world, almost single-handed, and she had almost conquered. Those who knew the most knew best the several occasions when the result of the Great War had trembled in the balance, and the accidents and chances which had turned the fateful scale. What prospect was there in the future that the Great Allies would once again appear in their millions upon the battlefields of France or in the East?" How could France, with one of the best-trained armies in the world, collapse so quickly during World War II a mere 20 years later? Part of the answer lied in the surprise strategy of the German forces, but part of the answer also lied in the sheer number of German forces - which can be traced to the favorable demographics of Germany over France dating back to the latter parts of the 19th century.

Of course, I am not implying that the developed world (especially Japan and Western Europe) is in danger of being physically invaded by countries with a greater general and youth population - but the 21st century globalized world economy is probably, in many ways, similar to a theater of war. Being prepared (educated and having the necessary legal and financial infrastructure) and having more favorable demographics (a large workforce that is both energetic and innovative) will be the key to economic dominance in the 21st century.

Before I go into the recent stock market action, I would first like to update our readers on what we discussed last week - the natural gas markets. Since our commentary last weekend, the spot price of natural gas has spiked over a dollar per MMBtu. Sentiment (as measured by Market Vane's) has become more bullish last week, but still not high enough relative to the sentiment prevalent in prior peaks:

Henry Hub Natural Gas Spot Prices vs. Bullish Sentiment (January 2001 to Present) - 1) Natural gas spot prices spiked over a dollar since our bullish commentary on the commodity last week! 2) Bullish Sentiment jumped quite a bit last week but still very low relative to sentiment in prior peaks - suggesting that investors are STILL skeptical of the recent rally in natural gas prices...

The bull market in natural gas remains structurally intact - and I still believe this is a better buy than crude oil given the fact that this is not as overbought as well as the fact that it is not as widely covered by the popular media as crude oil. Should this winter bring with it colder-than-expected weather, than natural gas prices could very well spike to the $15/MMBtu to the $20/MMBtu area. I encourage our readers to spend a little bit of time to learn more about the dynamics of the natural gas markets, as this is definitely an area where there are less market efficiencies (and more volatility) than crude oil. That is, going forward, it may be easier to make money investing via the natural gas markets - even though both crude oil and natural gas may be in a secular bull market.

In the short-term, however, there may be some headwinds - although both the oil and the natural gas market have continued to surprise on the upside. The latest OECD leading indicators has just been released, and with it, we have updated our MarketThoughts Global Diffusion Index (MGDI) to reflect the latest data as of the end of June 2005 (for a revision of how the MGDI is constructed, please see our May 30th commentary). The following chart shows the historical correlation of the performance of the MGDI vs. the CRB Energy Index, whose components include WTI crude oil, natural gas, and heating oil (please note that our MarketThoughts GDI is updated to June while everything else is updated to July 2005):

Global Diffusion Index (GDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to June 2005) - 1) Spike due to the natural gas crisis in Winter 2000/2001 2) A new era?!  Maybe, but probably not yet. 3) Historically, the rate of change in the GDI has also led or tracked the YoY% change in the CRB Energy Index very closely.  Again, note the recent divergence - my guess is that they will converge in due time.

The year-over-year change in the MGDI continues to decrease - declining from a rate of 1.54% in May to 1.32% in June, although the rate of decline has slowed slightly. Like I mentioned in a previous commentary - if this historical correlation holds true, then the yellow line should at least hit 0% at some point within the next three to six months. A 0% year-over-year increase in crude oil prices would translate to a range of $42 to $56 a barrel from now until December - suggesting that oil is definitely now very overvalued. At the same time, a 0% year-over-year increase in natural gas prices would translate to a range of $4.50 to $8.00/MMBtu (please note that as I am typing this, the September contract for natural gas is trading at $8.77, while the January 2006 contract is trading at $9.97/MMBtu). Given the historical correlation between the MGDI and in energy prices, I believe that - barring a severe winter - energy prices should correct as we head into the winter months.

The recent stock market action, meanwhile, has been forgiving for the bears. As shown by the following chart of the Dow Industrials vs. the Dow Transports, the market endured a slight correction last week, with the Dow Industrials declining 82 points and the Dow Transports declining 68 points on the heels of a continued gain in fuel prices:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to August 5, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) For the week, the Dow Industrials declined 82 points while the Dow Transports declined 68 points.  Last week, I stated: 'the question to ask is still: Will the strength of the Transports pull the Industrials higher or will the weakness of the Industrials signal weakness ahead for the Transports - and for the rest of the major market indices?'  Has this question been answered?  That is, did the weakness of the Dow Industrials prove too much for the Dow Transports and for the overall stock market?  It is still too early to tell, but like I mentioned last week, I am still relatively comfortable with our 25% short position in our DJIA Timing System.  Should no further selling pressure develop this upcoming week, however, we may be forced to cover our 25% short position in our DJIA Timing System and go completely neutral.

Please note that our DJIA Timing System switched from a neutral position to a 25% short position as of July 14th at a DJIA print of 10,618. Friday's close at 10,558.03 puts us 60 points in the black - a paltry gain but still a gain nonetheless. Going forward, I believe the index to watch will be the Dow Transports - as I don't believe the market can sustain its current uptrend without the participation of this index. A continued rally in the Dow Transports naturally means a correction in oil prices - as a negative correlation of the Dow Transports with crude oil has emerged in recent weeks - despite them moving in sync for most of the cyclical bull market since October 2002. Whether we will stay with our 25% short position, however, will depend a lot on what will happen in the market this week. Historically, the upcoming week has been fraught with negative activity (a busy IPO calendar as well as a flood of insider selling before they both recede in the latter parts of August and the first week of September) - and if significant selling pressure does not emerge this week, we may be forced into covering our 25% short position in our DJIA Timing System as opposed to looking to shift to a more bearish 50% short position. As always - whenever a new position is initiated in our DJIA Timing System - we will communicate that to our readers in real-time through email as well as post a message in the "Special Alerts" section of our discussion forum.

Let's now turn to our sentiment indicators - starting off with taking a look at the Bulls-Bears% Differential in the AAII (American Association of Individual Investors) Survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey is still giving us volatile readings  - as exemplfied by the latest decline from 40% to 22% in the latest week.  Since, the Bulls-Bears% Differential failed to stay at or above the 40% level in the latest week, this survey is now no longer overbought.  In last week's commentary, I mentioned that 'whether we turn 50% short in our DJIA Timing System later this week will depend on a great deal on what this and the Investors Intelligence Survey is telling us.'  Since this survey is no longer in an overbought condition, we will most probably have to forgo our '50% short stance' for now.

The bears just cannot get a break here - as the slight decline of the Dow Industrials and in the market last week were accompanied by a relatively big dip in bullish sentiment in the AAII survey - suggesting that retail investors were worried about the recent decline. Moreover, the 40% or higher reading that I was looking for as a signal to switch to a 50% short position in our DJIA Timing System did not materialize, which means that we will need to go back to the drawing board, once again. Like I said before, this week, however, is a seasonally difficult week so if no significant selling pressure materializes this week, we will be switching back to a completely neutral position.

Meanwhile, the Bulls-Bears% Differential rose slightly from a reading of 33.3% to 34.8% in the latest week. This survey is somewhat overbought - but it is still relatively far away from the "danger zone":

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - Meanwhile, the Bulls-Bears% Differential in the Investors Intelligence Survey got slightly more overbought last week - rising from a reading of 33.3% to 34.8%.  However, my message from last week and two weeks ago still remains the same - said message being that before we can confidently call a ST top in this market, the reading in this survey will need to surge to a level similar to the December 2004 levels of 40% (or even higher).  Based on the current readings from this survey, we are still not close to such a condition.

With regards to this survey, I stated in last week's commentary that: "Out of the three popular sentiment indicators that we keep track of, the Bulls-Bears% Differential in the Investors Intelligence Survey is the least overbought - with the latest one-week reading rising from 29.6% to a slightly overbought reading of 33.3%. In a "perfect world," we will also wait for the Investors Intelligence Survey to rise to a reading of 40% or above we shift to a 50% short position in our DJIA Timing System. For now, we will just take it one day at a time and we will definitely keep you updated - but if the right conditions exist, I would not hesitate to shift to a 50% short position before we see a reading of 40% or above in this survey - as long as the readings coming out of this survey doesn't tank below 30%." Obviously, we did not get what we wanted (more bullish sentiment) from the AAII survey, and ironically, it was the reading from the Investors Intelligence Survey that had gotten more overbought. In this instance, I will again follow our own advice from last week, but with a different twist. That is, before we switch to a 50% short position in our DJIA Timing System, I would prefer to see a more overbought reading in the AAII survey - even if the bulls-bears% differential in the Investors Intelligence Survey rises to above 40% next week. Since tops are inherently difficult to call, I would like to see confirmation from all three sentiment indicators before switching to a 50% short position. For now, we are still very far away from such a confirmation, and as a result, my current inclination is to not be more bearish until the first week of September at the earliest. For now, we will just take it one week at a time.

Our sentiment discussion concludes with the Market Vane's Bullish Consensus. Following is the latest weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus increased slightly from 68% to 69% this week - resulting in 11 consecutive weeks of over 65% readings.  The ten-week moving average of this reading continued to rise - now at 68.3% - a new eight-year high reading not seen since August 1997. Is this survey signaling an imminent top?  Or should we wait for 'confirmation' from the other two sentiment surveys/indicators?  My inclination is to wait, since tops are just inherently difficult to call.

Based on purely the above chart, the market is a "screaming sell" - as the ten-week moving average of the Market Vane's Bullish Consensus is now at an eight-year high (up from a seven-year high as of last week) at 68.3% - the most overbought ten-week reading since August 1997. However - like I have said many times before - tops are inherently difficult to call, and this author will definitely wait for an overbought confirmation from both the AAII survey and the Investors Intelligence Survey before switching to a more bearish position. As an aside, it is interesting to note that as of Friday at the close, the Rydex Cash Flow Ratio spiked from an already oversold reading of 0.91 to a yet more oversold reading of 0.96 - a reading comparable to the readings in mid-May. For now, the trend for this week should be down to neutral - so don't be surprised if we "take advantage" of this week's anticipated weak conditions to cover our 25% short position if no significant selling pressure develops.

Conclusion: I will be getting into a more detailed discussion on the implications of the "aging population" in Thursday's commentary - but the gist of it is this: "Demographics do matter - and it is not going to be a pretty picture for the stock market going forward." Combined with our current energy situation, and one can find a very plausible scenario in which the secular bear market (as defined by the Dow Theory) will reassert itself sometime in the next few years.

I believe natural gas still offers a compelling buy, and like crude oil, is also in a structural bull market - although in the short-run, it is definitely overbought. As for the equity markets, I am now definitely giving the benefit of the doubt for the bulls here. With the decline in bullish sentiment in the AAII survey and with the oversold condition in the Rydex Cash Flow ratio, we are going to change our stance and be more careful - in that if no significant selling pressure this week - there is a strong chance that we will switch to a completely neutral position in our DJIA Timing System, especially given that the last couple of weeks of August to the first week of September is traditionally a friendly period to stockholders.

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

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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