Let's Get the Action Started!
(September 4, 2006)
Dear Subscribers and Readers,
Before we dive into this week's commentary, I would like our readers to turn your attention to the latest Department of Labor report highlighting the major trends and dynamics in the U.S. labor market today. The lesson is clear: Parents and students alike should read this report with a sense of urgency – as a post-secondary education in our quickly-changing and globalized world is now a must. For those of us who are already in the labor force, this is a call for you to always be on the look-out – not only to see whether your job is “relevant” in the 21st century but also to keep an eye on any upcoming new opportunities for you to learn or finally be employed in a job or career that you like. For those who had always wanted to get that degree (whether it is the first, second, or some type of advanced degree), the time to do it is now! Quoting the BLS report: “The demand for a highly educated workforce is expected to continue. BLS projections for 2004 through 2014 indicate that nearly two-thirds (63.4 percent) of the projected 18.9 million new jobs will most likely be filled by workers with some post-secondary education.”
Of course – the above projections represent merely a continuation of what has been occurring ever since the end of World War II. To illustrate, let us take a look at the following table courtesy of the BLS report showing employment change broken down by major industry sectors from 1990 to 2005:
The above table should not be a surprise, as we have witnessed employment declines in mining and manufacturing (both durable and nondurable) since 1990, given increased productivity (the use of computers and robotics) and increased competition from countries such as China, South Korea, and Taiwan. Of course, the protectionists in Congress – all in the spirit of “saving” American jobs – would rather want you or your kids to work in a coal mine or on a conveyer belt than to work on a computer and in an office – with 10% unemployment to boot as the rest of the world retaliates to any protectionist policy we adopt going forward. As for the “current account deficit,” this author believes it is essentially a useless statistic – given the “hodgepodge” way in which it is compiled (at the U.S. ports) rather than how it should be compiled. In our February 13, 2005 commentary (“China – Background and Current Issues, Part III”), we stated: “Note that the current account deficit has historically been a bad estimate since it has grossly underestimated [U.S.] exports. For example, how does one estimate exports like university educations, downloadable software, and banking services - exports where Americans have a huge comparative advantage? Moreover, according to the IMF, the world had a $150 billion trade deficit with itself as early as 1997. Since the sum of all the surpluses and deficits has to equal zero, it basically means the system of measuring surpluses and deficits is inherently flawed. Another question would be: New York basically runs a trade deficit with many of the cities or regions in the United States. In terms or prosperity and wealth, how does New York rank compared to the rest of the major cities or regions in the United States?”
The bonus pool in New York City hit $20 billion last year – would one want to be a NY resident working on Wall Street or on a natural gas rig in Texas or Louisiana? Historically, countries with the most wealth have always run a current account deficit – and the 21st century no doubt would be no different relative to the 19th or 20th century. In the book “Schroders: Merchants & Bankers” (a biography of one of the greatest merchant banking families in Europe), the author writes of the firm and its trading activities: “The 206 clients located in the Americas and Asia were mostly engaged in the export of primary produce to Europe, and to a lesser extent to the United States. The most important export trade financed by the firm in the 1850s and 1860s was the shipment of sugar from Cuba to Europe and the United States. Other trades of major importance were the shipment of grain and flour from New York to London; cotton from New Orleans to Liverpool and Hamburg; coffee from Brazil to Europe and the United States; guano from Peru to Germany; indigo from India to Russia; and there was a long list of less significant commodities – tallow, cotton, nitrates, rum, and silver.” During that time in the 19th century, Europe and the United States were sucking a huge amount of commodities from these countries, and yet 150 years later, both Europe and the United States remain the strongest powers in the world during that period and up to today. Moreover, the amount of U.S. denominated assets increased by $2.5 trillion last year, while the U.S. current account deficit was only $700 billion. That is, Americans gained a net amount of wealth of $1.8 trillion in 2005 – hardly a cause for alarm especially given that American-owned assets (domestic and international equities, private equity funds, investments in one's own small business, etc.) are in general yielding more than foreign owned assets (U.S. Treasuries and residential real estate).
Let us now get on with our commentary. Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 – giving us a gain of 290 points. A real-time email was sent to our subscribers announcing this shift – and the justification for this shift was discussed in our August 10th commentary (“Is Our Short-Term Scenario Busted?”). In retrospect, this call was definitely too early or wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). As of Monday afternoon on Labor Day weekend, this author is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which, as I have discussed over the last few months, will regain a significant chunk of microprocessor market share from AMD), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc. The market action in these large caps has also been very favorable thus far.
Moreover, the market action within the markets themselves has also remained favorable – despite a lag in the Dow Transports and the mid and small caps. For one thing, the number of new highs is finally outpacing the number of new lows on the NASDAQ – something that has not occurred since early May. The U.S. homebuilder ETF (XHB) has also most probably bottomed and has traced out a good base for a sustainable bounce. And finally, the Dow Utilities – which, in a typical cycle, has historically been a leading market indicator of the broad market from 3 to 12 months – made a new record high as late as last Thursday, thus officially extending the life of this cyclical bull market. However, we are still sitting on the sidelines in the meantime, as the market action in August has not been truly convincing given the seasonally light volume. Again, this author is still cautiously bullish, and will most probably wait for a correction of the current overbought condition before shifting to a 50% long position in our DJIA Timing System.
In our commentaries over the last few weeks, we strongly cautioned and questioned against looking into too much the popular “forward-looking” market indicators out there, such as the NAHB Index (this author has shown that the movement of the NAHB index has really no predictive value), the percentage of auto sales increases over the last 12 months, etc. We also cautioned against drawing simple trend lines on the major market indices and claiming that stock prices will have to revert to the mean – as the picture can change drastically depending on your starting point. In conclusion, I stated that while I have always tried to make it simple for our subscribers, I am not going to make it simple just for simplicity sake – especially when one is doing it with misleading indicators. In this commentary, I will try to communicate to our readers what I am currently thinking and what I do know (or think I do know!).
Much of my views that I have developed over the last couple of years have largely come from speaking with people, reading current research, and studying history to see how the future may pant out and try to assign probabilities to each scenario occurring. As the saying goes, history doesn't repeat itself, but it surely rhymes. However, how can you be certain that what is occurring right now rhymes with a particular period in market history? Can you merely base it on P/E or P/B ratios, or is it something different? Moreover, many folks have compared the current spike in crude oil prices to spikes in the past – in particular to the spike during the mid 1970s and late 1970s. If so, then why aren't we already in a full-blown recession? I truly do not know, and I doubt anybody does. What I do know, especially when it comes to the stock market, is this:
Retail sentiment is now the most bearish since late 2002 and early 2003
- Merrill Lynch, Charles Schwab, and Time Magazine now openly calling for the higher-than-normal probability of a recession
- Famed economist Nouriel Roubini (of www.rgemonitor.com) openly calling that a recession is inevitable. Perhaps he is correct this time but his August 2004 paper calling for a significant slowdown even though oil was still below $50 a barrel at the time suggests that his record has not been perfect.
If Dr. Roubini is wrong this time, he will be famously wrong since there has been so much publicity surrounding his latest call, unlike the call on a slowdown because of $45 oil prices (the guy is relatively young - what can I say). As a sidenote: If he is wrong this time and the U.S. stock market takes off, then his business will no longer claim that it is the “number economic site” on the web – despite it having gotten the label in 1999, and not 2006. Also as a sidenote: Granted the probability of a recession has increased quiet significant since the beginning of this year (when this author made an out-of-consensus call for an economic slowdown later this year), but calling a recession is “inevitable” (and especially in such a public fashion) is somewhat bold. Nothing is certain in life – and if you want to have a lasting economic advisory business or a lasting stock market account, then one definitely should hedge his bets. Dr. Robuini is certainly not hedging his bets here. However, if he does call it correctly, then I will be the first to admit that I am wrong and then sign up for his service!
Getting back to the stock market, I also know we have had three years of P/E contraction on the S&P 500 and over five years of growth stock underperformance (as reflected by the five-year underperformance of the Value Line Ranking System, which has a great 40-year track record). I also know that contrary to public belief, there is no correlation between earnings growth (or revisions from earnings estimates) and the subsequent performance of the S&P 500. This has been "proven" by studies done by both Victor Niedorhoffer and Morgan Stanley. In fact, the former has even found a slight negative correlation (i.e. when earnings growth declines, the stock market actually outperforms). Following is a chart (courtesy of Morgan Stanley) showing that there has been little correlation between earnings surprises and calendar year performance of the S&P 500 from 1990 to 2005:
In fact, if Victor Niedorhoffer's findings hold true for this cycle, then the S&P 500 could conceivably outperform going forward in the next 12 to 18 months. So Henry, why do you think this lack of correlation has held true in the past, and does it make sense?
Subscribers should first take this into account – that individual stock outperformance after better-than-expected earnings do not translate well when one looks at the S&P 500 as a whole. As I have mentioned before, I would not be surprised if this negative correlation occurs again this cycle, for the following reasons:
- A significant chunk of the outperformance in earnings has been due to the energy and the materials sector. Should earnings surprised on the downside in these sectors going forward, this should increase margins in more productive sectors of the economy, such as technology, consumer discretionary, and real estate. While this may cause a downward adjustment in S&P 500 earnings, such a weakness in the energy and materials sector should be a boon for the rest of the sector – thus causing the S&P 500 to outperform.
- Interestingly, the 2004, 2005, and 2006 YTD points are all clustered towards the upper middle section of the chart – suggesting that the return of the S&P 500 has not been all that great over the last three years despite a successive string of earnings surprises. In other words, this negative correlation has held true over the last three years, so why can't it continue to hold for the rest of 2006 and into 2007? If that is indeed the case, then the S&P 500 should outperform even as earnings are ratcheted down going forward.
Based on the above, can the S&P 500 put in a 15% to 20% performance in the next 12 to 18 months? It is certainly possible. In fact, I will say that the likelihood of the above occurring is higher than the probability of a 15% to 20% decline from current levels.
At this time, I do not see any inevitable, huge washout in the U.S. stock markets, given the lack of speculation and retail interest we have had over the last two years. Emerging market countries - which will in general suffer from a general slowdown in the U.S. - should also perform relatively well compared to past cycles, given their huge dollar reserves and given that only 60% of all foreign debt is denominated in U.S. dollars today, as opposed to 90% a decade ago. Cash levels in U.S. corporations are now also near an all-time high. Besides Ford and GM, I cannot really see any great bankruptcies similar to the ones we had from 2000 to 2002 which may cause investors to bail from the stock market, such as Enron, Worldcom, Global Crossing, etc.
Moreover, the *relative valuation* between bonds and stocks is still strongly in favor for stocks - and history has shown that the "reversion to the mean" theory works much better in relative valuations than they do in "absolute valuation indicators" such as P/E and P/B ratios, etc. That is why LTCM adopted that philosophy. What caused their downfall was that towards the end, they engaged in strategies that were directional, such as betting outright that Russian debt would pay off and engaging in "stock merger arbitrage" strategies that were not true to their own philosophies.
To get a similar washout that we experienced in 2000 to 2002 or 1973 to 1974, we would have to witness one or more of the following:
- A true oil shock or embargo - such as Iran stopping all oil shipments. In which case, the government of Iran will collapse as well so that will not be in their interest. In fact, the Iranian government will probably collapse if oil goes back to $35 a barrel - or at least their nuclear and military programs will. Note that this argument applies to Venezuela as well.
- Protectionist policies that in turn drive retailiation from other countries that trade with the U.S. In other words, the great Senator Charles Schumer could be instrumental in causing a worldwide recession at the interest of "protecting" American manufacturing jobs.
- A Fed policy mistake. Judging from Ben Bernanke's record so far, I do not believe we will see one anytime soon, as I believe he definitely paused at the right time. As I also mentioned in our discussion forum, the ECRI Future Inflation Gauge just touched an annual rate of change of -0.7% - the lowest level since June 2005 and giving us a benign reading for six consecutive months in a row. Going forward, the CPI inflation number should continue to subside – especially given that crude oil is decisively under $69 a barrel as I am writing this.
It is interesting to see the resiliency of the stock market and the economy in recent years, given $70 oil prices, Hurricanes Katrina and Rita, the downgrades and layoffs at GM and Ford - not to mention a changing of the guard at the Federal Reserve - all in the context of fighting an expensive war in the Middle East. Some would attribute it to the housing bubble and the subsequent withdrawal of mortgage equity, but I doubt it is so easy. If you look around the world today, it is amazing to see the difference between now and even 10 years ago, let alone during the last oil shock in the late 1970s or from 1973 to 1974. Are things different this time? It always is, but will they translate to higher stock market prices ahead? The last thing I want to say is that "things are different this time," but if the world is bringing in over 2 billion into the capitalist world and creating a better world out of it, why can't profits at U.S. companies continue to rise more than U.S. GDP for the rest of this decade - and why can't we see P/E multiples increase going forward? If P/Es contract again next year, it will mark the fourth consecutive year we have seen such a phenomena, something that has only occurred twice in the last 100 years - during 1934 to 1937 and 1975 to 1979. This author doubts we will again witness this phenomena this time around.
Let us now discuss the Dow Theory. Following is 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:
For the week ending September 1st, the Dow Industrials and the Dow Transports both closed positively – the former rising 180 points while the latter 71 points. Granted, the Dow Transports is still 110.69 points below its August 16th close of 4,421.05, but so far, the latest action in the Dow Transports merely seem to be in a consolidation phase for an eventual move higher. As mentioned on the above chart, a more sustainable rally in the major market indices should develop once/if the August 16th high is surpassed. For now, the Dow Industrials is overbought – suggesting that it should experience some kind of correction in the coming days. Any upcoming follow-through will most likely not occur until we have seen such a correction. Until then, we will remain completely neutral in our DJIA Timing System. Readers please stay tuned.
I will now continue our 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. The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 12.2% in the latest week. 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:
As I mentioned in our last two weekend commentaries, there was a good chance that this survey has now bottomed and reversed – “suggesting higher prices over the near future.” Since that time, the market has indeed risen higher, and given the further rise in the four-week moving average in the latest week to 12.2%, the probability for even higher prices in the weeks ahead is definitely higher than 50-50. However, as I have mentioned before, we still remain cautiously bullish, and will not buy these markets in an aggressive way until we have received some confirmation (and/or correction) from the action after Labor Day Weekend.
This author will now introduce a sentiment indicator that we will keep track of going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
As one can see from the above chart, the 20-day moving average of the ISE Sentiment is now at a level not seen since late October 2002, while the 50-day moving average is at a level not seen since March 2003. This suggests that the market has already bottomed or is in the processing of bottoming out.
That being said, no technical indicator is infallible, and that is why I have always supplemented my technical research with other indicators as much as I can and consistently testing new ones to see if they make intuitive sense going forward. So far, the ISE Sentiment Index seems to have worked beautifully, and given that this sentiment index is still not as widely used as other sentiment indicators (such as the AAII survey and the Rydex Cash Flow Ratio), I am willing to bet that this indicator will at least work until the end of this bull cycle. It also definitely makes intuitive sense as a sentiment/contrarian indicator. Given the above readings and all else being equal, there is now no doubt that the Dow Industrials will surpass its all-time high within the next few months.
Conclusion: As folks all around us continue to predict a recession (where was Merrill Lynch and Charles Schwab when you needed them in March 2000?) and as folks around us continue to predict a 1987-style crash, this author has a lot of reasons to be optimistic – as I have outlined in this commentary and over the last several weeks. Probability now favors a 15% rise over the next 12 to 18 months rather than a 15% decline in the S&P 500.
As for the short-run, this author has been very frustrated in not being able to “get back in” with a 50% long position in our DJIA Timing System ever since we exited our position on the morning of August 10th. But isn't this what bull markets are made of? That is, isn't it supposed to kick you off the train and make sure you stay that way? That being said, for now, this author is still choosing to sit on the sidelines and will continue to observe the action after Labor Day Weekend. Should the market corrects on relatively weak downside breadth and low volume in the coming days, there is a good chance that this author will shift back to a 50% long position in our DJIA Timing System. Again, readers please stay tuned.
Henry To, CFA