Let's Get the Action Started!

By: Henry To | Thu, Sep 7, 2006
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Dear Subscribers,

Important Announcement: In last week's commentary, I stated that we were finalizing a plan that will reward our current subscribers for their loyalty and for staying with us through thick and thin. So what is that plan? Starting today and running until the end of September, we will give a referral bonus to those who get others (new subscribers only) to sign up for either a 6-month or 12-month subscription. The referral bonus is one-time and is $50 for each new subscriber who signs up to either our 6-month or 12-month subscription (and who don't cancel before the 30-day trial period ends). At the end of the 30-day trial period, just ask the new subscriber to send us your name and email address and we will provide the $50 referral bonus through Paypal (or a $50 personal check to those who do not have Paypal accounts). Please email us at support@marketthoughts.com should you have any further questions on this promotion.

Note: Our regular guest commentator and discussion forum moderator, Bill Rempel (you may also know him as nodoodahs) has relocated his website to the following address: http://www.billakanodoodahs.com/. For those who have links to his site, please change your links now as he will only be posting there in the future. Best of luck, Bill, and nice website!

Before we dive into this week's commentary, I would like our readers to turn your attention to the latest Department of Labor report highlighting the major trends and dynamics in the U.S. labor market today. The lesson is clear: Parents and students alike should read this report with a sense of urgency - as a post-secondary education in our quickly-changing and globalized world is now a must. For those of us who are already in the labor force, this is a call for you to always be on the look-out - not only to see whether your job is "relevant" in the 21st century but also to keep an eye on any upcoming new opportunities for you to learn or finally be employed in a job or career that you like. For those who had always wanted to get that degree (whether it is the first, second, or some type of advanced degree), the time to do it is now! Quoting the BLS report: "The demand for a highly educated workforce is expected to continue. BLS projections for 2004 through 2014 indicate that nearly two-thirds (63.4 percent) of the projected 18.9 million new jobs will most likely be filled by workers with some post-secondary education."

Of course - the above projections represent merely a continuation of what has been occurring ever since the end of World War II. To illustrate, let us take a look at the following table courtesy of the BLS report showing employment change broken down by major industry sectors from 1990 to 2005:

Employment Change Between 1990 and 2005, Major Industry Sectors

The above table should not be a surprise, as we have witnessed employment declines in mining and manufacturing (both durable and nondurable) since 1990, given increased productivity (the use of computers and robotics) and increased competition from countries such as China, South Korea, and Taiwan. Of course, the protectionists in Congress - all in the spirit of "saving" American jobs - would rather want you or your kids to work in a coal mine or on a conveyer belt than to work on a computer and in an office - with 10% unemployment to boot as the rest of the world retaliates to any protectionist policy we adopt going forward. As for the "current account deficit," this author believes it is essentially a useless statistic - given the "hodgepodge" way in which it is compiled (at the U.S. ports) rather than how it should be compiled. In our February 13, 2005 commentary ("China - Background and Current Issues, Part III"), we stated: "Note that the current account deficit has historically been a bad estimate since it has grossly underestimated [U.S.] exports. For example, how does one estimate exports like university educations, downloadable software, and banking services - exports where Americans have a huge comparative advantage? Moreover, according to the IMF, the world had a $150 billion trade deficit with itself as early as 1997. Since the sum of all the surpluses and deficits has to equal zero, it basically means the system of measuring surpluses and deficits is inherently flawed. Another question would be: New York basically runs a trade deficit with many of the cities or regions in the United States. In terms or prosperity and wealth, how does New York rank compared to the rest of the major cities or regions in the United States?"

The bonus pool in New York City hit $20 billion last year - would one want to be a NY resident working on Wall Street or on a natural gas rig in Texas or Louisiana? Historically, countries with the most wealth have always run a current account deficit - and the 21st century no doubt would be no different relative to the 19th or 20th century. In the book "Schroders: Merchants & Bankers" (a biography of one of the greatest merchant banking families in Europe), the author writes of the firm and its trading activities: "The 206 clients located in the Americas and Asia were mostly engaged in the export of primary produce to Europe, and to a lesser extent to the United States. The most important export trade financed by the firm in the 1850s and 1860s was the shipment of sugar from Cuba to Europe and the United States. Other trades of major importance were the shipment of grain and flour from New York to London; cotton from New Orleans to Liverpool and Hamburg; coffee from Brazil to Europe and the United States; guano from Peru to Germany; indigo from India to Russia; and there was a long list of less significant commodities - tallow, cotton, nitrates, rum, and silver." During that time in the 19th century, Europe and the United States were sucking a huge amount of commodities from these countries, and yet 150 years later, both Europe and the United States remain the strongest powers in the world during that period and up to today. Moreover, the amount of U.S. denominated assets increased by $2.5 trillion last year, while the U.S. current account deficit was only $700 billion. That is, Americans gained a net amount of wealth of $1.8 trillion in 2005 - hardly a cause for alarm especially given that American-owned assets (domestic and international equities, private equity funds, investments in one's own small business, etc.) are in general yielding more than foreign owned assets (U.S. Treasuries and residential real estate).

Let us now get on with our commentary. 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). As of Monday afternoon on Labor Day weekend, 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.

Moreover, the market action within the markets themselves has also remained favorable - despite a lag in the Dow Transports and the mid and small caps. For one thing, the number of new highs is finally outpacing the number of new lows on the NASDAQ - something that has not occurred since early May. The U.S. homebuilder ETF (XHB) has also most probably bottomed and has traced out a good base for a sustainable bounce. And finally, the Dow Utilities - which, in a typical cycle, has historically been a leading market indicator of the broad market from 3 to 12 months - made a new record high as late as last Thursday, thus officially extending the life of this cyclical bull market. However, we are still sitting on the sidelines in the meantime, as the market action in August has not been truly convincing given the seasonally light volume. Again, this author is still cautiously bullish, and will most probably wait for a correction of the current overbought condition before shifting to a 50% long position in our DJIA Timing System.

In our commentaries over the last few weeks, we strongly cautioned and questioned 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. We also cautioned against drawing simple trend lines on the major market indices and claiming that stock prices will have to revert to the mean - as the picture can change drastically depending on your starting point. In conclusion, I stated that while I have always tried to make it simple for our subscribers, I am not going to make it simple just for simplicity sake - especially when one is doing it with misleading indicators. In this commentary, I will try to communicate to our readers what I am currently thinking and what I do know (or think I do know!).

Much of my views that I have developed over the last couple of years have largely come from speaking with people, reading current research, and studying history to see how the future may pant out and try to assign probabilities to each scenario occurring. As the saying goes, history doesn't repeat itself, but it surely rhymes. However, how can you be certain that what is occurring right now rhymes with a particular period in market history? Can you merely base it on P/E or P/B ratios, or is it something different? Moreover, many folks have compared the current spike in crude oil prices to spikes in the past - in particular to the spike during the mid 1970s and late 1970s. If so, then why aren't we already in a full-blown recession? I truly do not know, and I doubt anybody does. What I do know, especially when it comes to the stock market, is this:

  1. Retail sentiment is now the most bearish since late 2002 and early 2003

  2. Merrill Lynch, Charles Schwab, and Time Magazine now openly calling for the higher-than-normal probability of a recession

  3. Famed economist Nouriel Roubini (of www.rgemonitor.com) openly calling that a recession is inevitable. Perhaps he is correct this time but his August 2004 paper calling for a significant slowdown even though oil was still below $50 a barrel at the time suggests that his record has not been perfect.

If Dr. Roubini is wrong this time, he will be famously wrong since there has been so much publicity surrounding his latest call, unlike the call on a slowdown because of $45 oil prices (the guy is relatively young - what can I say). As a sidenote: If he is wrong this time and the U.S. stock market takes off, then his business will no longer claim that it is the "number economic site" on the web - despite it having gotten the label in 1999, and not 2006. Also as a sidenote: Granted the probability of a recession has increased quiet significant since the beginning of this year (when this author made an out-of-consensus call for an economic slowdown later this year), but calling a recession is "inevitable" (and especially in such a public fashion) is somewhat bold. Nothing is certain in life - and if you want to have a lasting economic advisory business or a lasting stock market account, then one definitely should hedge his bets. Dr. Robuini is certainly not hedging his bets here. However, if he does call it correctly, then I will be the first to admit that I am wrong and then sign up for his service!

Getting back to the stock market, I also know we have had three years of P/E contraction on the S&P 500 and over five years of growth stock underperformance (as reflected by the five-year underperformance of the Value Line Ranking System, which has a great 40-year track record). I also know that contrary to public belief, there is no correlation between earnings growth (or revisions from earnings estimates) and the subsequent performance of the S&P 500. This has been "proven" by studies done by both Victor Niedorhoffer and Morgan Stanley. In fact, the former has even found a slight negative correlation (i.e. when earnings growth declines, the stock market actually outperforms). Following is a chart (courtesy of Morgan Stanley) showing that there has been little correlation between earnings surprises and calendar year performance of the S&P 500 from 1990 to 2005:

Little correlation between earnings surprises and calendar year performance of the S&P 500 from 1990 to 2005

In fact, if Victor Niedorhoffer's findings hold true for this cycle, then the S&P 500 could conceivably outperform going forward in the next 12 to 18 months. So Henry, why do you think this lack of correlation has held true in the past, and does it make sense?

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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. 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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