Divergences and the Dash to Trash
(April 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 Friday (11,367.14), this position is 497.14 points in the red. We then added a further 25% short position the afternoon of 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. 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. We had been trying to get rid of this latest 25% short position over the last three weeks. We had opted to wait for a more oversold condition before covering it – but it was not to be, as the Dow Industrials rallied a whopping 194.99 points the Tuesday before last (partly because of the March 28th Fed minutes released in the early afternoon). Again, we are now 75% short in our DJIA Timing System.
As of this point, we still do not anticipate changing our positions in our DJIA Timing System anytime soon. However, this author believes that a potential trigger point will be the May 10th Fed meeting. Should the market continue to rally or hold on to its current gains going into the Fed meeting, there is a strong likelihood that the market will sell off right after the Fed meeting – contrary to what many analysts and retail investors are currently expecting. In that case, there is a good chance that we will go 100% short in our DJIA Timing System. Again, we will let our readers know on a real-time basis once we have decided to make changes to our positions in our DJIA Timing System. We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: “A Change in our DJIA Timing System”).
Going forward, we would (and we hope our subscribers would) like to focus more on specific stocks and industries (since that is where the “big money” is made) – although we would definitely continue our macro economic and stock market analysis at least once a week. Again, any suggestions or thoughts are always welcome.
Since our mid-week commentary on Dell, I have received some good feedback – both on our discussion forum and through email. Please continue to send in your thoughts and analysis. Interestingly, the current thoughts of our subscribers on Dell are generally more negative than the mainstream. Among the chief concerns were:
- The lack of a brand name recognition in Asia, especially in China. More specifically, the subscriber stated that consumers had never really felt attachment to the Dell “brand name,” since Dell's strategy is to establish and cultivate relationships with businesses (this is where the fat margins are made). This was in response to my assertion that Dell could be as successful in China as it has been in North America – a feat which would further drive their revenues although it may compress overall margins. As an example, I cited the Buffett purchase of KO in 1998 – when many analysts had given up on the KO franchise primarily because they could not envision the explosive growth in the Far East.
- The Dell model of direct sales and being a low-cost producer has “advanced to its logical conclusion” – given that both HPQ and Lenovo are close to or have already closed the “cost gap” with Dell. Moreover, Dell has a significant disadvantage when it comes to consulting and services – since this is now the bread and butter of IBM's business and to a lesser extent, HPQ's.
Like I mentioned in our mid-week commentary, the price of action of DELL and HPQ have been trending in opposite directions since July 2005. While the new CEO of HPQ (Mark Hurd) is still trying to fix HPQ's problems, it is noteworthy to mention that Dell has benefited significantly from Carly Florina's missteps while she was CEO of HP. Is HPQ going to continue to take hits from Dell? Not if they could help it. Please note that HPQ remains one of the greatest American companies in this author's books – as it has continued to build shareholder value and reinvent itself through thick and thin since 1939. That being said, Dell remains heavily oversold – and should definitely be on the watch list for those who would like to purchase Dell at a discount to where it has been trading at over the last eight to nine years.
I would like to start this commentary on a different note to what we discussed last week (those topics being rising inflation as exemplified by a spike in the Cleveland Fed Median CPI and the so-far lack of a significant slowdown in the housing sector). This week, I would like to again discuss liquidity, divergences, and the “dash to trash” phenomenon that we are currently witnessing in the stock market.
This author has to admit – global liquidity (and what is relevant to the U.S. stock market) is getting more difficult to track by the month, as both China and India becomes global players in the world financial markets. Make no mistake, however: global liquidity continues to decline, as the European Central Bank is now signaling a further 100 basis point increase by the end of this year and as the Bank of Japan phases out its “quantitative easing” policy. In retrospect, however, there is little doubt that this author had underestimated the rise in Japanese liquidity over the last few years – and the effect this had on asset classes around the world, such as commodities, sovereign bonds, and to a lesser extent, domestic and international equities. The following chart from John Mauldin's latest commentary (and originally produced by GaveKal in Hong Kong) shows this plainly – as the Japanese monetary base immediately took off once the BoJ started its QE policy and actually surpassed the U.S. monetary base by the end of 2002. Quoting GaveKal: "One of the trademarks of perma-bears is to blame all the world's ills on an hyper-active Fed whose policy shifts endanger the state of our economies and the value of financial assets. But is this a fair indictment? Judging Fed policy by the growth rate of the US monetary base (see chart next page), we find that the US monetary base has been growing fairly steadily and in line with US GDP growth. In fact, if one wants to blame a central bank for volatility in global monetary aggregates, one should instead turn to Japan. "The chart below shows the US monetary base, the Japanese monetary base - in dollars - and the sum of the two (also in dollars) ... What emerges from this graph is very simple: all the volatility in the US + Japanese base aggregate has come from the Japanese part of the component. The volatility in global M has in the past thirty years come from Japan.”
Not only did this aid Japan's economic recovery, this ample liquidity also began to spill over to the global markets beginning in 2005 (when the Yen embarked on a multi-month decline) and basically muted the tightening effects of the U.S. Federal Reserve since June 2004.
Now that the Bank of Japan is phasing out its QE policy, this ample liquidity will began to disappear from the world's markets. We're starting to see the first effects of it now – as the Yen started its bounce from its low of 0.8250 in December to its current level of 0.8850. This decline in global/Yen liquidity has also been eating at the edges of the Yen carry trade, as both the currencies of Iceland and the New Zealand took a huge hit in the last few months.
In the meantime, the speculators are continuing to “fight the Fed” – as our MarketThoughts Excess M indicator continues to turn down from negative 2.47% to negative 2.55% in the latest week (please see our April 9, 2006 commentary for an in-depth discussion of how our MEM indicator is constructed). Following is a weekly chart showing our MEM indicator, the 52-week change in the St. Louis Adjusted Monetary Base, and M-2 outside of M-1 plus institutional money funds:
Make no mistake: There is still some “liquidity spillover” from the Bank of Japan but the world's three major Central Banks have and continue to “mop up” excess global liquidity. Initial signs include the collapse of the Icelandic Krona, the New Zealand dollar, the rising Yen, as well as the collapse of the Middle Eastern equity markets over the last nine months. At the same time, both the hedge funds and retail investors are “investing” whatever they have left in commodities, emerging market securities (including Russian equities and Iraqi bonds), and U.S. small and mid caps. Historically, whenever Main Street hits Wall Street and fights the Federal Reserve, it has ALWAYS ended in tears. This time will be no different.
Speaking of commodities and emerging market equities, Bill Miller of Legg Mason (who has the enviable record of beating the S&P 500 for 14 consecutive years – not an easy feat for a mutual fund manager) had this to say about these “asset classes” in his first quarter commentary last week. I will quote:
A big difference between today and the commodity bull markets of the 1970's is that then the US Fed monetized the rise in prices leading to persistent inflation. Today central banks are withdrawing liquidity, not adding it. So far there has been no impact on commodities, and except for a few scattered areas of the world, most assets and markets are continuing to rise. I think that will get more difficult to sustain, especially if liquidity becomes scarcer. The first to feel the pain could be where the gains have been the greatest, which would be emerging markets and commodities
The excitement and enthusiasm surrounding commodities, and the belief that they will continue to rise, is not surprising. People want to buy today what they should have bought 5 or 6 years ago; call it the 5 year psychological cycle. Today people want commodities, emerging market, non US assets, and small and madcap stocks. Those were all cheap 5 years ago and had you bought them then you would be sitting on enormous gains. But 5 or 6 years ago, everyone wanted tech and internet and telecom stocks, and venture capital and US mega caps. The time to buy them was in 1994 or 1995, when they were cheap. But in 1994 or 1995, people wanted banks and small and mid caps, which should have been bought in 1990, and well, you get the picture.
Many subscribers have contended that this secular bull market in commodities will last 10 to 15 years. I concur with this, since there has been an extreme underinvestment in many of the sectors that are involved in producing commodities from the early 1980s – such as oil & gas drilling, refining, gold, silver, copper, iron ore, uranium mining operations, and so forth. At the same time, we are seeing unprecedented surge in demand from the emerging markets, especially China and India. However, readers should keep in mind that the uptrends in many commodities over the last three years or so have been extreme in their own right – especially in commodities such as copper, natural gas, and zinc. Moreover, just like the various sectors in the stock market, every commodity is different. That is, not all commodities are going to top out at the same time. For example, during the 1970s bull market in commodities, cotton prices effectively topped out in September 1973 – a full six years and four months before the final top in gold and silver prices. Sure, cotton made a somewhat higher high in October 1980, but anyone who held on after the September 1973 top was effectively wiped out – as shown by the following chart showing the daily cash price of cotton (cents per pound) from June 1969 to December 1980:
As of last Friday at the close, the cash cotton price closed at 47.5 cents per pound – half the price of the peak in prices during September 1973. More recently, the rise in natural gas prices that we experienced last year has also been corrected in a big way – with the current spot price below $7.00/MMbtu and with the January 2007 contract closing at $11.36/MMBtu last Friday. This is a far cry from the $15.50 gas price that we experienced right before Christmas of last year. Should our natural gas infrastructure remain intact during the hurricane season this year, then natural gas (deliverable during the winter) could effectively retest the $10 level – even should we experience colder-than-normal weather during the upcoming winter.
In the meantime, readers should be very careful of a huge correction in commodity prices – even though the secular bull market in certain commodities may not be over yet. As stated by Bill Miller: “A big difference between today and the commodity bull markets of the 1970's is that then the US Fed monetized the rise in prices leading to persistent inflation. Today central banks are withdrawing liquidity, not adding it.” Even though there is still excess liquidity in the system (courtesy of the Bank of Japan), they have been quickly mopping it up and continues to do so at a frantic pace. Read: The secular bull market in commodities over the next five to ten years will be purely determined by demand and supply – and not by excess monetary inflation that we experienced during the 1970s (preceded by an ill-advised policy of price and wage controls). That is why this author is skeptical of any major rally in agricultural commodities – most notably cotton, wheat, and so forth. As for copper – if there is truly a corner being currently conducted by a group of hedge funds (which isn't overly difficult since the U.S. copper demand is only worth $12 billion or so a year), then this corner will eventually collapse, and it will take many years (if not over a couple of decades like silver) for copper to regain its former highs. That is just the historical experience of corners – nothing more.
Mr. Miller also discussed international equities – and here we see that U.S. mutual fund inflows into international equities for the first quarter of 2006 totaled $71.5 billion – more than the amount for the ENTIRE YEAR of 2005. By far the most expensive market in Asia is now India – and given an upcoming wave of IPOs, declining central bank liquidity all around the world, lax regulations in equity trading (the recent allegation that 24 entities in India manipulated the shares of 105 IPOs from 2003 to 2005 may just be the last straw that breaks the camel's back), and the lack of world-class companies that have gone public over the last couple of years, my guess is that the India stock market will crash sometime this year. It is not a matter of if – but when. Note that even if the India market goes down by 50%, it will still be trading at a level comparable to where it was a mere 12 months ago.
As for the U.S. stock market, we are continuing to witness significant divergences and a deteriorating technical condition in many of the indices – such as the NYSE A/D line, the NYSE/DJIA/Total Market McClellan Oscillator and Summation Indices, the number of new highs vs. new lows, and so forth. For the first time since this cyclical bull market began in October 2002, the NYSE A/D line has failed to make a new high even as both the NYSE Composite and the Dow Jones Industrial Average made a new rally high last week (the following chart is courtesy of Decisionpoint.com):
Some readers may now be pointing out: Well, nearly half of all NYSE issues are not standard operating companies – but rather “stuff” such as ADRs, close-end bonds funds, and so forth. And given that interest rates have been increasing, it makes sense that these issues would go down, thus dragging down the A/D line of all NYSE issues as well. This is definitely true, but as Lowry's noted, their proprietary A/D line consisting of only operating companies on the NYSE has also failed to make a rally high – the first time it has failed to do so since this cyclical bull market began in October 2002.
Since the bull market since the October 2002 bottom has been a small and mid cap bull market, there does not need to be a huge divergence between the NYSE A/D line and the Dow Jones Industrials before the major market indices finally top out. Moreover, the percentage of NYSE stocks making new all-time highs is now at a level which is consistent with where it was at prior bull market tops – signaling an imminent top is at hand.
A further divergence that we are currently witnessing and which has a great relevance in this current market (given our mid-cycle slowdown scenario due mainly to decreased consumer spending) is the performance of the retailers vs. the performance of the broad market (i.e. the S&P 500). Such a divergence can be witnessed in the following weekly chart showing the relative strength of the Retail HOLDRS (RTH) vs. the S&P 500:
Please note that the relative strength of the RTH vs. the S&P 500 over the last two weeks has declined to a level not seen since March 2003. Please also note the since the cyclical bull market began in October 2002, the relative strength of the RTH vs. the S&P 500 has been a great leading indicator of the broad market – typically leading the stock market from a period of two to eight weeks. The fact that relative strength of the RTH has now declined to a new low – and the fact that both the gasoline prices and interest rates continues to remain high – suggests that the stock market is currently on very dangerous ground. This market is now making an imminent top.
Finally, for readers that missed out on John Mauldin's latest “Outside the Box” article, you should definitely read his latest article (originally written by James Montier) entitled: “The Dash to Trash.” Montier not only shows that investors are getting into “trash,' but are willing to embrace it by paying top dollars for it (such as the India stock market where its P/E ratio is now significantly higher than the P/E ratio of the S&P 500). History has shown that the market only does is when it is making a top – such as the 1987 and the 2000 tops. It is now again time to let the inmates take over the asylum and let them do whatever they want with it.
Let's now discuss the most recent action in the stock market. First of all, the recent downfall of both DELL and MSFT should be disconcerting to many Wall Street analysts, but alas, these folks have not been overly concerned – instead choosing to restrict their latest declines to company-specific developments and/or remarking that the sell-offs were overdone and that now is a good time to buy. This author views things a little differently. When two of the biggest brand names in the U.S. start to underperform the way that DELL and MSFT have done over the last six to nine months, then it is time to take notice. As John Mauldin had pointed out, the NASDAQ Composite is still trading at a P/E ratio of approximately 40 – a still-laughable ration given that the index consists of mostly cyclical issues. Readers should also not forget that the technology sector has historically been a very cyclical sector – as the period 2000 to 2002 can attest to. Just playing “Devil's advocate” for a second: What if the market recognizes the fact that MSFT has already become “the market” for tech spending and that the structural story which had been intact all throughout the 1970s to 1990s is now gone – to be replaced by a growth factor that is somewhat similar to global GDP growth. What if the market also recognizes that tech spending will continue to be volatile for the foreseeable future? In that case, isn't a P/E ratio of 20 still high for MSFT? Shouldn't MSFT be valued more like a cyclical stock? Say with a P/E of 10 to 12? Wouldn't DELL, CSCO, and INTC fit into this category as well (note that Bill Miller specifically mentioned Citigroup, and not MSFT or DELL)? If so, then the NASDAQ may be in for some rough rides ahead. This scenario would also fit in with our “topping out” scenario as well as our secular bear market scenario. Readers should keep in mind that just like bull markets, bear markets will go further than anyone think it would – and at this point, if you ask anyone out there, they would assert that the secular bear had already ended in October 2002 and that the market can only go up from here. History suggests that they will be disappointed.
Let's now take a look at the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:
As mentioned in the above chart, there was negative divergence last week as the Dow Transports declined 41 points while the Dow Industrials rose 19 points. At the same time, the Dow Utilities declined 0.9 point to close at 397.46 last Friday. Please note that the Dow Utilities topped out eight months ago and is many points away from the all-time bull market high of 437.63 made on October 3, 2005. Moreover, given that bond prices have shown no signs of life even though it is in a very oversold condition, it is doubtful that the Dow Utilities could continue to build on its gains from two weeks ago. Given the recent underperformance of both the Dow Utilities and the Dow Transports, there is a strong chance that the Dow Jones Industrials and other major market indices will underperform over the next few days.
I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. Over the last few weeks, the average of our most popular sentiment indicators has remained very steady – again, while the short-term readings of these indicators may be more on the neutral side (relative to the readings we have gotten over the last couple of years), readers should note that these readings are still pretty overbought relative to the readings since January 1997.
During the latest week, the four-week moving average of the bulls-bears% differentials of these three popular sentiment indicators rose from 23.3% to 23.7%. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week (note that I have redid the scales and shortened the time period by changing the starting month from July 1987 to January 1997):
The fact that this sentiment indicator is still tilting towards the neutral side tells us that there may be more room to run on the upside – but given the weakening breadth numbers, tightening liquidity, and the overbought conditions in our other technical indicators, this author won't be willing to bet on the long side here until our sentiment indicators get significantly move oversold (for example, readings that would put us at the October 2005 levels. In fact, time is now not on your side if you're a bull.
Conclusion: The probability of a significant stock market top (and a top in international equities and many commodities) continues to increase by the day – as evident by declining liquidity, historically significant divergences, as well as a “dash to trash” – a phenomenon that typically only occurs at major stock market tops. At this point, readers are urged to be very defensive and to be very aggressive in culling weaker-performing stocks from their portfolios. For now, this author is still watching DELL. As I have previously mentioned, DELL may be a good buy at this point – but there has been a lot of technical damage done to the DELL stock price – and given my scenario of an impending market top, this author is definitely not jumping into DELL at this point.
In the short-run, this author will continue to remain 75% short in our DJIA Timing System – with no plans to change our signals during this upcoming week (although we may shift to a 100% short position should the market continue to rally going into the May 10th Fed meeting). For now, stock selection (both on the long and the short side) continues to be the key. As for bonds, the short-term and intermediate-term trend is still down, although we will continue to keep an eye on bonds and will most likely do some kind of trade on the long side within the next two to eight weeks.
Henry K. To, CFA