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November 21, 2007

Should We Even Pay Attention to Financial Stocks?
by Henry To

(November 18, 2007)

Dear Subscribers,

Note: Please participate in our latest poll. The question is: What is the probability of a US recession in the near future? According to the premier futures prediction market, intrade.com, the probability of the US entering a recession sometime next year is now even at 50%. As always, comments are welcome.

Also, for those who are thinking of buying the homebuilders at some point (even for a bounce), I urge you to read our latest conversations on the homebuilders in our discussion forum.

First of all, while I would be writing a mid-commentary this Thursday morning, I would like to wish our US subscribers in advance a great Thanksgiving. While US stock market activity is usually muted during the days revolving around Thanksgiving, I would not be surprised if we see more action than usual this week - given the recent volatility and "dislocations" in the financial markets. Let's face it - if I was a hedge fund manager or prop trader, I would certainly be paying attention to my Bloomberg terminal at my vacation house in the Hamptons, all the while cooking or frying my Thanksgiving turkey.

Also, while I will certainly be paying attention to the markets throughout the week, I would not be writing a "full-blown" commentary next weekend. Rather, I would be writing an "ad hoc" commentary instead next Monday evening, as in all likelihood, there would not be much significant market action during the Friday after Thanksgiving Day anyway. Things have been quite hectic for my lately, so I am going to take a short break. Rest assured, I will come back stronger than ever during December and into 2008.

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 779.21 points as of Friday at the close.

As of Sunday evening, November 18th, we remain 50% short in our DJIA Timing System. In last weekend's commentary, I stated: "Aside from the NYSE McClellan Summation Index, the NYSE ARMS Index, and the S&P 500's percentage deviation from its 200-day moving average, many of our technical indicators are now approaching a "fully oversold" status. However, subscribers should keep in mind that during the midst of a panic, stock prices tend to experience their greatest declines towards the end of the panic (the most extreme case was October 19, 1987, when the Dow Industrials declined 22.6% (even though the market had already reached a highly oversold level the previous Friday), and would ultimately decline a further 7% on October 20th before reversing to close 6% higher than the previous day's close."

We continue to stand by the above statement. While the NYSE McClellan Summation Index has gotten more oversold since last weekend, Tuesday's tremendous rally has rendered some of our other indicators less oversold than where they were last weekend, including the NYSE ARMS Index and the S&P 500's percentage deviation from its 200-day moving average. However, given our quick gains in our short position in our DJIA Timing System over the last few weeks, and given the current oversold conditions in the stock market, my current goal (which we initially discussed last week) is still to cover our short position in our DJIA Timing System should one of the following two conditions be met over the next few days:

1. An intraday decline in the Dow Industrials of more than 400 points;

2. An intraday NYSE ARMS Index reading of 2.5 or higher.

Should we decide to cover our 50% short position in our DJIA Timing System (to essentially go neutral), we will, as always, send a real-time email to our subscribers informing you of such a decision. Note that the two previous conditions are merely "guide posts" at this point, and should not be construed as "set in stone." The shift in our position will not be official until an actual email goes out.

Before we go on to the "gist" of our commentary and discuss the financial sector, I would like update our "MarketThoughts Global Diffusion Index" (MGDI) - which we last discussed in our October 7, 2007 commentary ("Global Economy Now Slowing Down"). As we discussed in that 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 in 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. However, as we discussed in our October 7, 2007 commentary, there was a strong chance that much of the world's economy was slowing down as well, as implied by our MGDI indicator. If that was the case, then chances were that earnings expectations for many US companies would be coming down for the foreseeable future as well.

So what are the latest readings telling us? To recap, we first featured the MGDI in our May 30, 2005 commentary - with our last two updates coming in our September 9, 2007 and October 7, 2007 commentaries. 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 September 2007 (the October 2007 reading will be updated and available on the OECD website in early December). 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) has continued to decline since our last update on October 7, 2007 - suggesting that the chances of a U.S. recession has again risen (intrade.com is now predicting a 50% chance of a US recession sometime next year). More specifically, the latest readings witnessed a wide dispersion in slowing economic growth among the OECD countries. E.g. the year-over-year change in the OECD leading indicators in Germany, Luxembourg, and Spain turned negative for the first time, while the year-over-year change in the Japanese leading indicator plunged from -3.7% to -6.6% from August to September. Even in South Korea - a country which has seen its stock market rise by 35% on a year-to-date basis - the year-over-year change in the OECD leading indicator declined from 6.2% in August to a mere 1.6% in September.

The weakness in the Euro Zone in particular (France's year-over-year change turned negative in August, and Italy's readings have been negative since August 2006) is not too surprising, given the tight monetary policy of the European Central Bank, as indicated by the Bank Credit Analyst's Monetary Conditions Index shown in the below chart:

As shown in the above chart, the Euro Zone's monetary policy - combined with its high exchange rate - is now the tightest in years and putting the brakes on the Euro Zone's economy in a dramatic way. Given that many central banks in Asia are still in tightening mode (such as the People's Bank of China and the Bank of Korea), my guess is that global economic growth will continue to slow down going forward.

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 over the next 3 to 6 months. For us to become more bullish on commodity prices, both the Bank of England and the European Central Bank will need to change their policy stances - with the former easing as early as December and the latter at least shifting from a neutral to an easing bias. Given the turmoil in the financial markets, and given the high dependence of the banking sector in the UK, I would not be surprised if this occurs - but my guess is that commodity prices will still need to correct from current levels before they can make a sustainable move higher. We will see.

Let us now get to "the gist" of our commentary. In previous commentaries and posts on our discussion forum, I had discussed the usefulness of both the Philadelphia Bank Index and the American Exchange Broker/Dealer Index as a leading indicator for the overall stock market (the S&P 500). This is particularly true in the cyclical bull market that began in October 2002, as much of it revolved around a bull market in U.S. financial stocks - in particular the bull market in the hedge fund, structured finance, private equity, and homebuilding industries. For example, if one had simply been tracking the AMEX Broker/Dealer Index over the last 18 months, one could've gotten ample "warning" and sold out prior to all the significant corrections over the last 18 months. The following daily chart showing the AMEX Broker/Dealer Index and its relative strength vs. the S&P 500, courtesy of Decisionpoint.com, illustrates this perfectly:

What isn't obvious, however, is the $64 billion question for those who are looking to go long: Does the financial sector or the AMEX Broker/Dealer Index also lead the S&P 500 on the way up? For example, immediately after the May 10 to June 15, 2006 correction, the relative strength of the XBD vs. the S&P 500 vacillated in a 2 ½ month trading range to early September, before finally breaking through in mid September. However, as many of our subscribers should recall, the S&P 500 had already bottomed in mid June (with a successful retest in mid July) - and ultimately retrace its entire decline by mid September. The relative strength of the XBD was a coincident indicator at best.

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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