The Evolution of the Markets

By: Henry To | Wed, Aug 23, 2006
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Dear Subscribers,

Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060. A real-time email was sent to our subscribers announcing this shift - and the justification for this shift was discussed in our August 10th commentary ("Is Our Short-Term Scenario Busted?"). Like this author mentioned in our mid-week commentary, however, subscribers could have used our service as a contrarian indicator at that time, as the market rallied early last week and never looked back. At this time, this author is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which, as I have discussed over the last few months, will regain a significant chunk of microprocessor market share from AMD), GE, American Express, etc. But in the meantime, we are still going to sit on the sidelines, given a slowing U.S. economy (for the first time in 14 months, the ECRI Weekly Leading Index has ventured into negative territory two weeks ago), a tightening Fed (the effect of the latest rate hike campaign is still yet to be fully felt), the lack of an oversold condition in the major market indices during the bottom a week ago, the fact that we are way overdue for a 10% correction in the Dow Industrials or the S&P 500, and the relatively low volume during the recent rally. Of course, if we are not careful - then the current economic slowdown we are experiencing may very well turn into a consumer-induced recession, but for now, it is still too soon to tell. For now, we are cautiously bullish, but since the market is now way overbought on a short-term basis, we will stay on the sidelines for now and re-evaluate the market fully after the Labor Day Weekend. However, should the market correct on weak downside breadth and low volume in the coming days, don't be surprised if this author chooses to shift back to a 50% long position in our DJIA Timing System.

Important Note: A recent survey of CEOs conducted by the NYSE reinforces the prevailing corporate belief that retirement benefits are not relatively important to retaining employees. In an 11-category survey (said categories including cash bonuses, stock incentives, education assistance, flexible schedules, etc.), the CEOs in the NYSE survey ranked "retirement benefits" as the third-to-last category as having the most importance on employee retention going forward in 2007. Coupled with the passage of the Pension Protection Act last week, this adds further uncertainty to the future of defined benefit pension plans for corporate America. For readers or subscribers who are over the age of 40 and who still participate in a defined benefit pension plan: Be proactive now and let your CEO know the importance of a defined benefit pension plan to you and your family!

Before I go on to discuss the evolution of the financial markets, I want to discuss the evolution of the global economy. Not only are the forces for globalization accelerating (The Association of Southeast Asian Nations, or ASEAN, are now fast-tracking plans to create an EU-Style single market by 2015), but the way that we are doing business (or living life) is now evolving much more quickly as well. If you will recall, this author discussed the online community, "Second Life" in our May 14, 2006 commentary. For those who do not go online very often, "Second Life" is a sim-like online community where folks can interact, explore, buy and sell goods, start a business, or even develop virtual real estate - all using its own virtual currency (which is convertible to U.S. dollars). Many folks on "Second Life" are now operating their primary businesses in the online community, and corporations like Wells Fargo, Toyota, and Adidas have caught on to the "craze" as well. The number of subscribers has literally exploded in the last 14 to 15 months from 20,000 to approximately 250,000 today. Plans are now in place to develop a more "business-friendly" environment in the online community - such as creating a "Second Life Chamber of Commerce" or to create a place for online business mediation and arbitration. Going forward, many more businesses will have virtual offices in online communities like "Second Life" or even start businesses in these communities. Potential language barrier aside, one will eventually, literally, be able to sell to the entire world (which this author is somewhat doing right now with our MarketThoughts website). Going forward, this will transform how governments and corporations think about business - especially as the world economy continues to shift to a more service-based society. For example, will the next generation of U.S. software companies relocate their headquarters to Hong Kong, given that no corporate taxes are imposed there? There will be no need to have a physical location aside from a PO Box, as these companies can "create" several different offices in virtual online communities. These companies can literally hire from all over the world, and employees can simply stay at home and move from office to office by logging on to different websites. This is one reason why the structural story of both lower corporate and income taxes in the United States will remain intact for the foreseeable future (it is thus no surprise that even Australia and New Zealand have been trending towards lower corporate and income tax rates). Let us now move forward to the concept of evolution in the financial markets.

Ever wonder why the market is so difficult to predict in the short or even intermediate term? Ever wonder why so many folks "get it wrong," even though they had learned so many "lessons" doled out to them by the financial markets in the past? Part of it is because things are usually only clear in retrospect - and reading the mainstream media definitely won't help unless all you want to learn a bit of history, Another major reason is the constant evolution of the stock and financial markets. We as humans tend to focus on the immediate past, along with the important variables that have impacted the market the most in the immediate past. In each successive bull or bear market, there are always different underlying forces at work - forces that are not currently known until after the fact. The genius is in seeing these forces before they happened or while they are happening. This is what makes figures like Winston Churchill one of the geniuses of the 20th century. By the time most people figured out what he was implying in his "Iron Curtain" speech at Westminster College on March 5, 1946, it was already too late.

Of course, we all now have the knowledge and the capability to do the same analyses that Peter Lynch did in the 1980s with minimal effort. Instead of having to run to the local library during lunch or after work to get the latest version of the 10-Q or 10-K, we can now download them over the internet at 2am in the morning on Saturday after coming back from the local bar. Instead of having to input and update all the data manually on your very-expensive PC and an archaic version of Lotus 123, we can now also download ten years of history on MSN Money for free. Present value analysis? Black-Scholes valuation using Monte Carlo Simulation? How about checking out the Egyptian stock market or the futures market in the Fed Funds rate? Oops, I forgot that we did not even have a futures contract in the Dow Industrials ten years ago, let alone a futures contract on the Fed Funds rate.

Our point is: The playing field has been leveled to a certain extent - but being able to invest successfully in the stock market or to speculate successfully in the financial markets is all about holding a relative advantage over other financial players. The stock market is arguably as competitive if not more competitive than ten years ago - given the proliferation of hedge funds, private equity firms, and other professional investors all with much better tools and information than most retail investors. This is the case with international markets as well, as many "locals" have now joined the financial world and are investing in their own stock and real estate markets. Ten years ago, trading in markets such as South Korea, Malaysia, Brazil, Turkey, Thailand, and Argentina were dominated by half a dozen investment banks or hedge funds (e.g. "mega funds such as Quantum or Tiger) operating out of New York. Today, that is no longer the case, as the "locals" are now supplying a significant chunk (if not most) of the liquidity. Moreover, I know this sounds like a cliché - but the evolution or change in financial markets are changing much more quickly nowadays, and will continue to change more quickly for the foreseeable future. Speculators such as Soros or Robertson were able to take advantage of the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s for a very long time - ending with the "breaking of the Pound" in 1992. Today, Central Banks of the world are much more knowledgeable, and "inefficiencies" in the world's major currencies have become much more difficult to exploit. After all, how long have the Chinese Renminbi bulls been waiting for an "inevitable rise" in the Chinese currency against the U.S. Dollar?

With that said, it is important to bring with us this mindset whether you are thinking of buying or shorting the markets today. On the one hand, one can try to predict what the economy will do this quarter and the next - based on many factors such as the slowing housing market, the U.S. Dollar (said direction which is pretty difficult to predict as well), oil and natural gas prices, and other exogenous factors such as the 2006 hurricane season (which I have already discussed), Iran, the Israeli-Hezbollah conflict, North Korea, and how your mother-in-law feels tomorrow when she wakes up, etc. Even in the off chance that one can predict the precise amount of economic activity this quarter and in 2007, there is no way to tell how this will affect stock market prices or even interest rates.

Today, this author sees a slowing U.S. economy, and nothing else. This is what this author had "predicted" would occur in January this year. In retrospect, it was a "cowardly" call - given elevated energy prices and an inevitable slowdown in the residential housing market - even though many economists at the time were still predicting 3% to 4% growth for 2006. However, the slowdown call was a high probability call, and it remains so today. To be calling for a recession in 2007 implies you have some advanced information - information that even Ben Bernanke, Alan Greenspan, Warren Buffett, George Soros, or Henry Kravis are not privy to. Again, this author does not see a U.S. recession up ahead (although he reserves the right to change his mind over the next few months). Instead, what this author is seeing is the lowest valuations (on a P/E basis) that we haven't seen since 1994 in many of the U.S. large caps such as WMT, MSFT, INTC, ORCL, GE, SYY, etc. If crude oil prices were at $60 a barrel instead, we would actually be seeing valuations that we have not witnessed since 1988 in many of the U.S. large caps.

This relatively low valuation in the U.S. large caps is also being accompanied by extremely bearish sentiment - sentiment that can be witnessed in both the AAII and the Individual Investors Survey, the high amount of mutual fund outflows from domestic large-caps over the last two years, and the fact that the U.S. has been the most unattractive place to invest for international investors since the inflationary days of the late 1970s to early 1980s (because of the Patriot Act and the fact that the developing markets have been maturing very quickly over the last few years). Such a scenario and bearish sentiment in the U.S. stock market in general have not been witnessed since October 2002. I have been mentioning this over the last couple of months and I will mention this again: Long-term investors who have spare cash on the side should start nibbling on the U.S. domestic large caps and be prepared to add later this year no matter what the market does in the meantime.

But Henry, what about all the "buzz" about how the stock market has nearly always experienced a decline after a pause in the Fed rate hike campaign? Well, this will depend on which time period you study. If one focuses strictly on the late 1950s to 1981 period, then this will be a resounding "yes." Following is an exhibit courtesy of Morgan Stanley chronicling the various Fed's rate hike campaigns since 1959 along with the subsequent 12-month performance of the S&P 500, the U.S. long-term Government bonds, and the CPI following the pause. Please note that the following does not include the "mini rate hike campaigns" of 1987 or 1997:

Mixed Returns Follow Fed Tightening Cycles

Note that the 12-month performance after the April 1966 and May 1974 pauses were both positive, but please keep in mind that it was not a happy time for folks who had to endure those rate hike campaigns:

  1. From February 9, 1966 to October 7, 1966, the Dow Industrials experienced a 25% decline from 995.20 to 744.30. For investors who capitulated during those eight months, the fact that the market was 6.9% higher 12 months after April 1966 certainly was not a consolation.

  2. From January 11, 1973 to December 6, 1974, the Dow Industrials experienced a 45% decline from 1,051.70 to 577.60. By the time the Fed paused in May 1974, the Dow Industrials had already declined to approximately 800 - accounting for already half of the 45% decline. As a result, it should not come as a surprise that the market actually rose 9.54% for the 12-month period after the May 1974 pause.

The experience during the 1980s to the end of the 1990s was different, however, as the market experienced substantial outperformance during the 12-month period after the end of each of the Fed rate high campaigns. This author believes that there were two major reasons for such a sea-change:

  1. After the near hyperinflation of the 1970s and early 1980s, the Federal Reserve became more pre-emptive in all their subsequent rate hike campaigns - making sure to hike earlier and err on the side of caution. This has the effect of slowing economic growth earlier in the cycle and making sure that the economy does not get "too hot to handle." This also meant that the Fed does not have to overshoot in the latter stage of the economic cycle a la the late 1960s and the 1970s decline subsequent to each rate hike pause.

  2. The United States experienced a structural and consistent decline in inflation during the 1980s and 1990s - thus allowing the P/E ratio to steadily increase during those two decades. This also had the effect of muting any stock market declines after the end of each rate hike campaign.

So where do we stand today? This author would argue that both Greenspan and Bernanke had been pre-emptive in their current rate hike campaign - raising the Fed Funds rate as early as June 2004. The current rate hike campaign was also very well communicated (with the possible exception of this year but overall, this has been a very transparent Fed especially compared to the Fed of the 1960s and 1970s) - thus significantly decreasing any chances of a hedge fund blowup or a sovereign default. At the same time, however, the period of structural disinflation of the 1980s and 1990s is most likely over - thus removing a significant pillar in the stock market going forward. The $64 billion question is: Can structural deflation from China and other emerging markets (which would effectively cause a decline in real interest rates) replace the structural disinflation that we had experienced during the previous two decades?

The following chart (again, courtesy of Morgan Stanley) suggests that the Fed has definitely been pre-emptive in their current rate hike campaign - as investors had already been discounting an inevitable slowdown in the economy by hammering down the P/E of the S&P 500 from 2004 to YTD 2006:

P/E Rarely Contracts Four Years in a Row

However, more importantly, readers should note that the P/E of the S&P 500 has rarely contracted for four years in a row. The Panic of 1907 resulting in the near-collapse of the entire U.S. financial system could not do it. Neither could the early years of World War I nor World War II (the market bottomed in the middle of 1942 and thereafter experienced a four-year bull market). The only two exceptions were during the intervening years of the Great Depression (keep in mind that the period from 1934 to 1936 was a great period for the U.S. stock market even though P/Es contracted) and the structural near hyperinflation we had experienced from 1976 to 1979. Unless crude oil prices rise to $100 or $120 barrel going into next year or unless foreign investors start dumping our Treasuries en masse, there is no reason to expect a fourth consecutive contraction in P/Es going into 2007. And even should P/Es continue to contract in 2007, readers should note that the stock market does not have to decline. In fact, my guess is that the stock market will remain range-bound in 2007 in the worst case scenario.

As an aside, this author believes that crude oil prices have topped out for this cycle - for the many reasons that I have discussed in our previous commentaries (such as an expected benign hurricane season and the non-confirmation we are currently witnessing on the Dow Transports and the OIH). And for readers who are skeptical, I now want to again rehash the following EIA chart that we showed you in our previous mid-week commentary:

Growth in World Consumption and Non-OPEC Production

As shown by the following chart courtesy of the EIA, the growth in Non-OPEC oil production is expected to exceed the growth in world oil consumption by the first quarter of next year - for the first time since the third quarter of 2003. More importantly, the above projection does not take into account the latest interest rate increase imposed by the Chinese central bank nor the Indian central bank. The above projection also does not take into account a significant slowdown in the U.S. economy. While this author certainly does not see an oil price of $40 a barrel next year, I definitely will not be surprised if we see a print below $60 a barrel. A $10 decline in the oil price would add an additional $200 million in liquidity on a daily basis to the U.S. economy. Put another way, the U.S. consumer will be able to transfer approximately 1% of his total expenditure from energy-related to more discretionary spending.

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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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