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The State of U.S. Households' Balance Sheets

(September 24, 2006)

Dear Subscribers and Readers,

In last weekend's commentary (“Canadian Dollar Now the Lone Holdout”), I discussed that while there is a good chance that this cyclical bull market in commodities have ended (note that I believe the secular story still holds, however), I was not willing to call the end just yet as long as the Canadian dollar is still holding on.  In that commentary, I stated: “the historical correlation between the Canadian dollar and the CRB and the CRB Energy Index has been quite significant (correlation of over 50%) over the last 16 years or so.  Consequently, any breakdown of the major commodity indices without the confirmation of the Canadian dollar on the downside should be viewed as suspicious.  At the very least, a non-confirmation on the part of the Canadian dollar should at least lead to some kind of bounce in commodities in general.  Are we about to see such a bounce – given that the Canadian dollar is still holding on?  Particularly in gold or crude oil?

As I am writing this on Sunday evening, the Canadian dollar is still holding up very well.  More importantly, there is a strong likelihood that the Canadian dollar will continue to hold its own for the foreseeable future – as the Commitment of Traders report is showing that small speculators (who are historically great contrarian indicators) are now holding the smallest long position in the Canadian dollar in nearly a year.  Following is the relevant chart, courtesy of

Canadian Dollar Net Commitments of Traders - Smallest long position in the Canadian dollar in nearly a year!  This should at least provide some support for the Canadian dollar going forward.

As mentioned in the above chart, the fact that small speculators are now holding the smallest long position in the Canadian dollar should at least provide some support for the Canadian dollar for the foreseeable future.  Moreover, given the downside non-confirmation of commodity and energy prices by the Canadian dollar, there is now a good chance for both commodity and energy prices to bounce going forward.

So Henry, which commodities are you focusing on for a bounce and in what kind of timeframe?

The obvious commodity is definitely natural gas, given the forced liquidation in the commodity that we saw over the last week by the hedge fund Amaranth as well as the fact that the crude oil-to-natural gas ratio of 8.0 ($60/7.50) is now higher than the traditional ratio of approximately 5.5 to 6.0.  However, this author is still not seeing an entry point just yet, given that:

  1. Next week is the end of the quarter and thus window-dressing time, which has traditionally meant that mutual and hedge funds alike will dump their losing positions during the last quarter – which inevitably means both crude oil and natural gas positions will be dumped.

  2. The amount of natural gas inventories is now at their highest level ever for this time of the year.  Combined with the fact that we are in the midst of an economic slowdown and that there has been record drilling of natural gas, and chances are that natural gas prices will continue to decline unless there is another destructive hurricane on the Gulf Coast in the next few weeks.  As I have outlined in my previous commentaries, the chances of this happening is virtually nil.

  3. This author believes that there are similar hedge funds that are overextended and who have still not liquidated their long positions in energy.  This upcoming week (window dressing) should thus bring more forced selling which should further depress natural gas prices.

In other words, look for a significant bounce in energy prices soon (especially in natural gas), but I am definitely waiting at least another week before even thinking about going long.  Moreover, any long positions that we initiate in natural gas going forward will strictly be short-term in nature (a week to a month) – as I have also discussed in last weekend's commentary. 

Let us now take care of some “laundry work.”  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.  In retrospect, this call was definitely 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 the afternoon on Thursday, September 7th, this author entered a 50% long position in our DJIA Timing System at a print of 11,385 – which is now 123.10 points in the black.  A real-time “special alert” email was sent to our subscribers informing them of this change.  As of Sunday afternoon on September 24th, 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 is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc.  Note that, however, both Wal-Mart and Sysco has had a tremendous run lately, so it may be prudent to wait for some kind of correction in these two stocks before buying if you are not already long.

I am also getting very bullish on good-quality, growth stocks – as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general).  The market action in large caps, retail, and technology have all been very favorable so far – and I expect it to remain favorable at least for the rest of this year.  At this system, I am looking to shift from a 50% long position to a fully bullish 100% long position in our DJIA Timing System but am waiting for more clarification from my market breadth indicators (they have been getting quite weak recently).  However, the market is still in an uptrend and since leadership is now shifting from small and mid caps to large caps, I am not as worried about market breadth as I would have been – say, just a mere 12 months ago.  Moreover, since this rally is being led by U.S. large caps, there is no doubt that the components of the Dow Jones Industrial Average will be one of the leaders going forward.  So don't be surprised if you see us going 100% long in our DJIA Timing System as early as Monday.

In this commentary, I want to give our readers a quick update on U.S. households' balance sheets, and what it may mean for the stock market going forward.  Let us first start with a chart I first showed in our April 2, 2006 commentary – a chart showing the net worth of U.S. households vs. the asset-to-liability ratio of U.S. households from the first quarter of 1952 to the second quarter of 2006:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 2Q 2006) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history!

As you can see on the above chart, the net worth of U.S. households again hit a new high during the second quarter of 2006, from $53.27 trillion to $53.33 trillion – a $60 billion increase.  Since the end of World War II, the net worth of American households have only experienced two notable declines – the first occasion during the 1973 to 1974 bear market and the second occasion during the 2001 to 2002 technology and telecom bust.  Given that the 2001 to 2002 bust represented the greatest washout in modern American history, there is a good chance we have already seen the bottom in both the Dow Jones Industrial Average and the S&P 500 on October 10, 2002, unless there is 1) a major policy mistake by the Fed, 2) a rise of protectionist sentiment in Congress, or 3) a major war in the Middle East.

The one notable worry is the consistent increase in the leverage of households' balance sheets – as evident by the consistent decline of the asset-to-liability ratio since the first quarter of 1952.  In our April 2, 2006 commentary, we stated: “Okay, we know that given the financial know-how of Americans and given the many online budgeting and “financial optimization” tools we have today, borrowing money and leveraging yourself like a U.S. corporation is now much more streamlined and is a strategy which makes perfect sense (in theory).  We also know that absolute total net worth of American households continues on a secular upward trend.  At the same time – as the U.S. economy switches to a service-based economy which requires a lot of formal education but is much more flexible, the business cycle has gotten less volatile.  Today, our financial system is also much less vulnerable to shocks (such as the relatively muted reactions to Enron, Refco, Delphi, Delta, and GM, and so on) than 20 years ago, for example, given securitization and given the ability for financial corporations to diversify much of their sources of risks.”

In that commentary, I also noted that despite all these developments and innovations, none of this fundamentally changes the fact that U.S. households now have the most leveraged balance sheets in history.  Moreover, in a credit-based and financially-leveraged society such as the United States, one needs to tread very carefully if you are a central banker, and thus the last thing that the Fed wants is a declining net worth of American households.  That is why both Alan Greenspan and Ben Bernanke were so fearful of a deflationary scenario back in 2002.  That is why there is no question that the Federal Reserve will start to cut rates by January of next year (the Fed Funds rate are now pricing in a 40% chance of a cut during the January 30/31 2007 meetings) – and possibly even by the December 12, 2006 meeting as an “early Christmas present.”

Now – assuming that:

  1. The net worth of U.S. households will continue to increase going forward; and
  2. That residential real estate will start to play a lesser role in net worth growth going forward; and
  3. That both intermediate and long-term bonds are not currently priced attractively; and
  4. Holding cash is no longer attractive once the Fed starts cutting rates again.

Then it comes to mind that the only obvious asset class that can play a significant role in shaping household balance sheets (in a positive way) going forward is equities.  Moreover, since – as I have argued many times before – U.S. domestic large caps are still the most undervalued equity class in the world, it is now time for a bull market in U.S. large caps and U.S. growth stocks.  This argument is also reinforced by the fact that U.S. equities today only make up 24.94% of total financial assets and 15.24% of total assets owned by households – which are at levels (with the exception of the bottom in late 2002 and early 2003) not witnessed since the second quarter of 1995 and the fourth quarter of 1994, respectively.  The history of these two ratios is shown by the following quarterly chart from the first quarter of 1952 to the second quarter of 2006:

Equities and Mutual Funds as a Percentage of Total Household Assets (1Q 1952 to 2Q 2006) - 1) As a percentage of total household assets, equities *only* make up 15.02% - slightly below its 54-year average of 15.24% and at a level (ex. the bottom in 2002 and early 2003) not seen since the fourth quarter of 1994. 2) As a percentage of total financial assets owned by households, equities *only* make up 24.94% - slightly above its 54-year average of 23.66% and at a level (ex. the bottom in 2002 and early 2003) not seen since the second quarter of 1995.

Unfortunately, no similar information can be found for individual sectors or classes broken down by company size – but if I had to bet, I would bet that household holdings of U.S. large caps and growth stocks as a percentage of both total and financial assets would be at their lowest levels at least going back to the third quarter of 1990.  Let me put this more bluntly: We are now at a point where we could purchase both U.S. large caps and growth stocks at a level not seen since nearly 16 years ago by this measure (with P/E ratios not seen since the late 1994 bottom).

The argument for higher equity prices just up ahead is also reinforced by the latest short interest numbers from the New York Stock Exchange (the NASDAQ numbers are not updated until this week).  As of September 15, 2006, total NYSE short interest rose approximately 100 million shares from the previous month and is now at another record high for the fourth consecutive month:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to September 15, 2006) - For the month ending September 15, 2006, total short interest on the NYSE increased approximately 100 million shares to 9.74 billion shares - the fourth consecutive month that it has made a new all-time high and only 260 million shares short of a 10 billion share short interest. Moreover, the 12-month rate of increase of 13.7% represents the greatest rate of increase since May 15, 2005 - suggesting that the market has already made a significant bottom and should now be seeing higher prices ahead.

The dramatic spike in NYSE short interest can also be witnessed in the NYSE Short Interest Ratio as of September 15, 2006:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - The latest NYSE SI ratio rose from an already high reading of 5.8 to 7.0 in the latest month - partly because of a decline in trading volume and partly because of another record high in NYSE short interest. With this latest spike, the NYSE SI ratio just a high not seen since July 1998 - suggesting the likelihood of higher equity prices ahead.

Note that since this cyclical bull market began in October 2002, a spike in the NYSE short interest ratio has always led to a subsequent rally in the stock market.  Given that the current short interest ratio of 7.0 is the highest we have seen since July 1998, chances are that the market will continue its rally going forward – and the Dow Industrials should make a new all-time high within the next few weeks.

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to September 22, 2006) - For the week ending September 15th, the Dow Industrials declined 53 points while the Dow Transports declined 76 points. At this point, last week's decline seems more like a consolidation phase within the uptrend from mid-August - although the lack of breadth during this rally is still a little bit worrying (although this will be somewhat consistent with our scenario of a new bull market for U.S. large caps). Readers please stay tuned, but my guess is that the Dow Industrials will most probably close above its all-time high at some point in the next few weeks.

For the week ending September 22, 2006, both the Dow Industrials and the Dow Transports consolidated their most recent gains – the former declining by 53 points with the latter declining by 76 points.  More importantly, the Dow Transports managed to close above its August 16th high of 4,421.05 during the Wednesday before although it has since given back some of those recent gains.  This close above its August 16th high by the Dow Transports a little bit over a week ago implies further strength in both the Dow Industrials and the Dow Transports going forward.  In last weekend's commentary, I stated: “The question now is: When will we shift to either a 75% or 100% long in our DJIA Timing System (from the current 50% long position)?  According to the Stock Trader's Almanac, the week after expiration during September has been a down week for 12 of the last 15 years.  Given that the major market indices are now short-term overbought, there is a strong likelihood that this week will be a down week.  Should the Dow Industrials experience some kind of consolidation phase on relatively low volume or okay breadth, then this author would not hesitate going 75% or 100% long (implying an additional 25% or 50% long position) in our DJIA Timing System.”  We got lucky in that the market acquiesced with our short-term views last week.  It is now time to heed our own advice and go 100% long in our DJIA Timing System at the earliest opportunity.  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 19.9% 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - As I have mentioned before, our most popular sentiment indicators have been very oversold - with the four-week MA of the combined Bulls-Bears% Differentials bottoming at 1.7% in late June (now at 19.9%). Given that the four-week MA has since reversed and is not overbought yet, readers may now want to look for higher prices here - and the market most probably won't endure a significant correction until this indicator gets overbought again.

Given that the four-week moving average of our popular sentiment indicators have reversed to the upside and is still not an oversold level, there is a good chance that the market will maintain its most recent trend of higher prices at least until this indicator gets overbought.  Again, given the opportunity, look for this author to shift to a 100% long position in our DJIA Timing System very soon.

A few weeks ago, I had introduced a new sentiment indicator that has worked well in the past and which I believe will continue to perform relatively well at least for the foreseeable future.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator 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:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - Lowest reading since late October 2002 - suggesting that the market has bottomed or in the process of bottoming...

As one can see from the above chart, the 20-day moving average of the ISE Sentiment is still at a level not seen since late October 2002 – even though it has bounced somewhat from last week's extremely oversold levels.  Meanwhile, the 50-day moving average is again at a level not seen since the recording of this indicator – declining yet further from 113.7 to 112.4.  This suggests that the market has already bottomed or is in the processing of bottoming out (most likely the former) – and is preparing itself for a powerful up move in the next few months.

Conclusion: My conclusion does not change from last week's or the week prior.  That conclusion is: U.S. large caps and growth stocks continue to be the most attractive asset class in the world today.  Sure, I also realize that one can essentially sit in cash and get a yield of 5% in many U.S. banks today, but that “parking in cash” mentality will start to change once the Fed is set to start cutting rates (which, in my humble opinion, will happen by the January 31, 2007 meeting at the latest). As for commodities such as crude oil or precious metals such as gold, I am now cautiously bearish (even though I believe that they have made significant tops), given that commodities are now very oversold on a short-term basis and given that non-confirmation (so far) by the Canadian dollar on the downside (again, note that both the Australian and the New Zealand dollar have confirmed by rolling over).  However, any position on the long side should be strictly short-term in nature – but for now – I do not even see any short-term trade materializing on the long side just yet.

As I also mentioned last week and the week prior, while folks all around us are predicting a further stock market correction or an economic recession over the next three to six months, it is important to remember the one big difference between this past hiking cycle and virtually all the cycles prior to the 1994 to 1995 hiking cycle.  The big difference is: Similar to the 1994 to 1995 rate hike cycle, this current cycle had been preemptive in nature – in that the Federal Reserve had attempted to “take away the punchbowl” as early as it can (in fact, as early as June 2004), while many of the past hiking cycles didn't actually start until inflation really got out of hand (e.g. the 1970s).  In those previous cycles, the Fed ultimately had to raise the Fed Funds rate to 8% to 15% - thus not only crushing inflation but the rest of the economy and stock prices as well.  The fact that his one has also been preemptive is evident by the popping of the housing bubble and the peaking of both gold and crude oil prices with the Fed Funds rate only at 5.25% (for comparison purposes, the Fed Funds rate peaked at 6% on February 1, 1995) – suggesting that the Fed does not have to raise any further – which should be a boon for both the stock market and the economy going forward.

As for the one big difference between the current hiking cycle and the 1994 to 1995 hiking cycle, it is this: While both had been preemptive in nature, the current hiking cycle had also been well-communicated in advance and did not involve any big increases (as opposed to a huge 75 basis point hike on November 15, 1994).  This has the additional effect of significantly decreasing volatility in the financial markets – as evident by the lack of high-profile hedge fund blowups and stock market volatility over the last two years compared to the 1994 to early 1995 period (when many hedge funds were forced to close).  In other words, there probably does not have to be a 10% correction in the S&P 500 before we see a sustainable rally going forward.

Signing off,

Henry To, CFA

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