What the Investment Folks are Really Saying
(February 23, 2006)
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. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Wednesday (11,137.17), our position is 267.17 points in the red.
The Japanese current account deficit for January 2006 was just released and it was worse than expected (349 billion yen vs. forecasts of 100 billion yen). As I am typing this, however, the Yen is up against the U.S. Dollar as well as many major European currencies. Could the Yen carry trade be ending here? Very possibly – readers should keep in mind that given its consistent current account surpluses over the decade – unlike the United States – Japan is not a “natural exporter” of its currency. Moreover, the Yen is also currently very undervalued against both the dollar and the Euro. In other words: Should the Bank of Japan end its “quantitative easing” program (which is expected in April) or should Japanese pension funds start repatriating their capital ahead of the March 31st fiscal year-end, there is a huge possibility that a “scramble” for Yen will emerge, similar to what occurred during the Fall of 1998. Make no mistake, the Yen carry trade is alive and well, and in recent weeks, this has grown into a frenzy. I am now hearing folks borrowing Yen to buy the Korean KOSPI, or to purchase Brazilian bonds, for example, in order to earn the huge “carry.” What will they think of next? Pricing U.S. residential mortgages in Yen? Of course, this author would not hesitate to do such a trade if the Yen was trading at 95 yen to the dollar, but at 85 yen to the dollar, this trade is getting increasingly dangerous by the day. And the kicker is: No one really knows how big the overall trade is – although everyone knows somebody that has done it or is currently doing more of it. It is no coincidence that the price of gold, commodities, etc, has been inversely tracking the value of the Yen more so than the U.S. dollar since the beginning of 2005.
The “permabears” would like to think that Wall Street is a place for crooks, but this author treats it mostly as a sales force – a sales force that have families and also have mouths to feed. Over the years, the “investment business” or the “wealth management business” have transformed into more of a business culture. If a fund isn't earning the necessary fees, they are usually shut down. Conversely, if a fund is getting wildly popular, more marketing dollars will be spent on it to attract more investors. Think of Asia in 2002 in the first instance and think of technology funds in the spring of 2000. From a business standpoint, this is the “logical thing” to do. The investment business is not just what it used to be.
Folks like me are usually locked up somewhere just so I can't do any damage to business. Recommending folks to sell our funds when everybody is buying? Are you crazy? Barton Biggs – in his delightfully-written book, “Hedge Hogging” discusses one such instance when proclaimed that there was no “new era” in late 1999. Ultimately, Barton Biggs won the argument, but not before he was literally laughed at or written off as “outdated” or “senile.” He eventually left Morgan Stanley in June 2003 to form his own hedge fund with two partners – proving that investment prowess does ultimately win out after all in Wall Street. The fact that many “mainstream folks” does not like his book makes me more confident in his analysis and insights that his book has to offer.
Once in awhile, you do meet some one in Wall Street that has investment prowess and that is willing to voice his position in a public forum. One such guy is Francois Trahan, Chief Investment Strategist of Bear Stearns, who was ranked number one in 2005 in the Institutional Investor All-American research poll. In a talk that he gave today to the Houston Society of Financial Analysts, he discusses his U.S. bearish equity outlook for 2006 – backing up his bearish beliefs by discussing such things as the inverted yield curve, the “leading indicators of leading indicators,” as well as the fact that the market usually does not cooperate with the “consensus” of individual investors. Mr. Trahan follows many of the same indicators that I follow. However, his analysis and talk was truly refreshing – especially for someone coming straight out of Wall Street – and I feel that many of our readers will gain a lot from his insights. I will try to cover many of his points in the following commentary.
As a summary, Mr. Trahan believes that the U.S. equity market today should be more broadly tied to current economic trends, and that Fed policy should continue to have a dominant influence on U.S. equities going forward. Trahan argues that with today's bond yields at such historically low levels, there is not much room for further price-to-earnings multiple expansion. This current stock market is unlike that of the bull market in the 1980s and 1990s – when the secular trend of disinflation had caused a secular rise in the price-to-earnings multiple of the stock market. In other words, the 1980s and 1990s bull market was driven by both forward earnings and declining bond yields. Today, there is only one “pillar of support” and that is earnings. Should earnings disappoint going forward, there is a very good chance that stock market performance will disappoint as well. Of course, this is all based on the assumption that real interest rates (nominal interest rates minus inflation) will remain steady. This is a very good argument for the “secular bear market case” that I have discussed so many times in our commentaries.
Trahan then goes on and discusses “the five most prevalent consensus beliefs” in the markets today and one by one shoots them out of the water, so to speak. Let me quote from his presentation:
The Five Most Prevalent Consensus Beliefs:
- Investor sentiment is bearish and the market will therefore “melt up.”
- Equities will immediately soar when the Fed is finished tightening policy, just like they did in 1995.
- The yield curve is antiquated and an inaccurate indicator therefore irrelevant to the equity market outlook.
- An undervalued market justifies an aggressive posture in equities.
- Corporate spending will offset sluggish consumer spending and sectors such as industrials and technology will therefore lead the next major equity rally.
To summarize, all these “consensus beliefs” could not have been “more wrong.” As this author has discussed before, the three most popular sentiment indicators that we look at (the Market Vane's Bullish Consensus, the AAII, and the Investors Intelligence Survey) were just at very overbought levels as recently as a month ago. In fact, the Market Vane's Bullish Consensus is still at a level not seen since August 1997. In telling us the story, Mr. Trahan uses a simple average of these three sentiment indicators – and his conclusion is that sentiment is still very bullish. As a matter of fact, sentiment levels were at nine-year highs as recently as January. I will provide a chart of this and more analysis based on our three popular sentiment indicators in our upcoming weekend commentary.
This extreme complacency on the part of stock market participants is also being reflected in the low levels of the VIX over the last two years, which is “not the stuff of sustainable rallies.” While he acknowledges that many folks out there are calling the VIX a “broken indicator,” the fact of the matter is that when one charts out the levels of the VIX and the S&P 500 over the last few years, one still gets a pretty good negative correlation between the VIX and the S&P 500. As for me, I believe that the low VIX (low premiums on S&P 500 options), by definition, is showing extreme complacency. This is also being reflected in record low emerging market spreads, as well as the fact that many market participants have now taken on extremely high levels of leverage. Again, I will expand further on this in this weekend's commentary.
Let's now go on and discuss point number two. Many commentators in recent months have been comparing the most recent stock market action with the action in 1994/1995 – claiming that equities will soar once the Federal Reserve is done hiking rates. Like I have mentioned before, this author cannot disagree more – as the experience of most Fed hiking experience is for the market to decline AFTER the Fed is done with hiking rates. The market has already been rising during the rate hike process (because of the fact that the economy is still going strong) – can the market continue to go up once the Fed is done? Again, I agree with Trahan – that this current stock market is unlike that of the bull market in the 1980s and 1990s – when the secular trend of disinflation had caused a secular rise in the price-to-earnings multiple of the stock market. Going forward, the performance of the major market indices such as the S&P 500 will be more or less tied to economic cycles – therefore, the economic slowdown that I have been looking for (which Trahan is also looking for) should lead to an upcoming period of lackluster returns for the stock market. Essentially, the Fed is going to continue to hike rates until both the commodity markets and the stock market “cracks.” If one compares the current stock market experience to that of the 1960s, one should witness a significant top about a month before the last Fed rate hike (i.e. either close to February 28th or April 10th), and a subsequent “relief rally” after the last rate hike (you can surely bet Wall Street will tell investors to get into the market en masse once the Fed is done) which should take us to a lower high. Unfortunately, for most investors, any relief rally after the last rate hike should be sold – and SOLD HARD.
Readers may not have caught this, but with the yield of the 30-year Treasuries declining below those of the Fed Funds rate yesterday, the yield curve is now very close to being fully inverted (the yield of the 10-year Treasuries is still a few basis points over 4.5%). Most of the popular commentators out there are now telling us to ignore the inverted yield curve as a signal of a slowing economy – telling us that it is an antiquated indicator, without really giving us the reasons why. Interestingly, virtually all these commentators were stating the same thing back in 2000. Like I have mentioned before, the record of the inverted yield curve as a leading indicator of an economic slowdown should not be ignored – the more so given that many commentators are now stating the opposite (if everyone was bearish because of a flattening/inverted yield curve, then a good argument can be more for ignoring it!). Trahan argues that the yield curve is as important as ever, if not more so since the last economic recovery has mostly been on the back of a housing boom/bubble (when folks treated their homes as an “ATM machine” and withdrew their rising equity from their homes in order to support their spending). An inverting yield curve signals tighter consumer lending standards just up ahead – which would further slow down the housing bubble (Trahan explicitly stated that the U.S. has had a housing bubble) and subsequently, consumer spending. Taking into account “multiplier effects,” such a further deceleration would put many mortgage brokers, real estate agents, etc, out of a job – thus further slowing down consumer spending. Besides, one can now open a savings account at HSBC for a yield of 4.8%. Such a “risk-free rate” starts to become very attractive when compared to the current low-yield environment in both the world bond markets and the domestic equity markets. Once the Fed Funds rate is raised to 4.75% on March 28th, there is a high likelihood that we may start seeing investors converting their bond and stock holdings to cash en masse.
Trahan then discusses the record of the global commodity currencies – and outlines the fact that these global commodity currencies (the Canadian dollar, the Australian dollar, and the New Zealand dollar) have collectively been a very good leading indicator of the U.S. economic leading indicators. As this author has mentioned before, there is now no doubt that both the Australian and the New Zealand dollar have topped out. All we are now waiting on is the Canadian dollar, and as I mentioned in our December 18, 2005 commentary (Have Currency Investors Gone Loonie?), there is a good chance that the Canadian dollar has either topped out or in the midst of topping out. Moreover, given the deteriorating trade balance (excluding resource exports) in the last two years (see below chart courtesy of the Bank Credit Analyst), it is now in the interest of Canada to see the value of the Canadian dollar decline going forward. After all, most of the natural resources in Canada are located in the provinces of Alberta and British Columbia – and you can bet many of the other provinces would be up in arms unless they can somehow benefit from this energy boom as well. In reality, these provinces are actually getting hurt primarily because of the high value of the Canadian dollar.
In other words, focus on the Canadian dollar going forward!
Turning to point number four: According to the Bear Stearns equity valuation model, U.S. equities are actually now significantly undervalued compared to bonds – but Trahan argues that valuation is not a good timing indicator. In fact, just like in the 1990s when valuations kept on getting more overvalued by the day, valuations could become even more valued as the economy slows down. While valuations are very compelling at this point (which is in itself very arguable unless real interest rates remain stable and at the current low levels for the foreseeable future), it is all outweighed at this point by a deceleration in the growth of the economy and earnings (guidance was terrible during the fourth quarter reporting season).
Finally, at this point of the cycle, investors should now be emphasizing noncyclicals over cyclicals – unlike the many recommendations coming out of Wall Street recommending folks to buy the Industrials and the technology sector (the late cyclicals). Late cyclicals are still outperforming precisely because they typically lag the economic cycle. The fact that the early cyclicals (retail, consumer finance, durables, and leisure) have been hugely underperforming signals that at some point, both the industrial and the technology sectors will turn down as well. This is further confirmed by the latest action of our relative strength indicator showing the dismal action of the Retail HOLDRS vs. the S&P 500 over the last six weeks. Again, I would also provide an update of this in our latest commentary this weekend. For folks who would like to hold on to stocks at this point, you should consider noncyclicals such as healthcare and defense. And for folks who are currently on the sidelines, you should start thinking about buying the early cyclicals such as retail, consumer finance, durables, and leisure. While they still do not represent good entry points currently, they typically bottom out earlier and is a good leading indicator of the stock market. For folks who are just focusing on the major market indices, you should follow the action of these early cyclicals and watch for any signs of strength relative to the market going forward. Late cyclicals such as industrials and technology should be avoided like the plague.
In conclusion: Francois Trahan is looking for a downturn in the S&P 500 of approximately 10% to 12% sometime in 2006, and this author could not agree more. We are now very late in the cycle, as indicated by the extreme complacency, the inverted yield curve, declining commodity currencies, as well as low cash levels at mutual funds, etc. As an aside, both this author and Mr. Trahan believes that both oil and most of the metals have topped out for this cycle – again, it is not a time to be long of risky assets.
Henry K. To, CFA