The Long View
(March 30, 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 Wednesday evening (11,215.70), this position is 345.70 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%. We subsequently decided to exit this last 25% short position on the morning of March 10th 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.
In our mid-week commentary two weeks ago, we stated that we will remain 50% short in our DJIA Timing System until at least the March 28th Fed meeting. Whether we were slightly early or not, this was not to be – as we subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. As of Wednesday evening, this position is 59.70 points in the black. This was also communicated to our readers on a real-time basis. For readers who did not receive this “special alert,” please make sure that your filters are set appropriately. We are now 75% short in our DJIA Timing System.
In this commentary, I will first give a quick update on the current state of the market, and then a subsequent “update and refresh” on what this author is thinking about over the long-run.
Long-term readers will know that I am a worrier – and am constantly reviewing all our indicators and making sure that most of them are lining up in our favor before establishing our position. There is no “sure thing” in the stock market, per se, but before establishing a sizable position, it is always good that the probability is in your favor (unless you are in it for the entertainment – in which case, I suggest you go to Vegas instead). So what is this author thinking now?
We all know that the accompanying statement from the FOMC meeting was slightly more hawkish than many participants were expecting. In essence, the Fed is communicating to us that they are worried about escalating commodity prices, which I have illustrated in our previous commentaries. At the time, I stated that the complacency (the fact that many participants were expecting an imminent pause in the rate hiking cycle) was misplaced, and that the Fed will continue hiking until one of three things occur:
- The stock market declines by 10%
- Gold, oil, and copper prices decline to below $500 an ounce, $50 a barrel, and $2.00 a pound, respectively
- The U.S. current account deficit shrinks dramatically in the next two months – which is not likely to happen
The policy statement released on Tuesday afternoon pretty much reaffirmed my views. The Dow Jones subsequently declined 95 points for the day – but yet, the Russell 2000 actually lost less than three points, while gold only declined a few dollars in the after-hours market. Meanwhile, other commodities such as crude oil, natural gas, silver, and copper actually held steady. During the post-Fed trading session on Wednesday, many of the market indices staged an impressive reversal on impressive volume – with the Russell 2000, the Brokers' Index, and copper actually making all-time highs in the process (and did I mention orange juice as well?).
Interestingly, this “speculative fever” is all occurring in the face of – not just an additional 25-basis rate hike with the promise of more rate hikes for the foreseeable future – but with also a 10-basis point jump in the 10-year Treasury yield over the last two days. As a result, borrowing costs and the cost of “carrying” equity holdings or a non-interest bearing asset such as gold or copper are continuing to increase, and yet hedge funds and pension funds alike are still pouring money into these markets. Over the last few commentaries, this author has also made a very good case of rising global yields going forward – and as such, there is no doubt in my mind that both borrowing and “carrying” costs will continue to increase going forward. The question is: How high is too high?
I know some folks out there look at things like earnings yield vs. the yield of the 10-year Treasury yields and so forth (similar to the Fed model) but what these models don't take into account is yields on the short-end of the curve as well as dividend yield on the S&P 500. The Barnes Index is an indicator that was developed by Professor Bill Barnes and is meant to be a measurement of the “relative value” of equities (the S&P 500) vs. bonds. The following quote and chart is courtesy of Decisionpoint.com:
[The Barnes Index] is based upon a comparison of short and long interest rates, and S&P 500 "as reported" (GAAP) earnings and dividends. The model implies that market risk is highest when return from stocks is low compared to the return on government securities. The formula is:
Raw Barnes Index = (T-Bill Yield * T-Bond Yield)/(S&P Earnings Yield * S&P Dividend Yield)
Assuming a Raw Barnes Index normal range of 1.0 to 3.5, Decision Point normalizes the Raw Index to a range of 0 to 100 using the following formula:
Barnes Index = (Raw Barnes - 1.0)/(3.5 - 1.0)
Following is the chart from Decisionpoint.com plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:
While the current value of 54.8 isn't overly high relative to the readings of the last 25 years, readers should note that the Barnes Index now represents the highest reading since this cyclical bull market began and since early 2002. More importantly, readers should also note that the S&P 500 topped out in January 1973 with the Barnes Index at around current levels. While we won't officially enter the “danger zone” until the Barnes Index hit the 65 to 70 level (which would be comparable to a Fed Funds rate of 5.0% and a long bond yield of approximately 5.5%), this author believes (as I have mentioned before) that the pillar of support provided by a secular decline of interest rates since the early 1980s is now officially over. Given an increasing rate environment, there is nowhere to go for the Barnes Index except for the up direction.
As I promised by one of my messages in our discussion forum, I am now going to provide an update on the Consumer Confidence Index as compiled and published by the Conference Board. Over the last month, the reading of the Consumer Confidence Index rose from 102.7 to 107.2 – representing the highest reading since May 2002. Newer readers may not know this, but the Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint. While it has always been significantly better in calling bottoms during a bear market, it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market – with its last successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90. During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points. Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to March 2006:
While the latest reading of 107.2 represents the highest reading since May 2002, this author would like to see this reading hit the 110 level before being sure that the ultimate top has come. Don't get me wrong – I still believe that the market is in the midst of making a significant top, but in the meantime, the Dow Industrials can always make a higher high.
Over the next few trading sessions, the most likely direction for the Dow Industrials is still down (given its short-term overbought condition and the fact that the 10 DMA of the NYSE high-low differential actually was down on Wednesday despite somewhat impressive breadth) – but as you know, I am a “constant worrier.” I also do not like to plunge into a position unless most (if not virtually all) of our indicators are flashing favorable signals – the most important (in the short-run) signals being sentiment indicators such as the put/call ratio, the Rydex Asset/Cashflow ratio, the AAII, Market Vane, and Investors Intelligence Surveys, and overbought/oversold indicators such as the level of short interest, margin debt, and the NYSE ARMS Index.
So Henry, what are you worried about? Well, we know that many of these indicators I have just mentioned are still not at very overbought levels. For example, margin debt outstanding actually declined over $10 billion in February, while both the AAII and Investors Intelligence Surveys have actually been flashing oversold signals over the last few weeks. When we went 50% short in our DJIA Timing System in mid-January, most of these indicators were indeed flashing overbought signals, but it has not been the case over the last few weeks. Our decision to add an additional 25% short position (bringing us to a total short position of 75%) in our DJIA Timing System on March 20th was mostly based on the fact that market breadth was dismal and that we were seeing many divergences in the components of the Dow Jones Industrials. Since then, the Dow Industrials has declined 59.70 points only – which is definitely not an optimal down move and certainly not one that I was expecting.
Given that the market had every opportunity to decline over the last ten days (especially given the relatively hawkish statement out of the Fed), this author feels that the “window” for the market to decline more from here may be closing. Sure, we know that there will be tax-selling across many of the small and mid caps. We also know that buybacks have turned very quiet over the last few days and that earnings reports will begin to pour out of Wall Street in about two weeks. At the same time, GM is not out of the woods yet – as they're still having difficulty selling GMAC – not to mention the fact the possibility of a strike at Delphi starting as early as next week. In light of this, this author is willing to “stay with the course” for just a little bit more of time – but in order to control for risk in our DJIA Timing System, there is a chance that this author will close out our March 20th 25% position in our DJIA Timing System sometime over the next few business days (especially if the market declines to an oversold condition). We will discuss more about this in our upcoming weekend commentary. A 59.70-point gain is really a pittance but we will take it and re-enter our short position once our sentiment indicators get more overbought if we have to.
At this time, I want to take this opportunity and refresh readers on what my views are for the stock market (and other markets) over a longer period of time. Readers who have been with us should know that over the next 12 to 18 months, this author is looking for a “mid-cycle slowdown” scenario – a scenario that will bring about both a correction in stock markets around the world as well as in the commodity markets. Over the longer-run, however, I believe the commodity market will continue to outperform – given the significant infrastructure and labor underinvestment we have seen over the last 20 years and given continuing increase in demand from many emerging markets – not just China and India (note that demand from Japan should now significantly increase as well given its recent economic recovery). As for the stock market – I have mentioned this before but I will mention it again. Valuations are somewhat cheap on the Fed valuation model basis but please keep in mind that the pillar of support that we have seen from 1980 to 2000 - an era of a secular decline in interest rates – has now disappeared. Going forward, I expect P/E multiples will stay relatively the same or even decline. Some of our readers will disagree with me that we are now in a secular bear market, but that is just playing with words here. Because of this, I expect the stock market action for the next five to ten years to be more cyclical in nature – somewhat akin to the action in the stock market during the period from 1966 to 1982. Let's just say that we are definitely not in a secular bull market anymore!
In the past, I have also discussed the topic of “Capital vs. Labor” and that the dismantling of the unions at the airlines and the auto companies may signal the trough of “labor power” and thus shift the balance of power back to labor – especially given the current relatively low unemployment rate. The question is: Is this trough cyclical or secular in nature? At this point, we have no way of knowing. As I have mentioned before, the breaking of the unions by Andrew Carnegie and Henry Clay Frick at the Homestead Plant in 1892 actually caused a further secular decline in union/labor power. Many steel mills would not be unionized ever again until the 1930s. Will we also continue to witness this trend – not only in union power but in general labor power? As the world gets more globalized, will the maldistribution of income and wealth levels in the U.S. (and other developed countries) continue to rise and converge with income distribution levels in countries such as China and India (where their respective governments are trying very hard to improve the lives of the general population)? Sure, real income levels for the average American will remain steady or increase going forward, but as what has been the trend over the last 20 years, much of the increased income and wealth levels will be focused on the righter-most end of the distribution (that is, the very wealthy) – especially in areas such as finance, entertainment, and executive management positions. While many of us can debate about this topic all day – it is notable to mention that such a maldistribution of wealth and income levels is actually a hallmark of capitalism – and as much of the world and the world's businesses continues to embrace capitalism going forward (including many nations in Africa), this maldistribution of wealth and income levels in the U.S. should continue to increase. For many of our readers, this may actually be the most important point you can take away from our commentary today – especially if you have kids that are now just entering college or thinking of getting some kind of graduate degree. On that last point – I'd recommend getting that graduate degree no matter what (even if one wants to be an entrepreneur) – since for most people, that is the best way to differentiate yourself in the business world today (and folks from India and Ghana, and so forth). The trend of continuing higher and even higher education among our population is still with us. Ten years from now, a bachelor degree will no longer be sufficient in many of the highest-paying jobs and careers, and many of our kids today will actually go on and get their masters and even their PhD degrees.
Henry K. To, CFA