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May 16, 2006

The Next Big Trend and the "Double Merit" Scenario
by Henry To

Dear Subscribers,

This week, we're going to dive right in and talk about the next "big trend." Subscribers who have been keeping track of both our commentaries and my postings on our discussion forum should know what I like best in terms of valuation relative to all other asset classes right now. That asset class is: the U.S. brand name, large to mega caps, such as INTC, MSFT, C, GE, EBAY, YHOO, WMT, CSCO, and thanks to Bill Rempel - GCI. Please note that I am not including cyclical stocks here, but rather stocks that are still on sustainable projected growth paths and who continue to innovate or diversify into other businesses that they can be good at.  Sure, Microsoft's core business is now subject to the whims of the technology spending cycle, but they still have a very high-margin business and have continued (or attempted) to innovate and diversify into other businesses. The question is: Can they succeed? They have actually been losing market share to both Google and Yahoo in the search business, but that "war" still isn't over yet (today's search technology is still very rudimentary compared to what is possible in even a few year's time). Bill Gates is also now pitching the idea of "Anywhere Gaming" in order to capitalize on the recent head start of the Xbox gaming console over the Sony Playstation 3 (the latter isn't scheduled to be released until this November). Make no mistake: The industry of online gaming has been growing exponentially, and it will continue to grow exponentially as the idea gets more accepted and as broadband connections become faster and more mobile. For folks who don't believe that this can become a huge money-maker, look no further than the initial successes of the game "Second Life" - where some gamers are now doing business and making a living from playing the game. The fact that online gaming cannot be pirated makes this idea even more attractive to MSFT - who have been having a hard time trying to deal with Chinese software pirates over the last decade or so.

As I mentioned in our discussion forum, please make sure you read Bill's latest guest commentary on Gannett (GCI). No, make that twice. From a valuation standpoint, GCI is a no-brainer - but this author would like to ask: Where is future growth (growth over GDP + inflation) going to come from? Please feel free to discuss your thoughts or insights on our GCI thread or by emailing me. As I said before: Going forward, we would (and we hope our subscribers would) like to focus more on specific stocks and industries (since that is where the "big money" is made) - although we would definitely continue our macro economic and stock market analysis at least once a week. Again, any suggestions or thoughts are always welcome.

We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,380.99), this position is 510.99 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275.

As I have mentioned in our weekend commentaries over the last couple of weeks, we had intended to add an additional 25% short position in our DJIA Timing System (bring it to a 100% short position) should the Dow Industrials continue to rally going into the May 10th Fed meeting. The market "obliged" early last week, and we entered our final 25% short position at a DJIA print of 11,610 on the early afternoon of May 9th. A special alert email was sent to our subscribers in real time - and a message was posted in our discussion forum alerting our subscribers of this change. As of Friday at the close, this final 25% short position was 229.01 points in the green.

Okay Henry, now that you have gotten your "scores" out of the way, what other trends do you see in the markets going forward? There are potentially many trends, but I want to go back and discuss the U.S. large caps for a second.

Okay, valuations for these large caps that I have mentioned are definitely very reasonable - especially when compared to other asset classes (such as all kinds of bonds, commodities, and real estate in both the developed and developing world - short of some asset classes in Africa). However, we are not in "dirt cheap, widespread capitulation territory" just yet - said territory which would put us on par with the 1990 bottom (in the midst of the last consumer-driven recession) or the bottom in gold in 2001 or in Asian equities in October 2002. Moreover, readers should note that the bubble in U.S. large caps only popped as recently as six years ago, and so the current downtrend in some of these stocks should continue at least for a little more while. At this point, this author will not plunge into these stocks on the long side until we see a much more oversold condition in the general market - and given that the Dow Industrials is still over the 11,000 level, this buying point probably won't come until the latter part of this year at the earliest.

As for specific trends in the markets that may not be obvious to the macro investor, this author would like to begin by discussing the S-curve - a logistic function which has been historically very useful in mapping the pace of technological innovation and subsequent adoption to maturity. The following chart is taken from NASA. There are two S-curves on the chart. The first S-curve describes the pace of advancement (or adoption) in the initial technology. As with virtually all technologies, the pace of advancement or adoption is slow at first (think of the adoption of steam engines, radio, automobiles, and the internet) and as demand reaches "critical mass" this pace tends to accelerate until much of the population has already adopted this technology. Any subsequent growth is consistent with further population or GDP growth - until a second breakthrough comes along. This second breakthrough is represented by the second S-curve. As represented by the discontinuity between the first and the second S-curve, the newer technology is usually too expensive (or has too many problems) initially (that is why the "measure of advancement of the second S-curve starts out lower than the first S-curve) - but as the early adopters continue to work on the technology (such as automobiles in the early 1900s or the adoption of cell phones in the early 1990s), the technology is eventually much cheaper and far superior. Sometimes (but not all the time), the subsequent path followed by the first S-curve ultimately turns into a reverse S-curve (such as railroad travel in the United States or union membership), although this is not shown on the below chart:

Recognizing such trends in various industries or technologies will help the stock market investor immensely - not so much to make outsized profits but more to protect his or her capital. How so? Well, recognizing such trends and studying the demise of former "great companies" will allow you to make the wrong investments. This is evident by the fact that many former U.S. blue chip companies have been devoured by such trends, such as Bethlehem Steel, Penn Central, K-Mart, Xerox, AT&T, United Airlines, Westinghouse Electric, and now GM and Ford.

So Henry, what are the current trends that you see? Since it is much easier to discuss trends that could topple companies (as opposed to trends that will make for very profitable investments), I will choose discuss those first:

1. The continued adoption of the online store - and the delivery of services via the cheapest route - most likely through the internet if one could help it. The concept of the "big box" bookstore has already toppled many local "mom and pop" bookstores, but with the widespread adoption of Amazon's Z-stores, many local used book stores will go out of business as well. In a few years' time - when the beta version of Google's Library project is finally done, most of today's local bookstores will be out of business.

2. The delivery of multimedia over the internet will continue to get cheaper and faster, and will result in the demise of local video rental stores like Blockbuster and Movie Gallery - if NetFlix doesn't get there first. Note that this author has devoted a whole thread to a discussion of Blockbuster on our discussion forum. Readers please feel free to contribute your thoughts to it.

3. The continuing adoption of capitalism in Asia, and the continuing "migration" of jobs from the agricultural to the industrial or information sector. A college education continues to gain in importance, as the maldistribution of income and wealth (the Gini Ratio) will continue to grow in the United States. No one is indispensable in the "new economy" - and the best protection against adversity is to continue to educate yourself and change and adopt new ideas. Change is scary, but it also can be exciting. Historically, no one has done this better than Americans. A corollary to this is the continued decline of union membership - which will be further exacerbated by the eventual Chapter 11 bankruptcy of GM or Ford. Denial at GM continues to reign supreme - and it is even more amusing to see senior leadership believing that GM can get out of this mess by more or less relying on the 2007 SUV lineup - in the midst of historically high gasoline prices and when everyone knows that GM's problems have been over 30 years in the making.

4. Transaction costs of many tradable goods will continue to decline - as exemplified by the rise of the discount brokers in the 1990s and the most recent explosion of derivative contract turnover not just on the local exchanges (such as the CME, CBOT, NYMEX, NYBOT, and ICE) but on the international exchanges as well. The 1990s officially meant the end of the full-service broker (the good ones can still make it by providing good research and advice and maintaining good relationships, but the industry has definitely shrunk). In the next few years, we will most probably witness the end of the full-service real estate agent - to be further exacerbated by the end of the U.S. housing bubble. Given that folks can now virtually inspect and tour a house on the internet nowadays, it really does not make sense to pay a 6% commission to buy or sell a house anymore.

All the above points may sound depressing, but this author believes that the fulfillment of these trends is inevitable. So as not to make our subscribers too depressed, I will now go on and outline a few disruptive technologies, but before I do so, I want to again discuss the economic concept of "acceleration" - a term I first discussed in our February 13, 2005 commentary ("China - Basic Background and Current Issues, Part III"). Coined by the French economist Albert Altalion in the early 20th century, the term "acceleration" refers to a very powerful demand phenomenon - that demand for certain goods or services tend to "accelerate" as the average income of society approaches a certain threshold. Acceleration takes advantage of the fact that income levels are usually distributed like a bell curve - not unlike most socioeconomic variables such as age, the level of education, or the average number of hours worked for a certain group of people in society. For example, history has shown that demand for long-term savings products is virtually non-existent until an individual earns US$15,000 or over - and as the average income of a society approaches $15,000, demand will literally explode (see below chart: the revised demand is the area between the green and the red line):

This demand phenomenon known as "acceleration" can be very powerful - as automobile and PC manufacturers found out first-hand during the 1920s and the 1990s. An off-shoot of this "acceleration theory" is Andy Kessler's guidepost to successful growth investing (as outlined in John Mauldin's "Just One Thing") - that of identifying the industries with high demand elasticity. In Kessler's own words, high elasticity means that "lower cost creates its own huge markets." Kessler relied on this guidepost for successful growth investing in the semiconductor industry during the late 1980s and the 1990s.

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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