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February 15, 2008

Contrarian and Sentiment Indicators
by Henry To

(February 10, 2008)

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Dear Subscribers,

I want to begin our commentary by reviewing our 7 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 on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 447.87 points as of Friday at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 467.13 points as of Friday at the close.

Before we go on with our commentary, it is important to remember that ALL of our above signals - similar to the majority of our past signals - were initially met with wide skepticism and sometimes, even anger. For example, when we effectively went 100% long in late September 2006, we were met with emails and messages questioning why we would go long given the "impending four-year cycle low," "bearish looking charts," etc. This was again the case when we established a 50% short position in early October 2007. At that time, many folks were looking for a "blow off top" to end this bull market in light of the beginning of the Fed easing cycle. 225 basis points later, all the major equity market indices are lower than where they were in early October of last year. Today, the situation is no different. Many folks who missed the subprime crisis and its potential/current impact on the equity markets are now calling for more downside - not only in housing but in the equity markets as well. However, it is important to remember that - even if one can get the timing of the subprime/housing crisis correctly (and this is a big "if" not only for most retail investors, but for many Wall Street strategists and analysts as well), it does not translate to an automatic "tell" on the equity markets.

Henry, why do you say that? Doesn't a recession or a credit crisis automatically translate into a bear market for stocks?

As I have mentioned in our commentaries over the last several weeks, it is important to keep in mind that the latest bubble has been in U.S. housing and structured finance products that were related to U.S. housing. Undoubtedly, this can also be extended into residential (and some commercial) real estate in other parts of the world, such as the UK, France, Australia, Spain, India, and so forth. The point is: Unlike the late 1990s - when the bubble was centered on U.S. large cap growth stocks (technology as well as others like Home Depot, Wal-Mart, etc.), the current bubble was centered on something else. That means the "2000 to 2002 playbook," or following the path of the 2000 to 2002 bear market, at least when it comes to predicting the future path of U.S. equities, is non-sensical. More importantly, similar to the aftermath of the 1990s large cap growth bubble, the Fed is now utilizing monetary policy to target the subsequent economic weakness, as opposed to policies that directly address the housing bubble. We can argue the pro/cons and the effectiveness of this policy all day, but it is important to remember that: 1) In the tradition of the Greenspan Fed, the Bernanke Fed does not consider the "most likely" scenario when it comes to implementing policy, but a "worst-case scenario" that has a reasonable chance of occurring. Hence, in the midst of a credit crisis, the Fed will always accommodate market participants and will more often than not surprise by easing more than market participants expect; 2) To the extent that the Fed bails out market participants, its target is generally the average U.S. consumer, and not overstretched folks who bought houses and paid more than they can afford via exotic means. This has the effect of "cushioning" the U.S. economy without posing "moral hazard" problems or "socializing losses" further down the road. Most likely, this will also mean any "excess liquidity" will flow to asset classes that were generally not in bubble territory during the last few years (such as U.S. equities), similar to the performance of U.S. REITs during the 2000 to 2002 bear market in stocks (REITs rose 26.4%, 13.9%, and 3.8% during the 2000, 2001, and 2002 calendar years, respectively). While I am not predicting a 20% rise in U.S. equities in 2008, subscribers should keep in mind that U.S. equities (excluding energy and materials), as we have discussed many times before, are still one of the most undervalued asset classes in the world, especially compared to government bonds, commodities, and global REITs (one can still find some value in private real estate). Combined with the fact that the U.S. dollar is also very undervalued, especially relative to the Euro, British Pound, and Australian dollar, the global allure of U.S. equities will get stronger as global estate comes down in price and as the global economy starts to slow down. While the short-term is "anything goes," I would not be surprised if the Dow Industrials hits the 20,000 level in four to five years time (this translates to an 11 to 14% annualized return over the next four to five years, which in actuality, isn't that aggressive) as global capital rotates to U.S. equities going forward.

As far as the possible impact of a recession on U.S. equity prices, we had discussed this in last weekend's commentary ("Looking Beyond a Recession"). Specifically, if we follow the timeline of the late 1990 to early 1991 recession (which in many ways, is more comparable to today's economic environment than the 2001 recession), the Dow Industrials or the S&P 500 should bottom out during the first month of the first quarter that the U.S. experience negative GDP growth. Assuming we experience negative GDP growth during this quarter, and assuming that the U.S. only experiences a mild recession,, then the stock market, in all likelihood bottomed out in late January. This assertion is made all the more conceivable given that information travels much more quickly than it did in the pre-internet days of the early 1990s. If the U.S. does indeed experience a recession this year, it would definitely be the most anticipated recession in U.S. history.

Let us now take a look at a contrarian/sentiment indicator that we have discussed in the past - but which we have not updated as frequently for our readers. Newer readers may not know this, but the Conference Board's Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint. While it has always been significantly better in calling bottoms during a bear market, it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market - with one of its most successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90. During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points. More recently, the Consumer Confidence Index gave us a "strong buy" signal during October 2005, and foretold the beginning of a bear market with its "rounding top" during the first half of 2007. Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to January 2008:

The last time the Consumer Confidence Index gave us such an oversold reading was at the end of October 2005 - the Dow Industrials would go on to rally over 15% over the next 12 months. The fact that this reading is now at a similar level to that of the October 2005 (not to mention the October 2001 reading) suggests that subscribers who are still cautious should start to think about implementing long positions in the stock market, if they had not done so already. This signal is especially powerful given the once-in-a-decade/generation oversold readings that we saw in the stock market (as exemplified by the new 52-week high/low readings, the NYSE ARMS Index, % of stocks above their 200-day EMAs on both the NYSE and the NASDAQ, etc.) during late January.

Another sentiment indicator - the insider buy-to-sell ratio, most recently at 1.44 for the month of January - is now at its highest reading since 1994/1995 - immediately before the tremendous "bull run" we experienced during the late 1990s. Prior to 1994/1995, the only instances when we experienced similar (bullish) readings in the insider buy-to-sell ratio was late 1990 (right at the bottom of the late 1990 to early 1991 recession) and early 1988, or immediately after the October 1987 crash. Following is a chart, courtesy of Bloomberg, showing these instances as well as the amount of short interest on the NYSE:

Given the recent popularity of 120/20 and 130/30 funds, the recent spike in the NYSE short interest should be taken with a grain of salt - at least in terms of its predictable powers of the stock market going forward. However, one thing is undeniable: Company insiders have historically been "correct" on the future direction of the U.S. stock market when they have acted in such a bullish manner. Even with the aggressive company buyback programs over the last few years, company insiders have never bought this much shares relative to how much they are selling since 1995. Again, while the stock market can "do anything" over the next few months, I continue to be long-term bullish on the U.S. stock market, especially in selected companies within the consumer discretionary, financial, health care, and technology sectors.

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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