"The Conundrum" in Reverse?

By: Henry To | Sat, Oct 20, 2007
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(October 14, 2007)

Important note: One of the following charts was 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 four 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.

4th signal entered: 50% short position October 4, 2007 at 13,956, giving us a loss of 137.08 points as of Friday at the close.

As of Sunday evening on October 14th, we are 50% short in our DJIA Timing System (subscribers can review our historical signals at the following link). In our "Special Alert" on the morning of October 4th, we briefly discussed our reasons for going 50% short in our DJIA Timing System. I had briefly discussed them again in last weekend's commentary, and as a result, would not repeat them here, but as of Sunday evening, two of the three reasons are still valid. The one reason that has been invalidated - the continuing strength in both the Shanghai and Hong Kong stock markets - has the least influence in our decision to go short in our DJIA Timing System. In fact, one could even argue that a stronger Chinese and Hong Kong market would attract more capital away from the US market, as exemplified by a recent Morningstar article describing how many mutual fund managers with a domestic mandate are now trying to take advantage of the boom in Chinese shares by buying up shares on the local exchanges, Chinese ADRs or companies that do a great deal of business with the Chinese.

For now, the most important reasons for us staying 50% short in our DJIA Timing System (and potentially going 100% short) remain technical in nature. Moreover, given that most of the world's economies are now slowing down (as signaled by declining readings in our MarketThoughts Global Diffusion Index), and given the increasing bullish readings in our sentiment indicators this week, the overall case for a short position in our DJIA Timing System just became significantly greater. Aside from the latest readings in our MGDI, another leading indicator of economic growth (container traffic within the Port of Los Angeles, which we discussed in last weekend's commentary), had also been signaling weaker economic growth going forward. These readings are also being confirmed by the recent weakness in US railroad car loadings, as shown in the following chart courtesy of Reuters EcoWin:

United States, Railroad Traffic

Aside from total railroad car loadings in the US, I have also shown the rate of growth for the top four types of goods that are shipped on US railroads today, those being: coal, chemicals, grain, and motor vehicles & equipment. Interestingly, even coal shipments - the one category that has had the strongest growth since early 2004 - is now seeing negative growth. The only major category that is experiencing growth is chemicals (it is thus of no surprise that third quarter margins of all major chemical companies exceeded the consensus). Given that railroad companies had been the strongest industry within the Dow Transports over the last 12 months, my guess is that we have seen the top in the Dow Transports in mid July - and at some point, this will put pressure on the Dow Industrials as well.

However, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last 7 weeks, there is a good chance that the Dow Industrials will continue to rise over the next couple of weeks, but we believe that any all-time highs will be short-lived. 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 we will establish a 100% 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. Last week, I happened to drop by into an old camera store in South LA. The owner of the store was a fellow in his late 50s who had been collecting older cameras since the mid 1970s. Most of them were bought at estate sales. Some of these cameras dated back to the 1870s, but the most amazing part was this: Modern photography technology had essentially remained unchanged ever since George Eastman pioneered the use of photographic film in the late 1880s. 35mm film, meanwhile, had been around since 1914. Virtually all the older cameras were in fine working condition, which meant that with the right size film, and under the right conditions, we could have started taking and processing pictures with the older cameras that dated back to the late 19th century. However, over 100 years after the arrival modern photography, digital cameras revolutionized the industry in only a decade. The arrival of the first true digital camera came in 1990. Kodak itself marketed a digital camera with a 1.3 mega pixel resolution for $13,000 in 1991. Mega pixel digital cameras were generally not available for the consumer market until 1997, however, less than 10 years later, Nikon would announce a nearly complete exit out of the film market. Moreover, it is estimated that over 90% of all cell phones manufactured today carries a digital camera.

To paraphrase Nassim Taleb in his excellent work "The Black Swan," history, and especially technology, does not move in a linear or consistent way, but make unpredictable jumps. Too often, most of us get comfortable with a way of life (or a certain technology) that has been the prevalent technology for at least over a generation, and are thus blindsided when it is replaced by something totally different, but more effective. Fans of Joseph Schumpeter would label this phenomenon as "creative destruction."

Such phenomena can be constantly witnessed in the financial markets. The collapse in liquidity of the CDO and asset-backed market is a prime example. While most quants would call this a "six-sigma" event, it is anything but. Of course, there are always true "100-year events' in the financial markets, such as the October 19, 1987 crash, the true rise of the emerging markets as a respectable investment class in recent years, and the Russian Default in 1998, the first time that a country has defaulted on debt that was denominated in its own currency. Another similar event occurred manifested itself starting in June 2004 as the U.S. long Treasury yields failed to decline despite the beginning of Fed tightening. This was the so-called "Conundrum." Quoting Alan Greenspan in his latest biography "The Age of Turbulence":

I was perturbed because we had increased the federal funds rate, and not only had yields on ten-year treasury notes failed to rise, they'd actually declined. It was a pattern we were accustomed to seeing only late in a credit-tightening cycle, when long-term interest rates began to fully reflect the lowered inflationary expectations that were the consequence of the Fed tightening. Seeing yields decline at the beginning of a tightening cycle was extremely unusual ... Unexplainable market episodes are something Fed policymakers have to deal with all the time. On many an occasion I have been able to ferret out the causes of some peculiarity in market pricing after a month or two of watching the anomaly play out. On other occasions, the aberration has remained mystery. Price changes, of course, result from a shift in balance between supply and demand. But analysts can observe only the price consequences of the shift. Short of psychoanalyzing all market participants to determine what led them to act as they did, we may never be able to explain certain episodes. The stock-market crash of October 1987 is one such instance.

... I did not come up with an explanation for the 2004 episode, and I decided that it must be another odd passing event not to be repeated. I was mistaken. In February and March of 2005, the anomaly cropped up again. Reacting to continued Fed tightening, long-term rates began to rise, but just as in 2004, market forces came into play to render those increases short-lived.

What were those market forces? They were surely global, because the declines in long-term interest rates during that period were at least as pronounced in major foreign financial markets as they were in the United States. Globalization, of course, had been a prominent disinflationary force since the mid-1980s ... With the new millennium, signs of it [disinflationary forces] became increasingly evident, even among development countries whose histories were rife with inflationary episodes.

But even though globalization had reduced long-term interest rates, in the summer of 2004 we had no reason to expect that a Fed tightening would not carry long-term rates up with it. We anticipated that we would just be starting from a lower long-term rates than was customary in the past. The unprecedented response to the Federal Reserve's monetary tightening that year suggested that in addition to globalization, profoundly important forces had developed whose full significance was only now emerging. I was stumped. I called the historically unprecedented state of affairs a "conundrum." My puzzlement was not assuaged b the numerous bottles of Conundrum-label wine arriving at my office.

I encourage readers to read "The Conundrum" chapter in Greenspan's biography in full. Greenspan would go on to discuss the deflationary forces in the world's labor markets as a result of continued globalization, as well as the proportionally high savings rates of the developing countries. Coupled with the lack of investments that had been made in the developed world over the last few years (as demonstrated by the large corporate cash flow that had been returned to shareholders), and thus it is no surprise that interest rates declined across the world. However, Greenspan is definitely a realist, as discussed in the following excerpts from the same chapter:

... These data are consistent with the notion that this decade's decline in long-term interest rates, both nominal and read, is mainly the effect of geopolitical forces rather than that of the normal play of market forces.

If developing countries continue to grow at a rapid rate and financial networks expand to lend more readily to the increasing number of citizens with rising discretionary incomes, developing-country savings rates are bound to fall, at least back to 1980s and 1990s levels. The inbred human desire to keep up with the Joneses is already manifest in the nascent consumer markets of the developing world. Increases in consumption would tend to remove the downward pressure of excess savings on real interest rates. But that would likely occur even if the rate of growth of developing country incomes should slow. In all economies, spending rarely keeps up with unexpected surges in income; hence savings rates rise. As income growth slows back to trend, savings rates tend to fall.

So, as erstwhile centrally planned workforces complete their transition to competitive markets, and as developing countries' increasingly sophisticated financial systems facilitate the inbred propensity toward higher consumption and less saving, inflation, inflation premiums, and interest rates will gradually lose their disinflation buffer of the past decade.

In a press release that we issued in April 2006, we discussed that the secular bull market in the US long bond was over, citing four major reasons: 1) The end of the quantitative easing policy in Japan, 2) The general lack of investment and the cash hoarding by US corporations were getting excessive and were not sustainable, 3) There was significant evidence of rapidly increasing labor costs in both China and India, and that wage concessions with US unions were in the final innings, 4) Unless crude oil spikes to nearly $100 a barrel over the next few years, the recycling of OPEC petrodollars would have a diminishing effect on bond prices across the world.

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. 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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