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September 13, 2006

Four-Year Cycle Low Now the Consensus
by Henry To

Dear Subscribers,

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Note: Our regular guest commentator and discussion forum moderator, Bill Rempel (you may also know him as nodoodahs) has relocated his website to the following address: http://www.billakanodoodahs.com/. Bill was busy last week working on his new website, and thus had to take a break from writing a regular guest commentary for us. However, he is going to come back to our website with a vengeance this week. Looking forward to your commentary, Bill!

I am actually starting our commentary on Saturday this weekend, since I will be on a plane early in the morning to New York City. This commentary should be a little bit abbreviated - so I apologize in advance. The plan is for me to meet a few money managers and my coworkers (in my day job) in our New York office, and I will be there from Sunday to Wednesday afternoon. I will be back in Los Angeles on Wednesday evening and will be attending an American Funds conference on Thursday. I will keep our readers up-to-date on both the markets and with whatever I hear during that time. Since Bill is writing a guest commentary for us this Wednesday evening, my schedule is not going to be as hectic as I thought (thank God). With that said, let us now start with our commentary.

Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 - giving us a gain of 290 points. In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). As of the afternoon on Thursday, September 7th, this author entered a 50% long position in our DJIA Timing System at a print of 11,385 - now at 7 points in the black. A real-time "special alert" email was sent to our subscribers informing them of this change. As of Sunday afternoon on September 10th, this author is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which, as I have discussed over the last few months, will regain a significant chunk of microprocessor market share from AMD), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. I am also getting very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). The market action in large caps has also been very favorable thus far.

The market action thus far has remained favorable, despite the correction of the major market indices last week. For now, the Dow Transports (now at 4,195.04) remains above its August 11th closing bottom of 4,141.62. And while both the popular mid and small cap indices such as the S&P 400 and Russell 2000 have severely underperformed the Dow Industrials and the S&P 500 - this is to be expected, given that leadership is now shifting away from U.S. small and mid caps to U.S. large caps. As for the number of new highs vs. the number of new lows on the NASDAQ Composite - this indicator dipped into slightly negative territory on both Thursday and Friday (32 new highs vs. 35 new lows), but subscribers should not be alarmed unless new lows outnumber new highs by 32 or more (said number which is equivalent to 1% of all issues trading on the NASDAQ Composite). As for the U.S. homebuilder ETF (XHB), this author continues to believe that they have collectively bottomed and is preparing itself for a sustainable bounce - as I will illustrate later in this commentary. And finally, the Dow Utilities - which, in a typical cycle, has historically been a leading market indicator of the broad market from 3 to 12 months - made a new record high as late as August 31st, thus officially extending the life of this cyclical bull market. Despite all this, however, we will continue to hold on to your 50% long position in our DJIA Timing System before there is more evidence of a sustainable rally going forward. I will provide more clarification on this in the introduction of this upcoming mid-week guest commentary.

If this weekend is just too hectic for you and you only have time for one article, I strongly urge you to read Ned Davis' interview on Smartmoney.com that was published late last week. In the article, Ned Davis discusses the history of election cycles and what those have historically meant for the stock market. While everyone and his neighbor should now be familiar with the so-called "four-year low" during the mid-term election cycle (such as 1990, 1994, 1998, and 2002), Mr. Davis suggests that the so-called "four-year low" has now reached a "comfy consensus," and since the stock market does not cater to the view of the majority, there is a good chance that this may be the year where we won't see such an easy repeat of history. In other words, there is a strong likelihood that the market has already bottomed in mid-August and is poised to continue to rally from now to the end of this year (such as what occurred in 1986). Interestingly, I have also been pounding the table on such a scenario occurring for the last few weeks. Subscribers who want a refresh should check out our archives that are available on the MarketThoughts.com website.

Another must-read is the weekly commentaries published by Mr. John Mauldin of Frontlinethoughts.com. In this weekend's commentary, he discussed the Dallas Fed's measure of inflation (called "Trimmed Mean PCE Inflation Rate") and why the underlying trend in this measure of inflation is bothering the Dallas Fed - perhaps leading to further rates hikes in the near future. The motivation for this mention was the August 30st speech made by Richard Fisher, the President and CEO of the Federal Reserve Bank of Dallas. Unfortunately, what Mr. Mauldin chose to not cover in his commentary is that Richard Fisher actually focused more on the "Taylor Rule" than the Trimmed Mean PCE Inflation Rate in deciding whether the Federal Reserve should raise the Fed Funds rate or not going forward (even though Richard Fisher does not have a vote on the FOMC Committee). Quoting from Mr. Fisher's speech:

In the simplest version of the Taylor rule, current inflation is the primary determinant of a central bank's policy actions. In the real world, policymakers look at many other indicators to gauge inflationary pressures before they show up in actual inflation rates. This makes sense, given the lags between policy actions and their ultimate effects on the economy--lags that economist Milton Friedman famously described as "long and variable."

Among the additional variables we look at are measures of capacity utilization of business operators and tightness in the labor market--for example, the unemployment rate. Strong job growth will lead to demands for higher pay. Many of you might wonder why that could ever be bad. Well, when it comes to workers' pay and benefits, it is not the increases themselves that cause concern. Problems occur when labor costs rise faster than gains in labor productivity. When that happens, firms often see shrinking profit margins, which add to pressure to raise product prices. What policymakers look at is unit labor costs, a measure of workers' pay adjusted for productivity.

Even if we cull out the misleading signals, the traditional data set may no longer be sufficient. At the Dallas Fed, we are exploring the notion that capacity measures must be extended beyond the domestic market. Today, we live in a world where goods, services, money, and the ideas and tasks performed by American businesses cross international borders with great ease. It stands to reason, then, that inflationary trends in any economy cannot be properly assessed without knowing how readily resources, inputs, finished products and capital from outside the country can be brought to bear. The Dallas Fed's globalization initiative is aimed at developing measures of these broader output gaps, which we hope will let us determine how the dramatic rise of China and India, for example, or the processing of tasks in cyberspace will impact inflation in the U.S.

In other words - in Richard Fisher's views - the Federal Reserve should also take into account whether China or India continues to have excess capacity and to thus export deflation, along with other countries like Japan, South Korea, Taiwan, and even Western Europe. As I have mentioned in my previous commentaries, China is still busy exporting deflation, and it has done so since over 12 months ago (China temporarily raised prices during 2004 and early 2005). Moreover, Japan has also continued to ramp up its capital spending (more than 15% year-over-year increases) and combined with a declining yen, you can bet that Japan is competing with China on a neck-to-neck basis in exporting consumer deflation all across the world. As for India, no doubt everyone and his neighbor already knows that the country is a deflationary force in terms of software and other "virtual services" such as technical support, etc., but what folks may not know is that places like India and Thailand are now becoming popular places for the outsourcing of medical services as well, such as surgeries and cosmetic services. Moreover, there is now a huge push by Wal-Mart, Walgreen, and CVS to open clinics across the U.S. to treat everyday ailments and write common prescriptions. These clinics will be run by nurse practitioners and physician assistants, and will also be a huge deflationary force on healthcare costs in the U.S. going forward. Given that healthcare costs have been one of the components with the highest inflation over the last five to six years, this (along with the outsourcing of medical services) will be welcome news for the Federal Reserve for most probably the rest of this decade.

The only worry for this author right now is the continuing high prices of commodities But with the price of crude oil experiencing a year-over-year decrease for the first time in many years, and with gasoline refining margins plunging from $20 a barrel to only $1 to $2 a barrel over the last four weeks - there is also not much to worry about on the energy front either. As of today, the only worry right now is the price of certain metals, as many of these base metals such as zinc, tin, copper, and lead, etc. have made serious attempts to challenge their all-time highs made earlier in May of this year - as illustrated by the below chart showing the daily price of the CRB Metals Index vs. its annual rate of change (ten-day smoothed) from January 1, 2002 to September 8, 2006:

Such a challenge, however, is not being confirmed by either the price of gold or silver. Moreover, as I have mentioned before, the year-over-year of copper imports into China for the first seven months of this year is down 23%, while copper demand from the U.S. should decline going forward given the huge glut of housing inventories on the market right now. Moreover, while automobile production has been the pillar of support for other base metals prices (such as tin and zinc), it is not obvious that global automobile demand will continue to hold up, especially given the current economic slowdown in the U.S. and the fact that the Japanese economy is still relatively weak. In fact, according to the OECD, the leading indicators for Japan has recently plunged to a level not seen since late 2001, as shown in the following chart:

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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