Identifying Trends and Risks for 2007, Part 2

By: Henry To | Thu, Jan 11, 2007
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Dear Subscribers,

Before we start our weekend commentary, I want to briefly mention a New York Times article that was published over the weekend entitled "Happiness 101." The field of "Positive Psychology" is now the hottest field in the psychology world - thanks to pioneers such as the ones described in the article and a subscriber I met over breakfast last Friday morning, who is teaching just such a course at the UCLA Medical School. The NY Times article is a must-read. After all, isn't being happy (or making others happy) one of the most important goals for many people in their lives? If not, then you are really in dire need of consulting a psychologist!

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 1,013.01 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 893.01 points

As of Sunday afternoon on January 7, 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 is most probably in the midst of a consolidation phase or a correction. Such a correction is definitely overdue, as bullish sentiment has turned higher in recent weeks (even though the market was in a consolidation phase) and as the market has not experienced a significant correction in over five months. Even though the major market indices probably still have more to go on the downside before we could find a sustainable bottom, there is a good chance that we have already seen a short-term bottom in energy stocks, particularly natural gas. Over the longer-run, however - as I have illustrated in last weekend's commentary - I still believe that U.S. equities in general will be one of the best performers in 2007. And even though I am a long-term energy bull, I continue to believe that both energy and commodity prices in general will struggle this year as they enter into a consolidation or correction phase. Astute traders will probably be able to make money by buying commodities on the dips and selling them when they get overbought, but overall, it will be a frustrating year for energy and commodity bulls.

In last weekend's commentary, I stated and discussed our outlook and potential risks to the world financial system for 2007 - starting with the equity and bond markets. In this week's commentary, I am going to proceed to the currency markets and the commodity markets - with a quick initial discussion of some of the sectors I like and dislike within the S&P 500. I am also going to change the format a little bit and do the following in Q&A format, as this allows me to quickly get to the point - which will definitely help our subscribers get through this commentary without the usual headaches!

Follow-up Questions on the U.S. Stock Market

Question: How do you think energy and energy service stocks will do this year? What about the NASDAQ, technology stocks, and the SOX?

Answer: As I have discussed before in our recent commentaries, I believe energy and other commodity prices will struggle in 2007 - even though I believe the long-term bull in energy and commodity prices remains intact. That being said, energy and energy stocks in general are now very oversold in the short-run, driven by abnormally warm weather and the liquidation of hedge fund positions as 2006 year-end redemptions from energy hedge funds accelerated in the wake of Amaranth Advisors. In particular, one would be very hard-pressed to find many hedge funds that are long natural gas right now (as I am finishing this commentary, natural gas prices are trading up over 30 cents on the NYMEX on Monday morning). The oversold condition of energy stocks can be illustrated by the following chart (courtesy of, showing the percentage of stocks in the Energy Select SPDR (XLE) that are above their 200, 50, and 20 EMAs, respectively:

Percentage of stocks in the Energy Select SPDR (XLE) that are above their 200, 50, and 20 EMAs

As shown on the above chart, the number of stocks within the XLE that are now trading below their 20 and 50 EMAs are at 10% or below - signaling a short-term oversold condition. For folks that want to trade energy stocks here, now may be a good time to buy - especially stocks that are natural gas drillers or producers.

As for shares in the NASDAQ, the SOX, and the technology sector, I believe they will outperform the market this year - even though they look to be vulnerable to a correction in the short-run. Part of the reason is the relatively low valuation in the technology and the semiconductor sector. Another reason is: As a cyclical bull market matures, the "new money" tends to be more speculative in nature. Not only is this historically true, it also makes logical sense, as the public usually doesn't enter the stock market in droves unless or until some new technology or sector captures the public's imagination. So far, we have not had this "killer technology" in the latest bull market just yet. This was true of the railroads in the 1850s, the industrials in the late 19th and early 20th century, the automobile, electricity, and radio in the 1920s, conglomerates in the 1960s (not to mention color TVs), PCs in the 1980s, and the internet and wireless in the 1990s. What could be the technology or combination of technologies in the upcoming year? It could be anything - but my bet would be on things such as stem cell research, alternative energy research (especially solar), capital spending plays spurred on by MS Vista and MS Office 2007 (although this probably won't occur until later in the year), Wi-Max, and potentially even selected nanotechnology plays such as companies that do research in new cancer fighting methods or new battery technologies. Many of these new technologies - if adopted commercially - will have a positive impact on the NASDAQ, the SOX, and many technology stocks overall. The speculative money will enter the market - it is just a matter of time. As an important aside, only then will the market top out.

Question: Henry, what if I am not comfortable with buying U.S. or other equities right now? Or what if I have too much of my assets allocated into equities and real estate? What should I buy in this case?

Answer: Note that this should not be construed as a strict recommendation (always seek an investment advisor that knows your personal/unique situation in life), but I do not believe a CD yielding 5% is the key. My guess is that many of our subscribers are in a high tax bracket, and given that interest from CDs are taxable, a typical after-tax, real return on a CD investment could be as low as 0.5% (a 5% return with a 30% tax rate and further deflated using a 3% inflation rate). For folks who are in the "upper middle class" or above, investing in CDs is particularly unacceptable, as you will typically experience higher inflation rates, as many of your consumption goods (such as country club memberships, dinners at the nicer restaurants, a trip to the Caribbean, etc.) cannot be easily substituted and are not subjected to deflationary forces coming from China, India, or Wal-Mart (such as PCs or other electronic goods). Moreover, the wealthier you are, the more you will be able to withstand short-term shocks in the equity markets and focus on making long-term investments.

Getting away from equities and CDs, I would recommend buying short-dated bonds, such as via the Vanguard Short-Term Bond Fund (VBISX) or the Vanguard Short-Term Tax-Exempt Fund Investor Shares (VWSTX), as I believe the Federal Reserve will ultimately ease no later than the second half of this year. Aside from a decent yield on these funds, you will be able to obtain some capital appreciation as well. I also would not recommend anything in the Euro Zone or Japan, given that the bond markets of both regions offer little or no value, and given the fact that I am bearish on the Euro and neutral on the Japanese Yen.

The Currency Market

There is now a good chance that we have seen a significant bottom in the U.S. Dollar Index in early December 2006. Let us first take a look at the oversold condition of the U.S. Dollar Index during that time:

USD Index vs. Percentage Deviation from its 50 DMA (December 1985 to Present) - The percentage deviation of the USD Index from its 50-day moving average hit a level of negative 3.55% on December 1st - the most oversold level since May 16, 2006. Given this huge oversold condition, bearish sentiment, and an improving U.S. economy relative to both the Euro Zone and Japan, chances are that the U.S. Dollar will continue to rally over the next few months.

As shown on the above chart, the percentage deviation of the U.S. Dollar Index in early December 2006 hit a level of negative 3.55% - representing the most oversold condition since May 16, 2006! Moreover, bearish sentiment was very widespread during that time, as exemplified by a cover story on the Economist and a speech from former Fed Chairman Greenspan noting that the U.S. Dollar still has further downside to go (the last time Greenspan publicly stated of a dollar bear in March 2005, the U.S. Dollar Index actually bottomed on the same day and mounted a huge rally over the next four months). Historically, Greenspan's timing has been very useful as a contrarian indicator. Another example is this following statement on January 7, 1973, right before the 45% decline in the Dow Industrials over the next two years: "It is very rare that you can be as bullish as you can now."

In many of our most recent commentaries, I have also made the case on why I believe the U.S. economy will outperform the Euro Zone economies over the next three to six months - with the most important reason being that the U.S. economy has historically lead the Euro Zone economies by approximately six months! Given that there are no indications that this relationship has decoupled, there is a good chance that the Euro Zone is just now slowing down, as did the U.S. economy during the Summer and Fall of 2006. This "slowing down" will further be exacerbated by the most recent rally in the Euro as well as the raising of the VAT in Germany and the raising of income taxes in Italy, both of which were effective beginning January 1, 2007.

More follows for subscribers...



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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