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August 21, 2008

Look for a Continuing Correction in Oil
by Henry To

(August 17, 2008)

Dear Subscribers,

Let us begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 512.10 points as of Friday at the close.

7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 203.10 points as of Friday at the close.

Paradigms change. Central bank policies come and go. "Star" investment managers and strategies are supplanted by others. Financing structures and risk management strategies remain in flux. The "standards" of today can easily become out of style as soon as one has figured it out (this applies especially to the realm of retail investors). Consider the latest record-breaking run in the 100-meter dash by Usain Bolt. As far as we know, he trains in a decrepit gym in his homeland of Jamaica with no formal track & field facilities, has no formal diet regimen (he claims to have had McDonalds nuggets for breakfast before his run), and had actually decelerated to celebrate his inevitable victory 15 meters before the race ended. If he had given his 100%, there is no question he would've run the race in 9.60 seconds or less. In the words of the NBC commentator, a sub 10.0 is no longer enough to guarantee an Olympics medal. We have now entered the realm of "video game time."

More dramatically for the 100-meter event, there is no doubt that there has been a paradigm shift. Prior to Bolt's record run in Beijing and his 9.72-run (also another world record) at the Reebok Grand Prix on May 31st, the consensus among experts has been that Bolt was just too tall to win (let alone dominate) the event, as tall men like him (Bolt, at 6' 5", is two inches taller than Asafa Powell and three inches taller than Carl Lewis) typically have slow reaction times - and in the 100-meter event, this disadvantage was regarded as crucial - even though Bolt could finish the run in 41 strides as opposed to the typical 46 strides. Bolt, of course, proved them all wrong. Even though he had the second slowest reaction time in the Beijing run, he nonetheless caught up with the field 30 meters into the run and would go on to easily win by nearly two-tenths of a second. By the 2012 Olympic Games in London, the majority of the 100-meter dash finalists could very well be 6' 5" or taller.

Paradigms shifts are also very common in the global financial markets. In the early 1950s, stocks were regarded as "risky" or a "gamble," even though stocks were trading near historically low valuations and corporate bond yields declined to below 3%. Throughout the 1950s and 1960s, inflation was regarded as "good" for stocks - as, in theory, inflation means higher prices and higher earnings for corporations in general. From the beginnings of the stock exchange to as recent as the 1970s, small caps (defined as companies with market caps of below $500 million in the mid 1970s), were also regarded as a gamble. As we now know, investors like Warren Buffett and Chuck Royce made a bundle during the 1975 to 1983 bull market in small caps - both by directly investing in them or starting an investment business revolving around small cap investing. Then it was the junk bonds and the leveraged buyout craze during the 1970s and lasting well into the late 1980s. By the early parts of this decade, real estate (mainly REITs) and international equities - which Sir John Templeton and Shelby C. Davis had helped popularized (both Templeton and Davis invested a substantial amount in Japanese equities in the 1960s) - became mainstream classes Today - equities, small caps, junk bonds, and international equities - are all regarded as legitimate asset classes by institutions and retail investors alike.

From my perch here on top of the institutional market, I believe we will witness the majority of the growth in the investment industry over the next decade in the following "asset classes" (in no particular order) : 1) hedge funds, 2) private investments (this category includes venture capital, buyout funds, infrastructure investments, private real estate, etc.), 3) emerging market securities (including emerging market small caps and real estate), 4) frontier market securities (including countries such as Vietnam, parts of Africa, the Middle East, etc.), and 5) quantitative finance or investments (please see our May 15, 2008 commentary for our position on quantitative strategies). Obviously, many of these "asset strategies" overlap. For example, there are many hedge funds that purely utilize quantitative investment strategies, while many "traditional" equity mutual funds also use quantitative screens as their initial filter for companies that may fit their investment criteria. On the opposite end of the spectrum, there are also many long-short equity hedge funds that solely indulge in fundamental analyses, whether it is in domestic, international, or emerging market equities. But our main point is this: In order to achieve outsized returns going forward, it is virtually imperative that one finds an investable market where there are great inefficiencies. Guys like Templeton, Buffett, Davis, and Soros were experts in doing just that back when their careers were peaking. Even folks like John Paulson and Andrew Lahde had to achieve their Herculean returns last year by shorting the subprime market through the purchase of severely under-priced derivative contracts linked to subprime loans, as opposed to implementing strategies within the more "efficient" areas of the financial markets, such as shorting homebuilders, subprime lenders, or banks. Of course, one can always make outsized returns in an otherwise efficient market simply by placing big bets on either the upside or downside - but such bets, from a probability standpoint - do not make sense over the long-run and can be very hazardous for your long-term financial health. The best hedge funds know it - the ones that don't are already out of business.

Given the above, and almost by definition, retail investors in general will always be at a disadvantage and can hardly expect to make outsized returns over the long run. The investment funds with the greatest amount of capital will always have access to (or the capital to create) tools that are highly restrictive to the retail investor. Even a basic subscription of Compustat or Capital IQ will set one back more than $10,000 a year. True, today, the retail investor has instantaneous access to 10-Ks, company's websites, and charting tools - but precisely because of this access, the playing field has now simply become much more level for all retail investors. Back in the early 1990s, a trip to the library will almost surely have given one a huge advantage over other retail investors. Today, unless a retail investor is spending over 40 hours a week on his investments and has access to a tremendous amount of research and databases, it is very difficult to even have a "leg up" over other retail investors. Otherwise, it is difficult to imagine why funds such as Renaissance Technologies, Clarium Capital, or even the American Funds family of mutual funds are still able to outperform their benchmarks nearly every year (and some by a substantial margin even huge fees). Or for that matter, why most investors who invested in the Fidelity Magellan Fund back in the Peter Lynch days never really made any money, even though Peter Lynch trounced the S&P 500 during the time he managed the fund from 1977 to 1990. That's because too many retail investors try to pick their own stocks or try to time the markets, even though they do not have the time, the discipline, or the "compulsion" to embark on such an endeavor.

For the majority of investors, the best advice we could give (aside from reading MarketThoughts.com?) is to either adopt a buy-and-hold strategy through smart asset allocation or to simply "buy when others are fearful, and sell when others turn greedy." And above all, never lose money. Don't ever try to enhance your returns by employing leverage - unless your broker is offering margins at 1% and unless the stock market is trading at a substantial discount (and even then, don't try to be more than 150% invested). The availability of ample margins at the broker has undone many great traders/investors. Case in point: If Shelby Davis did not have significant exposure to Japanese equities during the 1973 to 1974 bear market in US stocks, then most likely he would have been wiped out, as he had been utilizing margin to enhance his returns ever since the beginning of the great 1949 to 1966 bull market.

Let us now get on with our main commentary. As we discussed in last weekend's commentary, we believe that there's a good chance that the Chinese economy will slow after the Olympics and into 2009. At this point, my best "guestimate" of Chinese GDP growth for the next 12 to 18 months is somewhere in the range of 7% to 9%. Moreover, the latest reading in our MarketThoughts Global Diffusion Index (MGDI) is also confirming a tremendous slowdown in global economic growth over the next six to nine months. Such a global slowdown is consistent with a slowdown in Chinese economic growth as well. More importantly, in light of the continuing slowdown in global economic growth and with expected crude oil capacity expected to come online in various OPEC countries (such as Saudi Arabia) from now till the end of 2009, the Energy Information Administration (EIA) now expects OPEC surplus crude oil capacity to increase to as much as 3.6 million barrels per day by the end of next year, or nearly 700,000 barrels a day over the ten-year average in OPEC surplus crude oil capacity, courtesy of the following chart from the EIA:

In addition, non-OPEC supply growth is expected to grow by slightly more than 500,000 barrels a day in the second half of 2008 - followed by an additional 850,000 barrels a day by the end of 2009. The growth in non-OPEC supply growth over the next 18 months will be led (if all goes according to plan) by the United States (due mostly to the Thunder Horse and Tahiti platforms coming online over the next 18 months), Brazil, and Azerbaijan. The following table (courtesy of the EIA) summarizes non-OPEC crude oil production growth from 2007 to the end of 2009:

Taken together, the combination of slowing economic growth and the increase in OPEC and non-OPEC crude oil supply growth is expected to raise global surplus crude oil production capacity to approximately five million barrels a day. However, given the history of many project delays (as well as accelerating production declines in some older fields), my sense (and the consensus among many crude oil analysts) is that the EIA's projections are too optimistic. Nonetheless, even should global surplus oil production growth disappoint (e.g. if global surplus oil production increases to only three million barrels a day) the outlook remains bright, especially given the rapid adoption of alternative energy in both our power grids and transportation sector.

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

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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