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Tharp’s Thoughts

Market Update for December 5, 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 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

We have passed the rough part of the year (May through November) without a significant drop in the major averages.  And now is the time the pension money starts pouring into the stock market.  In fact, the mutual funds have lots of cash flowing in so that is part of the reason the stock market is going up in 2006.

There is also another reason for short term optimism in this secular bear market.  The Federal Reserve has not increased the discount rate since July 29^th 2006.  According to the 1-2-3 stock market model, when the Fed stays out of the way for six months, that indicator turns to green.  That will happen at the end of the year on December 29^th.  However, just to put things in perspective, look at the following bar chart of the discount rate changes over the last 25 years shown in Figure 1.  Notice that short term rates are as high as they have been in a long time.  They are higher than their peak in 2000, which may have partially triggered the bear market.  Also notice that the slow steady rise in rates that we’ve experienced recently is unprecedented.

However, the increase in the stock market must also be tempered by looking at the dollar.  The dollar index, against the world’s major currencies, now starts at 81.62.  It’s down nearly 5% and that’s under conditions in which money should be attracted to the U.S. dollar because it is being paid a fairly good interest rate.  In fact, when the Fed started to increase rates in early 2004, the dollar index was above 90.  Money should start to move into the dollar when interest rates start to rise.  But as the discount rate has risen from 0.75% to 6.25%, the dollar index has fallen steadily.  However, in December of 2003 when the discount rate was still 2%, the ten year bond was at 4.26% interest.  Today, with a discount rate at 6.25%, the ten year bond yields 4.425%.  In other words, we have a negative yield curve.  What does that tell you?

For those of you who have not yet read Safe Strategies for Financial Freedom, the US has had a fiat currency for thirty-five years since August 1971 when Nixon refused to back the dollar by gold.  At that time the federal government debt was $US 400 Billion. It has been a net international debtor for more than twenty-one years since March 1985 when federal government debt was just under $US 2 TRILLION. The present Bush Administration, now halfway through its second term, has already amassed nearly HALF of all Federal Government debt borrowed since 1787.  That should explain why the U.S. dollar has not gone up.

Figure 1: Changes to the Discount Rate since 1980

Now that the November elections are over, I’d expect that the real inflation data will begin to come up.  And, as you’ll see later in this update, data which looked deflationary last month are starting to look very inflationary. 

Next, let’s talk about the market making new highs.  During the bear market crash, the Dow Jones Industrials and the S&P 500 never retreated that much.  This is because most mutual funds were invested in them and they never sold them off.  They were quite happy to let their funds drop 20% or more during the market decline because that is what the major averages did.

Well, money is still pouring into pension funds (and thus mutual funds) and being invested in those two indices.  Consequently, it is not surprising that the DOW is making new highs.  But, ask yourself, what will happen when baby boomers start a net redemption of the retirement funds.  It won’t be pretty for the mutual funds or the major averages that they use as benchmarks.

Lastly, let me remind you that a secular bear market simply means that over the long term I expect valuations (i.e., PE ratios) to go down.  Below is a chart of PE ratios since the secular bear market began.  And I don’t expect this secular bear to be over until the PE ratio of stocks in the S&P 500 reach the single digit mark.  The PE ratio of the S&P 500 is currently estimated to be about 17.79, which is still above the historical average of 16.  And remember that secular bear markets (defined by decreasing PE ratios) do not end until those ratios are single digit numbers.

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

The Fed has stopped tightening, so are we still in Red Light Mode?  Yes, we are, but that could change on December 29^th if the market continues to rise as I explained earlier.

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., December 1st, 2006), so there is always a possibility of human error in our numbers.

The market is continuing to rise and it looks like the major averages could be up 10% or more by the end of the year.  If that happens, it’ll be interesting to compare the U.S. Market with the rest of the world for the same period.

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 use 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 2006, 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 once again shows that inflation is winning.  And, by the way, thanks for those of you who gave me the CRB data for September.  I think the CRB is one of the best measures of inflations and I’d like to show you a long-term chart of the monthly CRB.  Notice the great commodity boom of the 1970s, which ended in a hugely inflationary period.  And notice what’s happened to the index since the secular bear market started in 2000.

Part IV: Tracking the Dollar

The U.S. dollar is still looking weak.  It was relatively flat for about six months and then it started a major fall against the Euro which is still going on.  This is another reason that the Federal Reserve needs to keep rates high. 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%?