Market Now in Dangerous Zone
(February 26, 2006)
Dear Subscribers and Readers,
The latest issue of Business Week contains a huge cover story on private equity – discussing many recent deals as well as the fact that it is now “the place to be” for MBA graduates. And I have to now wonder: Is the private equity bubble about to burst? Note that CALPERS (California Public Employees' Retirement System) have already ratcheted down their investment allocation to private equity deals back in October of ‘05 – with the head of the fund declaring that private equity was “in a bubble.” Leverage in many deals is now enormous, with historically high valuations to go along with them. If our 2006 mid-cycle slowdown scenario holds true, then many of these deals will literally fall apart. By the way, here is some tongue-in-cheek humor for the week.
This is a repeat from last weekend's commentary: For readers who are currently still long on individual stocks, I highly recommend reading the latest two-part interview of Paul Desmond on TheStreet.com – President of Lowry's Reports. In the latest interview, Desmond discusses the art of picking stock market tops – which as this author has mentioned before – is inherently much more difficult than picking bottoms. In the two-part interview, Desmond discusses that we may be on the verge of a major top, and that the next few weeks of stock market action will be crucial for the bulls. To get a copy of Lowry's original report (cost $10), one can do so by surfing over to the Lowry's research studies page. Note that this author does not have any personal or business relationships with Lowry's reports at this time. The conclusion of the latest Lowry's research confirms with the divergences that we have been seeing and that we have been discussing over the last few weeks.
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, January 18th 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, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,061.85), our position is 191.85 points in the red – but again, given that the market is now showing signs of a classic “blow off” top, this author is betting that this position will ultimately work out. Going forward this week, I would not be surprised to see some more strength early in the week, but I believe that such strength should be sold. If we do see some more on Monday or Tuesday, then this author will “break tradition” and go 75% short in our DJIA Timing System. Such a position is a very bold move on our part – but since both the financial markets and the stock markets of the world are showing signs of a classic top – this author is willing to stand both the criticisms and the volatility. Let me be clear: We are still in a secular bear market. The era of disinflation that supported a secular increase in P/E ratios during the 1980s and 1990s ended in 2000. It does pay to be a trend follower most of the time, but not when bullish sentiment is rampant and not when the market is hugely overbought and showing many signs of divergences. This author is now choosing to take such a stand.
In our many commentaries over the last few weeks, I discussed the many divergences in the current stock market – citing the recent “market top” study done by Lowry's Reports, as well as relative strength of the Bank Index, the retail HOLDR (RTH), the weakness of the McClellan Summation Index in the Dow Industrials during 2005, the further deterioration of our MarketThoughts “Excess M” (MEM indicator), the flattening/inverting yield curve, and the continuing weakness of the commodity currencies (AUD, NZD, South African Rand) with the exception of the Canadian dollar. At the same time, complacency is now at extremely high levels, as evident by record low emerging market spreads, record low option premiums (as exemplified by the historically low VIX and the record low Merrill Lynch MOVE Index), and extremely high bullish sentiment in our three popular sentiment indicators as well as the Conference Board's Consumer Confidence Index. And if that wasn't enough, the amount of leverage in the world financial system is now at unprecedentedly high levels – as evident by the exponential increase in derivative volumes on the CME, the CBOT, and the ICE. The growth in derivative trading in East Asia has been the most notable. Derivative contract trading on the Korean stock indices surpassed $12 trillion in the third quarter of 2005 – surpassing trading in U.S. domestic stock index derivatives for the first time in history. According to the BIS, total derivative trading on all international exchanges totaled $357 trillion during the third quarter of 2005, or approximately six times the world's annual GDP. This is further evident with the explosion of LBO and private equity deals – and more recently, with the resumption of the Yen carry trade. All of this – combined with global tightening liquidity conditions – make this a very dangerous market to be long of at this point. From a macro standpoint, all eyes should now be on the Bank of Japan (and the Yen, since most of the borrowing nowadays is done in Yen) as well as the Canadian dollar.
Of course, just with any “top calling,” timing is of the essence. I have previously commented that trying to time a top is inherently difficult. Studies discussing divergences (similar to Lowry's), bullish sentiment, leverage, etc, definitely do help – but market tops typically take a significantly longer time to form – frustrating both bulls and bears alike. I'll admit that our January 18th and January 19th signals to go short the Dow Industrials (for a total of a 50% short position) were too early, but recent developments have further convinced me that we are in the midst of forming a significant top. I have previously discussed divergences, leverage, bullish sentiment, and tightening global liquidity, so I will start this commentary off by citing a somewhat unrelated indicator – that of the short interest outstanding on the New York Stock Exchange. Following is a monthly chart showing the NYSE short interest vs. the Dow Jones Industrial Average from November 15, 2000 to February 15, 2006:
As mentioned in the above chart, total short interest on the NYSE for the month ending February 15, 2006 declined 423 million shares – a record monthly decrease. Over the last three months, NYSE short interest decreased 8.32% - the highest rate of decrease since September 2003. Given the maturity of this cyclical bull market, this does not bode well for the stock market going forward. Should there be a general market decline, there will be much less support than what we have previously experienced. Please note that the NASDAQ short interest data will be released sometime this week. I will report this data to you as soon as I have it.
Subscribers should also know that we have always been fans of using both the relative strength of the Bank Index and the Retail HOLDRS (RTH) as leading indicators of the stock market. From both a fundamental and historical standpoint, consumer discretionary stocks have also tended to lead the stock market. Using consumer discretionary stocks as a leading indicator is all the more important in this cyclical bull market, since the recovery from the 2001 recession has very much been consumer-driven. Below is a weekly candlestick chart showing the AMEX Consumer Discretionary Select Sector SPDR (XLY) and its relative strength vs. the S&P 500 from January 2002 to the present (courtesy of Decisionpoint.com):
As mentioned on the above chart, the absolute level of the XLY peaked in January 2005 and has been trending down and making lower highs ever since. More importantly, the relative strength of the XLY vs. the S&P 500 also peaked in January 2005 and is now in fact at the lowest level since March 2003. Historically, the consumer discretionary sector is an “early cyclical” and thus is a very good leading indicator of the stock market, especially since this cyclical bull market has mostly been consumer-driven. The top ten holdings (in order of percentage makeup) of the XLY are Home Depot, Time Warner, Comcast, Lowes, Viacom, eBay, Target, Disney, McDonalds, and News Corporation. Other notable holdings include Carnival, Starbucks, and Best Buy. As a matter of fact, this author is now watching Starbucks and Best Buy like a hawk, as these two stocks have been two of the hottest stocks (with still very compelling growth stories) in this cyclical bull market and is still near or at all-time highs. Once either Starbucks or Best Buy takes a hit, this cyclical bull market in all likelihood will be over. Note that Best Buy announces its next quarterly earnings report on March 30th, with Starbucks reporting on May 3rd.
In our mid-week commentary (“What the Investment Folks are Really Saying”), I noted that historically, the global commodity currencies (such as the Australian Dollar, the New Zealand Kiwi Dollar, and the Canadian Dollar) have been great leading indicators of both the OECD and the U.S. Conference Board set of leading indicators. I also discussed that aside from the Canadian dollar, the world's major global commodity currencies (the list previously mentioned as well as the South African Rand) has most likely topped out and is now in a cyclical decline. It now looks like that the decline of these global commodity currencies is now being confirmed by both energy prices and the action of the metals. Readers who are more or less in tune with the markets should know that crude oil prices pretty much topped out in January (at a slightly lower high than the immediate post-Katrina high) and that natural gas prices topped out in mid-December of last year, but what about the base metals? I have previously discussed that copper prices have most probably topped out – given rising inventories and historically high bullish sentiment in the commodity in the last 12 months. As a matter of fact, the Market Vane's Bullish Consensus for copper hit 95% on February 6th, and was at 90% as recently as February 9th – suggesting that virtually all shorts have been squeezed from the commodity (it is interesting to note that copper failed to rally despite the production stoppages at Freeport's Papua mines last Wednesday).
More importantly, the cyclical bull market in two other important base metals – aluminum and zinc – also seems to be ending as well. The following chart shows the daily cash price of aluminum traded on the London Metals Exchange from January 2002 to the present. Please note that from the bottom in October 2002 to the most recent top in January 2006, the price of aluminum has risen by over 100%. More significantly, from September 2005 to the top in January 2006, the price of aluminum rocketed higher by over 55%. Unless the U.S. economy experiences 1970s style inflation again, or unless folks buy into the “peak aluminum” argument, the most recent rise of aluminum from September 2005 to January 2006 is most likely a “blow off top”:
Given that the Bank of Japan is about to end its “quantitative easing” policy (thus potentially ending the Yen carry trade); given that the Fed and the European Central Bank is still in the midst of hiking rates, and given rising inventories in the London Metals Exchange warehouses, it now looks like aluminum has topped out for this cycle – thus confirming the top in copper and energy prices. Zinc also experienced a similar rally from the bottom in October 2002. The only difference was in the magnitude of the move. From the bottom in October 2002 to the most recent top in January 2006, zinc rallied by over 200%. Moreover, from July 2005 to January 2006 (all in the space of six months), zinc rallied 100% from $1,200 per ton to $2,400 per ton:
There is no other way to look at these two charts but call them “blow off” tops. Of course, movements alone do not qualify them as “blow off” tops, but given the deteriorating liquidity indicators I have previously discussed (especially with the end of the Yen carry trade in plain sight), and giving rising inventories in virtually all of the base metals, it is most probably safe to label them as “blow off” tops. The tops being made in both energies and the metals confirm the weakness in the global commodity currencies – which further tells us that a global economic slowdown is now imminent (since the global commodity currencies have been a good leading indicator of the OECD and the U.S. Conference Board's leading economic indicators).
I would now like to end our commentary for this week with yet another discussion on the inverted yield curve. Our first thorough discussion on the yield curve began with our December 15, 2005 commentary (“Yield Curve Continues to Flatten”). In that initial commentary, we looked at the implications of an inverted yield curve from January 1997 to 2000, and discussed the many reasons why “it may be different this time.” We argued that while these many reasons were somewhat valid, it remains to be seen whether they would hold up, given that “…the flattening of the yield curve and the inversion after April 2000 marked a precursor for the 2001 U.S. recession, as well as the dismal performance of the stock market from March 2000 to October 2002. Please note that this inversion of the yield curve occurred as recently as five years ago. It may be too much of a stretch to believe that the U.S. economy and financial structure has changed so much in the last five years that we should totally ignore the flattening and inversion of the yield curve as both a leading indicator of the stock market and the U.S. economy.”
We then extended our analysis further back into the past (stretching as far back as 1965) in our December 22, 2005 commentary (“Flattening Yield Curve: Does the Stock Market Care?”) and concluded that while an inverted yield curve did not necessarily have a devastating effect on the stock markets (such as 1979 and 1989), it has always led to some kind of financial crisis in either the U.S. or somewhere in the world. In other words, an inverted yield curve has always meant a “clampdown” on liquidity – and such “clampdowns” usually affect the assets that have seen the most speculation or that is priced for perfection. In our December 22, 2005 commentary, I posed the following question: “So where are we now? We know that both the Federal Reserve and the Bank of Japan has been tightening liquidity. At the same time, financial and commodity speculation remains rampant, signaling that "financial velocity" has been increasing significantly - which I have discussed many times before and which has been captured and measured by our MEM indicator. Increasing "financial velocity" basically means a higher willingness to take on risks - and with the proliferation of hundreds of hedge funds, lots of borrowed money, and subdued returns over the last two years, it is no wonder investors have taken on a lot of risks - probably more than what is prudent. Interestingly, however, the current flattening of the yield curve is telling us that "financial velocity" (willingness to take on risk) is about to decrease! Combined with a world of declining liquidity, then you have a recipe for disaster going forward. Again, the logical question to ask is: Which market will blink first? Will it be the U.S. housing market? Or will it be the base metals market or emerging markets? How about China - given its huge overcapacity in nearly everything from steel manufacturing to commercial real estate to automobile manufacturing? Note that U.S. money inflows and asset allocation to emerging markets are at their highest since 1994 - the year during the Mexico Crisis and the year before a huge down year for Latin American equities during 1995.”
Again, readers should now be wary of holding such “risky” assets here – said assets being emerging market securities, commodities, domestic small and mid cap equities, and domestic cyclical equities. In our last mid-week commentary, we discussed the current position of Mr. Francois Trahan (Chief Investment Strategist of Bear Stearns – one of the more significant players in trading which have never had an unprofitable year in its history) on the yield curve. His conclusion was this: The yield curve is more significant than ever, given that the yield curve still drives consumer lending standards in the United States, and especially given that the economic recovery since 2001 has been more or less built on the housing boom. Following is the relevant slide from Mr. Trahan's presentation to the Houston Society of Financial Analysts:
Please note that the yield curve tends to lead consumer lending standards by 16 months, and given that the yield curve is about to fully invert, this does not bode well for the U.S. housing or the U.S. consumer going forward. Please note that our definition of the yield curve is the difference between the effective Fed Funds rate and the yield on the 30-year U.S. Treasury bonds, while the definition that Trahan utilizes is the difference between the Fed Funds rate and the yield on the 10-year U.S. Treasury notes. As of Friday evening, there is a two-basis point “positive carry” on the 30-year spread, but come March 28th (the day of the next Fed meeting), the yield curve will definitely have fully inverted. Moreover, the Fed Funds futures is now pricing in a 76% change of another rate hike on May 10th – thus opening the door for an even more inverted yield curve. The fact that the “consensus” is ignoring the yield curve (for the umpteenth time) as a bearish indicator makes this author even more confident of the yield curve as a good leading indicator of the economy. For more details and implications of the flattening/inverting yield, readers are encouraged to read John Mauldin's latest report on the subject.
Readers may now pose the question: The yield curves in both the UK and Australia have already inverted last year. Sure, housing prices in those markets have already cooled off, but why aren't equities tanking?
This is definitely a good question that deserves a considerable amount of attention and thought. Please note that the world is now as globalized as ever, so while the yield curve in the UK or Australia may drive local lending standards (which would certainly cool off consumer spending and housing prices), that is not necessarily the case with equity or commodity prices. In fact, the latter two asset classes (and I use this term loosely for commodities) are more or less dependent on global liquidity, and given that the British Pound or the Australian dollar do not represent popular mediums of exchange for the world economy, it can thus be said that neither the UK or the Australian yield curve is a good leading indicator of the global economy. Conversely – on a GDP basis – the United States represent nearly 20% of the world economy, and significantly more so if one only takes into account the amount of physical and financial trades that are being done in U.S. dollars, Euros, Yens, Pounds, and so forth. The Bear Stearns model actually has a 50% weighting on U.S. liquidity as a component of world liquidity – and thus while readers can ignore the inverted yield curve in the UK or Australia, readers can definitely not ignore an inverting yield curve here in the United States. The last remaining resort of world liquidity is now the Yen – and this author is now wondering how financial markets will react once the Bank of Japan ceases its “quantitative easing” monetary policy (there is now speculation that the Bank of Japan may change its policy as soon as its March 9th monetary policy meeting). In short, it is going to be one interesting ride.
Let's now cut to the chase and discuss the most recent action of the stock market. Along with the abundant evidence that I have previously discussed showing that we are in the midst of making a top, this stock market is now also moderately overbought – as exemplified by indicators such as the equity put/call ratio and the percentage of NYSE stocks above their 20, 50, and 200 EMAs. Following is a chart (courtesy of Decisionpoint.com) showing the latter:
Like I mentioned above, this author will not hesitate going 75% short (from 50% short) in our DJIA Timing System (thus breaking with tradition) should we see a rally in the Dow Industrials (on weak breadth) in the early parts of this week. The fact that many of our short-term indicators are now getting moderately overbought also makes a strong case for shifting to a more aggressive short position – to be cut back when the market declines back to a more oversold position.
Let's now look at the most recent action with the following chart showing the Dow Industrials vs. the Dow Transports. From last week's commentary: “I want to reiterate to our readers to focus on the long-run in these emotional times, when even the bears have gotten on the ride because of the “breakout” of both the Dow Industrials and the Dow Transports. Such “breakouts” have been much celebrated by the bulls over the last couple of years, and in all cases, the market has come right back and suffered a correction. This author believes that a secular bear market began in the spring of 2000 – a secular bear market which still shows no signs of exhaustion. In a secular bear market, primary non-confirmations on the upside should be taken seriously. And so far, the Dow Industrials has still failed to confirm the Dow Transports on the upside by bettering its all-time high of 11,723 established at the close on January 14, 2000.” The message remains the same for this week, even as the Dow Transports continues to “blow off” to the upside by making another all-time high last Wednesday – again without the Dow Industrials confirming on the upside. As a matter of fact, the Dow Industrials actually logged a 53-point decline for the week:
Over the last week, the Dow Industrials declined 53 points while the Dow Transports gained another 31 points – logging another all-time high as recently as Wednesday. Such action in the stock market is definitely impressive, but again, this author believes that given the many divergences, deteriorating liquidity, and the extreme complacency we are witnessing, readers should focus more on the “primary non-confirmation” by the Dow Industrials at this time instead of the day-to-day action in the two popular Dow indices. In the Lowry's interview last weekend, Paul Desmond stated that: “This past week, we took a look at the Dow Jones Industrial Average stocks, the 30 component stocks of the Dow, and what we found was that there were, based on our way of analyzing individual stocks, three of the 30 stocks in strong uptrend patterns -- just 10%. And 20 out of the 30 stocks were in well-defined downtrend patterns. So you can see the selectivity that is present there, with 3 of the 30 stocks in uptrends, 20 in well-defined downtrends.” The Dow Industrials is still definitely the weaker index, and it should be shorted on any strength (in points but not in breadth) going forward.
Let's now discuss our most popular sentiment indicators – but I want to break tradition this week and start with the Market Vane's Bullish Consensus vs. the Dow Industrials since the Market Vane's Bullish Consensus has been the most reliable sentiment indicator (in terms of timing) out of our three popular sentiment indicators over the last two years:
As mentioned on the above chart, the latest weekly reading increased to an extremely overbought level of 70% (relative to the readings over the last two years) from an already highly overbought reading of 69%. Please note that as recently as three weeks ago, the ten-week moving average of the Market Vane's Bullish Consensus stood at 69.7% - the most overbought reading since August 1997. As of the latest week, the ten-week moving average remained steady at 69.4%. Make no mistake: The market is now vulnerable to a significant correction – especially given the leverage and complacency (record low option premiums and emerging market spreads) currently in the world financial system. Given that the Dow Industrials has been the weaker index, this author will not hesitate moving to a more aggressive short position should we a rally in the Dow Industrials and the major market indices (again, on weak breadth) in the early part of this week.
Let's now take a look at the American Association of Individual Investors Survey. During the latest week, the Bulls-Bears% Differential in the AAII survey increased from 4% to a more neutral reading of 15%. The question to ask is: Did the reading of 4% from a week ago represent a sustainable bottom in both the AAII survey and the stock market? Given that the AAII survey was at an extremely overbought level as recently as six week ago, and given the overbought conditions in the Market Vane's Bullish Consensus, this author would argue “No.” That being said, this author would not be surprised to see another short-term rally attempt – a rally that would bring the weekly readings of this survey back to an overbought level before we see a significant correction again. Following is the weekly chart showing the Bulls-Bears% Differential in the AAII Survey vs. the Dow Industrials from January 2003 to the present:
Note that the ten-week moving average is still in oversold territory with a reading of 11.0% - although it is not definitely in an area that would give us a sustainable bottom going forward. My guess is that the ten-week moving average will consolidate at near current levels (as I believe the weekly readings will attempt some kind of a bounce in the next couple of weeks) before selling off again. Again, readers should recall here that significant corrections in the stock market tend to occur while the AAII survey is in an oversold condition (such as what we are experiencing now). For now, we will remain 50% short in our DJIA Timing System, but this author will not hesitate shifting to a 75% short position should the DJIA rally on Monday or Tuesday on weak breadth.
As for the Investors Intelligence Survey, the Bulls-Bears% Differential readings is telling us that while the weekly readings may be oversold (and therefore the market may tried to launch a ST rally here), the longer-term ten-week moving average at 29.3% is still in a moderately overbought condition – suggesting that any rally that emerges from current levels will not be sustainable. Following is the weekly chart showing the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the Dow Industrials:
Given that only 10% of the issues on the Dow Industrials is still in defined uptrends (as noted by Lowry's) and given that the Dow Industrials has been one of the weakest indices in this cyclical bull market (the DJIA A/D line peaked in December 2004 and has been declining ever since), this author believes that the 50% short position in our DJIA Timing System will work out in due time. Again, we will not hesitate shifting to a 75% short position in the Dow Industrials should it rally on weak breadth in the early parts of this week. If we do go ahead and shift to a 75% short position, our plan is to shift back to a 50% short position once the market gets back to a reasonably oversold level.
Conclusion: The most reliable historical leading indicators of the stock market and the economy – the consumer discretionary stocks, the weakness in the commodity currencies and the energies/base metals, the inverting yield curve, and the potential end to the Yen carry trade – are suggesting that the market is now in the midst of a topping out process. As Jesse Livermore would like to put it, they (along with bullish complacency, huge leverage, etc.) are now “megaphoning” such warnings signals all over the place – but similar to many topping situations, hardly anyone is listening to those warning signs. Readers please recall that implied volatility levels in both the stock market and the bond markets are at or near all-time lows, while emerging market spreads are also at all-time lows. I am reminded of the following quote from “When Genius Failed: The Rise and Fall of Long-Term Capital Management”: “Meriwether's traders were profoundly concerned with limiting risk. The idea that they could do so by targeting a specific level of volatility was central to how they ran the fund. If the portfolio was a little too quiet, they'd borrow more, raising the “vol”; if it was too volatile, they'd reduce the leverage, calming the fund down. Rather than target a specific return, they engineered the “hat” so that (they believed) it would fluctuate during most years about as much as the stock market did. With any more volatility, the risk would be too high. With less, they would be leaving money on the table.”
It is no doubt that many of the hedge funds out there still have a similar strategy today, and given that game of “the search for yield,” and given that both historical and implied volatility levels in the financial markets are at or near all-time lows, one can bet that many of the hedge funds out there are now very overextended. Any signs of trouble, and we could be seeing a stampede to the exits.
Henry K. To, CFA