Dear Subscribers,

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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 149.30 points as of Friday at the close.

As I mentioned in several posts in our discussion forum over the last 5 days, I was fortunate enough to be invited to the American Funds Institutional Forum in downtown Los Angeles last Monday and Tuesday. The American Funds family is the largest mutual fund family (in terms of assets under management, ahead of Vanguard and Fidelity) and has one of the most accomplished investment track records over the last 40 to 50 years.

In terms of their outlook on the markets, they made three key points. While they maintain that they're long-term investors, many of their managers are now becoming worried about the domestic equity outlook, after having been strongly bullish for the last five years. Two reasons were cited: 1) A dramatically slowing economy over the next 6 to 9 months, accompanied by much greater uncertainty in the financial markets than they have seen over the last five years, and 2) they believe that no matter who gets elected in the next Presidential election, taxes will be raised, and historically, this has not been bullish for equities.

Another major key point is that they continue to be more bullish on international equities than they are with US equities, given that many emerging markets still have a lot of ground to make up in terms of both GDP per capita and market cap per capita. Until or unless they see another new technology paradigm favoring the US (such as the PC or internet revolution in the 1980s and 1990s, respectively), they will continue to be more bullish on international equities in general. They are also overweight Continental Europe ex UK, as valuations remain decent and as profits still have a lot of room to grow given the push for more reforms in the Euro Zone. They are also significantly underweight the UK, given its heavy dependence on the financial sector and the UK housing market.

The final key point is that they continue to be bullish on energy prices (they have been heavily invested in energy for the last few years). While alternative energy will one day have a significant impact on energy supply (whether it is solar, nuclear, etc), they believe that alternative energy investing is more hype than reality at the moment. Moreover, many energy companies are still not confident that high oil prices are here to stay, and therefore, they have continued to be cautious in R&D and exploration spending - thus putting a ceiling on higher supply going forward. American Funds has two oil analysts, and both of them continue to forecast higher crude oil prices over the next few years. One of those analysts believes that $200 a barrel sometime at the end of this decade is now highly possible.

Given our current 50% short position in our DJIA Timing System, we fundamentally agree with American Funds' cautious outlook over the next 6 to 9 months (subscribers can review our historical signals at the following link). In our October 7, 2007 commentary ("Global Economy Now Slowing Down"), I articulated our initial reasons for establishing a 50% short in our DJIA Timing System. Again, many of these reasons - with the exception of the continuing strength in both the Shanghai and the Hong Kong stock markets - are still valid. Even within the Hong Kong stock market (the strongest developed market during 3Q), the number of new highs made a peak early this year, and has been consistently making lower highs since. Within the U.S. stock market, we are still witnessing major divergences, including lower highs in the NYSE A/D line, the non-confirmation of the all-time highs in the Dow Industrials and the S&P 500 by the Dow Transports, Dow Utilities, the American Exchange Broker Dealer Index, and the Russell 2000 Index, as well as lower highs in both the NYSE and the Dow Industrials McClellan Oscillators. Moreover, even within the UK stock market - one of the most liquid and international exchanges in the world today - breadth has been consistently weakening, as shown by the following chart courtesy of Reuters EcoWin:

As can be seen in the above chart, the 21-day simple moving average of the London Stock Exchange's A/D line peaked back April and has been consistently making lower highs for the last 6 months. Moreover, nearly each major peak over the last 4 years in the FTSE 100 has also been accompanied by a non-confirmation of the 21 DMA in the LSE A/D line. Given that LSE breadth peaked out in April, and more importantly, given that it has been consistently making lower highs since February 2005, my guess is that equities on the London Stock Exchange is now due for a breather, especially given the market and the economy's leverage on the financial and housing sectors in the UK. Given that the London Stock Exchange is one of the biggest exchanges in the world in terms of market cap (with a market cap of over US$4 trillion), my guess is that any weakness in the London Stock Exchange will not bode well for the U.S. stock market either, especially companies within the U.S. financial sector.

As for the US market, most eyes are now on the Fed meetings on the 30th and the 31st. The Fed is expected to lower the Fed Funds rate by 25 basis points, with another 25 basis point cut at the next meeting on December 11th. However, while further cuts in the Fed Funds rate make good headlines, it is to be noted that the Fed still remains relatively tight by historical standards, as demonstrated by the abysmal growth in the St. Louis Adjusted Monetary Base (the only liquidity indicator that is directly controlled by the Fed) over the last six months. This was last mentioned in our July 15, 2007 commentary as part of our update on our MarketThoughts "Excess M" (MEM) indicator. Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:

1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and ultimately, fighting the Fed usually ends in tears more often than not.

2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks, hedge funds, private equity funds, and foreign central banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has stopped publishing M-3 statistics, this author has revised our MEM indicator accordingly. Instead of using M-3, we are now using a monetary indicator that most closely resembles the usefulness of M-3 - that is, a measurement that tries to capture the monetary indicators that inherently have the highest turnover/velocity in our economy. We went back and found one measurement that is very close - that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 that the Fed is still publishing on a weekly basis). That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator. Following is a weekly chart showing our "new: MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

Since our July 15th discussion revolving around our MEM indicator, it has continued to decline - signaling a further deterioration of prime liquidity vs. "secondary" liquidity. That is, while foreign investment banks, commercial banks, hedge funds, and private equity funds are still creating liquidity (although this is slowing down as well), the Federal Reserve itself has continued to restrain liquidity from the global financial system, despite a lower discount and Fed Funds rate since July 15th. This is evident by the dismal 2.0% growth (a rate that is below that of inflation) in the St. Louis Adjusted Monetary base over the last 12 months.

Another indicator of deteriorating liquidity is the blowout of credit spreads in the U.S. markets over the last few months. With the rally off the mid August lows, one would think that credit spreads have settled down since then, but that has not been the case. Following is a chart showing investment grade and high yield corporate spreads (option-adjusted) from January 2003 to the present, courtesy of Merrill Lynch:

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