A Worrying Headwind for the U.S. Stock Market

By: Henry To | Thu, May 31, 2007
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Dear Subscribers,

First of all, I hope everyone is having a great Memorial Day Weekend and that you have had time to give "thanks" to those heroes who fought to turn back Nazism, Communism, and other "ism-s" in the 20th century which have killed millions of innocent lives all in the name of ideology. As anyone who reads our commentaries and who invests in the stock market can attest to - life is a constant struggle. Sometimes, we compete with our neighbors, and sometimes we embrace them. There is no one mechanism for making this world a perfect place - and if someone claims there is, you better find a way to lock him/her into a lunatic asylum, where he can do no damage. The Ponzi scheme artist who promises a 20% monthly return from trading currencies is one example (I've actually had decently smart people who approached me and ask if 20% consistent monthly returns are possible - the quick answer is no, you do the math). Life would not be fun if it were not for our day-to-day and month-to-month struggles.

Speaking of "struggling," there is no doubt that the folks who have been consistently shorting the U.S. and the world's stock markets (with the exception of the Venezuela market, homebuilders and subprime lenders, and Japanese small caps during 2006) have most probably struggled greatly over the last four years or so. There is a reason why out of the 9,000 hedge funds or so out there, probably less than 100 of them are dedicated short bias hedge funds. Going forward, I believe dedicated short-sellers will continue to struggle in the months or years ahead. I know, I know - this somewhat contradicts the title of this commentary - but I will illustrate why later in this commentary. Before we go ahead with our commentary, I want to alert our readers to the May/June commentary written by Bill Gross of PIMCO. It is a must-read, as always. Besides the fact that Mr. Gross and PIMCO has now "capitulated" to the bullish side, there are of course other things worth mentioning in the article as well:

On a more immediate basis, this re-allocation by PIMCO and other bond managers will continue to put pressure on U.S. Treasuries. Going forward, I believe a ten-year yield of 5% is inevitable sometime during this summer. As I am finishing up this commentary, Japan also surprised with a lower-than-expected unemployment rate and higher-than-expected household spending, thus also putting pressure on Japanese government bonds. All this will in turn put pressure on U.S. equities, especially given that they are still very overbought on a short to intermediate term basis. In the longer-run, the move by PIMCO into "riskier" assets is not only a reflection of a new-found stability in the global economy - but also because "the quest for alpha" is all anyone is concerned about today - no matter what one's "beta measure" is. This is true now for endowments, foundations, pension funds, and hedge funds alike - and pretty soon, for retail investors as well as we are now witnessing an expansion of 401(k) options into "absolute return strategies" such as carry trade funds, long-short equity funds, and so forth.

Now, let us continue the rest of our commentary. First of all, following is an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

While equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S. equities are now at its most expensive level since May 2006. Combined with the fact that the stock market is now overbought on both a short and intermediate basis, and given that there are now many divergences in place (such as the non-confirmation of the Dow Industrials by the Dow Transports on the upside, the weakness in the NYSE McClellan Oscillator and Summation Index, the new highs vs. new lows on both the NYSE and NASDAQ, etc.), my guess is that both the U.S. stock market and the global stock markets (especially China) will have a tough time this summer. In terms of liquidity, stocks are also not too attractive at this point, as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th. Should the U.S. stock market continue to rally further in the coming days or weeks, then we may actually initiate a 50% short position in our DJIA Timing System.

In a recent research publication on U.S. defined benefits pension plans - another must-read - McKinsey & Company discusses the tumultuous changes that are already going on in the defined benefits plan industry, with an emphasis on the asset management side. Not only with this shift (after all, the DB industry has a whooping $2.3 trillion in assets) have a significant impact on asset managers, but will also have an impact on all investors around the world. Quoting the McKinsey report:

Historically, the majority of U.S. plan sponsors have opted for a "traditional" 60/40 mix of equities and bonds - a strategy which has historically worked well until the bear market of 2000 to 2002 - when plan sponsors found out their assets and liabilities were really grossly mismatched. The combination of this "lesson" - along with regulatory forces (the Pension Protection Act of 2006 and FAS 158) and other demands of the marketplace has meant that this traditional mix is no longer sufficient or tolerated by CEOs or CFOs. Following is an exhibit (straight from the McKinsey report) showing the external forces that are driving the current changes in the DB industry:

As a participant in both the DB and the DC pension plan industry, I can definitely attest to this (please see our August 13, 2006 commentary "The New Pension Legislation and a Challenging Market" for a refresher). Going forward, the main goal of plan sponsors will be to minimize the volatility of pension funding statuses - and at the same time, achieve excess returns (or "alpha") by continually diversifying into new asset classes, such as local emerging market securities, real estate, infrastructure (October 20, 2006 commentary "The World of Private Infrastructure Investments"), hedge funds, or private equity funds. In terms of minimizing the volatility of pension funded statuses, plan sponsors can best do this by "matching" assets to liabilities (i.e. make sure that assets move with liabilities as closely as they can) - either by buying long duration bonds or getting exposure to some kind of long duration fixed income benchmark via swaps or other derivatives (especially if a pension plan has a particularly long duration, since most long duration bond funds max out at around a duration of 10 or so). That is, instead of using the traditional "risk free asset" as the benchmark of performance (such as three-month treasury bills) - pension plans are using their own liabilities as the benchmark. This makes perfect sense - and is one reason why the "high-risk" workers that are saving for retirement are those that are investing in money market or stable value funds, not those that are investing in equities, domestic or otherwise.

As more DB pension plans adopt this view, the obvious first loser is those group of long-only equity mutual funds that have consistently underperformed their benchmarks - be it the S&P 500, the MSCI EAFE, or the Russell 2000. On a less obvious level, the exodus of pension plans away from these long-only mutual funds (and into long duration assets, hedge funds, or private equity funds) will also create a significant headwind for U.S. equities. Assuming half of the $1 trillion are ultimately invested back into the world's equity markets (which is probably an overly optimistic number), this still means an annual outflow of $100 billion from the world's equity markets. This trend has already started and is now accelerating - and this is one reason why I am envisioning a tough summer for the bulls this year.

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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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