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Tharp’s Thoughts

Market Update for Period Ending September 1, 2006

1-2-3 Model Still in Red Light Mode

By
Van K. Tharp

Look for these monthly updates on the first issue of each month. This allows us to get the closing month’s data.  In these updates, we’ll be covering each of the major models mentioned in the Safe Strategies book:  1) the 1-2-3 stock market model; 2) the five week status on each of the major stock U.S. stock market indices; 3) our new four star inflation deflation model; and we’ll be 4) tracking the dollar.

Part I:  Market Commentary

Are we in a recession?  The CPI is now running at an annual rate of 4.1%, which is probably a low estimate.  The U.S. economy expanded by 5.9% in the first quarter, but that shrank to 2.9% in the second quarter.  That means that the economy expanded at a slower rate than inflation.  So doesn’t that mean we’re in a RECESSION?  I’ll leave the answer to that question to you.  However, the stock market doesn’t really show it, turning in a flat to slightly up month. 

Ironically, the Federal Reserve says that inflation may now be under control and is now worried about the “potential of a recession,” so it finally stopped raising interest rates.  It was probably too late to prevent the recession, based on the figures I just presented, but the U.S. government will probably not release any figures to suggest that we’re in a recession until after the November elections.  

Part II: The 1-2-3 Stock Market Model IS IN RED LIGHT MODE

Let’s look at what the market has done over the last five weeks and compare that with where the averages were December 31^st last year.  This is given in the next table. Incidentally, this data is calculated by hand based upon last Friday’s close (i.e., September 1st, 2006), so there is always a possibility of human error in our numbers.

Efficient stocks.  What’s the market telling me in terms of efficiency?  Here, the data is very interesting.  I now have a proprietary indicator of the entire market—its efficiency.  What percentage of the stocks that I screen show positive efficiency?  What percentage of the stocks that I screen show negative efficiency?  I’ve only been doing this for about six months so I don’t have much historical data.  Overall, the market has been moving wildly in terms of efficiency.  It was 80% positive efficiencies in February.  Two months ago it was as low as 37% positive, and right now it's 57% positive. 

Overall, last month was fairly positive.  We now have an overall positive efficiency rating of 57%.  There are currently 45 stocks with efficiencies above +10 and 41 stocks with efficiencies below –10.  I’ll talk more about efficiencies when I update our portfolio next week.

Part III: Our Four Star Inflation-Deflation Model

I now strongly believe that we are in an inflationary bear market and that our inflation rate is simply masked by government statistics.

So far our models have been telling us, that inflation/deflation is pretty steady, with a slight inflationary bias and that’s where secular bear markets tend to start.

So what’s our new indicator telling us about inflation?

1) The CRB Index

2) The Basic Materials Sector (XLB)

3) The London Price of Gold and

4) The Financial Sector (XLF)

Since the description of the model we’re now using is not in any of my books, I’ll continue to give it here.

1)  The CRB Index.  I believe that the CRB index is the one we have currently that is the least manipulated by the government.  But what’s the best way to measure it?  For consistency, I plan to give two measurements.

·        Is the CRB index higher than it was six months ago?  If it is, we are on track for inflation.

·        Is the CRB index higher than it was two months ago?

Now there are several ways to monitor these two indices.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for inflation.

·        And if both the two and six month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

2) The Basic Materials Sector ETF (XLB).  In an inflationary environment, basic materials will definitely go up and this sector, to the best of my knowledge, is not manipulated by the government.  Thus, we will use this sector to monitor inflation and we’ll use the same measurements used for the CRB.  (1) Is the XLB higher than it was six months ago?  (2) Is the XLB higher than it was two months ago?  These two measurements give us four possible results.

·        If both differences are higher, we’ll count one star for inflation.

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for inflation.

·        And if both the two and six month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

3) The London PM Gold price at the end of each month.  Although the government can manipulate gold, I still like to look at monthly gold prices.  However, to be consistent, we’ll use the same two measurements that we’ve used for the other indices that we are monitoring.  (1) Is the price higher than it was six months ago?  (2) Is the price higher than it was two months ago?  Again, these two measurements give us four possible results.

·        If both differences are higher, we’ll count one star for inflation.

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for inflation.

·        And if both the two and six-month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

4) The Fourth Measurement we’ll use is related to the Financial Sector of the S&P 500.

The financial sector (XLF) tends to do well when we have deflation and poorly when we have inflation.  Martin Pring, in fact, has used an index in which he divides the XLB by the XLF.  Since we already use the XLB, we’ll use the XLF by itself as well.  Again, we’ll use the change over six months and over two months.  However, the four possible outcomes with give us a different interpretation.

·        If both differences are higher, we’ll count one star for deflation (i.e., minus one for inflation). 

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for deflation (i.e., minus ½ for inflation). And if both the two and six month changes are lower, then we’ll be plus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be plus ½ star for inflation.  Obviously, the two minus scores will point to strong inflation.

Okay, so now let’s look at the results for the last six months.

We’ll now look at the two-month and six-month changes during 2005, to see what our readings have been.

The results of this model are much more sensitive (I believe) than the model I presented in Safe Strategies for Financial Freedom.

The model is now showing the increase in inflation with the CPI growing at a 4.9% annual rate.

Part IV: Tracking the Dollar

The U.S. dollar is still looking weak, although it’s relatively flat for the year and has a fairly low rate.  This is another reason why the Federal Reserve needs to continue to raise rates. When interest rates are high, people are attracted to the dollar.  But when rates are falling, they will dump it quickly.  The IMF has already said that the dollar, at current rates, is 35% overvalued.  Can you imagine the impact of the dollar falling another 35%?

What’s the impact of all of this?  I don’t really know except that it's part of the secular bear market that we are in and it’s part of the debt crisis that I’ve been talking about.  For a country to accumulate debt as significantly as we have, that country must have the world’s reserve currency.  And one implication is that, fairly shortly, the U.S. dollar will no longer have that status.  At that point, we’ll have a lot more problems selling our debt, which means T-bill and T-bond rates will probably go much higher.  And that could have an imploding effect on those who have a lot of debt.

I’m going to be traveling in Austra