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October 12, 2007

Global Economy Now Slowing Down
by Henry To

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 last Thursday (October 4, 2007) at 13,956, giving us a loss of 110 points as of Friday at the close.

As of Sunday evening on October 7th, we are 50% short in our DJIA Timing System (subscribers can review our historical signals at the following link). In our "Special Alert" last Thursday morning, we briefly discussed our reasons for going 50% short in our DJIA Timing System. I will briefly recap them here:

Continuing divergences among the major U.S. stock market indices - with none of them confirming the new recent all-time highs in the mega and large cap indices such as the Dow Industrials, the S&P 500, and the Russell Top 200 Index. Moreover, from a Dow Theory standpoint, we have continued to witness a significant amount of weakness in the Dow Transports since the rally off the mid-August lows. Even within the S&P 500 Index, only the larger names are outperforming. Case in point: Over the last three months, the total return (i.e. including dividends) of the S&P 500 Index is 2.03%. However, on an equal weighted basis, the S&P 500 Index is actually down 2.19% over the last three months.
The two major stock markets in the world with the most relative strength in the last few months - the Shanghai Stock Exchange and the Hong Kong Stock Exchange (the latter exemplified by the Hang Seng Index) is now losing significant strength. In fact, the latter index completed a huge one-day reversal in Wednesday's trading session. Moreover, aside from what I had just discussed in this morning's commentary on the Hang Seng, the number of new highs in Hong Kong actually topped out in late May - and has been consistently decreasing since that time. There is no question that the strongest stock markets in the world are now losing strength, and this will not bode well for the U.S. stock market going forward.
The recent strength in the U.S. Dollar - plus the fact that it is still significant oversold. Given that as much as 50% of earnings in the Dow Jones Industrials come from foreigners, there is a good chance that there will be a squeeze in the profits of the Dow Industrials' components over the next couple of quarters - should the USD Index continue to rally. This is significant, as any dollar rally against the Euro and the Yen will also mean a lower Chinese Renminbi - as the latter is pegged to a basket of the world's major currencies, including the USD.

Again, given the relatively weak rally (both in breadth and in volume) we have witnessed since the mid August lows, and given the non-confirmation of the rally by the major stock markets in Europe and in Japan, there is a good chance we could see a retest in the major indices before we see a sustainable bottom in the U.S. stock market. Also, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last six weeks, there is a good chance that the Dow Industrials could 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. Given that as much as 50% of profits within the Dow Industrials and the S&P 500 is derived from outside of the US, we would never have gone short within our DJIA Timing System if we had believed that profit growth from outside the US would "make up" for an earnings slowdown or decline within the US. In a way, this was what happened in the US during the second quarter, as virtually 100% of year-over-year profit growth came from outside of the US, while domestic earnings remained stagnant. The $64 billion quest now is: Given that US economic growth is set to continue to slow down over the next couple of quarters, will foreign earnings growth prove to be strong enough to offset any shortfall in earnings within the US?

Let us now try to answer this question by taking a look at the latest update of our "MarketThoughts Global Diffusion Index" (MGDI). We first featured the MGDI in our May 30, 2005 commentary - with our last update coming in our September 9, 2007 commentary. For our newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for the 25 countries in the Organization for Economic Co-operation and Development (OECD). Basically, the MGDI is an advance/decline line of the OECD leading indicators - smoothed using their respective three-month averages. More importantly, the MGDI has historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI on two occasions - first by incorporating the leading indicator for the Chinese economy, and second by dropping the one for Turkey. The first revision is obvious; as China is now the fourth largest economy in the world and actually has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth this year is expected to surpass that of the US). The second revision is less obvious. While Turkey is by no means a small or marginal country, many of the readings over the last six months have been very unreliable - and so we have chosen to drop Turkey in our MGDI instead. This is rather unfortunate, but it is better to omit certain data points than to incorporate unreliable data.

Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the CRB Index and the YoY% change in the Dow Jones Industrial Average from March 1990 to August 2007 (the September 2007 reading will be updated and available on the OECD website in early November). In addition, all four of these indicators have been smoothed using their three-month moving averages:

As we discussed in our February 25, 2007 commentary, "The strength of the MGDI is essential to keeping our U.S. economic slowdown scenario alive - as a slowing global economy in the midst of a U.S. economic slowdown can mean many negative feedback loops around the world's economies which could in turn induce a classic U.S. economic recession." Ominously, as the above graph suggests, global economic growth (OECD + China - Turkey) is now trending down - suggesting that the chances of a U.S. recession has just gotten a little bit higher (although we are still not looking for one at this stage). More importantly for now, a slowing global economy has nearly always meant a decline in commodity prices, and to a lesser extent, equity prices. Given that the consensus view is that commodities (and gold) will continue to rise going forward as the Fed cut rates, there is a now a good chance that the commodity markets could actually surprise us and turn down instead.

The deteriorating global economic growth is also being confirmed by the most recent weakness in base metal prices - a definite leading indicator of global economic growth given that much of the recent growth has been dependent on industrialization and infrastructure construction in countries like China, India, Brazil, Vietnam, United Arab Emirates - not to mention a real estate bubble in countries like the UK, Spain, France, Australia, and the US. Following is a daily chart showing the spot prices of selected base metals with a base value of 100 on January 1, 2003:

As mentioned on the above chart, copper and aluminum prices have most probably topped out in May 2006, while nickel made a significant top in May 2007 and tin in early August 2007. The only metal of consequence (a metal that is not shown is zinc - an essential ingredient of stainless steel - and which is down about a third from its November 2006 all-time highs) that is still making all-time highs is lead. Given the divergence of all other base metals, and given the continued weakness in silver prices, chances are that:

1) The up cycle in metal prices in general have topped or is in the midst of topping out;

2) Global economic growth will at least slowdown over the next several quarters, as base metal prices have been a great leading indicator of the current global economic cycle.

While the bulls would claim that the new highs in the Baltic Dry Index is still signaling immense growth, subscribers should keep in mind that the Baltic Dry Index is merely a coincident indicator of the global economy at best - as it is just a representation of spot shipping rates of dry, raw materials. That is, it is a representation of shipping rates for dry, raw materials that is being shipped right at this instant - raw materials that were bought as long as a few months ago, when prices were still high. The recent decline in base metal prices suggests that the Baltic Dry Index will also start to reverse and decline over the next several months. Moreover, a better leading indicator of global economic growth - container traffic within the Port of Los Angeles (the busiest port in the US) - is expected to be stagnant on a year-over-year basis for the rest of this year. Given that much of the container traffic within the Port of Los Angeles is in the form of finished goods, this is a much better leading indicator of US (and to a lesser extent, global) economic growth than the Baltic Dry Index.

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.