Research + Forecast USA Corporate Profits, Dow Jones Index

NOVEMBER 28, 2008 RECOMMENDATION: S T A Y I N

We recommend to stay invested in the Dow Jones Industrial Average Index (DJIA) until the next quarterly update at the end of March 2009.

Review of the past 3 months

The Third Quarter’s 2008 US NIPA Corporate Profits announced in November 2008 by the USA Government at www.bea.gov Table 6.16.D fell 1% due to the weaker Financial Sector. The Non-Financial Sector Corporate Profits rose strongly by 6.1%.

Dow Jones, S&P500 and all global markets crashed during October 2008 and I am sorry that our Index did not avoid it. Our Australian Subscribers would be cushioned by a 30% appreciation of the American Vs Australian Dollar. Events like that show importance of prudent leverage and risk management at all times.

Our Index was only partly right avoiding the first 6 months of the bear market from October 2007 till March 08; then gave well timed Buy signal in March 08 which was followed by a two months recovery but then the bottom fell off the market. Why?

There have been many crashes, typically occurring during our “Out Periods”, but this is different in two aspects:

1. The unprecedented high level of leverage in the financial system mainly due to unregulated derivatives and structured products based on low quality assets such as subprime mortgages, and

2. Prolonged uncertainty over the depth of the unhedged exposure.

The stock market psychology just could not withstand the continuous stream of bad news with no end in sight. Major financial institutions collapsed one after another in a domino effect. Every time when investors thought it was over, thanks to a swift intervention by a Central Bank or a Government, a new even bigger problem surfaced requiring yet another even bigger rescue. The News page at www.BusinessCycleInvestor.com/news.htm has a chronology of the events.

The financial intermediaries who normally just create market and facilitate transactions became highly leveraged investors. They tried to hedge the bets, but it became too big and complex and hard to liquidate when the tide turned against them putting them at high risk; in some cases bankrupting large global financial powerhouses.

To illustrate, the situation can be compared to racetrack owners betting on the horses bought on credit by the punters. And to make it worse, the horses were slow and the punters could not afford the credit but were hoping the horses will be more valuable after a few wins. When they did not win the punters had to sell the horses to pay off the debt and the racetrack owners rushed to the exit door even quicker. The end result was a massive fire sale and crashing prices.

This has happened in the past but this time around the buildup was the largest ever and there was not enough disclosure and market did not know about the true exposure and risk associated with the derivatives and supposedly hedged positions sometimes held in the off-balance sheet structures.

The incentives system in the banking and funds management industry encouraged the unwelcomed behavior and the problem was magnified by inadequate regulations, disclosure, reporting standards and poor quality of the securitized assets.

Risk assessment

The first question any investor should ask all the times and especially now is “what is the possible worst case scenario and would I be able to survive it?”

Is this crash going to lead to a major depression similar to the 1930s when stocks fell 90% across the board? If the answer is yes - it would be time to get out of the market and put away the cash in a very safe place regardless of what this or any other investment model is forecasting.

Our analysis of the 1930s environment with limited available data concluded that the worst case scenario is less likely in this cycle but possible as there are still significant risks. See the full analysis at: “2008 Credit Crisis should not lead to1930s style Great Depression: Fed’s perspective”

The analysis focused on one of the key questions: Is the Central Bank injecting required liquidity during the credit crisis? The answer is “yes” so far, which is good news.

This time, the Fed is supporting the financial system with vigor providing unprecedented large injections without delay while during the early 1930’s it apparently did not do that sufficiently. The current crisis is similar to the 2001 environment when Fed also injected large amounts; be it for a short time.

The next few months will be a period of a political “vacuum” until the new US President Elect Obama takes office in January 09. This may delay the much talked about fiscal stimulus to support the struggling consumers. Almost all support so far has been directed to the financial system only restoring balance sheets of the distressed financial institutions during the deleveraging process.

The massive funds injections have not been yet passed to the consumers in any significant way. The USA mortgage interest rates are still high hovering around 5.5% and 6.5% for 30 year fixed, despite Fed’s reduction of its target rate from 4.5% to 1% and prime rate (charged to banks) from 5% to 1.25% over the past 12 months. Banks’ margins are still declining suggesting they are not yet done with the deleveraging process. Even Freddie Mac (FRE) and Fannie Mae (FNM), now controlled by Government, have not reduced their rates to consumers. The high 10% rate Freddie and Fannie pay on the Government’s capital injection is not making it easier.

Falling stock market and home values are helping to clear the system deleveraging consumers and investors contributing to a massive redistribution of wealth from equity to bond holders. It is unclear however how much of the deleveraging is still required simply because it is unclear how much exposure is still out there. In case of consumers, it is easier to identify and there is a bottom to the exposure measured by painful foreclosures and bankruptcies.

The next Quarter’s Outlook

The updated value of our proprietary Business Cycle Index (green line on the charts above) points to a favorable environment for the USA Corporate Profits and stock market over the next few months and we recommend to "Stay In" the market subject to inherent predictable and unpredictable risks always requiring appropriate risk management.

Please keep in mind that the methodology does not deal well with sudden stock market crashes that by themselves can cause decline in corporate profits disregarding the prevailing macroeconomic environment. This model, as any other model, is limited and not perfect; it is only one of the tools to use when making an investment decision.

The “IN PERIODS” identified by the proprietary formula have been historically characterized by solid and consistent returns underpinned by favorable macroeconomic fundamentals such as stronger Corporate Profits growth.

The methodology delivered average 27% ungeared return per 15 months average "In Period" or 20% annualized over 60 years history, including last 4 years of actual results (see Performance record).

The Charts above illustrate recent performance until November 28, 2008.

Next quarterly update is planned for the end of March 2009 and we may issue interim reports when important events unfold.

Business Cycle Investor
Nov 28, 2008

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More information about the research methodology can be found at www.businesscycleinvestor.com/methodology.htm

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USA Corporate Profits & Dow Jones Forecast

Business Cycle Investor