An Update on the Markets
(July 27, 2006)
Dear Subscribers and Readers,
In this mid-week update, I will provide a bit more background on why I think we are still in “capitulation phase” – with an emphasis on cash levels at the S&P 500 companies, corporate bond spreads, the NYSE short interest ratio, as well as a more detailed illustration on the latest outstanding margin debt data. Again, I believe the U.S. stock market will give us a substantial low to go long within the next couple of weeks or so. In our last weekend's commentary, I stated that we would wait until GM's earnings to decide whether to go long the current stock market. Based on today's positive reaction to GM's earnings and its better-than-expected earnings, it is obvious that GM definitely did not bring about capitulation. Since this author is still very skeptical of GM's turnaround plans, we are definitely not going to go fully (100%) long in our DJIA Timing System until we have seen another washout in the stock market.
Let us now get on with our commentary.
In our July 9th commentary (“The Bulls vs. the Bears”), we stated that: “Lowry's has already declared we are in a bear market – citing the lack of demand from investors and the lack of broad-based strength in many industries and individual stocks. However, please keep in mind that Lowry's does not analyze its “buying power” or “selling pressure” indices separated/based on each class of individual investors, such as corporate insiders, hedge funds, or retail investors. Looking at mutual fund inflows over the last 12 months, it is obvious that the retail investor has continued to shun domestic equities – and thus we know that retail investors have been directly responsible for the weakness in many of Lowry's technical indicators. On the other hand, TrimTabs claims that corporate managements have been buying back their own shares at a record pace. Combined with the record amount of cash acquisitions in recent months and the lack of IPOs, and you have a wildly bullish leading indicator – as corporate insiders have historically been much “smarter” than retail investors in predicting future stock price trends. The question now is: Will retail investors continue to exit the market and if so, will it crash the major market indices?
Should retail and foreign investors continue to shun U.S. domestic equities; will insiders and private equity funds have enough firepower to keep stock prices afloat?”
We then followed up with a chart courtesy of the Bank Credit Analyst showing the historically high amount of cash held by corporations as a percentage of total assets, as well as another chart showing that M&A activity is still significantly below the peak reached during the late 1990s.
Since our July 9th commentary, share buybacks and cash acquisitions by U.S. corporations have continued to be very robust. In fact – based on TrimTabs' proprietary analyses and liquidity indicators – they are now at their most robust level since March 2003. It is interesting to note that TrimTabs' model portfolio only allows them to be at a maximum of 200% long. However, if their rules along them to have an even more bullish exposure, there is no doubt that they would be 300% or even 400% long based on their current analyses. The Bank Credit Analyst chart we showed you in our July 9th commentary provides a very powerful argument for the continuation of today's robust pace of share buybacks by U.S. corporations. However, the bears could still potentially come up with two arguments against this, such as:
- The chart is more than three months ago, and cash levels at U.S. corporations may have dwindled since then given the rapid pace of share buybacks over the last quarter or so;
- The cash level indicator on the BCA chart shows cash levels as a percentage of total assets, and given the record amount of intangible capital (intangible capital that are not counted on company's balance sheets) in today's platform companies such as Dell, Microsoft, IBM, etc., this indicator may not compare that well over time – especially over a 25-year timeframe. A better cash level indicator may be cash at U.S. corporations as a percentage of total market capitalization.
Fortunately, TrimTabs took care of both of these potential concerns in a weekend commentary from two weeks ago. The following chart from TrimTabs shows both the absolute amount of cash and cash as a percentage of market cap of the S&P 500 Industrials from 1988 to 2006 YTD:
Of special interest is that as a percentage of total market cap, cash levels at the S&P 500 Industrials have actually remained relatively flat over the last three years – and that collectively, this percentage is at the highest level it has ever been since 1988. The above chart suggests that share buybacks by U.S. corporations should continue at their current pace at least in the near future, given the immense amount of cash still sitting on companies' balance sheets today. More importantly, the robust cash flows that corporate America has been enjoying over the last few years still shows no signs of letting up, as exemplified by the following monthly chart showing corporate bond spreads between the Moody's Baa and Aaa Bonds over the 20-year U.S. Treasuries from January 1996 to July 2006:
If corporate cash flows were to decline anytime soon, the corporate debt market would have been the first to catch wind of it. Given the relatively stable spreads we have been seeing in both the Moody's Baa and Aaa bonds over the last few months, however, this author's best guess is that corporate cash flows should stay relatively robust for the foreseeable future. Coupled with the historically high cash levels in U.S. corporations, corporate share buybacks should thus continue to be robust at least for the rest of this year.
So Henry, why has the U.S. stock market been performing so poorly despite these bullish liquidity indicators coming out of both U.S. corporations and private equity investors? There is only one answer: Widespread capitulation of both U.S. retail and institutional investors. Collectively, the latter two groups have historically been very poor timers of the market, and this time should be no different. Again, I expect the capitulation phase to end relatively soon – probably within the next couple of weeks or so. Once the selling from retail investors is exhausted, I expect the U.S. stock market to perform relatively well – especially the U.S. large caps which this author has started to get very fond of over the last few months.
As I mentioned in last weekend's commentary, the latest NYSE short interest ratio (for the month ending July 15, 2006) also just spiked to 6.1 – the most oversold reading since September 2005. I will now provide a historical context of this reading as evident in the following chart:
As shown on the above weekly chart comparing the NYSE Short Interest Ratio vs. the Dow Industrials, significant bottoms in the stock market have tended to occur while the NYSE short interest ratio is above a reading of six. Moreover, this “over six” reading has been especially reliable since the beginning of this cyclical bull market in October 2002. With the most recent spike from 4.9 to 6.1 in the NYSE SI ratio, another good pillar of support has thus been added to the current stock market.
And finally for the bulls, it is also interesting to see that the recent growth of margin debt outstanding on both the NYSE and the NASDAQ (or lack thereof) has been relatively muted. In fact, margin debt growth over the last three months (ending June 2006) has actually gone into negative territory – something that has not occurred since December 2005, and prior to that, June 2005. In terms of the six-month rate of growth in margin debt, we are now actually at the lowest since October 2004, which in retrospect, turned out to be a huge buying opportunity. Following is a monthly chart showing the rate of change in margin debt (over three, six, and 12 months, respectively) vs. the action in the Wilshire 5000 from January 1998 to June 2006:
Given a further correction in stock prices during the last few weeks in July, there is good reason to believe that the total amount of margin debt outstanding should further decline in July. Assuming (conservatively) that the amount of margin debt outstanding at the end of July stayed flat from the end of June, the three-month and six-month change in margin debt at the end of this month would be at their lowest since September 2002 and December 2002, respectively. Unless we are now entering a vicious bear market (which this author doesn't think we are), then we have probably found or in the midst of finding a good bottom in the U.S. stock market.
And finally for the bears: The relative strength of the Merrill Lynch Retail HOLDRS (RTH) vs. the S&P 500 just declined to its lowest level since January 2003 – and we all know what happened to the U.S. stock market during February and the early parts of March in 2003. Historically, the relative strength of the RTH vs. the S&P 500 has tended to lead the stock market by two to eight weeks. If the short history of this indicator holds true (a weekly chart of this indicator is shown below), then we could be seeing lower lows in the Dow Industrials or the S&P 500 over the next two weeks to two months. For those who always view their glasses as half-full: This latest dip (caused by Amazon.com) of retailers vs. the S&P 500 should be viewed as another good opportunity to add a cross-section of retail stocks that you like to your individual portfolios.
Again, the relative strength of the RTH vs. the S&P 500 bears watching – but at this point, there is still no totally convincing reason that we will see lower lows in the stock market right up ahead. More details to come in this upcoming weekend's commentary.
Henry To, CFA