Identifying Risks in the Upcoming Year

By: Henry To | Tue, Jan 10, 2006
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Dear Subscribers,

Welcome to my first official commentary for 2006 and I hope every one of you had a great New Year's. I would like to take this opportunity again to thank you for all your support in 2005 and I sincerely wish all of you can stay with us going forward as we try to navigate these treacherous markets ahead. Remember - we are all still learning here. We get a lot of ideas from our subscribers and appreciate you for keeping me "honest," so to speak. Please continue to email me at should you want to discuss some market issues or should you have any suggests for our website. Over the years, I have learned that you can't get anything (e.g. promotions, dates, etc.) if you don't ask. And if you do ask, chances are that you may be surprised!

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. As of Sunday, January 8th, this market is starting to become overbought. However, this author believes that the market will still remain investor-friendly for the foreseeable future (at least over the next two weeks) - as the market has not become hugely overbought yet and liquidity remains ample. The key will be the January 31st Fed meeting and how investors choose to respond to the comments of that meeting and the official appointment of Ben Bernanke as the new Chairman of the Federal Reserve. Should the market continue to rally relentlessly in the next couple of weeks, there is a good chance we may go 50% short in our DJIA Timing System (our maximum allowable short position). Like I have mentioned before, I believe a DJIA print of 11,000 is now inevitable - our target to short is at around the 11,200 to 11,300 level. More details to follow in the days ahead. For now, we will remain completely neutral in our DJIA Timing System.

In our "ad hoc" commentary that I sent all of you on the day after New Year's Day, I reiterated the purpose and mission of our website and commentaries (for readers who would like a copy of that commentary, please email me) - that to keep our readers abreast of economic trends and to help our readers make the correct economic decisions - whether those decisions are related to investing, your career, or your formal education. Another good way to learn is to learn from each other - and the best way to do that is through our discussion forum. Going forward in 2006, I would like to see more of you posting messages in our discussion forum!

Our "ad hoc" commentary dealt with the broad economic trends that I envision for 2006 and possibly into 2007. I discussed the fact that I still see a U.S. dollar bull market in 2006 (although I would not discount some weakness in the U.S. dollar in the first few months of 2006 given that the market will need some time still to "digest" the appointment of Ben Bernanke as the new Chairman of the Federal Reserve), and my concerns regarding the upcoming decline of Mortgage Equity Withdrawal (MEW) and its adverse effects of GDP growth going forward. I would like to begin this commentary by identifying the risks to stock market investors in 2006. For investors who have been timing the markets in the last couple of years (and this includes me), 2006 may finally be the "year of living dangerously." That is, I believe that we will see some kind of market breakout in 2006. For traders who have been accustomed to shorting on overbought and going long on oversold situations, watch out. I believe there is a good chance we will see some kind of trend for 2006. My preferred scenario is to see a severe downside correction (greater than 10% in the S&P 500) first and then a huge recovery in the latter parts of the year. But since I never get precisely what I want when it comes to the stock market, I believe investors should just take it one day at a time here. For now, the environment still remains friendly for stock market investors.

For retail and professional investors alike, I believe reading Warren Buffett's letters to his shareholders is an invaluable exercise in terms of being successful in long-term investing. Let's take a look at what Warren Buffett had to say in his 2004 letter to shareholders:

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful. [Emphasis mine]

So what is Warren Buffett saying? For most retail investors, holding a diversified portfolio of stocks (such as a S&P 500 index fund) has been the key to successful long-term returns. According to Buffett, market-timing (and chasing the hot stocks) has been generally detrimental to returns - since most investors can never be successful with adopting such a strategy. Nonetheless, as investors, we still choose to do it, despite the historical record.

So Henry, what are you trying to do - are you trying to shoot yourself in the foot? Definitely not. It is to be kept in mind that the market is always changing. What has worked in the past does not necessary work in the future. In fact, if something has worked in the past and if most people now know about it, then you can bet that it WILL NOT work in the future. According to "Mister Johnson," (written in 1976) the founder of Fidelity and the father of Ned Johnson: "The market … is like a beautiful woman - endlessly fascinating, endlessly complex, always changing, always mystifying. I have been absorbed and immersed since 1924 and I know this is no science. It is an art. Now we have computers and all sorts of statistics, but the market is still the same and understanding the market is still no easier. It is personal intuition, sensing patterns of behavior. There is always something unknown, undiscerned."

And according to Benjamin Graham in his classic "The Intelligent Investor," the returns from stock market investing are usually proportional to how much work you put in. As an example, witness the relative underperformance of the S&P 500 (and other major market indices that were popular for index funds in the late 1990s) in recent years relative to an equal weighting of the S&P 500 and international stocks. Basic indexing of the S&P 500 has worked in the past simply because it was not easy to replicate or popular to do so. This has drastically changed in the last six to seven years. This has two immediate implications for retail investors:

  1. Basic indexing (for example, indexing one's portfolio to the S&P 500) will continue to lead to underperformance in the future. That is, the "alpha" that will be generated if one chooses the right stocks will be significant higher than they were 10 or 20 years ago. The age-old adage holds true in the stock market: There is no such thing as a free lunch. For those who think they can retire by just buying an S&P 500 fund going forward and dollar-cost averaging down (or up), I believe one will be severely disappointed.

  2. If one wants to generate relatively good returns without investing in individual stocks, one will need to continue to time the markets going forward - and not just with the S&P 500 but with the whole universe of country and industry ETFs.

In general, I agree with Warren Buffett, but I believe the key to successful returns in the stock market for retail investors going forward is to try to pick good, solid companies trading at low valuations and holding them for the long-run (and constantly re-evaluating their prospects and sell them if the fundamentals have deteriorated). Our job here at is to identify potential risks - whether those are industry-specific risks (such as in the energy or retail sectors), country-specific, or currency-specific. Once in awhile, timing the markets can be extremely rewarding - such as selling technology stocks in spring 2000, buying gold and silver in late 2000, or buying U.S. stocks in late 2002 and early 2003. And this is where we come in as well - using our sentiment indicators as well as our liquidity and valuation indicators.

Before I go on and outline a list of potential risks in 2006, let me emphasize my overarching theme: With the exception of energy, precious metals, real estate, and potentially retail stocks, the downside risks in 2006 is no longer with U.S. stocks. That is, any potential decline in the U.S. stock market will be only triggered by an external event - and if such an event did occur (such as a breakout of the Bird Flu pandemic) I believe on a relative basis, the U.S. stock market will be one of the best-performing markets in the world, including Japan. Let's now outline the "laundry list" of risks for 2006, in no particular order:

1) The appointment of Ben Bernanke as the new Chairman of the Federal Reserve. Whether your perception of Bernanke is an "inflation fighter" or "Helicopter Ben," I believe there will be quite an amount of uncertainty in the markets in 2006 as we all try to anticipate the world's second most powerful man's moves and policies going forward. For what it is worth, I believe his "helicopter speech" made on November 21, 2002 was severely taken out of context by the press, since virtually all his publications and speeches have been in favor of a specific, well-communicated "optimal long-term inflation rate" - as we have previously discussed in our October 27, 2005 commentary (The Ben Bernanke Grand Experiment). This perception of Ben Bernanke is unfortunate, since this will only add to the uncertainty of his policies in 2006.

2) As I discussed in our "ad hoc" commentary sent to our subscribers on January 2nd, I believe the decline of "Mortgage Equity Withdrawal" (MEW) would contribute to a significant decline in consumer spending - in the process shaving approximately 1% to 2% off annual GDP growth, excluding any multiplier effects. Given that 40% of all jobs created since 2001 is related to the real estate sector, however, we could ultimately end up in a vicious cycle (where the decline in consumer spending contributes to higher unemployment which further exacerbates the decline in consumer spending, and so on). Please keep in mind, however, that this author is only looking for a "mid-cycle slowdown," and not a full-blown recession. Folks who have a heavy weighting in the retail sector should be on the lookout - as growth in this sector should be directed affected by any upcoming slowdown in consumer spending. Given that P/E ratios have come down significantly in the last six years, however (WMT more than 50% and HD more than 70%), this may just ultimately end up as an anti-climax. In other words, could investors have already discounted an upcoming slowdown in consumer spending when it comes to retail stocks? Please note that the relative strength of the retailers (using the RTH HOLDR as a proxy) vs. the S&P 500 it now at its lowest level since March 2003. Going forward into 2006, we will continue to keep an eye out on the retail sector:

3) Readers should know that I have not been particularly bullish on emerging markets in the last few months. This remains the case in 2006 - given that emerging market spreads are now at their lowest in history. In other words, there is now a complete disregard for risk in emerging market investments. This can also been seen in the week-after-week inflows into emerging market funds (as opposed to small inflows into or even outflows out of domestic funds), as outlined by The current favorable environment for emerging markets has even allowed Turkey (which is hitting the news as the first cases of Bird Flu are reported in the country) and Iraq to price their bonds for sale in the international markets. Let there be no mistake: Such pricings (with so much ease) can only occur in an environment of huge optimism. Finally, according to the publication "Triumph of the Optimists" (which contains the most comprehensive studies of the world's financial markets - much more so than Ibbotson's work), a diversified portfolio of world equities have actually returned less than a diversified portfolio of U.S. equities in the 20th century (on an absolute basis as well as a risk-adjusted basis). This remains true whether one looks at the first half or the second half of the 20th century. Is it different this time? Perhaps - but as a somewhat defensive/value investor, I am not going to bet on it. For readers who have a significant amount of emerging market securities, I encourage you to reevaluate your situation very carefully.

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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. 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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