Dear Subscribers,

Now that Guidant has accepted Johnson & Johnson's acquisition offer of $24.2 billion, is it time to take a hard look at Boston Scientific? One of my concerns about investing in Boston Scientific had been that it may be overpaying for Guidant - and while BSX can still come back with a higher bid next week, my guess is that this is not very likely to happen. While its trailing P/E of 36 would scare any value investor away, readers should keep in mind that the calculation of this P/E consists of many non-recurring charges. The forward P/E of slightly over 13 gives investors a better picture of BSX's true valuation. Given that Boston Scientific is one of the better companies in the healthcare/medical devices field (an industry which this author likes in both the short and the long-run) - it is definitely a company to keep track of in the weeks ahead.

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. As of Sunday, January 15th, this market is now becoming very overbought. Readers who have not gone long should refrain from entering the market at this point - especially in light of the fact that we are only two weeks away from the January 31st Fed meeting and in the beginning of earnings reporting season. Our position on the DJIA does not change from last week. Should the market continue to rally into the January 31st Fed meeting (our target is the 11,200 to 11,300 level), there is a good chance we will go 50% short in our DJIA Timing System (our maximum allowable short position) sometime in the next few weeks. Like we have mentioned before, history suggests that the stock market tends to underperform (on average) during the year after the peak in short-term interest rates compared to the year leading up to the peak in short-term interest rates. That is, if history holds true and if the Fed stops hiking right after the January 31st or the March 28th meeting, then the performance of the S&P 500 in 2006 should end up faring worse than 2005. This should not come as a surprise, as the Fed has historically tended to stop hiking only after the economy is showing signs of a slowdown. For now, we remain completely neutral in our DJIA Timing System.

One of our themes for 2006 is "getting back to the basics." In other words, all our predictive models and sentiment indicators are fine - but ultimately, our mission is not only to help our readers make outsized returns in the stock market - but to do that in the least stressful way and in to help our readers in their financial educations and to keep tabs on upcoming economic and social trends. Over the long-run, having a basic idea of where the global and U.S. economy is heading and which individual industries and stocks to invest (or to avoid) is the key to long-term success.

So what are you saying, Henry? Are you saying that you won't give us a week-to-week run-down of sentiment indicators anymore?

No, that is not the case at all. Over the last two years, our most popular sentiment indicators (such as the AAII, Investors Intelligence, and the Market Vane's Bullish Consensus) have been immensely useful in helping us navigate this range-bound market. But while these indicators (just like other overbought/oversold indicators such as the NYSE ARMS Index, the equity put/call ratio, etc.) can be very useful in timing entry points for individual stock purchases - it is essential to keep in mind that the key to long-term success in the stock market is to selectively purchase undervalued equities (whatever your metrics may be) and to hold them for the long-run. Moreover, there have been many periods in the stock market when using overbought/oversold indicators to call tops/bottoms just plainly did not work, such as during sustained bear markets and the great bull market of the late 1990s. In other words, this author is not going to kid himself - and I want to let our readers know now: There will come a time when tracking the sentiment indicators on a consistent basis will be a fruitless task.

Look - the greatest investor in the world did not make his fortune by trying to forecast where the markets are heading next year. Nor did he ever try to "outwit" the stock market by getting out of stocks ahead of everyone else just because he thought the stock market was getting overbought or because he foresaw a recession ahead of time. No, Warren Buffett did all this by sticking to the basics - by studying companies and their businesses - and buying their stocks when their share prices were undervalued or when the general market sold off. The only time he liquidated his entire portfolio was in 1969 - and that was only because he could not find any undervalued stocks to buy at that time. Sure, Buffett made other plays as well, such as equity arbitrage during the 1980s and buying junk bonds in 2002 - but those were mainly one-time plays (during those times when he actually took advantage of extreme investors' sentiment or inefficiencies in the financial markets). At the core, Buffett remains a value investor. More importantly, he also tried to make sure that all the businesses that he owns are run as efficiently and as low-cost as possible.

And this is the second part of our "getting back to the basics" theme that we want to touch on further. In other words, it is not sufficient to be a good stock-picker or good investor (note that being a good investor also means knowing which stocks or industries to avoid). It is also not sufficient to "merely" be able to pick the right career for yourself or hoping your kids will pick the right careers for themselves. Being able to do well financially in the long-run basically means that you need to have some kind or organization when it comes to running your own finances or your family's finances. A company cannot be successful if all it can do is increase its revenues without controlling its costs. Studies have shown that the profession with the least ability to retire comfortably is doctors. Now, that is definitely saying something.

Now that we have that out of the way, I want to reiterate that our mid-cycle slowdown scenario remains in play for 2006. How this will affect the S&P 500 specifically, however, I am not going to say - but it is important to keep in mind what I have previously mentioned. At this stage of the bull market, a mid-cycle slowdown will affect the most cyclical industries - along with the industries that have witnessed the most speculation. Going into 2006 and 2007, this author is bearish on (in no particular order) energy (including natural gas), homebuilding, steel, copper, precious metals, along with emerging market stocks. Remember, it is crucial to keep in mind that avoiding the worst stocks is as important (if not more important) than finding the right stocks to invest in. Such a mid-cycle slowdown may or may not lead to a general sell-off in the non-cyclical shares of the S&P 500 - stocks such as WMT, MSFT, DELL, KO, C, MCD, IBM, HPQ, AMGN, and so forth. In fact, history suggests that anytime we have a peak in short-term interest rates, industries such as financials, healthcare, and consumer discretionary tend to outperform the market significantly.

It is also important to keep in mind that some of the large cap brand names such as KO, BUD, WMT, etc., are now trading at valuations not seen in over ten years. While we may not be at an optimal buying point yet - given all the risks that I see in 2006 which I outlined in last weekend's commentary - we are definitely getting pretty close. Case in point: At the beginning of 2005, Berkshire Hathaway was sitting on $43 billion of cash - equivalent to 46% of shareholders' equity - which is historically unprecedented for Warren Buffett unless you go back to 1969 when he liquidated all his portfolio holdings and returned all the money to his shareholders. During the first three quarters of 2005, Buffett actually found some equities to buy, including a $900 million stake in WMT, a $2 billion stake in BUD, and additional stakes in Wells Fargo as well as a stake in a European liquor company called Diageo PLC. All in all, Berkshire Hathaway spent $5.7 billion on equities in the first three quarters of 2005. Should the market suffer a general sell-off sometime in 2006, then there could be a huge buying opportunity in large cap, brand name stocks.

But Henry, isn't the S&P 500 still trading at a historically high valuation as indicated by the P/E and price-to-dividend ratios? Yes, and that is why it is so important to look at specific individual stocks and asset classes. Readers who have kept track with our commentaries should know that this author is a cautious optimist at heart. While I have outlined and acknowledged the significant amount of economic risks that we should experience in 2006, I am also optimistic that any subsequent market sell-off will lead to a buying opportunity in many of the large cap, brand name stocks that I like. As I have outlined in many of our previous commentaries, not only have domestic investors been shunning U.S. large cap stocks since 2000, international investors have been doing the same as well - even as large cap stocks in Europe and most of Asia continued to rally in 2005. At the same time, equities and mutual funds held by U.S. households as a percentage of their total assets is now at a low (excluding the 2002 and early 2003 bear market bottom) not seen since the second quarter of 1995, as shown by the following chart:

Please note that as of the end of the third quarter of 2005, the percentage of household assets that are invested in equities "only" stood at 15.34% - approximately 0.9% above the 50-year historical mean of 15.43%. While this percentage could of course decline further, it is important to keep in mind that as a percentage of market capitalization, the U.S. large cap, brand name stocks have been declining on a relative basis since 2000 - relative to mid caps, small caps, and international equities in general. Moreover, much of the rise in the market in the past couple of years could be attributed to the rise in cyclical stocks such as energy, steel, and precious metals. Case in point: Six of the top ten best-performing stocks in the S&P during 2005 are in the energy sector. Bottom line: Unless investors believe U.S. households are entering a prolonged period of balance sheet recession, any general market sell-off this year could lead to a huge buying opportunity for some of the large cap, brand name companies.

And while the expected decline in mortgage equity withdrawal could be significant (as I have discussed in our January 2nd ad hoc commentary), it is important to keep in mind that while a significant amount of mortgage equity withdrawal have directly gone into consumer spending over the last few years (as much as one-half to two-thirds), general consumer credit growth over the same period had also declined significantly - as exemplified by the following monthly chart showing the annualized growth of consumer credit (both on a revolving and non-revolving basis) from January 1989 to November 2005:

More importantly, it should be noted that consumer credit growth has been less than nominal GDP growth since the middle of 2002. This has two immediate implications:

1. A significant number of households have been using their mortgage equity withdrawals to pay down their debts - especially debts that have historically had the highest carrying costs (e.g. revolving debt such as credit card debt).

2. Given that 70% of American households did not experience a boom in housing prices and given that 30% of households still do not own their own homes, this lackluster growth in consumer credit suggests that many households have been "saving for a rainy day" in the aftermath of the March to November 2001 recession and the stock market crash of March 2000 to October 2002.

In other words, any upcoming decline in Mortgage Equity Withdrawal on GDP growth may be muted simply because U.S. households - in recent years - have improved their balance sheets and should subsequently have a better ability to take on debt in order to support consumer spending going forward. This is a major reason why this author is only calling for a mid-cycle slowdown sometime in 2006; and not a major recession.

But Henry, isn't the savings rate in negative territory right now?

Good catch; but as always, what you see in economic statistics is not usually what you get. According to the Federal Reserve's Flow of Funds data, U.S. households' net worth has continued to grow, and is now at a level much higher than it was at the previous peak in 2000. Moreover, Americans contributed approximately $650 billion into savings products in 2005. Money market assets also grew from $4.9 trillion to $5.3 trillion in the same year. And all this in the face of historically high oil and natural gas prices!

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