Sell Financials and Commodities
(October 9, 2005)
Dear Subscribers and Readers,
We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of Friday at the close, the Dow Industrials stood at 10,292.31 - giving us a respectable gain of 323.69 points. In last week's commentary, I stated that I had two concerns regarding the current markets - namely the lack of an oversold condition dating back to October 2004 (history has always shown that the markets will swing to an oversold condition sooner or later) and the fact that the Federal Reserve board has signaled its intent to continue hiking - at least through the end of this year, for now.
Given the trendless market since January 2004, I stated that I would be reluctant to go long unless the market is generally in an oversold condition. The stock market action of last week has proven me correct - and the latest Future Inflation Gauge reading from the ECRI did not help the bulls either (which was the highest reading since June 2000). Most likely, the Fed will now continue to hike until the end of this year - with Deutsche Bank and Goldman Sachs now predicting the Fed Funds rate to peak at 5.0% by next year. This is a great change of heart on the part of the Fed and the banks (although interestingly enough, the Fed stopped its last cycle of rate hikes at precisely June 2000 - the last time the ECRI's Future Inflation Gauge was this high).
Of course, the stock market doesn't just revolve around purely technical indicators and what the U.S. Federal Reserve intends to do (although it comes close). Another significant concern this author has recently is the huge increase of velocity - that is, the willingness of institutional and retail investors, along with the majority of the population to take economic risks despite a tightening Fed. We have witnessed it in the form of rising energy prices, the continuing inflows into international equities and emerging markets, the continuing rise in home prices - and of course, ever-bigger SUVs and high-powered cars (although this trend is definitely waning). At some point, the Fed rate hikes should have their intended effects (Fed rate hikes are always effective in a structurally deflationary environment - which the world have been living in since the fall of the Berlin Wall in 1989). However, other concerns are now popping up all over the place, including the threat of an ECB rate hike, and the deflationary effects of the Northwest, Delta, and Delphi bankruptcies. By the time October 17th comes along, we would have seen another surge in corporate and personal bankruptcies.
These factors are all deflationary. Obviously, these developments are bearish for the general market, but dear readers, please keep in mind that not every sector is created equal. The clampdown on liquidity and speculation will affect the sectors that have depended on them the most over the last few years, i.e. the sectors that have "boomed" the most. This includes the various "hard" commodities, the financial sector, and finally, the homebuilding sector. I will use this commentary to discuss commodities and the financials.
Readers who have been reading our commentaries on a regular basis should know about our MarketThoughts Global Diffusion Index (the "MGDI"). We first brought it to light in our May 30th commentary, with subsequent monthly updates in our June 12th, July 10th, August 7th, and September 11th commentaries. For newer readers, I will begin with a direct quote from our May 30th commentary outlining how we constructed this index and how useful this has been as a leading indicator. Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages."
Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Index from March 1990 to August 2005. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to the end of September (the September OECD leading indicators won't be released until November 10th). In addition, all four of these indicators have been smoothed using their three-month moving averages:
As I mentioned in our May 30th commentary and on the above chart, the rate of change (second derivative) in the MGDI has historically led or tracked the YoY% change in the CRB Index very closely. The recent divergence has been going on for an unusually long period - primarily because of commodity demand coming from China - but combined with declining global liquidity and a "blow off" in prices of certain commodities, I fully expect "hard commodities" to be significantly lower in price by the end of this year (possibly with the exception of natural gas). Over the next few months, the 2nd derivative of the MGDI and the year-over-year % change in the CRB Index should converge.
I want to take this "commodity analysis" further and focus on one such commodity that this author is paying very close attention - said commodity being copper. I initially discussed the fundamentals of copper and argued how overbought the commodity was in our September 18th commentary. Since then - despite a further 20-cent rise in the commodity - my views have not changed. Copper is now drastically overbought on a short-term, intermediate term, and on a long-term basis. In our September 18th commentary, I stated: "The MGDI aside, there has also been a very reliable historical (inverse) correlation between the direction of the Fed Funds rate and copper prices - with the former leading the latter by approximately 20 months." The following chart is an update to our September 18th chart showing the inverse relationship between the month-end Fed Funds rate (set forward 20 months) vs. the month-end copper spot price from January 1984 to September 2005:
Please note that the left axis (the axis for the monthly Fed Funds rate) has been inverted in order to better show the correlation between the Fed Funds rate and the copper spot price. Further, please also note that the September month-end (shown above) spot price for copper was $1.81 per pound. Since September 30th, copper has further appreciated to $1.87 per pound, thus rendering copper as an extremely overbought commodity. This overbought condition is all the further evident when one looks at the most recent trend of the Fed Funds rate - and given the fact that the Fed has continued to signal higher rates immediately ahead, this author just cannot be bullish on copper, and on commodities in general.
This overbought condition in copper is also very evident when one takes a look at investor sentiment as shown by the Market Vane's Bullish Consensus. Following is an updated chart showing the daily copper spot price vs. the Market Vane's Bullish Consensus (21-day and 55-day smoothed) from January 2003 to October 7, 2005:
As evident on the above chart - not only is the copper spot price staying at extremely elevated levels, investor sentiment towards the metal has also been extremely elevated - with no correction to below the 70% bullish level since January earlier this year. Such a long, uninterrupted streak of high bullish sentiment is copper is unprecedented. Chances are that copper prices will be significantly lower in the months ahead.
It is to be said here that being able to speculate in the markets successfully in the long-run involves intelligence, patience, flexibility, and a little bit of common sense. The latter is especially important - as it is this trait that commonly prevents you from losing money. Common sense tells you to not leverage your positions excessively, as well as cautioning you when everyone is bullish on a certain stock or commodity. This is one of those times, especially for copper - given its extremely overbought condition and the continuing clampdown on global liquidity (especially with the ECB now being thrown into the mix as well).
Make no mistake - the Fed and the world's central banks are clamping down on liquidity. In my commentaries over the last six months, I have continually discussed the breakdown of the Philadelphia Bank Index. As outlined in our September 29th commentary, the relative strength of the Bank Index vs. the S&P 500 is still in shambles - and is continuing to make new lows as we speak. Historically, the relative strength of the Bank has been a leading indicator for the broad markets, but any sector that underperforms during a cyclical bull market definitely has its underlying problems. For the financial sector, those problems are a hawkish Fed, a flattening yield curve, and a long awaited "wash out" of the excesses during the times when the Fed Funds rate was set at 1% (such as the inevitable slowdown of the homebuilding sector, and the willingness to take risks in emerging market equities, etc.). Please keep in mind that Wall Street is essentially a sales force - and sales and deals are not done when the willingness to take risks is declining - such as what this author is expecting to happen within the next few months.
Moreover, it is important to keep in mind that both corporate profits in the financial sector and corporate profits in the financial sector as a percentage of GDP is near or at an all-time high - suggesting that there is a lot to go on the downside for corporate profits in the financial sector. Following is a chart showing the absolute value of corporate profits of finance companies as a percentage of GDP from the 1Q 1980 to 2Q 2005:
As the above chart illustrates, the historical mean for corporate profits of finance companies as a percentage of GDP is 1.75% - which is significantly below the 2.83% reading that we witnessed for the second quarter of 2005. An optimist will argue, however, that the U.S. economy is today more "service-centric," and thus it is no surprise that financial services are growing to be a bigger part of our economy (it is one industry where Americans have an edge in relative to its European and Asian neighbors). Obviously, this is true, but please note the huge jump in both the red and green lines in the above chart over the last five years, and that as late as the second quarter of 2000, the corporate profits of finance companies as a percentage of GDP sat at 1.91%, or close to its 25-year mean. Moreover, it is not difficult to see that today's corporate profits of finance companies are outsized, given the domestic housing boom as well as a huge appetite (not seen since right before the 1997 Asian Crisis) for emerging market bonds and equities. Please keep in mind that this week is the beginning of "earnings season" - so we should know more as the days roll on. My guess is that corporate profits for finance companies topped out during the first quarter of this year, and has since rolled over. That means financial stocks such as mortgage financing, auto financing, and even investment banks should underperform going forward.
In last week's commentary, I stated that while the oversold condition that I have been looking for is still not in place, some of my longer-term indicators are starting to get there. These include the plunge in the Conference Board Consumer Confidence Index (the biggest monthly plunge since October 2000 - which should be interpreted as a contrarian indicator), the continuing decline of equities and mutual funds as a percentage of total household financial assets (which again should be interpreted as a contrarian indicator), and the fact that with each successive rake hike, we are closer to the end of the hiking cycle than we previously were. This week, we can add a couple of more items to that longer-term list - such as the Lowry's 90% downside day that we witnessed last Wednesday, along with the following chart courtesy of Decision Point showing the average price of the S&P 500 relative to its 52-week low and 52-week high:
For example, if all 500 stocks of the S&P 500 closed at the middle of its 52-week low and high range, then the above value would be 50 - which is close to where we are now. If 250 stocks in the S&P 500 were 10% within their 52-week highs and the remaining 250 stocks were 10% within their 52-week lows, then this reading would also be at 50. Since the bull market began in October 2002/March 2003, this indicator has only declined to the 50% level four times - during August 2004, October 2004, April 2005, and last week. This means that based on the above indicator, we are approaching a longer-term oversold condition - although this author doubts any sustainable rally would emerge from the 50% level. The "optimal" level that this author is looking for is somewhere closer to the 40% level - which is where this indicator was in July 2002, October 2002, and March 2003. Such a reading would probably even make Warren Buffett proud.
From a shorter-term point of view, however, and the Rydex Cash Flow Ratio aside (which is now at a very high reading of 0.98) - most of my trustworthy technical indicators such as the 10-day moving average of the NYSE ARMS Index, the equity put/call ratio, and the number of new highs vs. new lows are still not close to oversold conditions. This author would keep you up-to-date should we see more oversold conditions in these indicators, but for now, I would hold off buying - especially purchases within the oil & gas and the metal sectors, the financials, and the homebuilding sectors.
Let's now turn to the most recent action in the U.S. stock market. The most significant news of last week from a Dow Theory point of view is this: The refusal of the Dow Transports to decline below its September 20th low is a bullish non-confirmation of the Dow Industrials. If the Dow Transports does not decline below its September 20th low within the next couple of weeks, then this author will most probably cover our 25% short position in our DJIA Timing System. Following is the daily chart showing the Dow Industrials vs. the Dow Transports:
While the 276-point decline in the Dow Industrials was impressive for the bears, the Dow Transports fared "less well" on the downside - and since the Dow Transports has been the leading index out of most major stock market indices since this bull market began, this author would be very reluctant to stay 25% short in our DJIA Timing System should the Dow Transports failed to confirm on the downside within the next couple of weeks. For now, however, this trade still looks okay - especially given the lack of an oversold condition in our technical indicators - but like I mentioned, this is no time to be complacent, although we will stay 25% short for now.
Let's now quickly take a look at our most popular sentiment charts - starting - starting with the Bulls-Bears% Differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials. The latest weekly reading is somewhat puzzling, and from a contrarian standpoint, such a reading is not good for the bulls. The following chart will illustrate why:
While a further decrease in the bulls-bears% differential in the AAII survey would have given the bulls a pretty oversold condition in terms of AAII sentiment, this was not meant to be. Rather, the weekly reading actually increased from negative 7% to positive 23% - the most bullish sentiment reading since late July. Such an increase in the face of such a brutal decline in the market is bearish - and this author would be getting pretty worried if he currently has long positions in the market (fortunately, he doesn't - just yet). As usual, we will keep our readers updated throughout the week with regards to our views on the stock market, but for now, we will remain 25% short in our DJIA Timing System.
The Bulls-Bears% Differential in the Investors Intelligence Survey, meanwhile, declined from 26.6% to 21.7% in the latest week - rendering this survey in its most oversold condition since late May on a weekly basis. The four-week moving average again declined slightly from 26.5% to 25.9%:
In last week's commentary, I mentioned: "While the four-week moving average at 26.5% is relatively oversold, it is still not as oversold as we have seen during the corrections of the past 18 months - suggesting that more downside is in order." Readers should keep in mind, however, that the Investors Intelligence Survey has a little bit of a lag, so don't be surprised if the bulls-bears% differential plunges in the upcoming week and the four-week moving average plunges along with it - but this is not likely at this point, given the fact that the bulls-bears% differential in the AAII survey has recently increased despite the dramatic decline in the stock market last week.
Finally, it is probably fitting to say that watching the readings from the Market Vane's Bullish Consensus has been akin to watching paint dry (this is one for Victor) - but while this is somewhat "boring," we really do need to keep track of this indicator on a week-by-week basis - just to keep us on our toes. During the latest week, the Market Vane's Bullish Consensus declined from a reading of 63% to 62% - again, a relatively oversold reading given the history of this survey over the last two years but most probably still not oversold enough for a sustainable rally going forward:
For months, I have mentioned that the "optimal oversold reading" would be a weekly reading of approximately 50% - and I still stand by this view. History has shown that the market cannot enjoy a sustainable rally without the Market Vane's Bullish Consensus declining to at least a reading at 50% or lower - no matter how oversold the AAII or the Investors Intelligence Survey became. Again, this indicator definitely bears watching going forward.
Conclusion: While the current declining liquidity environment and the current appetite for risk-taking is bearish for the general market going forward, it is important to keep in mind that not all sectors are created equal. That is, sectors that have depended on the accommodative global liquidity for growth will be the most affected, such as the hard commodities, the financial sector, and the homebuilding stocks. In my opinion, the oil & gas stocks, the steel and copper stocks, the mortgage and auto financing, and along with the homebuilding stocks are all a "sell." This is important since even as more of our longer-term indicators are now getting friendly for the bulls, most of our short-term technical indicators are still not confirming - and history has shown that holding such stocks as the market moves from an overbought to an oversold status can be very gut-wrenching indeed. For now, we will remain 25% short in our DJIA Timing System, although we would not hesitate to close out our position and shift to a neutral position should the Dow Transports fail to confirm on the downside within the next couple of weeks.
Henry K. To, CFA