Shifts in Market Behavior

By: Henry To | Thu, Oct 4, 2007
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Important note: Many of the following charts were created using the Reuters Ecowin service - a service that I am currently trialing. However, as I have mentioned before, this data is not cheap - and there is a good chance I won't end up subscribing to the services UNLESS I get many more subscribers over the next few weeks. For those who have wanted to subscribe to our newsletter, now is the time to do so! For existing subscribers, please pass this message on to your friends or family who may be interested in our services.

Dear Subscribers,

Let us begin our commentary by first providing 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.

As of Sunday evening on September 30th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). Given the relatively weak rally (both in breadth and in volume) we have witnessed since the mid August lows, and given the non-confirmation of the rally by the major stock markets in Europe and in Japan, there is a good chance we could see a retest in the major indices before we see a sustainable bottom in the U.S. stock market. As we mentioned in last week's commentary, for those who prefer to stay long, our favorite stock selections are still those within the large cap (preferably mega cap) growth areas, as well as Asia ex. Japan and China (note that Bill Miller is also now agreeing with us). Also, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last six weeks, there is a good chance that the Dow Industrials could rise to another all-time high - perhaps as early as this week. Should this occur, however, chances are that many other major market indices will not confirm this all-time high, such as the Dow Transports, the Dow Utilities, the S&P 400, the Russell 2000, the American Exchange Broker/Dealer, the Value Line Geometric, and the Philadelphia Semiconductor Indices. Should the Dow Industrials make another all-time high - preferably in the 14,200 to 14,500 area, and should this be accompanied by continuing weak breadth and divergences among many market indices, then there is a chance that we will establish an initial 50% short position in our DJIA Timing System. As always, whenever we change signals in our DJIA Timing System, we will inform all our subscribers via email as soon as we make the change.

Let us now begin our commentary. Late last week, I was fortunate enough to be able to listen to an institutional conference call held by Chuck Royce of Royce Funds - one of the best small cap mutual fund managers in the US today (over the last five years, one of the bigger funds that he manages - the Royce Value Trust fund - is ranked in the 1st percentile in the Morningstar small cap category and had outperformed the Russell 2000 by an annualized 8% over the same time period). Despite the quick 30-minute call, he managed to cover a lot of ground. Among other things he discussed were 1) the probability of a recession in the US is now very high and even though he does not believe there is much correlation between the economy and the stock market, he still believes that a larger correction (in the order of 15% to 20%) for small caps will occur in the foreseeable future, 2) the five-year performance of the Russell 2000 for the period ending in the 3Q 2007 will be one of the best five-year performance periods that we will ever witness in our lifetimes, 3) that rotation into large caps and growth stocks from small caps and value stocks have been evident for sometime now, but despite this rotation, he does not believe that any large cap outperformance from current levels will resemble the huge gap in performance that we witnessed during the late 1990s.

This rotation is obvious if one takes a look at the most recent performance of the different Russell style indices, as illustrated in the below table (note that the below performance represents total returns, i.e. capital appreciation plus dividends):

most recent performance of the different Russell style indices

During the third quarter, the best performing "style" was large gap growth, or more specifically "mega cap growth" - as the Russell Top 200 Growth Index returned 5.24% (seven out of the top ten names in this index are technology names. They are, in market cap order, Microsoft, Cisco, Intel, Hewlett-Packard, IBM, Apple, and Google). For comparison purposes, the Russell 1000 index returned only 1.98%, while the S&P 500 returned 2.03%. As we move down the market cap spectrum and from growth to value, the 3-month returns continue to decline. For example, while mid cap growth stocks (as represented by the Russell Mid Cap Growth index) returned a respectable 2.15% during the third quarter, the Russell Mid Cap Index returned -0.39%, and the Russell Mid Cap Value Index returned -3.55%. The worst-performing style, not surprisingly, was the Russell 2000 Value Index, with a return of -6.26% during the third quarter.

The shift to large cap stocks, and in particular, large cap growth stocks, was inevitable, as we had discussed in our March 25, 2007 commentary ("Brand Name Large Caps Still a Buy"). Not only had large caps been trading at a discount to small caps, but large cap growth stocks had been severely underperforming all styles since early 2000 (as you can see from the above table, the 7-year annualized return of the Russell Top 200 Growth Index is actually negative 4.07%!). Moreover, given the current credit-constrained environment (an environment which should continue to linger at least through 2008), and given the current slowdown in the U.S economy - U.S. large caps, with its much more geographically diversified earnings stream - should experience higher earnings growth than U.S. small caps going forward. As for value stocks, the majority of the underperformance during both the 3rd quarter and on a year-to-date basis was due to the severe underperformance of the financial sector - whose components make up about 30% of the various Russell value indices (versus about 10% for the Russell growth indices).

My current guess is that in general, large cap growth stocks will continue to overperform small caps and small cap value going forward. This has more to do with the composition of the various "style indices" and the behavior of institutions as opposed to the fundamentals of the components of each individual index. For example, as I can attest to given my institutional investment consulting day job, virtually none of our clients had been interested in large cap growth managers over the last few years. On the other hand, allocations to small cap and small cap value stocks had continued to rise. This represented a 180-degree shift from early 2000 - when small caps were regarded as "opportunistic" in nature and not part of a formal, long-term asset allocation for any respectable institutional investor, despite the fact that small caps had great fundamentals at the time. As performance in large caps and large cap growth stocks perk up, institutions and high net worth individuals (not to mention foreign investors) will inevitable reallocate some of their assets into these asset classes - and given the size of these funds, what was a vicious cycle from early 2000 to early 2007 will turn into a virtuous cycle for large cap growth stocks, as the greater inflow of funds will lead to better relative performance, thus attracting even more funds. While a significant amount of individual stock opportunities will stay in the small cap space, I believe picking the right small cap stocks will be more difficult going forward - especially within the financial sector.

Moving on from the stock market, let us now discuss the foreign exchange markets - in particular, the U.S. Dollar Index. In our last commentary on the US Dollar index on September 16, 2007 ("Tactical Trade on the U.S. Dollar?"), we wondered out loud whether a short-term buying point was approaching for the U.S. Dollar. Based on the dollar's oversold conditions (based on its deviation from its 200 DMA), and based on the rate of accumulation of foreign reserves in the custody of the Federal Reserve, we determined that, while the dollar was getting oversold, it was still not a good time to go long the U.S. Dollar just yet. There are two reasons for that. Firstly, while the U.S. Dollar was very oversold relative to its readings over the last 9 months (it closed at 3.61% below its 200 DMA on September 14th), there have been cases over the last five years when the U.S. dollar has gotten much more oversold, such as during July 2002, May 2003, January 2004, and December 2004 - when the U.S. Dollar Index declined to as low as 8% to 10% below its 200 DMA. Secondly, growth in foreign reserves held in the custody of the Federal Reserve had continued to increase exponentially over the last six months, signaling that there is still "too much U.S. Dollars" in the system.

So Henry, what do you think of the U.S. Dollar Index right now?

Again, we still stand by our original thesis - that over the longer-run, while most Asian currencies should out perform the U.S. Dollar (not only because of higher economic growth in Asia ex. Japan, but also because of the valuation differences from a purchasing power parity standpoint), things are not so clear in the Euro Zone, the UK, and Japan (collectively, the currencies of these three regions make up more than 80% of the U.S. Dollar Index). I have discussed our many reasons before, but among them are: 1) deteriorating demographics, combined with the lack of a coherent immigration policy of young and enthusiastic talent with good education, 2) lack of structural reforms, 3) housing bust in Spain, along with the fact that both the UK and France's economic boom over the last few years have, in no small part, been helped by rising housing equity in both countries, 4) the fact that much of Euroland (especially Germany) is the marginal manufacturer in the world - and therefore, at the first sign of an economic slowdown, European exports will come to a screeching halt, and 5) a hugely overvalued currency from a power purchasing parity standpoint, as exemplified by the wave of UK tourists doing their Christmas shopping at Macy's during 2006. More importantly, I also believe that both European and Japanese economic growth will be, at best mediocre going forward, and over the longer-run, less than that of the US.

In the short-run, I believe the U.S. Dollar should bounce sometime over the next couple of weeks, as the U.S. Dollar Index is now trading at 5.68% below its 200 DMA - an oversold level that we have not seen since May 2006.

USD Index vs. Percentage Deviation from its 200 DMA (December 1985 to Present) - The percentage deviation of the USD Index from its 200 DMA hit a level of negative 5.68% last Friday. While this reading is definitely oversold relative to the readings we have seen over the last 18 months, it still does not compare favorably with oversold readings of years past. Moreover, the amount of foreign reserves in the custody of the Fed is still rising at a rapid pace, suggesting that there is still too many US dollars in the financial system. While I am still bullish on the USD against both the Euro and the GBP in the longer-run, I would not buy the USD until we get a more oversold reading - along with a confirmation of a higher shortgage of U.S. dollars in the market.

However, as mentioned on the above chart, and as mentioned in our September 16, 2007 commentary, the amount of foreign reserves held in the custody of the Federal Reserve is still increasing at a rapid, suggesting that there is still too much dollars in the financial system. Before we decide to go long in the U.S. Dollar Index, we prefer to see either 1) the U.S. Dollar Index reach an even more oversold level, preferably selling at 8% to 12% below its 200 DMA, 2) at least a slowdown in the growth of foreign reserves held in the custody of the Fed - and preferably a decline, suggesting a higher demand for U.S. Dollars by foreign entities (or less of a supply from U.S. entities, such as less buying of foreign goods by U.S. consumers). For now, we will continue to take a "wait and see" approach - as I believe that any potential long position will probably not occur until the November to December timeframe at the earliest.

An Update on our Global Overbought/Oversold Model

Now, moving on, given that we have just approached the end of September, it is now time to update the readings of our "Global Overbought/Oversold Model" - a model that we first discussed in our August 2nd commentary. As we mentioned in that commentary, the inner workings of this global overbought/oversold "model" are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility. Following is our Global Overbought/Oversold Model as of the end of September 2007 (note that we have also added the CRB Total Return Index in this model since our August 2nd commentary):

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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