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Global Liquidity Warning

(December 4, 2005)

Dear Subscribers and Readers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  For now, we are still completely neutral and in cash.  With the exception of the Dow Industrials, the Dow Utilities, and the Philadelphia Semiconductor Index, virtually all major market indices (including the Russell 2000 and the S&P 600) made new cyclical bull market highs over the last couple of weeks.  Like I mentioned in last weekend's commentary and in our commentaries over the last several weeks, I believe that the Dow Industrials will make a new cyclical bull market high and once it does (topping out 11,000 in the process), the "breakout" will be accompanied by the popular media declaring a new bull market and will subsequently result in many retail investors being pulled back into the stock market - thus completing the last phase of this cyclical bull market.  That is, I believe many of these "new investors" will be sorely disappointed going forward.

In last weekend's commentary, I discussed my long-term views of the stock market, and concluded by taking a bearish view as we head into 2006.  Among other things, I discussed current valuations relative to its historical range (and for the most part, discredited the bulls' argument against using the P/E ratio has a yardstick for current stock market valuation), the continuing decline in global liquidity, and the recovery of bullish sentiment in recent weeks - which, from a contrarian standpoint, is bearish for the stock market.  I argued that while the stock market is overbought in the short-run, the four-week and the ten-week moving averages of our sentiment indicators are still calling for more upside in the next couple of months.  So far, I am still sticking to this timeline.  Recent deteriorations in global liquidity and the continuing increase in the overbought conditions of our sentiment indicators are telling us that we are getting close to a significant top in the stock market.

I would first like to begin this commentary by reiterating our stance on the deterioration of global liquidity.  Ever since the underperformance of the Philadelphia Bank Index over six months ago, we have been warning of an impending liquidity squeeze.  This has been further compounded with our work on the growth of the amount of foreign assets held at the Federal Reserve banks - as first discussed in our May 1st commentary entitled: "The U.S. Dollar is Going Up."  Of course, deteriorating global liquidity may not be much of a concern if investors and consumers around the world have been more cautious with their money, but that has not been the case - as our MarketThoughts "Excess M" (MEM) Indicator had first tried to take into account in our October 23rd commentary.  As a compliment to our commentaries, I had also highly recommended reading John Mauldin's recent "Outside the Box" article on "Deteriorating Global Liquidity" (original author: Mr. Niels Jensen, President of Absolute Return Partners).

Speaking of our MEM indicator, it has been more than three weeks since our last update of this indicator.  Readers who would like a review of our MEM indicator should go back and read our October 23rd commentary, but in short, our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages).  Such an indicator is used to measure "financial velocity", or in other words, the amount of speculation that exists in our financial markets today.  Since more than three weeks ago - U.S. liquidity - as measured by our MEM indicator, has continued to turn for the worst.  This does not bode well for the stock and commodity markets going forward:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 (February 1985 to Present) - 1) Speculators continues to be aggressive in the face of the Fed reining in the monetary base.  Our MEM indicator stretched further to the downside in the last two weeks from negative 3.44% to negative 4.06% - the lowest since Jan 2002.  This does not bode well for the markets going forward. 2) Markets did well during the 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade!  But now, the BoJ is tightening as well...

As one can see, the fact that our MEM indicator continues to trend down, coupled with the fact that M-3 continues to increase while the Monetary Base is increasing, is especially bearish for the stock market and commodity markets going forward.  For readers who would like a review of the latter, please read our November 10th commentary entitled: "Seeking Guides for the Financial Markets."  Per the guide post (the quadrant signaling four possible scenarios of the direction of the monetary base and M-3) in that commentary, we are now definitely getting deeper in the bottom, left-hand quadrant.  In brief, this means that speculators continue to be more risk seeking in the face of a continuing decline in global liquidity.  Finally, as mentioned in the above chart, our MEM indicator has not been this bearish since January 2002 - just four months prior to the huge May to July 2002 decline.

A discussion of declining global and U.S. liquidity would not be complete without an update of the chart showing the relative strength of the Philadelphia Bank Index vs. the S&P 500.  As I mentioned last week, the relative strength of the Bank Index was on the verge of breaking through its huge resistance line - a resistance line that was initially pierced (downwards) approximately nine months ago and that stretches back to early 2003.  The action of the Bank Index over the last week, however, has been significantly bearish, as relative strength of the Bank Index vs. the S&P 500 is once again turning down after testing the resistance line:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1)  The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3)Relative strength of the Bank Index finally broke through support convincingly approximately nine months ago and and has stayed down since - with the exception of a back-kiss off the same line 31 weeks ago.  Note that relative strength of the Bank Index has recently been trying to push through major resistance, but has so far, failed to do so.  In fact, the significant decline of the Bank Index relative to the S&P 500 last week most probably signaled a new downward trend in relative strength.  Bottom line: Global liquidity continues to deteroriate. 

Please note that the last time this resistance line was tested was more than six months ago - and my guess is that the latest test will be a failure once again.  In fact, the dismal performance of the Bank Index relative to the S&P 500 last week (without any significant news from the financial sector) was telling.  The fact that the Federal Reserve should continue to tighten on December 13th and January 31st should ensure that the Bank Index will continue to underperform going forward.  Coming off an era of extremely generous liquidity, there is little chance that the stock market or the commodity markets will hold at current levels.  In fact, this author would not be surprised if we see some kind of "financial accident" in either an emerging market country or in one of the companies of the S&P 500 - such as the bankruptcy of GM or Ford, for example.

As for stock market liquidity, it is interesting to note (according to ICI's November 29th press release) that mutual fund cash levels as a percentage of total mutual fund assets are currently at 4.0% at the end of October 2005 - representing an increase of 0.2% from an all-time low of 3.8% at the end of September 2005.  Note that as of the end of October 2005, the S&P 500 stood at 1,207.01.  At the close on Friday, the S&P 500 stood at 1,265.08.  Based on the fact that the market has rallied nearly 5% during November, my guess is that cash levels as a percentage of total mutual fund assets have again declined in the latest month.  If so, then stock market liquidity (based on mutual fund cash levels) has again turned for the worst.

According to TrimTabs however, all is still well in the land of company stock buybacks, cash acquisitions, and primary and secondary offerings.  At this point, the former two are still swamping the latter two, although the IPO calendar is scheduled to pick up steam a little bit in the upcoming week.  However, in the wake of general stock market weakness and Hurricanes Katrina and Rita, many IPOs that were scheduled for the September to October period were never done.  While this was a bullish development for the stock market a month ago, that is no longer the case - as the recent strength of the stock market has convinced many of these companies to try to market their shares to the public over the next few months.  As the following article illustrates, what was supposed to be a banner year for IPOs (an expected total surpassing 2004's 216 IPOs) did not materialize, as nearly 60 companies delayed their IPO plans to early next year.  Due to this delay, as many as 90 companies are now expected to go public in the first few months of 2006 - easily surpassing the number of companies that went public in the first few months of 2004.  For comparison purposes, the number of IPOs for the whole year tallied 374 and 541 during the "mania years" of 1998 and 1999, respectively.

Another way to gauge market liquidity is the use of the NYSE advance/decline line - which is basically a cumulative sum of the daily differences between the number of issues advancing and the number of issues declining on the NYSE.  Following is a daily chart showing the NYSE A/D line vs. the NYSE Composite over the last six months:

NYSE advance/decline line vs. the NYSE Composite over the last six months

As I mentioned on the above chart, it is interesting to note that despite virtually all the major market indices making new highs in recent days, the NYSE Advance/Decline line has still failed to surpass its early September highs so far.  At the core, the NYSE A/D line is a breadth indicator, and the fact that breadth is underperforming despite many major market indices making new highs is a sign that a significant number of stocks are not participating in the recent rally.  This is also a sign of deteriorating liquidity.  Please note that during the late 1990s bull market, the NYSE A/D line topped out in April 1998, at precisely the same time the relative strength of the Philadelphia Bank Index topped out.  If the NYSE A/D line had indeed topped out in early September, then there is a very good chance that we are in the midst of tracing out a significant top in the stock market.

I now want to take the opportunity to discuss the Japanese markets - specifically, the recent "performance" of the Japanese monetary base vs. the Nikkei Index.  In our MEM indicator mentioned above, I had discussed why the major markets did well despite a decline in our MEM indicator during the period 1995 to 1998.  A major reason was the implementation of the "Yen Carry Trade," where foreign investors borrowed Yen at negligible interest rates and reinvested the proceeds in U.S. dollar-denominated assets.  Even though short-term rates in Japan are still currently negligible, this author does not currently see any evidence of a Yen carry trade.  As I mentioned in last weekend's commentary, the reasons why the Yen has been declining recently are two-fold:

  1. Many Japanese pension funds have been investing in higher-yielding U.S. Treasuries over the last few years since government bond yields have been dismally low in other developed countries and in particular, Japan.  Historically, these pension funds have hedged their currency risks by taking a short position in U.S. dollars vs. the Yen.  This was a very cost-efficient hedge when overnight rates were at 1% - it isn't anymore when overnight rates are at 4%.   That is, pension funds have been quietly taking away their hedges, thus pushing down the Yen in the process as they are forced to purchase U.S. Dollars.  Coincidentally, this "new strategy" has worked immensely well, since Japanese pension funds have been getting the high yields as well as the currency appreciation.  As other Japanese pension funds jump on the bandwagon, the pace of the decline in the Yen has accelerated.

  2. Most of the recent up-rise in the Japanese stock market has been due to foreign buying - and these same foreign investors have been hedging their currency risks by shorting the Yen or borrowing the necessary Yen to buy Japanese equities.  Both American and European investors have been doing the same type of trades - and thus they have managed to push down the Yen against both the U.S. Dollar and the Euro in the process.

As of Sunday night, this author still does not see any evidence of a Yen Carry Trade.  Moreover, the latest monetary base growth number for November has been dismal - with only a 1.5% growth in the Japanese monetary base on a year-over-year basis.  Such a dismal growth in the monetary base cannot provide a Yen Carry Trade on the scale that we witnessed during 1995 to 1998:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to November 2005) - 1) Note that Japanese money growth has been plunging since the end of 2003 - with the latest year-over-year increase registering only 1.5% (half of what was expected).  Such dismal growth will not support another yen carry trade. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory - and has again turned down with the latest November reading. 3) Momentum of the Nikkei SIGNIFICANTLY diverging from monetary growth...

Another point for Japanese investors: Note the historical correlation of the second derivative of the Japanese monetary base vs. the year-over-year performance of the Nikkei.  Secondly, note the huge divergence of these since the beginning of this year.  The fact that the Nikkei has been rallying despite the dismal growth in the Japanese monetary base suggests that foreigners have been doing all the buying of Japanese equities - which, according to everything I have read so far, are true.  A rally without any domestic buying in a relatively developed market such as the Japanese stock is simply not sustainable. 

For most Americans, the more immediate implications of the lack of a Yen Carry Trade are two-fold:

  1. At some point in the immediate future, the Yen should embark on a huge rally.

  2. Global liquidity will continue to decline going forward, despite the fact that interest rates in Japan remain at near zero.

At some point early next year, the stock market and the commodity markets will be a significant short - but for now, let's just go ahead and enjoy our Christmas holidays.

Let's now take a look at the most recent action in the stock market.  The consolidation that we have been waiting for finally came last week.  However, the stock market still remains overbought in the short-run, so my guess is that a longer consolidation phase will be needed before this rally will resume.  Again, over the intermediate term, the current uptrend remains very much intact - with the Dow Industrials a mere 63 points away from breaking to a new cyclical bull market closing high.  Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to December 2, 2005) - For the week, the Dow Industrials declined 54 points while the Dow Transports declined 40 points.  Coming off a five-week rise of 15.3% in the Dow Transports, it is no surprise that we are seeing some consolidation among the major Dow indices.  In our commentary over the last several weeks, I stated: 'My guess is that the Dow Industrials will eventually surpass its March 4th high of 10,940.55, but definitely not its all-time high.'  Despite last week's decline, the Dow Industrials is still only a mere 63 points from its March 4th high - thus setting up for an eventual breakout within the next couple of months.   My guess is that any breakout of the Dow Industrials will result in more retail investors being pulled in - but which will ultimately disappoint most investors.  For now, we will continue to stay neutral and not chase any rallies from current levels.

My commentary from last week and two weeks ago regarding the Dow Industrials remains the same: "It is to be said here that at the tail-end of all bull markets, the market usually stays irrational longer than anyone thinks.  Such was the case with gold and silver in January 1980, the Nikkei in 1990, as well as the NASDAQ Composite in early 2000.  This is what has been happening with copper, as well as the stock market.  If the cyclical bull market is to end soon, then we should have a "blow-off" of significant proportions - a blow-off which should definitely take the Dow Industrials above its March 4, 2005 highs - thus sucking in all the investors who are currently on the sidelines.  Only then would this cyclical bull market finally end.  Please note, however, that this author is not looking for an all-time high in the Dow Industrials, although stranger things have happened."  This author believes that this cyclical bull market will only end when the "last bear" has finally capitulated - and the best way to do this would be for the Dow Industrials to make a new cyclical bull market as well as pierce through the 11,000 level in a very convincing fashion.  Can the Dow Industrials close above its all-time closing high of 11,723.00 made on January 14, 2000?  This author does not believe so, but stranger things have happened.  In fact, I would not be surprised if we get close to that level in the Dow Industrials before this cyclical bull market ends.

Before I go ahead and discuss our most popular sentiment indicators, I want to point our readers to the latest Mark Hulbert article regarding stock market newsletter sentiment.  In the article, Mr. Hulbert pointed out (as of November 29th) that the Hulbert Stock Newsletter Sentiment Index stood at a reading of 66.6% - the most overbought reading since November 2001 - suggesting that newsletter writers who are short-term market timers are now at their most bullish in four years.  Historically, these folks have been a great contrarian indicator, and that is why Mr. Hulbert is urging caution.  In light of this indicator and the deteriorating condition in global liquidity, this author would definitely avoid going long here.  However, it is important to keep in mind that while the weekly readings of our most popular sentiment indicators are highly overbought - the longer-term readings (such as the ten-week moving averages) are still calling for more upside over the next couple of months.

Let's now discuss those most popular sentiment indicators - starting with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials.  Last week's reading of 41% was our most overbought reading since late July 2005.  During the latest week, the Bulls-Bears% differential readings in the AAII Survey declined from 41% to 29% - which is consistent with a stock market that is in a consolidation phase:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey declined from 41% to 29% in the latest week.  Unless something comes out of left field (such as a terrorist event on the order of 9/11) in the next few weeks, the bias of this survey (and thus the market) still remains up.  While this survey is consolidating at relatively overbought levels, it is important keep in mind that markets rarely top out with the first 40%+ reading (last week), as well as the fact that the ten-week MA, meanwhile, rose from 13.1% to only 15.3% - hardly an overbought reading over a longer time period (this author would not start to 'panic' until we see a 25%+ reading).  For now, we will remain neutral in our DJIA Timing System - with recent events are signaling an impending top in the stock market.

Please note that the latest weekly reading is still somewhat overbought.  Coupled with the 41% reading of last week, readers may be asking us: Are we now close to a top in the stock market?  In terms of timeframe - maybe - but please keep in mind, however, that market rarely top out with the first 40%+ reading in this survey, as highlighted by the fact that the ten-week moving only rose slightly from 13.1% to 15.3% - a still oversold reading from a long-term standpoint, suggesting a continuation of the intermediate uptrend.  In fact, this author would not call an imminent top in the stock market until we see at least a 25%+ reading in the ten-week moving average of the Bulls-Bears% differential in the AAII survey.

The Bulls-Bears% Differential in the Investors Intelligence Survey jumped slightly from 30.4% to 34.7% in the latest week - nearly confirming the extremely overbought reading of 41% in the AAII survey a week ago.  Meanwhile, the ten-week moving average increased from 23.1% to 23.7% - again, suggesting a continuation of the current intermediate uptrend, even though on a very short-term basis, the market still most probably needs more consolidation before it can rally again:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey rose from 30.4% to 34.7% - continuing the short-term uptrend from six weeks ago.  The four-week moving average, meanwhile, increased from a reading of 26.5% to 30.3%, while the ten-week moving average increased from 23.1% to 23.7%.  For now, this survey is still implying more upside in the intermediate term.

Our long-awaited consolidation phase finally occurred last week - with many of the major market indices experiencing very minor corrections.  Given that the market still remains highly overbought on a short-term basis, this author is expecting the market to consolidate further this week - with the market vulnerable to significant corrections in the order of two to three percent.  For now, both the readings in the AAII and Investors Intelligence Surveys are still implying a continuation of the current intermediate uptrend over the next couple of months.  My advice for the last couple of weeks does not change: Better to sit back and enjoy your upcoming Holiday time as opposed to trying to outsmart the Mr. Market here!  Again, unless one is very familiar with certain individual stocks (or commodities), I just do not see any good opportunities in the stock market right now.

Similar to the AAII survey, the latest weekly reading in the Market Vane's Bullish Consensus is consolidating at current levels - declining slightly from 69% to 68% in the latest week. The four-week moving average increased from 64.3% to 66.0%, and while the four-week moving average is also now overbought (albeit mildly overbought), this, along with the AAII survey suggests to me that the intermediate term uptrend is still intact, for now:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus declined slightly from 69% to 68% in the latest week - still signaling an extremely overbought reading at least on a weekly basis.  Meanwhile, the four-week moving average increased from 64.3% to 66.0% - a somewhat overbought reading relative to the readings since January 2004.  The most likely scenario is for this survey to trend higher in the coming weeks, with a top coming within the next couple of months or so.  Just like the AAII survey, the market rarely tops out with the first overbought reading (or for that matter, the first couple) from the Market Vane's Bullish Consensus.  For now, we will remain completely neutral in our DJIA Timing System.

At this point, all of the longer-term readings (four-week and ten-week moving averages) of the three popular surveys that we keep track of are still sufficiently oversold to give us some further upside, although any new highs here may take the next several weeks to achieve given that market is still due for some more consolidation over the next week or so.

In last weekend's commentary, I stated: "Over the next several weeks, this author will be looking for a new four-year high on the Dow Industrials, as well as a new all-time high on the S&P 600 and the Russell 2000."  Since that time, the latter two has been achieved.  The Dow Industrials came close to besting its March 4th closing high - falling nine points short as of the close two Fridays ago.  Over the next several weeks, however, this author is still looking for the Dow Industrials to make a new cyclical bull market high, as well as pierce the 11,000 level for the first time since June 2001.  Bears should still definitely stay on the sidelines for now.  However, this stock market will most probably again be "a short" once the four-week or ten-week moving averages of these surveys become overbought.  For now, we will remain completely neutral in our DJIA Timing System.

Conclusion: While the current rallies in both the stock market and commodity market may look attractive on the surface, readers should take note of the fact that global liquidity is still embarking on a dangerous decline.  Coupled with the fact that many investors are still willing to speculate at this point, then you have a recipe for disaster going forward.  While the intermediate-term uptrend (over the next couple of months) still remain intact, readers should take note that we are now very close (if not at) the tail-end of this cyclical bull market.  For now, we will remain completely neutral in our DJIA Timing System, and if all goes according to plan, we will establish a short position again sometime within the next couple of months.

Signing off,

Henry K. To, CFA

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