Identifying Risks in the Upcoming Year
(January 8, 2006)
Dear Subscribers and Readers,
Welcome to my first official commentary for 2006 and I hope every one of you had a great New Year's. I would like to take this opportunity again to thank you for all your support in 2005 and I sincerely wish all of you can stay with us going forward as we try to navigate these treacherous markets ahead. Remember - we are all still learning here. We get a lot of ideas from our subscribers and appreciate you for keeping me "honest," so to speak. Please continue to email me at firstname.lastname@example.org should you want to discuss some market issues or should you have any suggests for our website. Over the years, I have learned that you can't get anything (e.g. promotions, dates, etc.) if you don't ask. And if you do ask, chances are that you may be surprised!
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. As of Sunday, January 8th, this market is starting to become overbought. However, this author believes that the market will still remain investor-friendly for the foreseeable future (at least over the next two weeks) - as the market has not become hugely overbought yet and liquidity remains ample. The key will be the January 31st Fed meeting and how investors choose to respond to the comments of that meeting and the official appointment of Ben Bernanke as the new Chairman of the Federal Reserve. Should the market continue to rally relentlessly in the next couple of weeks, there is a good chance we may go 50% short in our DJIA Timing System (our maximum allowable short position). Like I have mentioned before, I believe a DJIA print of 11,000 is now inevitable - our target to short is at around the 11,200 to 11,300 level. More details to follow in the days ahead. For now, we will remain completely neutral in our DJIA Timing System.
In our "ad hoc" commentary that I sent all of you on the day after New Year's Day, I reiterated the purpose and mission of our website and commentaries (for readers who would like a copy of that commentary, please email me) - that to keep our readers abreast of economic trends and to help our readers make the correct economic decisions - whether those decisions are related to investing, your career, or your formal education. Another good way to learn is to learn from each other - and the best way to do that is through our discussion forum. Going forward in 2006, I would like to see more of you posting messages in our discussion forum!
Our "ad hoc" commentary dealt with the broad economic trends that I envision for 2006 and possibly into 2007. I discussed the fact that I still see a U.S. dollar bull market in 2006 (although I would not discount some weakness in the U.S. dollar in the first few months of 2006 given that the market will need some time still to "digest" the appointment of Ben Bernanke as the new Chairman of the Federal Reserve), and my concerns regarding the upcoming decline of Mortgage Equity Withdrawal (MEW) and its adverse effects of GDP growth going forward. I would like to begin this commentary by identifying the risks to stock market investors in 2006. For investors who have been timing the markets in the last couple of years (and this includes me), 2006 may finally be the "year of living dangerously." That is, I believe that we will see some kind of market breakout in 2006. For traders who have been accustomed to shorting on overbought and going long on oversold situations, watch out. I believe there is a good chance we will see some kind of trend for 2006. My preferred scenario is to see a severe downside correction (greater than 10% in the S&P 500) first and then a huge recovery in the latter parts of the year. But since I never get precisely what I want when it comes to the stock market, I believe investors should just take it one day at a time here. For now, the environment still remains friendly for stock market investors.
For retail and professional investors alike, I believe reading Warren Buffett's letters to his shareholders is an invaluable exercise in terms of being successful in long-term investing. Let's take a look at what Warren Buffett had to say in his 2004 letter to shareholders:
Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.
There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful. [Emphasis mine]
So what is Warren Buffett saying? For most retail investors, holding a diversified portfolio of stocks (such as a S&P 500 index fund) has been the key to successful long-term returns. According to Buffett, market-timing (and chasing the hot stocks) has been generally detrimental to returns - since most investors can never be successful with adopting such a strategy. Nonetheless, as investors, we still choose to do it, despite the historical record.
So Henry, what are you trying to do - are you trying to shoot yourself in the foot? Definitely not. It is to be kept in mind that the market is always changing. What has worked in the past does not necessary work in the future. In fact, if something has worked in the past and if most people now know about it, then you can bet that it WILL NOT work in the future. According to "Mister Johnson," (written in 1976) the founder of Fidelity and the father of Ned Johnson: "The market . is like a beautiful woman - endlessly fascinating, endlessly complex, always changing, always mystifying. I have been absorbed and immersed since 1924 and I know this is no science. It is an art. Now we have computers and all sorts of statistics, but the market is still the same and understanding the market is still no easier. It is personal intuition, sensing patterns of behavior. There is always something unknown, undiscerned."
And according to Benjamin Graham in his classic "The Intelligent Investor," the returns from stock market investing are usually proportional to how much work you put in. As an example, witness the relative underperformance of the S&P 500 (and other major market indices that were popular for index funds in the late 1990s) in recent years relative to an equal weighting of the S&P 500 and international stocks. Basic indexing of the S&P 500 has worked in the past simply because it was not easy to replicate or popular to do so. This has drastically changed in the last six to seven years. This has two immediate implications for retail investors:
- Basic indexing (for example, indexing one's portfolio to the S&P 500) will continue to lead to underperformance in the future. That is, the "alpha" that will be generated if one chooses the right stocks will be significant higher than they were 10 or 20 years ago. The age-old adage holds true in the stock market: There is no such thing as a free lunch. For those who think they can retire by just buying an S&P 500 fund going forward and dollar-cost averaging down (or up), I believe one will be severely disappointed.
- If one wants to generate relatively good returns without investing in individual stocks, one will need to continue to time the markets going forward - and not just with the S&P 500 but with the whole universe of country and industry ETFs.
In general, I agree with Warren Buffett, but I believe the key to successful returns in the stock market for retail investors going forward is to try to pick good, solid companies trading at low valuations and holding them for the long-run (and constantly re-evaluating their prospects and sell them if the fundamentals have deteriorated). Our job here at MarketThoughts.com is to identify potential risks - whether those are industry-specific risks (such as in the energy or retail sectors), country-specific, or currency-specific. Once in awhile, timing the markets can be extremely rewarding - such as selling technology stocks in spring 2000, buying gold and silver in late 2000, or buying U.S. stocks in late 2002 and early 2003. And this is where we come in as well - using our sentiment indicators as well as our liquidity and valuation indicators.
Before I go on and outline a list of potential risks in 2006, let me emphasize my overarching theme: With the exception of energy, precious metals, real estate, and potentially retail stocks, the downside risks in 2006 is no longer with U.S. stocks. That is, any potential decline in the U.S. stock market will be only triggered by an external event - and if such an event did occur (such as a breakout of the Bird Flu pandemic) I believe on a relative basis, the U.S. stock market will be one of the best-performing markets in the world, including Japan. Let's now outline the "laundry list" of risks for 2006, in no particular order:
1) The appointment of Ben Bernanke as the new Chairman of the Federal Reserve. Whether your perception of Bernanke is an "inflation fighter" or "Helicopter Ben," I believe there will be quite an amount of uncertainty in the markets in 2006 as we all try to anticipate the world's second most powerful man's moves and policies going forward. For what it is worth, I believe his "helicopter speech" made on November 21, 2002 was severely taken out of context by the press, since virtually all his publications and speeches have been in favor of a specific, well-communicated "optimal long-term inflation rate" - as we have previously discussed in our October 27, 2005 commentary (The Ben Bernanke Grand Experiment). This perception of Ben Bernanke is unfortunate, since this will only add to the uncertainty of his policies in 2006.
2) As I discussed in our "ad hoc" commentary sent to our subscribers on January 2nd, I believe the decline of "Mortgage Equity Withdrawal" (MEW) would contribute to a significant decline in consumer spending - in the process shaving approximately 1% to 2% off annual GDP growth, excluding any multiplier effects. Given that 40% of all jobs created since 2001 is related to the real estate sector, however, we could ultimately end up in a vicious cycle (where the decline in consumer spending contributes to higher unemployment which further exacerbates the decline in consumer spending, and so on). Please keep in mind, however, that this author is only looking for a "mid-cycle slowdown," and not a full-blown recession. Folks who have a heavy weighting in the retail sector should be on the lookout - as growth in this sector should be directed affected by any upcoming slowdown in consumer spending. Given that P/E ratios have come down significantly in the last six years, however (WMT more than 50% and HD more than 70%), this may just ultimately end up as an anti-climax. In other words, could investors have already discounted an upcoming slowdown in consumer spending when it comes to retail stocks? Please note that the relative strength of the retailers (using the RTH HOLDR as a proxy) vs. the S&P 500 it now at its lowest level since March 2003. Going forward into 2006, we will continue to keep an eye out on the retail sector:
3) Readers should know that I have not been particularly bullish on emerging markets in the last few months. This remains the case in 2006 - given that emerging market spreads are now at their lowest in history. In other words, there is now a complete disregard for risk in emerging market investments. This can also been seen in the week-after-week inflows into emerging market funds (as opposed to small inflows into or even outflows out of domestic funds), as outlined by amgdata.com. The current favorable environment for emerging markets has even allowed Turkey (which is hitting the news as the first cases of Bird Flu are reported in the country) and Iraq to price their bonds for sale in the international markets. Let there be no mistake: Such pricings (with so much ease) can only occur in an environment of huge optimism. Finally, according to the publication "Triumph of the Optimists" (which contains the most comprehensive studies of the world's financial markets - much more so than Ibbotson's work), a diversified portfolio of world equities have actually returned less than a diversified portfolio of U.S. equities in the 20th century (on an absolute basis as well as a risk-adjusted basis). This remains true whether one looks at the first half or the second half of the 20th century. Is it different this time? Perhaps - but as a somewhat defensive/value investor, I am not going to bet on it. For readers who have a significant amount of emerging market securities, I encourage you to reevaluate your situation very carefully.
4) Unless one is very familiar with individual stocks in the energy sector, I would not go long in either crude oil or natural gas. The potential upside (with crude oil at $64 a barrel and natural gas at $9.60/MMBtu) just isn't worth the downside risks. This is supported by the latest readings in our MarketThoughts Global Diffusion Index model (readers who are unfamiliar with our MGDI model can read more about it in our May 30, 2005 commentary):
As noted on the above chart, the rate of change (second derivative) in the MGDI has historically led or tracked the YoY% change in the CRB Energy Index very closely. Over the last 12 months, however, a divergence has appeared between them - most probably because of outsized demand from China, the lack of energy infrastructure investment in recent years, and the destruction caused by Hurricanes Katrina and Rita in August/September 2005. Commodity bull market or not (and I do believe we are in a secular bull market in commodities), I don't believe the current scenario will ultimately be any different. This argument also extends to the precious metals and the base metals sector, such as copper, aluminum, and lead. This is also consistent with a "mid-cycle slowdown" scenario for 2006. As a side note, the Chinese demand of imported crude oil has only been increasing at an annualized rate of 5% in recent months. Finally, please also note that the OECD usually reports their data on a six-week lagging basis, and so the December OECD data won't be released until about four weeks from now (although the CRB Energy and the Dow Industrials data are updated to December 31, 2005).
5) Moving away from the U.S. and emerging markets, the author believes that another potential area of risk is Western Europe, given that historically, the projection of Western European growth has always been revised lower as we get close towards the end of the forecasting period (as illustrated in the chart courtesy of CSFB and GaveKal in our January 2nd "ad hoc" commentary). In the event of a U.S. consumer spending slowdown, this will also severely affect Western Europe, especially on an export-dependent economy like Germany. The fact that the Euro is now trading at 14-year highs (prior to 1999, the Deutschmark) against the Japanese Yen does not help either. Finally, it is to be noted that Germany will enact one of the biggest tax increases in post World War II history in January 2007 - equivalent to approximately 2% of GDP. This will involve an increase in consumption tax, as well as a loss of tax incentives for first-time home buyers. Can real estate get any worse in Germany? Please also note that real appreciation in housing prices has been effectively zero in Germany for the last 35 years. Any further tax increases here should choke the German economy, the largest economy in Europe. The last time a developed country try this (Japan in 1997), it effectively killed off her economic recovery as well as nearly every other country in Asia (think 1997 Asian Crisis). Any significant weakness in Europe going forward should have adverse consequences in the U.S. as well.
6) Let's now move back to the U.S. and discuss the potential pension crisis for companies who have implemented defined benefits pension plans as well as provided retiree healthcare. Like I said earlier, the more immediate effects will be felt by the workers - as DB pension plans continue to be terminated or frozen (think IBM). This effectively assigns more responsibilities to the workers to provide for themselves in retirement. Going forward, readers should continue to try to take more responsibility in making sure they have enough for their lifestyles after they have retired. Trying to "get rich" in the stock market should be the last thing on your mind (although you should definitely try to go for market-beating returns in your individual portfolios and your IRAs). For investors who are picking individual stocks, I encourage every one of you to do the necessary research and learn more about pension and healthcare obligations incurred by the company before you invest. At this point in time, the author does not expect any significant macro "financial dislocation" from the under-funding in corporate America's pension plans. Rather, this will be felt by individual companies, and the best way to avoid that is to do the necessary research when it comes to picking individual stocks. For stock market investors in general, this continuing under-funding may actually be a benefit, as many companies will forced to make more cash contributions to their pension plans in light of this continued under-funding. Since more than half of such cash contributions directly flow into mutual funds and equities - this should provide a further boost to stock market liquidity in the months ahead.
It is to be kept in mind that we are seeing relative undervaluation in U.S. stocks in general - especially in large cap stocks. Please also keep in mind that most of the recent speculation has been in the emerging markets, as well as energy, precious and base metals, and real estate. That is, should we experience any external event that will cause investors to lose confidence (or a continuing decline in liquidity), the U.S. stock market should generally hold its own. The relative caution on U.S. corporations is also reflected in the following monthly chart showing the spread between Moody's Baa bonds and the 20-year U.S. Treasuries from January 1996 to December 2005. Note that the spread over 20-year Treasuries is now at its highest since August 2003 and is higher than at any time from January 1996 all the way up to August 1998 - just weeks before the Russian, Brazilian, and the LTCM crises. This caution is significant given that emerging market spreads at this time are at their lowest in history:
Like I said in our "ad hoc" commentary, I also believe the U.S. dollar will continue its bull market this year, although we may continue to see some weakness in the early months of 2006 as the policy of Bernanke is still uncertain in the eyes of the financial markets. The strength of the U.S. dollar should also act to prevent any further inflationary pressures. Case in point: The most recent monthly ECRI Future Inflation Gauge reading came in at a benign reading of 1.6%.
As a stock market investor, the only thing I will worry about right now is point number one and number two. While all the other risks that I have outlined should decrease investor confidence in the markets - those should affect the U.S. stock market n a minimal way. On the other hand, while having only having two sources of risks (points number one and two) may not sound too much to the stock market investor on the surface, they definitely could cause some significant short-term gyrations - or even long-term ones should the decline in MEW cause a vicious cycle in consumer spending and employment levels. For now, I believe our "mid-cycle slowdown" scenario will prevail in 2006. How this will affect the major market indices we will not be completely sure until we get there. Like I said, this will depend mostly on the amount of uncertainty surrounding Bernanke's policies as well as how significant a slowdown the decline in MEW will cause. But no matter what happens, you can bet that our timing indicators will get us out of the stock market should there be a serious decline in store for the stock market in 2006. For now, stock-picking will again be the key to outperformance in 2006. If one is currently not long, this is not a good spot to go long here. At the same time, we will not go short either. For those who are confident with their stock market picks in 2006, one strategy that you should seriously consider is to short an appropriate amount of S&P 500 or Nasdaq-100 futures to offset any potential declines due to a serious decline in the broad market. This is a strategy that this author will be implementing in 2006 - although as you all may guess, we will most probably not go short the major indices (even for hedging purposes) until the market gets overbought in a big way.
I will definitely let our readers know once we believe that the market is overbought enough to short. For now, we are not there yet - as you will see with our popular sentiment indicators towards the end of this commentary. The only indicator that is giving us a "hugely overbought" situation is the equity put/call ratio - with its ten-day moving average now at 0.56. For comparison purposes, the ten-day moving average of the equity put/call ratio came in at 0.53 in December 2004 and 0.50 in July 2005. The Rydex Cash Flow Ratio, however, is still at a somewhat overbought reading of 0.79 (it came in below 0.60 in December 2004) - while the ten-day moving average of the NYSE ARMS Index is currently at 1.17. Before this author is willing to go short in our DJIA Timing System, one of our first criteria is to see this reading drop to the 0.90 to 0.95 level.
Let's now end with a discussion of the most recent action in the stock market. After a less-than-thrilling week leading up to the Christmas Holidays, the market "faded" many investors, as it declined into the New Year's Holiday but subsequently rallied last week on the "dovish" minutes of the last Fed meeting that was released last Tuesday afternoon.
Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:
Over the last two weeks, the Dow Industrials rose 70 points while the Dow Transports declined 36 points. On the surface, this will seem like a Dow Theory non-confirmation, but if one looks closely at the above chart, it is obvious that the even though the Dow Transports did not confirm the new cyclical bull market high in the Dow Industrials last week, it is not far away from doing so. In our commentary two weeks ago, I stated: "Since the Dow Transports has been the leading Dow index throughout the entire cyclical bull market, this author will have to conclude that this latest rally in the Dow Transports is most probably a sign of things to come for the Dow Industrials. That being said, the inability of the Dow Industrials to confirm the Dow Transports in the latest week by bettering its March 4th highs is definitely worrisome in the longer-run, but for now, it is a virtual certainty that the Dow Industrials will surpass the 11,000 level in the upcoming weeks." This has proven to be the case. For now, the fact that the Dow Transports is holding its own despite a $64 crude oil price tells me that the trend of the stock market remains up at least in the short-run. The real test of the markets will come after the official appointment of Ben Bernanke as the new Chairman of the Federal Reserve on January 31st.
Let's now discuss our most popular sentiment indicators. In brief, while the latest readings of the American Association of Individual Investors Survey remain benign - we are now starting to see highly overbought readings in both the Investors Intelligence Survey and in the Market Vane's Bullish Consensus. For now, however, the trend of the broad market remains up - that is, this author will not go short in our DJIA Timing System (or the major market indices in his own portfolio) until we see more overbought readings in the Rydex Cash Flow Ratio, the NYSE ARMS Index, as well as more extreme readings in the AAII survey and in the Investors Intelligence Survey. Let's now start with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials. During the latest week, the Bulls-Bears% differential readings in the AAII Survey decreased further from 1% to 0% - after having declined from 13% to 1% in the week prior. The readings over the last few weeks are still consistent with a stock market that is in an uptrend:
Meanwhile, the ten-week moving average increased from 21.4% to a still-neutral reading of 22.0% in the last couple of weeks - still suggesting that the intermediate uptrend remains intact. Like I have been saying for the last few weeks, this author would not call an imminent top in the stock market until we see at least a 30%+ reading in the ten-week moving average of the Bulls-Bears% differential in the AAII survey - preferably accompanied by a weekly reading of 40% or higher.
On the other hand, the Bulls-Bears% Differential in the Investors Intelligence Survey remains relatively overbought - as the weekly reading declined from 34.0% to 32.0% in the last two weeks (after jumping to 39.6% in the week prior) - despite the fact that there is an approximate two-week lag in this survey. Meanwhile, the ten-week moving average increased from 27.8% to 31.8% - which is now highly overbought. Like I said before, however, this author will not be willing to go short in our DJIA Timing System until we at least see a 40%+ weekly reading in this survey.
Over the next week, the probability still favors a continuation of the intermediate uptrend at least until right before the January 31st Fed meeting. For now, the IPO calendar remains benign - until next week, while the market should continue to hold until after the appointment of Ben Bernanke as the new Chairman of the Federal Reserve. For investors who are happy with their individual holdings here, one should just hold - and possibly hedge them with short positions in the major indices if/once the market gets too highly overbought. For now, my definition of "highly overbought" would be a surpassing of the 11,000 level by the Dow Jones Industrials and a further rally to the 11,200 to 11,300 level. Once we get such a confirmation (and hopefully a subsequent further spike up), then this author should go 50% short (our maximum allowable short position) in our DJIA Timing System, depending on whether the readings in our overbought indicators confirm nor not.
The Market Vane's Bullish Consensus continues to surprise on the upside - staying at an elevated level of 69% to 70% in the last two weeks. Meanwhile, the ten-week moving average increased from 65.1% to 67.3% - which is now officially "highly overbought" and in the "danger zone.. Given that the weekly readings of the AAII survey remain relatively benign, however, this author will continue to remain neutral in our DJIA Timing System:
Again, depending on what happens from now to January 31st, there is a good chance we will be shorting the major market indices at that time (both in our DJIA Timing System and in our personal portfolio for hedging purposes) - should the Dow Industrials become overbought and rise to over the 11,000 level and possibly spike to the 11,200 to 11,300 level.
Conclusion: Going forward in 2006, the major downside risks continue to be for emerging markets, the real estate sector, the metals, and the energies - given that most of the immense speculation over the last couple of years have occured in those sectors. A stronger U.S. Dollar in 2006 will also exacerbate any declines in those sectors, while acting as a depressant on inflation and as a cushion for the U.S. consumer. In the author's opinion, we are in for a "mid-cycle slowdown" in 2006 - driven by a significant decline in Mortgage Equity Withdrawal which will depress consumer spending and subsequently shave 1% to 2% off annual GDP growth going forward. While investors should logically be wary of the retail sector here, it is not a given that it will continue to go down, as valuations and sentiment in the retail sector have come down quite a bit since the peak of six years ago. The relatively high spreads of the Moody's Baa bonds relative to the U.S. 20-year Treasuries suggest that investors are still relatively cautious on U.S. companies - even as they continue to speculate on emerging market securities, the metals, and the energies.
Meanwhile, the intermediate uptrend in the stock market continues to remain intact, and should continue to remain so until at least until the January 31st Fed meeting. 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 towards the last few trading days of this month. Over the long-run, however, the road to successful long-term investing is still having the ability and the patience to study and pick individual stocks and hold them for the long-run - while constantly re-evaluating their fundamentals at all times. This theme will continue to gain importance given the continued proliferation and popularity of index funds, as well as individuals looking to market time those index funds.
Henry K. To, CFA