Global Economic Growth Continues to Disappoint
December 9, 2007
As I mentioned in last weekend's commentary, I will be leaving for Houston, Texas, on December 18th to visit my folks, relatives, and friends and will be back in Los Angeles on January 3rd. At this point, I still haven't finalized my writing schedule yet (most likely, you will be getting more of my "ad hoc" comments than usual), but I will try to work as hard as I can - given the recent volatility and day-to-day swings in the stock and financial markets. This week's mid-week commentary will come from guest writer Bill Rempel, while next week's mid-week commentary will come from Rick Konrad, as usual. I am definitely looking forward to spending some time on R&R - hopefully, this will fully prepare us to tackle the markets in 2008 - and my guess is that it will be the toughest market to navigate since the early days of 2003.
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 gain of 330.42 points as of Friday at the close.
Before we go on to the "gist" of our commentary, I want to devote a few paragraphs to the state of our infrastructure in the US - an issue that we first discussed in our October 20, 2006 ("The World of Private Infrastructure Investments"). Aside from infrastructure demand in the booming parts of Asia (it is estimated that Asia will need to spend US$200 billion a year on infrastructure in order to maintain its current growth rates), there is no doubt that US infrastructure (such as roads, rails, airports, pipelines, dams, etc.) is also in dire need of upgrading or maintenance - as demonstrated by the I-35W bridge collapse in Mississippi on August 1, 2007. According to the American Society of Engineers' 2005 report card, approximately US$1.6 trillion is needed to bring our infrastructure up to "acceptable standards." Following is a few examples demonstrating the sorry state of our infrastructure in selected States:
Massachusetts: 36% of all bridges in this State are structurally deficient or functionally obsolete. In order to maintain the state's roads and rails at current levels, the State will need to spend $15 to $19 billion on maintenance alone over the next 20 years.
Texas: Only 6 staff members are available to inspect over 7.500 dams on a regular basis. At the current rate, there will be some dams that will never be inspected in the next three centuries.
New York: Due to aging water pipes, the State estimated that over one billion gallons of drinking water is lost every month. Not only do leaks result in water loss, they can also allow toxins and other chemicals to enter the state's drinking water.
Louisiana: 31% of all bridges in this State are structurally deficient or functionally obsolete.
California: 37 levees from are at risk of failure - far more than in any other State. Moreover, the levees that have been studied so far make up only a small part of the entire system. An additional 10,000 miles of levees still have not been inspected.
As I mentioned in our October 20, 2006 commentary, the time is getting ripe for a boom in private structure investments - especially if State budgets become severely constrained in the upcoming economic slowdown - thus forcing States to privatize or seek private capital to fund infrastructure investments (such as toll roads, bridges, parking garages, etc). An additional tailwind for a boom in private infrastructure investments will come if raw material prices start to decline - a trend which we are starting to witness already (base metal prices have peaked, although steel and cement prices have yet to follow). Finally, should construction spending and employment decline next year on a weaker housing and commercial real estate market, there will most likely be a huge push to create construction jobs by providing incentives to the private sector to fund infrastructure spending - especially since most parts of the world are still awash with capital. The biggest obstacle is mostly political in nature. From an investment standpoint, infrastructure investments are close to a "no-brainer," given infrastructure's attractiveness for diversification purposes, especially for those investors with a long-term investment horizon (such as pension plans and sovereign wealth funds). We will continue to stay abreast of this asset class going forward.
Let us now get back to the subject of this commentary. As of Sunday evening, December 9th, we remain 50% short in our DJIA Timing System. As we discussed in our commentaries over the last couple of weeks, there are several reasons for our continued bearish stance - and those arguments remain in place, despite the stock market rally that we witnessed over the last few days. For example, as we mentioned in last weekend's commentary, TrimTabs, one of the most bullish publications (and who also "got it right" during the 2000 to 2002 bear market) over the last few years (including during the summer correction of 2006) has continued to be bearish on the US stock market, citing, among other factors, a) a decline in personal income growth, leading to less discretionary spending and less savings going into brokerage and retirement accounts, b) an IPO and secondary offering backlog totaling over $35 billion, one of the largest backlogs we have seen in this bull market, despite the fact that many large companies are choosing to list on other non-US exchanges, and c) a virtual freeze on cash acquisitions, given the recent LBO cancellations and lack of new LBO announcements (which is not surprising given the current credit crunch). This continues to hold true as of tonight. Moreover, the BLS is notorious for overstating employment gains during the transition to an economic slowdown/recession (and vice-versa when the economy is emerging out of recession). According to TrimTabs, employment growth over the last two months is probably 200,000 less than the official numbers from the BLS.
Furthermore, as we also mentioned last week, the NYSE Common Stock Only Advance/Decline Line did not confirm the new highs in the Dow Industrials or the S&P 500 in early October - a development that has not occurred since the bull market began in October 2002. In fact, the NYSE CSO A/D Line had already topped out in early July - three months prior to the most recent high. A non-confirmation of the NYSE CSO A/D Line of a new high in either the Dow Industrials or the S&P 500 usually signals selectivity, or in other words, a lack of general buying power. Over the last 50 years, such non-confirmations have always resulted in a correction in the Dow Industrials or the S&P 500 of 12 % or more - and sometimes, much more, such as during the 1973 to 1974 bear market or those fateful two months from late August to late October 1987. In other words, this is a classic warning sign of, at the very least, a more severe-than-normal stock market correction. If this were your typical "10% bull market correction," then in all probability, there would not have been such a flagrant non-confirmation by the NYSE CSO A/D Line. Following is a three-year chart (courtesy of Decisionpoint.com) showing the NYSE CSO A/D Line and the NYSE Composite:
More ominously, the latest uptick in the NYSE CSO A/D line has been rather muted despite the impressive gains in both the Dow Industrials and the S&P 500. Furthermore, this weakness in the A/D line is also confirmed by the weakness in the NYSE CSO A/D Volume Line (which is the cumulative daily differences in NYSE CSO Advancing Volume and NYSE CSO Declining Volume) - suggesting that the most recent rally is very weak from both a breadth and a volume standpoint.
Of course, the Dow Industrials and the S&P 500 could always retest or even surpass their highs until we see a more severe decline. But given this continued weakness in breadth, the continuing credit crunch in most of the world's financial markets, the lack of "teeth" in the White House's subprime "bailout" plan, my guess is that both forward earnings and the stock market will continue to be weak over the next several months. Should the Dow Industrials move higher over the next several weeks, and should we continue to see a negative divergence in terms of weak breadth or a lower low in the NYSE CSO A/D line, there is a good chance we would shift to a fully (100%) short position in our DJIA Timing System.
Speaking of the general credit crunch - while CMBS, ABX, and credit spreads in general have eased over the last couple of weeks, the same cannot be said for the "TED Spread." The TED spread is defined as the difference between the three-month LIBOR rate and the yield of the three-month Treasury bill, and is usually interpreted as the willingness of banks to lend to high-grade corporate borrowers or fellow banks. Following is a chart showing the TED spread (smoothed on a five-day basis) from January 1983 to the present:
While it is not obvious from the above chart, it has usually been a great time to buy stocks after a spike in the TED spread, such as during the July 1984, October 1987, December 1990, October 1998, and October 1999 spikes. However, there have been exceptions, such as during May 1987 and during the most recent spike in late August of this year. While the stock market did initially rally subsequent to the May 1987 and the August 2007 spikes, the market would eventually turn lower (the former much lower). In other words, a spike in the TED spread is not in itself a buy signal. Rather, the TED spread is a reflection of general credit conditions - conditions that also have an impact on the stock market. Should a spike in the TED spread (in our case, a new 20-year high in the TED spread) be not accompanied by a genuinely oversold condition in the stock market, chances are that the stock market will eventually fall further, as exemplified by the May 1987 and the August 2007 spikes. Given that the TED spread is now at a 20-year high, and given that the stock market did not get that oversold during the latest decline in late November, my guess is that the major market indices will eventually break their November 26th lows - whether it is later this month or early next year.
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