Identifying Trends and Risks for 2007

By: Henry To | Thu, Jan 4, 2007
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Dear Subscribers,

I hope every one of you has had a great New Year's, not to mention a great 2006. The year 2006 was especially difficult for many retail investors and traders, as both the lack of volatility and the lack of a "capitulation low" (the closest we came to a capitulation low was during the decline from May 10th to mid July) frustrated many of those who were looking for a solid bottom in the stock market. Rather, the Dow Industrials experienced a "mere" 8% decline from May 10th to mid July and, except for a small scare during mid August, has never looked back since.

I would like to take this opportunity again to thank you for all your support in 2006 and I sincerely wish all of you can stay with us going forward as we try to navigate these treacherous markets ahead. I would also like to take this opportunity to say "thank you" to our regular guest commentators, Mr. Bill Rempel of and Mr. Rick Konrad of Value Discipline for making so many value contributions to both our main site and in our discussion forum. As for our subscribers, we definitely get many 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. Both my partner, Rex, and I looking to serving you all in 2007 and beyond!

Before we continue with your commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,078.15 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 958.15 points

As of Monday afternoon on January 1, 2007, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel, GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We are also very bullish on good-quality, growth stocks.

In the short-run, the market probably still has further room to go on the upside, even though investors' sentiment have gotten more bullish (which is bearish from a contrarian standpoint) and given the continued divergence of the Dow Transports from the Dow Industrials on the downside. Ironically, I believe that the most bearish scenario in the short-term would be for the Dow Industrials to rise towards the 13,000 level on mediocre breadth and volume over the next few weeks. Should the market experience a correction (which is not too likely) or should there be further consolidation over the next few weeks, then the Dow Industrials can probably rally significantly above 13,000 over the next few months. Make no mistake: The Dow Industrials will only experience a short-term top if there is more bullish sentiment - and right now, we just don't have that. Ironically, the bullish sentiment that I am looking for may only start appearing if we get some kind of good economic news - such as higher-than-expected retail sales across the board or a higher-than-expected reading in the ISM (manufacturing and service) indexes.

Let us now cut to the chase and discuss our outlook and potential risks to the world financial system for 2007 - starting with the equity and bond markets, proceeding to the currency markets and the commodity markets in next weekend's commentary. Without further ado...

The World's Stock Markets and Economies

In a similar "outlook" commentary that we authored last year for 2006, we started off with a quote from Warren Buffett and another quote from Benjamin Graham. I am going to skip any references to Mr. Buffett this year, but I would like to start off with a quote from the 1973 (Fourth Revised) Edition of "The Intelligent Investor." In a section discussing "new common-stock offerings," Graham states:

Somewhere in the middle of the bull market the first common-stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history.

In our prior commentaries, I discussed that based on relative valuations (equities relative to bonds, commodities, and real estate), retail investor sentiment, along with the amount of liquidity and the leverage in the financial system, the U.S. stock market is definitely still not close to a top just yet. This is confirmed by the above snippet from Benjamin Graham. That is, despite the recovery of the IPO markets over the last few months, the level and "quality" of activity is still not representative of an imminent top in the stock market. What would construe as an indication of an imminent top, you may ask? While things will most probably not get as crazy as the late 1998 to early 2000 period (and probably won't for at least the next decade), I would not be surprised if we see the IPO market "open up" to many of the speculative biotechnology or "nanotechnology" issues before we see a significant top in the stock market. Most likely, such an imminent top will be accompanied by a relative underperformance of the blue chips vs. the most speculative issues.

As for relative performance from a geographical standpoint, I expect the U.S. equity markets to outperform the European, Asian, and Emerging Markets (with a portion of that coming from strength in the U.S. Dollar Index, which I will illustrate later in next week's commentary).

So Henry, why the relative overperformance? Let us first start with Western Europe (or the countries comprising most of the Euro Zone). As we have discussed previously in our commentaries, there are four primary - perhaps not mutually exclusive - reasons (not including the potential underperformance in the Euro vs. the U.S. Dollar):

  1. As illustrated by the Bank Credit Analyst, the U.S. economy has historically tended to lead European economic growth by approximately six months. Given the dip into negative territory in the ECRI Weekly Leading Index during August and September 2006, and given its most recent rise, there is a good chance that the U.S. economy is now actually reaccelerating after the most recent slowdown during both the 3Q and 4Q 2006. Should that be the case, then there is a good chance that European GDP growth has already peaked and should slow down going into the 1Q and 2Q of 2007.

  2. Historically (and this remains true today), European manufacturers (including German manufacturers, despite the "quick fix" reforms we have seen over the last 12 months) have been the highest-cost manufacturers in the world. In an inflationary boom (a period which we had experienced from October 2002, and arguably to May 10, 2006) - when manufacturing and mining capacity is strained around the world - the best assets to invest in is so-called "hard currencies," commodities, and very cyclical industries such as manufacturing, agricultural industries, and mining companies. This is especially true in Europe - where rigid labor policies have made wages very sticky on the downside and where automation is not as valued as in the US or Asia. As a result, the European economy benefited in a significant way, despite continuing structural problems in the European financial and labor system.

  3. In the 21st century information age, one of the best gauges of future and sustainable economic growth is the amount of R&D spending a country or a region is willing to spend. As measured by a recent Bureau of Economic Analysis study, R&D spending has historically been in the range of 2.3% to 2.5% of GDP. The U.S. is set to spend approximately $330 billion R&D spending in 2006 (approximately 2.6% of GDP), followed by China at $136 billion, and Japan at $130 billion. Meanwhile, the EU-15 (which includes the UK) will spend approximately $230 billion, or 1.9% of GDP. Among the major countries, Germany is projected to spend 2.5% of GDP, France 2.2%, Italy 1.1%, UK 1.9%, and Spain 1.1%. Interestingly, the 2.6% U.S. number is approximately the same amount that the U.S. is spending every year on education. Contrast that to France, Germany and Italy - which collectively spends about 1.1% of GDP. Today, the university systems in many parts of Western Europe are in shambles - as demonstrated again in 2006 when the U.S. swept the Nobel Prizes with the exception of the Nobel Peace Prize. Going forward, only a combination of high R&D and education spending will be enough to sustain high economic growth going forward, and on this score, only the U.S. qualifies - with China in a distant second.

  4. The rise of the VAT in Germany from 16% to 19%, and the raising of income taxes in Italy all across the board. While this will definitely dent European GDP growth, readers should keep in mind that this will also serve to "cannibalize" retail sales in Germany - at least for the first quarter of 2007, as many households sought to buy consumer items before the increase of the VAT in the latter parts of 2006.

As for Japan, while P/Es are still relatively high (at approximately 25), compared to P/Es of U.S. and European large caps, it should be noted that profit margins of Japanese corporations have a lot of room to expand. Japanese equities are doubly (or triply) attractive given the relatively low yields of Japanese bonds, and the undervalued Yen (on a purchasing power parity basis, especially against the Euro). Besides exporters like Toyota, Honda, or Sony, however, there are still not that many high-quality, global companies in Japan. Moreover, the economic news coming out of Japan has continued to disappoint. Coupled with a central bank and government that have continued to implement bad economic policies over the last decade and a half, and you can count this author as being "skeptical" of Japan. Bottom line: I will not buy Japanese large caps until we have seen a significant sell-off sometime in 2007.

As for any upcoming risks to the equity markets in 2007, the culprits are usually tight money, increased risk aversion of retail investors, or a combination of exogenous factors that could create a credit crunch, such as a crash in another asset class, including housing, emerging markets, and/or a bankruptcy of a large global corporation. Such market events are usually preceded by a declining bond market or an increase in corporate bond or emerging market yields (which do not exist today). Given the $160 billion sitting on the balance sheets of private equity shops, the immense cash levels held by U.S. corporations, and the ample amount of reserves held by foreign central banks, this author currently does not see any evidence of "tight money" or a potential credit crunch going into January. I also do not see any imminent increase of risk aversion of the part of retail investors, as current retail investor sentiment is still not overly bullish and as valuations still remain reasonable. Moreover, much of the recent rise in stock prices have occurred in blue-chip, large-cap names - as opposed to small caps or stocks that are very speculative in nature (such as technology, biotechnology, or nanotechnology stocks).

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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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