Rising Rates Now a Given
(March 12, 2006)
Dear Subscribers and Readers,
We switched from a 25% short position to a neutral 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 (11,021.59), this position is 151.59 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.
We then added a further 25% short position on Monday afternoon (February 27th) at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%. However, I have warned our readers that we were looking to exit this 25% short position as soon as we could – in order to control for risk/volatility. We subsequently decided to exit this last 25% short position last Friday morning at a DJIA print of 11,035 – giving us a gain of 89 points. This latest signal was sent to all our subscribers on a real-time basis. True, the market did not get severely oversold on the way down. Breadth has also been getting progressively worse, but the refusal of the Dow Industrials to fall further given the negative sentiment (as exemplified by the latest readings in the AAII and Investors Intelligence Surveys) had this author worried. The least we could have done (even though we still maintain our longer-term bearish views) was to pare down our 75% short position in our DJIA Timing System to a more manageable 50% short position, and this is what we chose to do. In retrospect, this was a good move, since the Dow Industrials rallied further to close at 11,076.34. For now, we will remain 50% short at least until the next Fed meeting on March 28th.
Over the last four weeks, virtually all of the stock markets in the Middle East suffered serious corrections. Finally, the Kuwaiti government could stand no more – as it pledged US$700 million at the end of last week to support the Kuwaiti stock market. Folks in Kuwait are now scrambling to find “the reasons” being the recent fall. But after a 600% rally since 2002, and given that global leverage is high and global liquidity is declining, what more can you expect? Not only is this a sign of desperation, but readers should know that such intervention/manipulation in the free market has never worked in the long-run. Thomas Lamont and Richard Whitney could not stop the crash during 1929. The London Gold Pool had to abandon its price-capping scheme of gold at US$35 an ounce in 1968. Neither could the Hong Kong government achieve success during the emerging market panic of 1998. The current situation is especially relevant given that the selling in both the Middle Eastern markets and emerging markets in general is nowhere close to exhaustion. In fact, this author would argue that we are still in the topping out process in emerging markets in general. Going forward in 2006, Middle Eastern investors and emerging market investors in general should brace for more losses.
In previous commentaries, I have argued that the world's stock and bond markets are now dangerously overbought and overleveraged – all in the midst of a tightening global liquidity situation. That is why I think emerging market investors should brace for more losses up ahead, as well as commodity investors and any other investors who choose to “invest” in cyclical or speculative issues.
Readers must be getting tired of all our discussions on bullish sentiment (as indicated by record low emerging market spreads and record low implied volatility levels), high degree of global leverage, and tightening global liquidity. So this week I will take a different route – and discuss something that probably has a more immediate impact on your investments (in particular, your bond investments as well as other investments that are interest rate sensitive) than anything else. Readers may recall that we first discussed long-term interest rates in our March 27, 2005 commentary (“Rising Rates not a Given”). At that time, many Wall Street analysts were calling for a resumption of a rise in long-term rates in light of a declining dollar and a rising CPI. I argued at the time that “rising rates were not a given,” and that in fact, yields should start to decline for the foreseeable future – citing, among other things, the extreme bearish sentiment in bond timing newsletters, relatively low assets in the Rydex Government Bond fund, and the fact that both the Chinese and the Japanese had no intention of paring down their U.S. Treasury holdings.
When our March 27, 2005 commentary was published, the yield on the 30-year Treasury bond was 4.84%. Over the next two to three months, the yield of the 30-year Treasury bond fell over 60 basis points and did not hit bottom until it retreated to a yield of approximately 4.2%. Since that bottom in June to July of last year, the 30-year bond yield has risen over 50 basis points and is now sitting at 4.74%. Given that the 30-year yield is now sitting near the top of its 18-month trading range (see the following chart courtesy of Decisionpoint.com), one would think that buying bonds here would be a no-brainer. This author would argue otherwise.
First of all, it is important to mention here that investors are now getting more sophisticated and that financial transactions are now getting more complex by the day. Because of this, dear readers, we will always strive to evolve and try to stay ahead of the curve (see lesson three in our commentary “On Jesse Livermore And His Legacy”). It is not sufficient to be more sophisticated if you are still one step behind the crowd. For example, in the most recent article on the Middle East, BusinessWeek states that the Middle Eastern countries are now much better positioned than they were in the last boom/bust cycle from 1973 to 1985 – and therefore there is a much lesser chance of a bust this time around. They cite familiar reasons such as more private sector participation, more sophisticated acquisitions in Europe, Asia, and Turkey, as well as more sophisticated investments in asset classes such as real estate and private equity funds (as opposed to parking those petro-dollars in bank accounts). What they ignore, however, is that the business cycle has not gone away – and that folks who are generally financially less sophisticated than their U.S. and Western Europe counterparts will always, by definition, be contrarian indicators and bear the majority of the pain in a typical boom/bust cycle. Today, this author would argue that real estate in many parts of the world are overvalued, and that private equity is in a huge (and soon-to-burst) bubble. Ironically, parking their petro-dollars in cash this time around may not be such a bad idea, after all. Not to mention that the Middle Eastern countries are still very much dependent on oil – and that their private sectors are grossly inefficient compared to the United States. Going forward, the biggest concern of countries such as Saudi Arabia is demographics. Unless oil stays at $60 a barrel and rise to $100 a barrel by the end of the decade, the welfare state in many of these countries will be close to collapsing.
Another example of the need to evolve: This is the same old saw, but I would argue that the concept of globalization is as important as ever. At $35 to $40 a barrel, everyone thought that crude oil was overpriced in early 2004 (for an example of this, read Chapter 3 of Barton Biggs' “Hedge Hogging”). All their models based on historical data and events confirmed this. Barton Biggs had a model telling him “fair value” was approximately $32.50, while the rest of Wall Street had a model claiming fair value was somewhere in the upper $20s. All the OECD leading indicators confirmed this as well. The majority of these folks could not be more wrong, however, as they all failed to anticipate the increase in Chinese demand (whether it is real or ultimately artificial) and most importantly, the lack of spare production capacity and its psychological effect on crude oil traders. The price of oil proceeded to steadily rise, topping $70 a barrel by the time Hurricanes Katrina and Rita made landfall on the Gulf Coast.
But just as everyone and his neighbor (and his neighbor's dog) is now looking for crude oil to break $80 a barrel or even $100 a barrel, this author would now argue otherwise. Note that the price of crude oil has been steadily losing momentum since the ultimate top in late August 2005. Moreover, many of the oil majors have boosted their capital spending by 25% to 35% over the next few years. Inventory levels all across the world are now near or at all-time highs. To illustrate briefly, following is the latest U.S. crude oil inventory chart courtesy of the Energy Information Administration:
U.S. crude oil stocks for the week ending March 3, 2005 topped 335.1 million barrels – approximately 25 million barrels above the high-end of its five-year average range and 32.5 million barrels above last year's levels. Sure, inventory levels didn't matter on the way up – but it will matter on the way down. More importantly, spare capacity is projected to rise by 500,000 barrels a day this year – which should go a long way toward alleviating the fears of a worldwide shortage in oil in 2006. It is also interesting to note that despite the cumulative “destruction” of 135 million barrels of oil supply since the end of August 2005, inventory levels are still 25 million barrels above its five-year high. Should the 2006 hurricane season pass through without any major disruptions to oil supply in the Gulf of Mexico, there is a very good chance that oil prices will collapse back to $50 a barrel or even below. Once oil prices start to decline, the downtrend will be further exacerbated by E&P producers who have failed to so far hedge their forward production (thinking that oil prices will continue to remain high).
The fact that oil prices should ultimately experience a significant correction is also being confirmed by the action in our MarketThoughts Global Diffusion Index (MGDI). For newer readers, I will begin with a direct quote from our May 30th commentary outlining how we constructed this index and how useful this has been as a leading indicator. Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages." Since the middle of 2004, the action of the MGDI and the CRB Energy Index has experienced a significant divergence – most probably due to unanticipated demand in China and the lack of global spare producing capacity. Given that oil demand from China is showing little signs of a significant jump this year, and given that spare production capacity is set to increase 500,000 barrels a day this year, both the action in our MGDI and the CRB energy index should continue to converge going forward. Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Energy Index from March 1990 to January 2006. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to March 10th (the February OECD leading indicators won't be released until early in April). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Historically, the MGDI has done a very good job of leading or tracking the CRB Index and energy prices. In short, the latest reading of the MGDI (even though the second derivative is now in positive territory) still suggests that both the CRB Index and energy prices will continue to correct going forward. Moreover, the leading indicator of the OECD leading indicators – the world's major commodity currencies such as the Australian dollar, the New Zealand Dollar, and the South African Rand have been significantly weakening in the last few months. The last holdout is the Canadian dollar, but after making a new 14-year high the week before last, the Canadian dollar has declined in earnest – even in light of the latest 25 basis point hike by the Canadian central bank. This author expects the Canadian dollar to continue to weaken going into 2006 – and thus for the MGDI to weaken again going forward as well.
But anyway, I digress. Let's now go back and talk about the long bond. While the long bond (both the 10-year and 30-year U.S. Treasuries) is definitely quite oversold right now (after the yield of the 30-years rose 25 basis points in as little as two weeks) – and thus may rally at any given moment – there is a good chance that the long bond will continue to decline going forward (and thus for yields to rise). In previous paragraphs, I discussed the need to continue to evolve when it comes to the financial markets (this concept should be applied to life in general as well, as many of our readers should know!). Folks who continue to model or predict the long bond based on domestic indicators only is definitely not seeing the whole picture. Alan Greenspan and Ben Bernanke had previously mentioned the “global savings glut.” Some folks have argued a combination of things, such as the large-scale purchases of Treasuries by the Japanese and Chinese governments as well as defined benefits pension funds' inclination to better “match their liabilities” by buying long-term government bonds. These factors are perfectly logical and may well all be true, but this author would also argue that the Bank of Japan's policy of “quantitative easing” which began in March 2001 (and which officially ended last week) also played a large role in compressing yields all around the world.
So what do you mean, Henry? How did the Bank of Japan policy of “quantitative easing” compress yields all around the world, especially yields here in the United States?
First of all, it is imperative to explain what the policy of “quantitative easing” that began in March 2001 entailed. Starting in March 2001, both the Japanese government and the Bank of Japan decided that a “non-traditional” monetary policy was needed in order to prevent Japan from falling deeper into a deflationary spiral – especially in light of the bursting of the technology bubble both in the United States and in Western Europe. Short-term interest rates were already near zero, so similar to what Paul Volcker did in the late 1970s and 1980 (when he set a monetary target ceiling instead of a Fed funds target in order to kill inflation), the Bank of Japan set a monetary target (US$250 to US$300 billion) it force fed into the bank system everyday. These funds were mainly injected via the purchase of government and commercial securities by the Bank of Japan. At the same time, the Bank of Japan bought approximately 1.2 trillion Yen worth of government bonds every month – including long-term (10-year) Japanese government bonds. This had the significant effect of capping domestic yields at the long-end and lowering yields all across the Japanese yield curve, with the 10-year yield falling to 0.53% by the end of May 2003 (even though Japan's sovereign rating is rated lower than Botswana's by S&P and Moody's). For readers who recall Ben Bernanke's anti-deflation (“dropping money from helicopters”) speech in 2002, what the Japanese government and the Bank of Japan did over the last five years with their “quantitative easing” policy came as close to “dropping money from helicopters” as any developed country has gotten since the end of World War II. It is interesting to note that all the Austrian economists had a field day with Bernanke's 2002 anti-deflation speech, and yet most of them had no idea that the Japanese had been doing this very precise thing since March 2001.
The policy of “quantitative easing” has officially ended, but it will take a few more months for the Bank of Japan to wind down all their operations. In the meantime, the Bank of Japan will continue their policy of purchasing government securities all across the yield curve – but this too, shall pass.
Given the lack of a meaningful yield in investing in domestic assets, both Japanese pension funds and private investors had to go elsewhere in their “search for yields.” The world's stock markets were mostly off-limits to pension funds (who were quite happy to settle for a 3% guaranteed rate of return), and thus they naturally turned to the world of Western European and U.S. government long-dated bonds. Make no mistake: Japan is the largest credit nation in the world, and it is the largest player when it comes to the world's developed sovereign bond markets. It is certainly true that the Chinese government holds a significantly large amount of U.S. Treasuries, but it is important to keep in mind that this amount is dwarfed by holdings in the private sector – and when it comes to the private sector, the Japanese private investor is by far the largest holder of U.S. Treasuries. As such, the yield on both long-dated U.S. and European government bonds had and will be determined by Japanese pension funds and private investors for the foreseeable future. This phenomenon can be witnessed in the movements of the 10-year Japanese government bond yield vs. the 10-year U.S. Treasury note from March 2001 to the present:
Please note that the correlation of the monthly yield on the 10-year JGB and the 10-year U.S. Treasury note from March 2001 to March 2006 is as high as 70%! From the inception of its quantitative easing policy in March 2001, the yield on the 10-year JGB declined form 1.27% to 0.53% by May 2003. At the same time, the yield on 10-year U.S. Treasuries fell from 4.89% in March 2001 to only 3.33% in June 2003! Since that time, the yield on the 10-year JGB has risen back to 1.66% (as of the close last Friday), but given that the Bank of Japan will gradually phase out purchase of 10-year JGBs, long-term rates in Japan should ultimately rise going forward. Should the yield on the 10-year JGB be more in line with long-term economic growth, long-term rates in Japan could rise by another 40 to 60 basis points in the months ahead – thus putting further upward pressure on both European and U.S. 10-year yields. In fact, this author now believes that rising rates in the U.S. (and Western Europe) is now inevitable – even though in the short-run anything can happen, since the long bond is definitely oversold.
So what does that mean for subscribers? Obviously, this will mean lower bond prices all across the board. Moreover, a rising rate environment should put further upward pressure in both corporate bond and emerging market spreads. Rising rates will further put a damper on U.S. housing and homebuilding stocks, along with (justifiably) lower valuations in the world's stock markets. Moreover, given that rising rates also means a higher opportunity cost for “carrying” and storing commodities, we should see more commodities move to a “contango” environment (when prices in the distant future are higher than near-term and spot prices) – most likely meaning lower commodity prices ahead. In other words, a rising rate environment is bad for global liquidity – especially for cyclical industries like mining, steel manufacturing, and airlines (MorningStar recently published an excellent article arguing that airline stocks in general are now very overvalued all across the board). And one more thing: don't forget emerging market economies.
Let's now take a look at the most recent action in the stock market, starting off with the daily chart of the Dow Industrials vs. the Dow Transports. Over the longer-run, I believe the stock market is making a top, but given the ST oversold conditions in our sentiment indicators (including Investors Intelligence, AAII, the NYSE McClellan Oscillator, and the Rydex Cash Flow ratio – which actually INCREASED from a reading of 0.87 to 0.89 on Friday), the market could experience a decent bounce in the next few weeks. This is the major reason (along with the fact that we also want to control for volatility and risk) why we shifted from a 75% short position to a 50% short position in our DJIA Timing System (at a DJIA print of 11,035) on Friday morning. For the week ending March 10th, the Dow Industrials and the Dow Transports mainly languished in “consolidation mode” as the former index rose 54 points while the latter declined 53 points for the week:
Given that the Dow Transports has been leading the Dow Industrials since the cyclical bull market began in October 2002, subscribers who are long should be careful here – but at this point, this decline in the Dow Transports is most probably just telling us that we are in “consolidation” mode as the market continues to digest its gains since the end of December. However, this author is still of the belief that the current rally in the Dow Transports is nothing more than a “blow off” rally – and that eventually both the Dow Transports and the Dow Industrials will endure a very significant correction later this year. In the meantime, this author will refrain from initiating any new short positions – as the market could still mount a decent rally in the next few weeks (and probably even subsequent to the March 28th Fed meeting as investors decide that the Fed is close to ending its series of rate hikes that began in June 2004). This author would still like to wait for the latest NYSE short interest and margin debt data (which should be released during the week of the 19th) before making a claim, but should the market mount a rally after the March 28th Fed meeting, however, there is a high likelihood that this author may again switch to a 75% short position in our DJIA Timing System.
Let's now discuss our most popular sentiment indicators – again, this author will continue to “break tradition” 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 I mentioned earlier, this author will now start with the Market Vane's Bullish Consensus in all our future commentaries until either the AAII or the Investors Intelligence sentiment surveys start acting more reliably than the Market Vane's Bullish Consensus:
As mentioned on the above chart, the latest weekly reading decreased remained steady at a still highly overbought reading of 68%. Please note that as recently as five 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 declined slightly from 69.3% to 69.2%. Our message remains the same of that from last week: Based on the readings of the Market Vane's Bullish Consensus (which has been the most reliable near real-time sentiment indicator over the last two years) – and given the leverage and high levels of complacency in the world financial system, the market is now very vulnerable to a significant correction. In the short-run, however – given the short-term oversold condition in both the AAII and the Investors Intelligence Survey, this author will most probably wait until the Market Vane's Bullish Consensus hit the 70% level (or until the AAII and the Investors Intelligence Surveys rally back to a more neutral or even an overbought level) before establishing a new short position again. For now, we will remain 50% short in our DJIA Timing System.
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 decreased slightly from 12% to a moderately oversold reading of 10%. Meanwhile, the ten-week moving average of this reading increased from a very oversold reading of 10.9% to 11.9% - which is a pretty significant bullish reversal and thus entitling the market to at least a few more weeks of general upside action. I argued last week that “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. However, any rally that emerges from here should be purely short-term in nature and should definitely be sold.” I fully believe that this is still the case. Following is the weekly chart showing the Bulls-Bears% Differential in the AAII Survey vs. the Dow Industrials from January 2003 to the present:
The message remains the same as last week: The weekly readings should attempt some sort of bounce here, but my guess is that any rally over the next few weeks should be sold – especially more so if breadth and volume is dismal. Actually, this author would not be surprised to see a “blow off” rally in the Dow Industrials, and which doesn't stop until the 11,250 to 11,400 area. For now, we will remain 50% short in our DJIA Timing System after switching back from a 75% short position last Friday morning at a DJIA print of 11,035.
As for the Investors Intelligence Survey, the weekly Bulls-Bears% Differential readings remains in very oversold territory – with the weekly reading again declining from 11.8% to 11.4% over the last week – signaling that an “oversold rally” could continue for the next few weeks. Meanwhile, the longer-term ten-week moving average decreased from 27.1% to effectively a neutral reading of 24.3% – suggesting that any rally that emerges from current levels will purely be short-term in nature and thus not sustainable (but again, watch breadth and volume in the days ahead). Following is the weekly chart showing the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the Dow Industrials:
Based on our current sentiment indicators, this author is still bearish in the longer-run – but for now, the market should remain intact given the short-term oversold conditions in both the AAII and the Investors Intelligence Surveys. This author believes that any upcoming rally over the next few weeks will not be sustainable – but again, readers should continue to monitor breadth and volume across all markets and industries in order to watch for signs of weakness or strength. Watch the Bank Index, the retailers, as well as the consumer cyclicals. The fact that the long bond is also oversold in the short-run (and as a result, should rally in the days ahead) should also provide some short-term support for the stock market. In the long-run, however, this author is bearish on long-dated government bonds and is thus bullish on rates.
Conclusion: As the Bank of Japan continues to phase out its “quantitative easing” policy, the yield on 10-year Japanese government bonds should rise – given that a significant amount of buying support from the Bank of Japan will disappear. Over the long-run, the yield on the 10-year JGB should be closer to long-term economic growth, and the current 1.66% yield is anything but. In fact, this author is arguing for an upward adjustment for 40 to 60 basis points going forward in 2006. More importantly, this support of the 10-year JGB over the last five years has also acted to keep yields down all across the world – as evident by hard data and the huge positive correlation between the 10-year JGB and 10-year U.S. Treasuries since March 2001. Ultimately, this recent action by the Bank of Japan should put pressure for higher rates all across the world – thus further decreasing liquidity especially for debt-dependent industries such as mining, steel manufacturing, the legacy airlines, Ford and GM, as well as for emerging market economies and the housing industry.
Over the next few weeks, this author will continue to monitor the stock and financial markets for any signs of a bullish reversal, but for now, virtually all the evidence is telling me that the market is in the midst of topping out. Again, the fact that not many mainstream analysts are now listening to or discussing these “topping out” indicators is just the way I like it – thus making me more convinced than ever that we are in fact tracing out a significant top. I will talk to you again on Thursday morning (or on our discussion forum), and don't forget: There will be no full commentary next weekend.
Henry K. To, CFA