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Tharp's Thoughts Weekly Newsletter

February 06, 2008 — Issue #358
  
Article

Market Update for January 2008 by Van K. Tharp Ph.D.

Workshops

Singapore Workshops

Trading Tip

Uncertainty - The Ugliest Word in Trading and Investing – Part VI by D.R. Barton, Jr.

Melita's Corner

The Frog Genie by Melita Hunt

Feature

Tharp’s Thoughts

Market Update for January 2008

1-2-3 Model Is in Red Light Mode 

by Van K. Tharp Ph.D.

Look for these monthly updates in 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 four star inflation-deflation model, and we’ll be 4) tracking the dollar, and 5) the five strongest and weakest areas of the overall market.

Part I:  Market Commentary

The high in the market was on October 9, 2007, and at one point we had a 16% down movement, which is nearly a bear market.  And we’ve had two events -- the subprime crisis and the largest loss ever by a Rogue trader – which could have led to this decline.  Many banks have had to virtually write off all of their assets involving subprime mortgages and for many banks that amounts to losses that are several times their book value.

At the same time, we’ve had the Federal Reserve lowering interested rates a full 125 basis points.  This is a huge stimulation for the market and it’s put a temporary stop to the decline.  But is it enough or will the market resume its downtrend this month?

While I don’t know the answer, I’d like to remind everyone that we are in a secular bear market in which PE ratios go down and will continue to do so for some time.  If you haven’t read my article, Lies, Damned Lies, and Government Statistics, then I suggest that you do so.  Basically, the government has made major adjustments to the CPI .  For example, based upon how the CPI was calculated for many, many years, inflation last year was over 10%.  Furthermore, since the GDP has to grow more than the CPI , if you look at the real CPI figures, we’ve been in a recession since 2000 with the exception of one quarter in 2003. 

Last month, I showed that with real inflation and the decrease in the value of the dollar, you needed to make 20% on your investments just to break even.  Gold did this, and countries stock markets like China , India , and Brazil did much better.  However, even they are affected by the subprime crisis because when a lot of assets are suddenly worthless, other assets need to be sold to maintain some liquidity and, in my opinion, this is what the markets are facing right now.

Part II: The 1-2-3 Stock Market Model Is in RED LIGHT MODE and That’s Bad for Stocks

The 1-2-3 Model is in a clear red light mode and that’s not good for the stock market.  The Fed is not in the way and has actually started to lower interest rates.  That’s positive.  The market is acting poorly and the PE ratio of the S&P 500 is above 17, both of which are negative. Thus, we are 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 31st last year.  These data are given in the table below.

Weekly Changes for the Three Major Stock Indices

  Dow 30 S&P 500 NASDAQ 100
Date Close % Change Close %Change Close % Change
Close 04 10,783.01   1,211.12   1,621.12  
Close 05 10,717.50 -0.61% 1,248.29 3.07% 1,645.20 1.49%
Close 06 12,463.15 16.29% 1,418.30 13.62% 1,759.37 6.94%
Close 07 13,264.82 6.43% 1,468.36 3.53% 2,084.93 18.50%
4-Jan-08 12,800.18   1,411.63   1,963.52  
11-Jan-08 12,606.30 -1.51% 1,401.02 -0.75% 1,912.81 -2.58%
18-Jan-08 12,099.30 -4.02% 1,325.19 -5.41% 1,844.09 -3.59%
25-Jan-08 12,207.17 0.89% 1,330.61 0.41% 1,789.17 -2.98%
1-Feb-08 12,743.19 4.39% 1,395.42 4.87% 1,855.27 3.69%
Year to Date 12,743.19 -4.09% 1,395.42 -5.23% 1,855.27 -12.38%

Notice that market has returned to more normal volatility and that only the Fed intervention saved the last week from a major downturn.  

When we look at the strongest and weakest areas of the markets, it seems to be mostly commodities, with even the strongest country ETFs taking big hits.  As of January 30, the date of my last reliable internet connection while traveling, these are the figures for the five strongest and the five weakest components in the market. These can change daily, but the information will be accurate as of the publication of this update.  The relative strength of each component is given in parenthesis.

Five strongest components:

1)  Gold (97)

2)  Commodities (75)

3)  Oil (63)

4)  Corporate Bonds (61)

5)  Mexico (60)

Five weakest components:

1)  China (16)  -- hopefully you’ve sold your Chinese stocks.

2)  South Korea (21)

3)  NASDAQ (29) 

4)  India (29)

5)  Singapore (31)

Remember when the Chinese stock market led the list a few months ago?  Also notice that while Gold is very strong, gold stocks are not.  But I think this is due to the liquidity problem produced by the subprime crisis.

Incidentally, the Wall Street Journal reported that Standard and Poors has downgraded (or threatened to downgrade) more than 8,000 mortgage investments.  As a result, they are projecting mortgage securities losses totaling more than $265 billion. The market has been shell shocked by $100 billion in losses as big financial firms go through mortgage downgrades.  So imagine the impact of another $100 billion.   In my opinion, make sure you have some short positions.

Part III: Our Four Star Inflation-Deflation Model

As I’ve stated many times in these monthly updates, we are in an inflationary bear market.  The bear market is not necessarily reflected in prices, but in PE ratios.  PE ratios will continue in a downtrend even when the Dow makes new highs.  And the inflation is obvious, but simply masked by government statistics.  Okay, so now let’s look at the results for the last six months.  And remember that the Fed has now chosen to produce inflation and a strong dollar devaluation over the pain of the subprime crisis.

Date

CRB

XLB

Gold

XLF

Dec-05

347.89

30.28

513

31.67

Dec-06

394.89

34.84

635.5

36.7

 Jul-07

424.52

39.42

665.5

32.9

Aug-07

413.49

39.15

672

33.75

Sep-07

447.57

42.11

743

34.32

Oct-07

453.26

43.86

789.5

33.73

Nov-07

451.26

41.65

783.5

31

Dec-07

476.08

41.7

833.3

28.93

Jan-08

503.27

39.62

923.2

29.14

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

 

CRB2

CRB6

XLB2

XLB6

Gold2

Gold6

XLF2

XLF6

Total Score

 

Higher

Higher

Lower

Higher

Higher

Higher

Lower

Lower

 

 

+1

 

+1/2

 

+1

 

+1

+3.5

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 slightly.  Click here for more information on the model.

As of this writing, Gold is well over $900 per ounce and has hit all time highs.  However, these are not inflation adjusted all time highs.  The Gold market has a long way to go to reach that number, especially if you look at real inflation and not the fake government CPI statistics. By the real inflation numbers, Gold would have to climb above $6250 per ounce to reach a new high.

Similarly, the CRB has really shot up.  As a result, this is a time to be in commodities, and real assets such as precious metals, and top quality collectables such as rare stamps, which we’ve talked about previously in this newsletter.  There are also starting to be real estate bargains out there if you know where to look. 

Part IV: Tracking the Dollar

With the Federal Reserve lowering interest rates, I expect the dollar to really be weak now.  Who wants to buy treasury bills as the interest rate gets lower and lower?  So expect currency traders to start selling the dollar and moving to currencies that pay a better interest rate.  Look at the data in the chart because it really says it all.

Month 

Dollar Index 

Jan 05 

81.06 

Jan 06 

84.29 

Jan 07 

82.37 

 Feb 07 

82.07 

Mar 07 

81.23 

Apr 07

79.87

May 07

79.20

Jun 07

78.93

July 07

77.51

Aug 07

77.51

Sep 07

75.91

Oct 07

73.93

Nov 07

72.94

Dec 07

73.69

Jan 08

73.06

My current trip in Brazil gives me a good example of how weak the dollar is.  The dollar is now worth about 1.75 Brazilian Real.  It used to be way over 3 Real to the dollar.  Until next month’s update, this is Van Tharp.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

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Trading Tip

Uncertainty - The Ugliest Word in Trading and Investing – Part VI

by D.R. Barton, Jr.

“So what do we do? Anything. Something.  So long as we just don't sit there. If we screw it up, start over. Try something else. If we wait until we've satisfied all the uncertainties, it may be too late.”—Lee Iacocca

The phone company came to run the fiber optic cable to my house so that we could enjoy the wonders of light transmitted communication (yes, Seinfeld re-runs do look more life-like with fiber optics…).  Of course, they ran into the same problems that confront every crew doing field work – there is never a straight shot from the junction box to the house with no obstacles.

In our case, we have a willow tree at the corner of the house.  And so, when confronted with a big root sprawling out from the tree and blocking their path, the installation crew had to decide how to get from one side of the root to the other.  They could have brought out the equipment that uses compressed air to “blow” the cable under things like sidewalks and driveways.  Or, they could just take the easy path and cut through the root without a second thought as to how it would affect the tree's health.

Guess which option they chose…

In the first article in this series on uncertainty, I talked about how every profession has to deal with uncertainty.  This is clearly true for problem solvers like engineers, doctors and lawyers who have to survey the environment and react  to what they find there.  The same is true for construction contractors and anyone who does field work.  Nothing is ever built according to plan!

And when uncertainty rears its ugly head (or some manifestation of uncertainty), we have to make decisions on how to react.  Sometimes we can find an elegant solution, and sometimes roots get cut.

As traders and investors, when we deal with uncertainty, we do it on two broad fronts:  uncertainty that is built into price movement (a close cousin to volatility and variability) and uncertainty that comes from the outside environment (news and other events that move prices).

And we need different tools and mindsets to deal with the different types of uncertainty.

The volatility / variability type of uncertainty requires us to deal with day-to-day, even minute-to-minute machinations in price.  These can be repeatable and predictable, right up until the point where they act completely different than they have in the past.

The good news is that our tools for dealing with this “structural” uncertainty are pretty good and provide a useful roadmap for navigating within the world of volatility and variability.

On the flip side of the coin, we have uncertainties that show up out of thin air:  hurricanes devastate distilling plants and distribution stations, causing price shocks in crude oil and associated commodities.  Wars and other conflicts break out.  Finance ministers make bone-headed pronouncements at bone-headed times. Seemingly sound companies divulge accounting irregularities – or worse.

These types of unexpected events that cause huge price shocks are much more difficult for investors or traders to handle because they have some characteristics that are psychologically and statistically counter-intuitive.  For one, they happen much more often than we think they should.

Last week we talked about dealing with the impact of price shock news that we know is coming (things like Fed Funds announcements, earnings reports, etc.).  In the coming weeks we’ll delve into useful ways for traders and investors to deal with both structural uncertainty and unexpected price shocks.

We will continue to delve into uncertainty and look at quantifying it, ignoring it, transferring it and living with it.  And I would love to hear your stories on dealing with uncertainty.  If you’ve had an experience dealing with uncertainty that provided a great learning, a vexing question, or just a good belly laugh, please forward it to me:  “drbarton” at “iitm.com.  ” Let me know if I can use the story (either anonymously or credited) in a future article.

Great Trading!

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV,  and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

 

Melita's Inspirational Corner

The Frog Genie

by Melita Hunt

Last week I ended my article with a request that people write down ten things that you find great about yourself. How many of you took the time to do that? And how many of you actually did it every day for a week like I had suggested? I hazard to guess that most of you didn’t for one reason or another.

How do I know that? Because I did exactly the same thing. I forgot to continue to write down ten great things each day literally the day after I wrote it because I got so caught up in everything that I had to do this week. Sound familiar? And it is only in hindsight that I can see what a benefit it would have been to have done it and given myself a pat on the back a few times during this very busy week. Something so simple is so easy to forget. Therefore this week, I am going to put a reminder in my calendar to make sure I do it and I’ve also decided to do it at night because sleeping on nice thoughts will probably be an added bonus. I encourage you to do the same. When is the last time that you could honestly say that you gave yourself 70 compliments in a week?

So other than that idea, there isn’t a whole lot of inspirational “pow wow” oozing out of me this week. I am currently hooked up to IVs while undergoing treatment in Mexico and being true to my convictions (i.e., kind to myself) I have decided to keep things simple. I had planned ahead and decided that if I wasn’t up to writing I would just share a joke or something else that I had on hand instead.

So here is my joke of the week. Don’t cringe, just lighten up and have a laugh! 

The Frog Genie: 

A woman was golfing one day when she hit her ball into the woods. She went into the woods to look for it and found a frog in a trap. 

The frog said to her “If you release me from this trap, I will grant you three wishes.”

The woman freed the frog and the frog said “Thank you, but I failed to mention that there was a condition to your wishes. That whatever you wish for, your husband will get ten 10 times more or better!”

The woman said “That’s okay.” and she wished to be the most beautiful woman in the world. The frog warned her, “You do realize that this wish will also make your husband the most handsome man in the world, an Adonis that women will flock to.”

The woman replied, “That’s okay; I will be the most beautiful woman, so he will only have eyes for me.”

KAZAM – and for her second wish she chose to be the richest woman in the world. 

The frog said, “That will make your husband the richest man in the world and he will be ten times richer than you.”

The woman said, “That is okay; what is mine is his and what is his is mine.”
So, KAZAM, she’s the richest woman in the world!

The frog then inquired about her third wish and she answered:

“I’d like a really mild heart attack.”

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita’s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com.

You can contact Melita at mel@iitm.com

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