What is this World Coming to?
(June 1, 2006)
Dear Subscribers and Readers,
There are currently several secular trends which I am keeping an eye on, such as the aging of the general population and workforce, the continuing maldistribution of both wealth and income, as well as the “industrialization” of both China and India and the trend towards capitalism in many parts of the world (did you see the welcome party that the Communist Party of Vietnam recently gave to Bill Gates when he visited the country?). I have previously discussed the aging of the population many times (my conclusion is that it would not be good for the stock markets around the world) – and I have also touched on both the widening gap between the “haves” and “have-nots” as well as the fact that both China and India are embracing rapid economic growth, often at the expense of the general population or the environment. When discussing China and India, Americans tend to discuss how many jobs we are losing to those countries (e.g. Did you know that China is now exporting in excess of 10 million oil paintings to be sold in the Western world?). We see those countries as “economic miracles” or the “factory to the world,” but what else do we see or mention? In the case of China, do we mention the destruction of the environment and the accompanying lack of government regulation? Do we mention all the imitation foodstuffs that are going to grocery stores – sometimes causing great sickness to those who had bought and ingested them? Do we mention the government forcibly uprooting homes so they can build the “Three Gorges Dam” or the next manufacturing site? Or the infamous “organs harvesting” factories? Sure, both China and India have recently become the economic engines of the world, but to look at different parts of these countries is similar to looking at the difference between night and day – as the poor in these countries have continued to suffer even as many of the wealthy have become some of the wealthiest individuals or families in the world. I am not one to believe that money buys happiness, but one can sense a growing discontent in these countries – and we may be just a natural disaster or a worldwide recession away from seeing its manifestations.
In a way, what is occurring in both China and India is a reflection of trends in the Western, and in particular, American society as well. Sure, in general, American standards of living have steadily increased over the last ten years (thanks in partly to the “technology revolution” and globalization), but the distribution of both wealth and income have continued to widen. The ample issuance of stock options during the 1990s is all but one example. There is also the astronomical rise in CEOs' pays – not to mention the sums being paid to the most popular entertainers, the best athletes and lawyers, and so forth. On the other end of the spectrum, many other careers are being commoditized, including former high-paying careers such as being an airline pilot, a computer programmer, and even an actuary. The steady erosion and the recent acceleration in the decline of the labor union in the private industry is a direct manifestation of this. Look – I am not trying to take sides here. No doubt, the U.S. is enjoying a higher standard of living, and corporations are more profitable than ever – but at what costs? In the pursuit of the Greenback, more kids today are studying law, medicine, and finance more than ever. Kids are losing their passion for science and engineering – and the U.S. is steadily losing its competitive advantage when it comes to new discoveries. But more importantly, the pursuit of the Greenback has now become very mainstream. As a result, many of our traditional concerns and values are being thrown to the wind, such as our political and economic responsibility to the world, our awareness of political policies and implications, as well as our awareness for the global environment (although it has again become popular to be environmentally responsible with oil at $70 a barrel). In the financial industry, it seems that everyone and his neighbor (and their dogs) are starting a hedge fund, and I ask myself: What is this world coming to? Have we all gone crazy? There is no doubt in this author's mind that at some point, there will be a huge shakeout in the hedge fund industry.
In a way, our collective ignorance can be more or less forgiven, as anyone under the age of 45 nowadays have typically not fought in a war or gone through a severe recession or depression (the 1982 recession was probably the last severe recession). But this does not diminish the fact that we are obsessed with materialism. After all, when was the last time you saw anyone picking up a history book or some kind of biography? We are obsessed with both the book and the movie “The Da Vinci Code,” but how many of us have actually recently read the scriptures? After all, this is a culture where we spend the most time trying to figure out the next SUV or MP3 player to buy. The last time Americans rallied together was after the tragic events of September 11th, but today, the country is more divided than ever – and it is not getting any better. Unfortunately, this author believes that this trend will continue going forward – as the rest of the world adopts capitalism and the pursuit of money (but not necessarily the Greenback). In the past, both our MarketThoughts discussion forum poster rffrydr and I have mentioned the concept of “Capital vs. Labor,” and how balances of power between American capital and labor have varied and followed a cycle in the past. I have also previously asked the questions: “This may be ironic, but is the recent destruction of unions in the airline sector signaling a trough in labor power? Given the tightness in the American labor markets nowadays, are employees and workers gaining back some of their bargaining power?” I may have also those questions too early (like I usually do). Given the secular trend of both industrialization and increasing education levels in both China and India, there is no doubt that these countries will continue to export deflation going forward – not only consumer goods deflation but labor pricing deflation as well. In other words, a general recession in Asia will hit U.S. employees and workers disproportionately (as wage levels in Asia will plunge) – and will again widen the distribution of income in this country. With the aging of the U.S. population, these differences in wealth and income will be made much more clearer, and Americans will not like what they see (despite the articles they have already seen coming from the mainstream media). We are going to be in for a rough ride just ahead.
But enough, let's back to the markets. This week has been a quick week, indeed. And in terms of “quick action,” the stock market did not prove to be a “disappointment, as the Dow Industrials dropped a whooping 184 points on Tuesday and subsequently bouncing 74 yesterday. By the time the market closed on Tuesday, the VIX registered its biggest relative (30%) one-day rise since the week after the terrifying events of September 11th. The NYSE ARMS Index also became quite oversold by registering a reading of 2.41 – the most oversold daily reading since October 8, 2004. At the same time, however, the longer-term moving averages (the 10-day and 21-day moving averages) are still not as oversold as this author would like them to be. Following is a daily chart showing the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Industrials from January 2003 to the present:
Please note while the 10-day moving average is getting quite oversold at 1.34 (at its most recent top), it is still not as quite oversold as it was back in October 2004 or any other sell-offs during that year. Moreover, the 21-day moving average at 1.17 is also not oversold enough to indicate a sustainable rise from current levels. To get a sustainable rise going forward, one will really need very strong buying, and chances are we won't see any strong interest in stocks unless 1) oil declines substantially while the economy is still strong 2) Still yet lower prices in the next couple of weeks. At this point, point 2) is the surer bet, and so probability suggests that we will at least see more of a consolidation period in the days ahead – with a possible final push to new lows before the market can enjoy any further gains. Should the market hit a new low in the days ahead, there is a good chance this author will shift our DJIA Timing System from its current 50% short position to a more “bullish” (whether one is bullish is in the eyes of the beholder, I guess) 25% short or completely neutral position.
In a post on our discussion forum, I also promised that I will post the latest NASDAQ short interest numbers. Well, look no further – following is a monthly chart showing the amount of shares shorted on the NASDAQ and the value of the NASDAQ Composite from September 15, 1999 to May 15, 2006:
Please note that NASDAQ short interest again made an all-time high in the latest month – a third consecutive all-time high, as a matter of fact. As mentioned on the above chart, the three month increase in short interest of 11.20% represents the highest reading since April 2005 – during which time the NASDAQ Composite also made a significant low. Again, chances are that we will see more of a consolidation period (or a drift lower) over the next couple of weeks, but from a macro standpoint, it looks like that conditions are now ripe for some kind of short-term bottom. I still yet need to get a confirmation from NYSE short interest, but the immense recent increase in short interest on the NASAQ alone is probably enough to guarantee a short-term bottom soon. I also believe that relative strength will again shift back from the Dow Industrials to the NASAQ Composite.
In the “Nothing is Obvious” department, I encourage readers to try to get their hands on the latest edition (Volume 62, Number 3) of the “Financial Analysts Journal.” There is a very interesting article in that journal, entitled “Dividend Payout and Future Earnings Growth,” by Ping Zhou, CFA and William Ruland. In a synopsis of the article, the authors state: “Because dividends reduce the funds available for investment, many market observers and investors associate high dividend payout [dividends as a percentage of net income] with weak future earnings growth. Tests using aggregate data, however, provided evidence that contradicts that view. Because aggregate results may not apply at the company level, we conducted a company-by-company analysis of the relationship between payout and future earnings growth. Our tests also show that high-dividend-payout companies tend to experience strong, not weak, future earnings growth. These results are robust to alternative measures of payout and earnings, sample composition, mean reversion in earnings, the effects of particular industries, time periods, and share repurchases.”
In this author's opinion, the above results are virtually ground-breaking, as previous studies of the dividends vs. future growth have been totally focused on the aggregate level. Typically, a high dividend payout on the aggregate level have meant a disinterest in both the stock market and the economy – and thus many investors would not be surprised should earnings growth “revert to the mean” and explode to the upside after a depression in the collective earnings of U.S. corporations. This article changes this perspective, as the authors make a good case stating that a company that has a high dividend payout typically has great future earnings growth – no matter whether the economy is in recession today or not. In other words, folks can now use this analysis and evaluate prospects at the company level and pick individual stocks. In fact, the authors claim that companies with a high dividend payout and relatively low past earnings growth typically enjoy the greatest growth of earnings in latter periods (the authors looked at 12-month, 24-month, and 60-month periods). Of course, one condition is that the dividends have to be sustainable (this will scratch GM off the list as new accounting rules will kick in that will prevent GM from paying a dividend by the end of this year). We will continue to explore this concept in our latter commentaries, but for now, I am keeping high dividend payout companies like Tuesday Morning (TUES) on my watch list. For folks that want to get a copy of this article, please email me for further details.
Henry K. To, CFA