Beware of Simplified Models

By: Henry To | Thu, Aug 31, 2006
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Dear Subscribers,

Important note: We are currently finalizing a plan that will reward our current subscribers for their loyalty and for staying with us through thick and thin. We will announce something next week that will provide you with more details. Please stay tuned!

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 - giving us a gain of 290 points. 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?"). In retrospect, this call was definitely too early or wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). 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, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. The market action in these large caps has also been very favorable thus far.

In the meantime, however, we are still sitting on the sidelines waiting for signs of a more favorable market environment. Since volume is going to continue to dissipate this upcoming week (it always does during the week before Labor Day Weekend), we will most probably not find out until sometime after the Labor Day Weekend. For now, this author is still sitting on the sidelines, but am cautiously bullish. However, should the market continue to 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.

This upcoming week is promising to be a very slow week. In light of the strengthening of Hurricane Ernesto last Friday, this author had wanted to devote a few paragraphs (mostly as a refresher since we had already discussed this in our June 11th commentary: "Oil Shortages this Hurricane Season - Last Thing to Worry About"), but given that Ernesto has already been downgraded and is now projected to veer away from the Gulf of Mexico, this author does not really see the point. But let us now remind our readers our position on the 20006 Hurricane Season: Given the current NOAA forecasts (which have actually been weakening since the initial forecasts back in May) of hurricane activity this year, there is virtually no chance for a Katrina or Rita-style natural gas/crude oil supply interruption this year. The mainstream media has always liked to sell newspapers or attract more traffic to their websites, and playing on the public's fears is one tool they would like to use. Quoting from the EIA: "Although Hurricanes Katrina and Rita caused long-lasting effects on oil and natural gas operations in the Gulf of Mexico, severe weather in the region has historically had only a relatively minor impact." Moreover, this "lack of interruption" was not accompanied by lack of hurricane activity in the Gulf either, as evident by the following chart (courtesy of the EIA) showing the major hurricanes in the Gulf of Mexico from 1995 to 2005:

Major Hurricanes in the Gulf of Mexico, 1995-2005
Source: National Oceanic and Atmospheric Administration (NOAA) Coastal Services Center

Given that many oil and natural gas drilling rigs have "beefed up" their defenses in light of Hurricanes Katrina and Rita, there is a strong likelihood that the chance of another significant supply interruption in the Gulf has further diminished going forward. In other words - while anything is possible - this author would definitely not bet on a further rise in either the price of crude oil or natural gas due to a supply interruption in the Gulf of Mexico this year.

In our last weekend commentary, we also discussed the continuing evolution of the global economy (with a brief mention on ASEAN's fast-tracking plans to create an EU-style single market by 2015) - with an explicit discussion of the virtual online community of "Second Life." We also discussed why the structural story of both lower corporate and income tax rates around the world will generally remain intact. Nevertheless, there is one continuing trend we did not mention (although we have been discussing this on-and-off in both our commentaries and in our discussion forum) - and that is the structural story of deflation will continue to persist - at least in the consumer goods world anyway. To illustrate briefly, read no further than the huge increases of capital spending in Japan over the last two years. Combined with an aging domestic economy and a persistence in the lack of consumer spending (not to mention a weak Yen), and there is no doubt that Japan will continue to export deflation for the rest of this decade. Or consider Vietnam - a country with 84 million whose workers (with an average wage approximately half the amount of China's) are rapidly displacing Chinese manufacturers and works at the margin. These two "deflation stories" are what the mainstream media have been missing. Moreover, since the end of this year, China has again been exporting consumer good deflation (after exporting inflation for most of 2004) - something the media still has not caught on yet at this point.

Let us now get to the gist of our commentary. In our last mid-week commentary, we strongly cautioned against looking into too much the popular "forward-looking" market indicators out there, such as the NAHB Index (this author has shown that the movement of the NAHB index has really no predictive value), the percentage of auto sales increases over the last 12 months, etc. In this commentary, we would like to quickly go over the concept of trending in the stock market, including the concept of "reversion to the mean."

On examining the performance of the stock market since the beginning of the 20th century, any stock market historian should be able to tell you this: Since that time, the U.S. stock market has been steadily trending on an upward path - with some occasional significant overshooting (such as the late 1990s boom) and undershooting (such as the 1973 to 1974 crash). A typical chart showing the history of the Dow Industrials from the beginning of the 20th century to the present (and we use the Dow Industrials for our purpose since it has such a long and rich history vs. the S&P 500) along with its trend may look like the following:

Monthly Chart of Dow Industrials vs. Trend (January 1901 to July 2006)

Please note that the above is a monthly chart (showing month-end closing prices) and the y-axis is in logarithmic scale - which is the way that it should be shown. The black line shows the trend - which is essentially the "line of best fit" according to standard regression rules.

So Henry, what are you trying to say or "disprove" here? Isn't the above chart showing that despite the crash of 2000 to 2002, the Dow Industrials is still above the "trend" and should therefore revert to the mean at some point (the uptrend line is sitting at approximately 6,000 right now)?

Yes, that is what the above chart shows. Moreover, the tendency for something to revert to the mean has been observed in the financial markets for centuries and is one of the most reliable ways to make money (as opposed to virtually all other technical indicators or even momentum investing). However, here is the rub: The above results can and will change depending on your starting point. Instead of taking January 1901 as the starting point, how about if, we instead take June 1932 (bottom of the Great Depression) as the starting point? Following is the monthly chart showing the Dow Industrials from June 1932 to July 2006 along with its trend line:

Monthly Chart of Dow Industrials vs. Trend (June 1932 to July 2006)

While the current level of the Dow Industrials is still over the trend line, readers can now see that it is not as far above trend compared to the previous chart. While the trend line in the previous chart was sitting at approximately the 6,000 level, the trend line in the above chart is more than 30% above the previous trend line - at approximately 8,000.

Obviously, the Dow Industrials still look very much overvalued in the above chart - and based on this and the concept of "reversion to the mean," this author would no doubt be very bearish now. However, what if we change the starting point to October 1974 - right at the bottom of the last secular bear market? Again, following is the monthly chart of the Dow Industrials from October 1974 to July 2006 along with its trend line:

Monthly Chart of Dow Industrials vs. Trend (October 1974 to July 2006)

Suddenly, the Dow Industrials is below its uptrend line stretching from October 1974. In fact, it has been below its uptrend line since early 2002 and is "on par" with oversold levels that were reached during the October 1990 and December 1994 bottoms. Based on the above chart, one should now be extremely bullish.

So are we thoroughly confused yet? What can we conclude from the above? Based on the above "analysis," readers should be very wary of simple or "simplified indicators" that attempt to rationalize where the market is heading by painting an overly simple picture. When it comes to communicating to retail investors, the mantra has always been to "keep it simple," but in the stock market, this is a dangerous practice - given that the stock market is impacted by millions of (both independent and dependent) variables on any given day, not to mention any given minute in every trading day. To believe that one can find a "simple, but foolproof" indicator is simply hubris in the highest form.

Interestingly, the period from the end of 1996 to the end of 2001 is above the trend line in all of the above three charts, but investors who got out of the markets at the end of 1996 based on the above charts most likely missed one of the greatest stock market booms in U.S. history. As an aside, however, the investor who relied on the above charts most probably got out of the market much sooner than the end of 1996, given that the subsequent upward action in 1996 also caused the trend line to be much steeper than it was at the time. To illustrate, this author in the following chart has removed the monthly closes of the Dow Industrials from the above chart from January 1997 and beyond:

Monthly Chart of Dow Industrials vs. Trend (October 1974 to December 1996)

I now rest my case. Based on the above chart, the investor who based his market-timing moves on a typical trend analysis would have gotten out by the end of 1995, if not sooner.

Another example of an overly simple study is one that has been presented by Dr. Hussman at the Hussman Funds. Note that I have the highest respects for Dr. Hussman. Moreover, his trading record speaks for itself - in that his fund has overperformed the S&P 500 by a wide margin over the last three and five years. In fact, the Hussman Strategic Growth Fund is ranked in the top 1% of all equity mutual funds by Value Line over the last three years. In his March 20, 2006 commentary, however, he presents a chart showing the growth in earnings of the S&P 500 from 1950 to today - arguing that the current earnings of the S&P 500 is now hitting the upward trending resistance line (which has historically grown at 6%) and in all likelihood, should head down in the near future.

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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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