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January 09, 2008

Identifying Short and Long Term Trends for 2008 - Part II
by Henry To

(January 6, 2008)

Dear Subscribers,

It is great to be back in Los Angeles and in "full force" - as we try to tackle what I believe will be the toughest market environment in five years over the next 3 to 6 months. I hope all our subscribers had a great New Year's - don't forget to go back and skim over your New Year's Resolutions every now and then!

In Part I of this commentary, we discussed our 2008 domestic equity outlook, as well as more thoughts on both the US energy supply/demand and demographical issues going forward. There were three main themes in our domestic equity outlook: 1) We haven't seen the worst of the latest "credit crunch" just yet, and that interestingly, the whole episode continues to be a sad "slow motion train wreck" which has been well-documented in advance and probably preventable in retrospect. Denial, at this point, is still in full bloom; 2) Once the latest correction is over, we will see new leadership - within the US, this author is now looking for the health care, consumer staples, and to a lesser extent, technology to outperform going forward, and 3) I believe there will be a great buying opportunity sometime over the next six months - which will coincide with a kind of "capitulation low" that we haven't witnessed since March 2003.

In this commentary, I will expand on our themes and discuss the foreign equity markets as well as the U.S. Dollar Index. Before I do that, however, I want to 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 1,155.82 points as of Friday at the close.

A great way to start off with our discussion on the foreign equity markets is to first review our Global Overbought/Oversold model. Under normal circumstances, we usually use our monthly Global Overbought/Oversold Model as cues to either go long in a substantial way or cut back on long positions (overbought indicators are notoriously bad timing indicators), and this is what we are going to do in this instance. This model was first discussed in our August 2nd commentary. As we mentioned in that commentary, the inner workings of this global overbought/oversold "model" are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility. We also added the CRB Total Return Index since our August 2nd commentary. Following is our Global Overbought/Oversold Model as of the end of December 2007 (note that this does not take into account last Friday's global decline):

In Part I of this commentary, I discussed that Japanese small caps may be a buy at some point this year. This is confirmed by the oversold condition as implied by the Global Overbought/Oversold Model. Specifically, Japanese small caps are now oversold (below the 15th percentile, or approximately one standard deviation below the average) on both a 3-month and 6-month basis. A further decline in January would also put Japanese small caps into oversold territory on both a one and two-year basis - suggesting that it is now time to take a hard look at Japanese small caps. Another country to keep in mind is Ireland. It is now very oversold on a 3, 6, and 12-month basis. Moreover, the Irish financial system remains sound, and the weakness in its housing sector has gone on for longer than the US housing sector. From a valuation standpoint, Irish equities are now trading at a forward P/E not seen since the mid 1980s - when interest rates were nearly three times higher than today's. Within Ireland, my current pick is Allied Irish Bank ADR (AIB) - I will appreciate it if subscribers can send in any of their "Irish ideas."

As for the UK and most other European stock markets, I am still staying away from them at this point, given the fact that the ECB has their hands tied (labor unions are asking for significant pay raises in the middle of a global credit crunch) and given the overvalued Euro on a purchasing power parity basis. Moreover, while real housing prices in the US appreciated about 50% from 1997 to 2005, they actually rose significantly more in countries on the "Continent," with the UK seeing a 125%, Spain 120%, and France 80% appreciation during the same time period. Interestingly, while there are only about half a million excess homes in the US housing inventory, there are approximately one million in Spain alone. Coupled with rising wages and a Central Bank that is still hanging out to its tightening bias, there is no doubt that corporate profits in Western Europe should exhibit lower-than-expected growth this year.

As far as emerging markets goes, I believe the "decoupling" thesis is being strongly tested today - especially in light of the recent assassination of former Pakistani Prime Minster Benazir Bhutto, and the subsequent weakness in the Pakistani stock markets. At this point, the jury is still out, but I sincerely do not believe that emerging markets can effectively decouple from the weakness in the US stock market going forward, especially since the current weakness is being accompanied by a weakening Japanese, South Korean, and Western European economy.

Let us now discuss the U.S. Dollar Index. We last discussed the U.S. Dollar Index in our November 4, 2007 commentary ("The Various Bear Markets"). At the time, and subsequently in our commentaries and in our discussion forum, I had mentioned that a good buying point was only several weeks away. Now, I believe we will not see a good buying point until the February to March period at the earliest. I will get to the reason why in a second. For now, let us just take a look at a couple of indicators on the U.S. Dollar Index that I track on at least a weekly basis. One of the indicators is the growth in foreign reserves held in the custody of the Federal Reserve. While the growth in foreign reserves has decelerated over the last few months, it has continued to increase, signaling that there was still "too much U.S. Dollars" in the system. For readers who have not been with us for long, we first discussed the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index in our May 1, 2005 commentary. In that commentary, I stated:

Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.

Since our May 1, 2005 commentary, this inverse relationship has more or less has held. More importantly for us, the growth in foreign reserves has continued to slow down over the last couple of months, as evident by the following monthly chart showing the annual change in the U.S. Dollar Index. vs. the annual change in the rate of growth (second derivative) in foreign reserves:

Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that aside from the decline in the growth of foreign reserves, the U.S. Dollar Index has also been declining - meaning that the divergence between the rate of growth in foreign reserves and the decline of the U.S. Dollar Index is now getting rather "long in the tooth." Assuming that foreign reserve growth continues to slow down in the weeks ahead, and assuming that the U.S. Dollar Index remains weak, I believe the above chart will flash a "buy" on the U.S. Dollar Index sometime during the February to March period. We will update our readers once we get to a good buying point.

Another way to spot a good entry point on the U.S. Dollar Index is to keep track of its percentage deviation from its 200-day simple moving average. This is one of the major advantages of using an overbought/oversold indicator on a major currency - and especially the world's reserve currency - as major currencies usually do not gap up or down in a major way. That is, as along as there are no abnormal forces in the market place (such as Japanese housewives speculating on foreign currencies) - buying the dollar index when it is oversold (e.g. when it is trading at 5% below its 200-day moving average) has usually been a profitable endeavor, as long as one is not heavily leveraged. Following is a daily chart showing the U.S. Dollar index and its percentage deviation from it 200 DMA from December 1985 to the present:

As mentioned on the above chart, the U.S. Dollar Index closed at 4.81% below its 200 DMA last Friday. While - by this measure - the U.S. Dollar is now oversold relative to readings over the 2 ½ years, there have been cases over the last ten years when the U.S. dollar has gotten more oversold, such as during October 1998, July 2002, May 2003, January 2004, December 2004, or for that matter, just two months ago on November 30, 2007 - when the U.S. Dollar Index declined to as low as 8% to 10% below its 200 DMA. While the U.S. Dollar Index does not need to decline to 8% to 10% below its 200 DMA before I will go long, I would prefer to see the U.S. Dollar Index to make a lower low (below the 73 level) before going long - as well as accompanied by a greater divergence in the rate of annual growth in foreign reserves held in the custody of the Federal Reserve.

As far as the February to March timeframe goes, I believe that will be the time when the majority of investors start to discount a US recession - while at the same time, continue to discount decent growth for the Euro Zone, and perhaps the UK as well. This will also be the timeframe when the European Central Bank starts to realize that they will need to slash rates - and quickly - in order to avert a recession in the Euro Zone. As far as the UK is concerned, it is definitely way behind the curve (just like the Northern Rock "rescue") in terms of its easing campaign - by the time this is all over, we may actually see the Bank of England easing more aggressively than the Fed, given that its economy is way more leveraged to the financial and housing sector, versus the US economy. Subscribers please stay tuned.

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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