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The Most Vulnerable Sectors

Note: I pulled up the front page of CNN earlier today and came across a Times Magazine article discussing the possibility of a military draft, for the umpteenth time. For folks who are interested, Rod Powers at About.com has written a great article dispelling any possibility of a military draft for the foreseeable future.

Dear Subscribers,

For those who would like to do some additional reading on the financial markets during this week, I urge you to read a couple of very well-written articles by GaveKal during April and May of this year. In these articles, GaveKal reasserted why they were bullish on the world's stock markets, as well as the specific things that could derail their bullish views. Keep in mind, however, that the equity markets have continued to rally since those commentaries were published - and so while their secular stories do not change, that does not mean you should now jump into the markets in full force. For those who would like to read more of their research - I would highly recommend purchasing their book "The End Is Not Nigh" either on their website or on Amazon.com. Read this before you read the final book in the Harry Potter series!

Before we begin this commentary, I would like to let our subscribers know that we will be sending out a marketing piece sometime over the next week or so. This marketing piece will contain an update of our MarketThoughts discussion forum, as well as one of our recent commentaries in PDF format. This piece will go to both our current list of subscribers as well as those subscribers who were on our free mailing list prior to our transition to a subscription model (so for those who have been with us for a long time, you may actually get a duplicate email). While we usually don't like to bother our subscribers on this, please forward this upcoming marketing piece to whoever you believe may be interested in subscribing to our commentaries. As I have mentioned before, this is part of our effort in improving our services, as many of the global data vendors which I am currently evaluating involve substantial capital investments. Because of this, we would love to recruit as many new subscribers as possible over the next few months!

Let us know begin our commentary by providing update on our three 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.

As of Sunday evening on July 22nd, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). While it would have worked out well if we had continue to hold our long position since May 8th, we decided to exit our position at that time since there were many signs - including most of our valuation, sentiment, and liquidity indicators - that the rally was getting tired. We continue to stand by this position, given that:

  1. Liquidity within the world's financial markets is continuing to decline. Not only are the world's major central banks still on a tightening bias (China raised rates as late as last Friday and also slashed taxes on deposits in order to induce the public to leave their savings in their bank accounts) but both institutional investors and hedge funds are now cutting back their risks - as exemplified in the continuing "blowout" of subprime, CMBS, junk bond, and even emerging market spreads.

  2. Even as the Dow Industrials, the Dow Transports, and the S&P 500 made all-time highs last Thursday, the NYSE Common Stocks Only, the S&P 500, and the S&P 600 A/D lines all failed to surpass its all-time high - an all-time high that was made in early June, or more than seven weeks ago.

  3. The Yen carry trade is going to get more overstretched by the day, while the Swiss carry trade has most probably ended already. In other words, the Yen carry trade is now definitely one of the primary pillars or liquidity in the world today - so that any reversal in the Yen to the upside will most probably cause dramatic problems not only for the world's financial markets, but in funding private takeovers and infrastructure deals as well.

By the beginning of August, a secondary pillar of liquidity will also be removed - as insiders are typically not allowed to sell any shares during the two weeks (before and after) surrounding the reporting of its earnings numbers. Given that the flood of earnings reports is in the midst of peaking, this means starting in early to mid August, there is a strong likelihood that insider selling will flood the market, especially if the stock market continues to hold at current levels or rally into August. Should the stock market rally further this week, there is a high probability that we will then initiate a short position in our DJIA Timing System - given what we had just discussed regarding the continuing deterioration of general market liquidity.

Let us now discuss the main subject of our commentary. Over the last couple of weeks, several subscribers have asked us that - when/if we decide to go short via our DJIA Timing System - which sectors would we consider shorting if we have to choose. Before we discuss this and our reasons (note that whatever we discuss below should not be construed as a recommendation), let us now do a recap of how the various sectors within the S&P 500 have done over the last five years. Following is a table showing trailing performance for the Sector SPDRs of the S&P 500 over selected time periods in the last five years (note that performance highlighted in yellow means that the sector was one of the top four performing sectors during that selected time period). Also, note I have used the iShares DJ US Telecom ETF to represent the telecom services sector since there was no comparable SPDR ETF for this sector):

Trailing Returns for Select Sector SPDRs as of July 20, 2007

As one can easily see (and to no one's surprise), the energy sector has been - by far - the best-performing sector within the S&P 500 over the last five years and across all of the selected time periods (except for the one-year trailing time period, even though it still ranked in the top three). The next best performing sectors over the last five years were materials, telecom services, and utilities. However, over the last three months and since the beginning of this year, a significant portion of the strength has shifted to technology and to industrials.

However, despite the tremendous rallies we have seen in the energy, materials, and utilities sectors over the last five years, they collectively still only make up 22% of the S&P 500 on a market cap basis (following chart is courtesy of Goldman Sachs):

Sector composition of the S&P 500 by equity capitalization, 1974-2007

For comparison purposes, the financials sector alone makes up 21% of the S&P 500. Moreover, as a percentage of the S&P 500 market cap, the sectors that have shrunk over the last five years are health care and consumer staples. This also comes as no surprise - as these two sectors are regarded as "defensive sectors" and are thus expected to under perform during a strong bull market - just like what we have been witnessing (and on a global basis) over the last five years.

Let us now look at the sector composition of the S&P 500 from another perspective. That is, instead of breaking down the S&P 500 on a market cap basis, let us now break it down on a net income basis instead:

Net Income contribution by sector to the S&P 500, 1974-2007

Interestingly, as a percentage of market cap, the financials and energy sectors only make up 21% and 11%, respectively, even though the sectors contribute 28% and 15% of the S&P 500's total net income. This is expected, as both sectors' earnings tend to be relatively cyclical in nature. On the other hand, health care and information technology contribute significantly less on a net income basis, versus on a market cap basis. Again, this is to be expected, as 1) health care stocks tend to either be growth stocks (biotechnology, etc.) or have high barriers to entry (big pharma), and 2) technology stocks tend to be growth tocks. In other words, it makes sense for both the health care and technology sectors to possess higher P/Es.

One disparity that doesn't make too much sense, however, lies in the industrials sector. Indeed, on a market cap basis, the industrials sector makes up 11% of the S&P 500, even though on a net income basis, it only contributes 10% to the overall index. More importantly, the industrials sector - which consists of industries such as industrial conglomerates, aerospace & defense, transportation, construction and farm machinery, and industrial machinery - also tends to have relatively cyclical earnings. Given this, it is difficult to see how the industrials sector could maintain a P/E that is higher than the P/E of the S&P 500 going forward.

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