Sunday, January 03, 2010

The Year in Review and outlook for 2010

The year in review and a look forward to 2010

At the end of each year I like to take a look back at what transpired and use that information to look ahead to give me an idea as to what we might expect in the following year.

The past year was one of the most challenging years for the markets in history. It has been a roller coaster ride that has not been for the faint of heart (as the chart below shows).

Click on all charts to enlarge:

SPX 2009 daily:

The year started out with a 26% decline from the beginning of Jan to the March lows. It then reversed into a screaming ascent upwards that took literally everyone (with very few exceptions) totally by surprise.

The volatility was unprecedented and left the investment community in 2 distinct groups:

-those who underestimated the strength of the rally and were left scrambling to catch up from the March bottoms (including myself), and

-those who continued with a bearish stance throughout the year and either stayed in cash or attempted to short each rise in the market. Those investors have been hurt both in opportunity cost (if in cash) and direct cost (if short the market).

While I rely mostly upon technical analysis in my work, I do keep an eye on economic fundamentals as well. It is obvious (in hindsight) that the U.S. Federal Reserve’s unprecedented capital infusions (in coordination with the U.S. Treasury issue of government debt) lit a fire under the world’s stock markets over the past 9 months.

For those who are campers (or have built a fire in a fireplace), I equate what has happened to-date as like trying to light a campfire with gasoline. I’m sure at some point we all have put a pile of wood together, poured gasoline over the logs, and then lit the match. The corresponding “whoosh” and short lived flame is a wonder to see. Suddenly you go from nothing to huge flames and great amounts of heat.

The problem is if the wood is wet or if it is not cut small enough to allow the flames to take hold, very quickly the fire burns out once the gasoline has been burned off. The only way to get that fire going again is to either continue pouring more gasoline on it until finally it catches (dangerous) or the more correct way would be to pull the logs apart, cut them into smaller kindling, build a proper “fire structure” such as a tee pee with newspaper and small amounts of combustible material in the middle, and then gradually start adding larger wood to the fire once the initial kindling has truly caught fire and is self-sustaining.

The advantage to this is obvious as in the long run you have a sustainable fire that burns as long as you want to keep stoking it with additional wood; the disadvantage is your kids are sitting there impatiently asking you why it is taking so long for the fire to start! They like to see the “whoosh” fire with the gasoline but they have no idea how unsustainable it is.

This is where we are currently at in the worlds markets. We’ve seen the “whoosh” with the gasoline the Fed as poured on the fire; we now are waiting to see whether those flames take hold and the fire truly starts to self-sustain or whether this whole thing will burn out quickly and the Fed will need to either add more gasoline or go back to the beginning and rebuild the fire the way it should have been done in the first place.

As I see things going forward into 2010, I think the key points to watch are:

-the level of U.S. debt and their ability to continue to "borrow" their way to recovery,

-the U.S. housing market and its influence upon the banks in the U.S.,

-the U.S. unemployment situation, and

-the "Chinese miracle" and whether it is both real and sustainable.

U.S. Debt Levels:

The key question we are faced with is whether this entire stimulus that has been thrown into the system will lead to a sustainable recovery. My analysis suggests in the end it can’t given simple mathematics, interest compounding and the ever growing size of the U.S. government’s debt obligations.

Many more bullish pundits have suggested this last recession is no different then previous recessions. In each of the past recessions since the 1960’s, fiscal stimulus and credit expansion injected into the American economy (debt) has ultimately resulted in renewed business activity (GDP increase) due to consumer spending.

The key is this increased consumer spending is solely the result of increased credit availability and increased debt levels taken on by consumers over the past 60 years in an attempt to “live the American dream” (note the “American dream” has now become McMansions, 2 BMW’s in the driveway and a plasma TV in just about every room in the house).

It is staggering to think that currently in the U.S. 70% of GDP relies on the U.S. consumer and his/her ability to spend. In order to sustain GDP growth the U.S. must have a consumer who spends. However, the consumers ability to spend depends solely upon either income or credit. Think about that as you read further.

Here are some interesting charts I found the other day (from the Market Ticker blog forum) showing the total cumulative debt outstanding in the U.S. from the 1950’s to present:

Cumulative debt 1950's

Cumulative debt 1960's

Cumulative debt 1970's

Cumulative debt 1980's

Cumulative debt 1990's

Cumulative debt 2000's

Note the nice upward sloping lines for each decade since 1950 until the last graph. The last graph is the key.

Up until now it can be seen that every recession over the past 60 years was countered with increasing levels of U.S. debt. It can be seen in the last graph that total debt has begun to reduce for the 1st time in 60 years.

During the last “recovery” from the 2000-2003 recession it took 21 Trillion USD in debt (an expansion of 66%) to fuel the 2003-2007 recovery. The fuel to power out of the “tech wreck” recession was not fuelled by fundamentals, organic increases in GDP through exports or anything else. It was fuelled by nothing other than debt.

To get the U.S. out of the current recession would take a similar amount of debt (an expansion of 66% or an additional 35 Trillion USD in debt) to fuel a similar “recovery” to that which occurred in 2003-2007. That is not what is happening given the last chart above; debt is contracting.

It is apparent to me that the U.S. has reached a "debt saturation" level. Going forward it will not be able to increase debt levels at the rate it needs to sustain "debt recoveries" from recessions as it has in the past. This time it is truly different.

With this in mind, it is interesting to see how the 2 main "players" in this event (the consumer and the government) have functioned over the past year:

Total Government Debt outstanding:

Total Consumer Credit outstanding:

As can be seen, consumer credit has fallen off a cliff and government debt has stepped in to attempt to fill the gap. I do not need to tell you how significant these changes are; you simply need to look at the charts.

It is a well documented fact the foreign governments have all but ceased to purchase U.S. debt since late in 2009. Over the past 6 months it has been the U.S. government (acting through the actions of the U.S. Fed by printing money) who has been purchasing the majority of new debt issues by themselves (the U.S. government through the U.S. Treasury) and then swapping those “good” government debt assets with the banks (taking the toxic garbage the banks are still holding on their balance sheets (CDO’s, MBE’s,etc) and exchanging them for government bonds). To me it is obvious this is a well run money laundering Ponzi scheme that is due to self destruct at some point in the future. It really is as unbelievable as it sounds.

Having said the above, an interested fact is over the years the degree to which debt has been able to create a corresponding reaction upon GDP has diminished over the years. In other words, it takes higher and higher levels of debt to provide the same effect upon GDP output (as seen in the following chart):

Diminishing Debt to GDP returns since 1960:

At some point this whole thing comes to an end. That point is shown as "Zero hour" on the chart and is the point at which each dollar of debt adds ZERO to GDP. That is the debt saturation point and the point at which the entire game comes to an end (as it did in the late 1920's with the Great Depression). The linear point at which this was due to occur was 2015.

The next chart is an update on this data calculated by a well known market blogger who obtained the data from recent U.S. government statistics (he gets his data straight from the Treasury and BEA). I cannot vouch for its accuracy but, if it is accurate, it paints a truly scary picture going forward.

The author, Christopher Rupe, tracks this information by the quarter and charts it on a spread sheet. According to his data, during the third quarter one dollar of debt produced NEGATIVE 15 cents worth of goods and services. If this is the case, we are already past the ZERO hour on the above chart.

Updated Debt to GDP returns:

If this is correct, adding debt now subtracts from the economy more than it offers - that's debt saturation. And if this is the case, a deflationary depression is on the way.

U.S. Housing Market:

There has been some optimism expressed by analysts that the U.S. housing market might be in the early stages of recovery. I do not think anything could be further from the truth:

Case-Shiller Home Price Index:

A quote from the most recent data release:

New York, December 29, 2009 – Data through October 2009, released today by Standard & Poor’s for its S&P/Case-Shiller Home Price Indices, the leading measure of U.S. home prices, show that the annual rate of decline of the 10-City and 20-City Composites improved compared to last month’s reading. This marks approximately nine months of improved readings in these statistics, beginning in early 2009.

The chart above depicts the annual returns of the 10-City and 20-City Composite Home Price Indices, declining 6.4% and7.3%, respectively, in October compared to the same month last year.All 20 metro areas and both Composites showed an improvement in the annual rates of decline with October’s readings compared to September.

“The turn-around in home prices seen in the Spring and Summer has faded with only seven of the 20 cities seeing month-to-month gains, although all 20 continue to show improvements on a year-over-year basis. All in all, this report should be described as flat.” says David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s.

“Coming after a series of solid gains, these data are likely to spark worries that home prices are about to take a second dip. Before jumping to conclusions, recognize that the one time that happened at the beginning of the 1980s, Fed policy saw dramatic reversals, which is very different from the stable and consistent Fed policy we have today. Further, sales of existing homes – those included in the S&P/Case-Shiller Home Price Indices – have been very strong in recent months, working off the inventories of houses for sale. At the same time, housing starts remain weak, fears that the market will be swamped by a wave of foreclosures are heard and government programs aimed at the housing market will expire in the first half of 2010".

I think this "glass half full" mentality towards the U.S. housing market is misplaced. Note prices are still falling at an annualized rate of approximately 7%.

Now look at the mortgage reset chart I have presented previous:

Note where we are in the chart......the eye of the hurricane. Is it any wonder according to the above quote "this marks approximately nine months of improved readings in these statistics, beginning in early 2009" when you look at this chart. Note 9 months ago was EXACTLY the end of the 1st wave of the mortgage reset cycle.

We are right at the cusp of the 2nd leg of this mortgage fiasco. The coming tsunami of foreclosures have the potential to destroy what is left of the fragile banking system. Do you think the reason why the banks have not been lending the past year has anything other than to do with this chart? They know it is coming and they are battening down the hatches and hoping to survive this next wave. I think this is reflected in their stock prices and needs to be kept in mind when reading all the "all is good" news out there currently.

U.S. Unemployment

The U.S. unemployment rate has continued to climb throughout 2009. At the end of the year the U3 unemployment rate stood at 10% with the U6 rate (unemployed + those who are “underemployed” in part time positions while looking for full time work) at 17%. This means that almost 1/5 of the U.S. workforce is essentially unemployed.

On the bright side it must be noted the December non farm payrolls number showed a significant reduction in the number of jobs lost as per the following:

US unemployment rate eases to 10%

The US unemployment rate fell in November to 10% from 10.2% in October, Labor Department figures show.

Employers in November cut the lowest number of jobs since the recession began in December 2007.

In all, 11,000 jobs went over the month. That was far fewer than the 130,000 expected by most analysts.

President Barack Obama said the figures were "good news", but warned that there were "more bumps in the road to economic recovery".

"There is a lot more to do before we can celebrate... good trends don't pay the rent," he said.

For an economy the size of the US, the change was so small that the Labor Department described employment as "essentially unchanged".

In further good news for the US economy, factory orders rose by 0.6% in October, Commerce Department figures showed. Analysts had expected orders to remain unchanged.

The good data pushed the dollar higher against major currencies.

'Much-needed progress'

Payrolls have fallen every month for almost two years, but this year, the pace of decline has slowed sharply.

Revised figures for October also showed an improving trend. Originally, official estimates said 190,000 jobs were lost, that was revised down to 111,000.

The White House spokesman, Robert Gibbs, said the sharp slowdown in job losses showed "much-needed progress", but added that the Obama administration was still looking at providing help to the labor market.

More than 15 million Americans are out of work, twice the number at the start of the recession. Mr Gibbs said they were looking at the prospects for using remaining financial bail-out funds to help create employment.

Four sectors added jobs in November, the Labor Department figures showed: professional and business services, education and health, temporary help employment and the government itself.

Suffering sectors

Although the unemployment rate has risen for almost two years solid, the rate of increase has been dropping throughout the year.

However, there are still some sectors that are seeing substantial job losses. Construction is still suffering, with 27,000 jobs lost over the month.

Manufacturing is another area badly hit. It saw payrolls shrink by 41,000 between October and November.

There was a mixed reaction to the better-than-expected figures. Some saw it as simply a rogue month.

"Today's US employment report for the month of November was surprisingly good, but we believe it is a blip," said Jason Schenker, president of Prestige Economics. "The worst is not behind us - at least not for the job market."

Peter Morici, professor at the Smith School of Business at University of Maryland, said the fall in the unemployment rate was more to do with people leaving the workforce in frustration than people actually finding work.

He added that, considering the level of government stimulus, more jobs should have been created.

But others, although taken by surprise, thought the figure might signal a turning point.

"These numbers are almost too good to be true. Having said that, they
are consistent with the weekly decline in initial unemployment claims," said Tom
Sowanick, chief investment officer of the Omnivest Group.

"There's a 193,000 net improvement in jobs for the month. Average weekly hours worked [are] also up which is good for consumption spending. These are eye-popping numbers."
The question that remains unanswered is whether November’s numbers were a “one off” event or the start of a recovery. In any case, it is important to note that the U.S. requires approximately 150,000 jobs to be created monthly in order to keep up with population expansion due to births vs. deaths and immigration.

Until we see JOB GROWTH at these levels (+150,000/month) you will continue to see consumers retrench in their spending:

Record 20 million collect US unemployment checks in '09

WASHINGTON: A record 20 million-plus Americans collected unemployment benefits at some point in 2009, a year that ended with the jobless rate at 10 percent.
As the pace of layoffs slows, the number of new applicants visiting unemployment offices has been on the decline in recent months.

But limited hiring means the ranks of the long-term unemployed continues to grow, with more than 5.8 million people out of work for more than six months.
The number of new claims for jobless benefits dropped last week to 432,000, the Labor Department said Thursday, down sharply from its late March peak of 674,000.
The decline signals that the economy could begin adding a small number of jobs in January, several economists said.

Still, hiring is unlikely to be strong enough to quickly bring down the unemployment rate, which fell from 10.2 percent in October to 10 percent in November.
December's rate will be announced Jan. 8.

Companies will remain cautious about adding staff until they are confident the economic recovery is sustainable - something they remain unsure about as consumers and businesses keep a lid on spending, and as the government begins to wind down various stimulus programs.

The Federal Reserve and private economists expect joblessness to stay above 9 percent through the end of 2010.

The slow pace of hiring will force Congress and the Obama administration in 2010 to spend as much as $70 billion to extend jobless aid for the long-term unemployed, or else let benefits _ which were extended several times in 2009 - expire for millions of people.

"Fewer people are getting fired, but nobody is finding a job," said Dan Greenhaus, chief economic strategist at Miller Tabak.

Thursday's report illustrates the two different trends: first-time jobless claims are falling as layoffs ease, but the total number of people collecting unemployment checks is still rising.

More than 10.1 million people collected jobless benefits in the week of Dec. 12, the latest data available.

That's up by about 200,000 compared with the previous week.
That figure includes 5.3 million people receiving the 26 weeks of aid customarily provided by the states, and 4.8 million people that have shifted to the extended benefit programs enacted by Congress over the past two years and paid for by the federal government.

Unemployment insurance averages about $300 per week.

But the extensions are set to expire in February.

That could mean as many as 1 million people would run out of unemployment aid in March, according to the National Employment Law Project, a nonprofit group.
The total number of people who at one point collected benefits in 2009 - roughly 20.7 million - is also a record.

A larger proportion of the unemployed received jobless benefits in the last steep recession in 1981-82, but the work force has grown by about one-third since then.
Fifteen million Americans are out of work, an increase of 3.8 million since the start of 2009.

There are six unemployed people, on average, for each available job. And the so-called underemployment rate, counting part-time workers who want full-time jobs and laid-off workers who have given up their job hunt, stands at 17.2 percent.

Budget-strapped state governments will struggle with higher spending on unemployment insurance in 2010.

States are required to set aside money in a trust fund to pay jobless benefits, but 25 have already run through their funds and have borrowed $26 billion from the federal government.

The Labor Department has projected that 40 states may need to borrow as much as $90 billion by 2012.

Thirty-five states have already increased the unemployment insurance taxes they levy on employers for 2010, according to the National Association of State Workforce Agencies.

Some are also cutting benefits as they try to reduce the size of budget shortfalls that are expected to reach $180 billion in the coming fiscal year.

The drain on federal and state finances could force Congress to consider raising the federal unemployment insurance tax, which is currently 0.8 percent on the first $7,000 of wages, or making other changes. - AP

The statistics are sobering:

“There are six unemployed people, on average, for each available job”.

In my mind the math is simple:

-No jobs = no consumer spending (either via salary or credit)
-no consumer spending = no GDP growth
-no GDP growth = no recovery
-no recovery = no sustained stock market advance

The China Story

If there is one area where most pundits place most of their faith in further worldwide economic expansion, it is China. The common thesis that China will take over from the U.S. and provide the economic leadership to move the world through a possible depression is intriguing.

While the numbers that come out of China are certainly impressive, it must be noted that when you look at China GDP figures they are calculated different from either the U.S. or Europe.

In the U.S. the headline number is the real (inflation adjusted) quarterly change, seasonally adjusted at an annual rate (SAAR). In Britain and the EU, the headline GDP number is the real quarterly change, but it is not the annual rate. So a 1.5% decline in the U.K. is about the same as a 6% decline (SAAR) in the U.S.

China reports the year-over-year change in real GDP for the quarter, so the 6.8% GDP for Q4 recently reported includes the changes in Q1 through Q3 too.

As Roubini noted:

The Chinese came out today with their 6.8% estimate of Q4 2008 growth. China publishes its quarterly GDP figure on a year over year basis, differently from the U.S. and most other countries that publish their GDP growth figure on a quarter on quarter annualized seasonally adjusted (SAAR) basis.

When growth is slowing down sharply the Chinese way to measure GDP is highly misleading as quarter on quarter growth may be negative while the year over year figure is positive and high because of the momentum of the previous quarters’ positive growth.

Indeed if one were to convert the 6.8% y-o-y figure in the more standard quarter over quarter annualized figure Chinese growth in Q4 would be close to zero if not negative.

As can be seen, the GDP data that comes out of China can be misleading given the methodology they use to calculate it. Using yearly “averaged” data smoothes over weak quarters and hides potential declines in growth that may have occurred over a given quarter.

In addition, it is interesting to note that China bases its GDP calculation upon including a “product” in their calculation when that product is produced; not when it is sold as is done in the U.S. and Europe. As such, it is possible for them to show continued GDP growth (based upon production) when there might not be demand for the products they are producing. Evidence of this is the growing supply of empty townhouses and apartments accumulating in smaller cities outside the main population centers in China.

How far does that go? Who can say? The Chinese are not exactly models of transparency so the degree of game-playing they can get away with before someone yells "FIRE!" and runs for the door (along with everyone else) is more difficult to discern than it is in more developed countries.
It is something that needs to be watched closely.

Stock Markets

Below is the 2009 performance returns for the S&P 500 Index (SPX), the Dow Jones World Index (DJW) and the U.S. dollar index (USD):

2009 performance (31 Dec 2008 close-31 Dec 2009 close):

S&P 500 Index: +23.5%
Dow Jones World Index: +32.0%
U.S. dollar: -4.0%

Price change off 2009 extreme (bottom for stock indexes, top in the case of the USD):

S&P 500 Index: +67.2% from 06 Mar 09 bottom
Dow Jones World Index: +74.3% from 09 Mar 09 bottom
U.S. dollar: -12.6% from 09 Mar 09 top

As can be seen, it was an extraordinary year in the markets. We went from a “falling off a cliff without a bottom in sight” situation to a “meteoric rise with no top in sight” situation.

The current euphoria in the markets has me worried we have come WAY TO FAR-WAY TOO FAST. I think for 2010 the key will be to participate in the markets with a very firm eye on the exit.

As always, I will start with a top-down view of the SPX (click on all charts to enlarge):

SPX monthly chart:

As most subscribers know, I rely upon 2 medium-to-long term charts to govern the majority of my longer term investment decisions. Those charts are the monthly and weekly charts.

The monthly SPX chart turned bullish at the end of July, 2009 when price closed on a monthly closing basis above the 12 month simple moving average (12 mSMA, shown as the blue line on the chart) along with the various technical indications I have annotated on the chart.

As can be seen on the chart, this indicator has an excellent record over the past 10 years in defining longer term bull and bear markets. It works extremely well in “normal” market conditions but, given the extraordinary liquidity injected into the markets, this chart was not able to adjust quickly enough to catch much of the meteoric rise off the March, 2009 bottom.

Having said that, it returned 12.9% rate of return from the signal date (31 July 2009) to the end of 2009.

The chart is still bullish and will remain so until price closes on a monthly closing basis below the 12 mSMA (currently at 948.52 and rising).

SPX weekly chart:

The second of my medium to long term charts is the weekly chart. I use this chart in 2 different ways.

First, within the Emirates Provident fund, I use the 13 week (13 wEMA) and 34 week (34 wEMA) exponential moving averages (blue and red lines on the chart) to indicate when it is safe to be invested in equities within the Provident fund.

When the 13 wEMA crosses above the 34 wEMA it signals a new bull market has begun. Conversely when the 13 wEMA crosses below the 34 wEMA this signals a new bear market has begun. It was this bearish 13/34 cross that signaled me to move to cash in the provident fund in late Dec, 2007.

Normally this indicator is quite accurate but, like the monthly chart previous, the extreme market volatility the past year led to a later than desired signal and therefore much of the advance from the March, 2009 bottoms was missed.

It signaled a buy signal near the same levels as the monthly chart and therefore delivered a similar performance.

The second way I use this chart is in my personal trading account. As mentioned previous, I commit only the minimum required to the EK provident fund and manage my own funds within the ECAM Asset Allocation Fund (details of which I have blogged previous).

Since I am able to move in and out of equity positions much quicker within the ECAM fund than within the Provident fund (which can lag up to several weeks), I am able to shorten up the indicators to give me more “intermediate” rather than “long” term signals.

The chart gave a bullish buy signal Apr 03, 2009 on a weekly closing price of 842.50. In 2009 it delivered a return of 32%.

As of the end of 2009 the chart remains bullish. I have spoken previous about the critical point we are at in this chart:

-on the bottom trend line of the bearish rising wedge,
-at the 50% Fibonacci retracement level of 1121.44,
-at the downtrend line from the 2007 top, and
-at the area of the last line of strong volumetric resistance at 1120

It is the confluence of these various technical indications that has held price in such a tight range the past few months. It is impossible to predict which way things might go therefore it is extremely important to be watchful of market action over the next few weeks and the 1st month of 2010. I think that “tell” will be the indication as to which way we go throughout the rest of the year.

SPX Point and Figure chart:

The Point and Figure chart is one I like to use due to the lack of "noise" it generates. It is unique as it is one of the few technical charts that relies only upon price (and not time) in determining buy and sell signals.

The chart last turned bullish in July on a price print of 935 and has remained bullish thoughout the remainder of 2009.

The current price objective on the chart (determined by the structure of the chart pattern) is calculated to be 1295. I do not use this as a "hard and fast" rule but use it in determining the degree to which we may have yet to run in any given move.

The PNF chart is still bullish.

SPX daily from March, 2009 bottom:

This chart from the March, 2009 bottom to date shows the well established rising bearish wedge along with the volumetric support/resistance levels over the past 9 months.

A bearish rising wedge is one of the more reliable technical patterns that form on daily charts. Theoretically should price break below the lower trend line the price target would be back to where the bearish wedge began (666.79).

While it is unwise to make long term investment decisions based upon price patterns, they need to be watched closely as many times they do work out "textbook".

Needless to say I am watching this pattern closely.

SPX 6 month daily:

The 6 month daily chart remains bullish. Price broke above the 1120 level and the bull flag pattern 5 trading days ago but this was done on extremely low volume. This to me is very unconvincing as all significant breakouts of support/resistance levels MUST be supported by volume to confirm the move. As there was essentially no volume on the break, there is no reason to believe it was a true breakout.

There are 2 possible scenarios going forward:

1) the price breakout was real and the low volume was stricly a function of the time of year when most traders were on holiday vacation and unable to participate. If so price should consolidate at present levels before the next rise to the bull flag target of 1197, or

2) the price break was a false break and once the major players return to work in early 2010 they use this elevated price to short the market. If so this could be the start of a major market decline.

Any break below 1080 (with volume) will be bearish. Alternately, if there is a decline back into the flag and subsequent rally above 1120 (with volume) will be bullish. Irrespective of direction, a break of these key levels with volume support will point to the trend over the next month. We need to wait and watch.

SPX 60 minute:

A 60 minute chart showing how important the 1080 and 1120 levels are. It is extremely unusual for the markets to be stuck in such a tight trading range for such a lengthy period of time. We can expect when these levels are violated (once all market participants are back next week) there may be some "fireworks".

I round out my update with a chart that brings us back to fundamentals; the CAPE ratio.

The CAPE was originally developed by Benjamin Graham (reknown value investor and mentor to Warren Buffet) and has been used by various analysts since then; the most notable proponent has been Professor Robert Shiller of Yale University (of Case-Shiller fame above).

The "Cycle Adjusted Price Earnings ratio" considers the average inflation adjusted earnings of a company over the last 10 years. This smooths out the fluctuations in earnings that occur from one year to the next, while still giving a sense of how high or low the price of a particular stock is.

EPS can be calculated using last year’s earnings or the projected earnings for the next year. This is the reason the term "earnings" is so contentious; every analyst has his/her own take on what inputs to use in coming up with fare value EPS.

CAPE takes the average earnings of the last ten years and adjusts it for inflation: this smooths out the fluctuations in earnings due to booms and busts, which occur from one year to another. As such, it is one of the few fundamental tools I use in assessing whether a market is undervalued, fair valued or overvalued.

CAPE & q chart:

As of Dec 10, 2009 (SPX @ 1102) the CAPE is showing the SPX to be OVERVALUED by 48%. This is not a market that is cheap; this is a market based upon true (unbiased and unaltered, no bullshit valuations) that can be considered to be expensive.

These are not the times you want to enter a market based upon fundamentals thinking all is well. Until we see a CAPE at 15 or are expensive.

A look forward to 2010

It is common this time of year to prognosticate about the year going forward. Market “guru” predictions have a nasty habit of being consistently wrong so I caution those who read “advice” from those who espouse their ability to “predict” the market to do so with a very large grain of salt. I do not claim to have any such powers.

Having said the above, I will give you my basic ideas as to what to look for in 2010.

As I have mentioned previous, we are within some interesting market cycles (search for the "Cycles" blog previous if necessary). The two that I believe could have the greatest impact upon investments in 2010 are the 10 year Decennial Cycle and the 4 year Presidential Cycle.

The 10 Year Decennial Cycle:

The 10 year decennial cycle was 1st revealed by Ned Davis Research many years ago. The theory is that years ending with 1 and 2 have the lowest returns; years ending with and 5, 8 or a 9, the highest returns:

10 Year Decennial Pattern:

As can be seen, if the pattern repeats (as the data for the past 130 suggests), the years ending in "0" tend to have the worst performance of any year of a given decade.

Using the above historical data, we can project a possible course for the Dow Jones Industrial Average as follows:

DJIA Decennial Pattern projection:

The 4 Year Presidential Cycle

The second important cycle is the 4 year stock cycle; often referred to as the "Presidential Election Cycle".

This the best "general" forecasting tool I'm aware of. Regardless of the state of the economy, this four-year cycle does contain useful information. Many theories have been put forth to try and explain it. Some say it is due to the presidential cycle, some that it is due to the business cycle, some to astrology or other esoteric phenomena. While the reasons are up for grabs the results are quite clear.

4 Year Presidential Cycle General:

You can see that the market runs into a wall in the year after an election, and stays flat through most of the mid-term election year (Nov 2010 is the midterm elections).

The theory is that the incumbent president tries to make the economy look great for Election Day, and everything goes to hell shortly afterward.

The actual returns on the Dow Jones Industrial Average using this theory are shown below (data was based on the market’s total return (dividends included) from 1926 through 2005):

4 Year Presidential Cycle DJIA actual returns:

If history repeats, we would expect to see a weak market into the fall of 2010 with a market low in October. From that point there should be a 15-month "power zone" which starts just before the mid-term elections.

Normally, the "power zone" is preceded by a healthy market correction or the end of a multi-year bear market. It seems that investors get pretty nervous from June to October before the mid-term elections. The third quarter of the mid-term election year has been the worst quarter in the cycle. The Dow has lost a total of 3500 points during this quarter since 1900.

Once we get past this weak period, we hit the "power zone", the best historical time to be in the markets.

This five-quarter period (the last quarter of the 2nd year of a presidential cycle to the top at the end of Dec the following year) hasn't been down since 1931, averaging just under 30% total return for the Dow Industrials over the past 79 years. During this period, the market's return has been about four times greater than average. This "power zone" starts October 1, 2010 and would end December 31, 2011.

Of course, this 4 year cycle theory doesn’t have a perfect track record. But it is a damn good one. Out of the last 27 four year full 4 year cycles, only 5 of them have not worked "as advertised" (and there has not been a single failure to advance during the "power zone" as mentioned above). As such, they are a great tool to keep in mind when investing in the stock markets.

To sum it up:

Year two (2010) of the 4 year presidential election cycle contains the worst of times (for most of the year) and the beginning of the best times (near the end of the year). Based on historical performance, I'd bet on a flat market to declining market through the 1st half of 2010 with a hefty market decline from June to October, a bottom at that point, and then a strong year-end rally well into the end of the year.

Since 2010 is the worst year of the 1o year cycle, this Oct-Dec rise would not negate the earlier market weakness and 2010 would end up being a "losing" year. However, if you are in cash until the 2010 bottom, it would be expected the period from the last quarter of 2010 to the end of 2011 would provide very good market gains.

Irrespective of the above, I will continue to use my technical indicators to guide the way forward. As of today I remain 50% equities/50% cash in the Emirates Provident Fund and 100% invested in the ECAM Asset Allocation Fund.

The best of the season to you all and successful investing in 2010.

Dwayne Malone

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