Are Things Really Different This Time?
(October 8, 2006)
Dear Subscribers and Readers,
Before we begin our commentary, let us first 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). On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 – which is now 465.21 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 345.21 points in the black. Real-time “special alert” emails were sent to our subscribers informing them of these changes.
As of Sunday afternoon on October 8th, we are still fully (100%) long in our DJIA Timing System and 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. We are also 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 has all been very favorable so far – and I expect it to remain favorable at least for the rest of this year. While investors have been worried about a lack of breadth in both the S&P 400 and the S&P 600 since the current rally began in mid August – that is to be expected, given that this market is now favoring large caps over mid and small caps. Moreover, the action of last Wednesday went a long way in improving the breadth of the market, as I will illustrate a bit more later in the commentary. For now, the so-called divergences are not a concern to me.
Let us now get on with our commentary. Investors who are fans of stock market history (IMHO, a comprehensive knowledge of stock market history over at least a 40-year cycle is essential to long-term success) should know that the four most expensive words in both the stock market and the financial markets are: “It's different this time.” But as many participants in the financial markets found out to their dismay over the years (such as Long-Term Capital Management or George Soros), history cannot act as a complete guide either. For example, in an interview with “The Emerging Market Specialist” – Marko Dimitrijevic of Everest Capital – in the book “Inside the House of Money,” the author discussed the nuisances of Mr. Dimitrijevic's Russian position just before its 1998 default and why it was unprecedented. I will now quote from the book:
Question: I understand that you liquidated your Russia position before the 1998 meltdown but then reentered just before they devalued and defaulted. What happened there?
Answer: We had invested successfully in Russian debt instruments for several years prior to 1998, including MinFin domestic dollar-denominated bonds of the Russian Republic, the former Soviet Vneshekonombank debt, and S- Account GKOs. By the spring of 1998, we were not completely out of Russian debt but we had reduced our position significantly. Then in July, when yields really started to rise, we thought it was a very good opportunity. We thought there was a decent probability that they would devalue, but in a controlled fashion … What we didn't expect was a devaluation and a default at the same time. It doesn't make economic sense. It was the first time a country had devalued and defaulted at the same time, so it created a real panic. It was unprecedented that a government would do that, as you always got either one or the other.
In other words, Russia could have paid off their debts simply by printing rubles, as the debt was not dollar-denominated. Even Weimar Germany never defaulted on their own, local currency-denominated debt. The move by the Russians in the Fall of 1998 was simply unprecedented.
So Henry, what are you saying? Are you saying that things are “truly different this time” in the stock market? And perhaps that we are now in a bull market?
No, I am not saying we are now in a new bull market. I am also not saying “things are different this time.” But then, not everything is the same either. For example, the latest rate hike cycle starting in June 2004 has been truly different, as I have discussed in previous commentaries. The fact that 1) it has been pre-emptive – similar to the 1994 to 1995 hiking cycle, and 2) all rate hikes have been very clearly communicated prior to the actual hike is truly unprecedented. Not only have we most likely achieve a mere “mid cycle slowdown” in the U.S. economy (as I have been discussing since the beginning of 2006) because of this pre-emptiveness – we have also not seen any major hedge fund blowups that have affected the major stock market indices. Case in point: We have not seen a 10% correction in the S&P 500 since early 2003.
At the same time, we know that the P/E ratio of the S&P 500 is still near historical highs at a level of approximately 18. That is, over the longer-term, stock market returns will still most likely be sub-par – especially relative to the returns during the 1980s and the 1990s. That is I do not believe we are now in a genuine multi-year bull market.
But Henry, aren't you 100% long now in your DJIA Timing System? Aren't you also bullish on U.S. large caps and U.S. “quality” growth stocks? What is your rationale on that?
As I have discussed many times before, the P/E ratio of the S&P 500 or any other “straight up” valuation indicator that attempts to measure how much the stock market is worth relative to its historical valuation is not a good timing indicator – at least over a period of 12 to 24 months anyway. This was apparent during the periods from late 1928 to late 1929, 1936 to 1937, 1945 to 1946, 1956 to 1957, 1963 to early 1966, 1968 to early 1969, mid 1971 to early 1973, early 1987 to Fall 1987, and finally 1992 to the present – the latter a period of over 14 years of “historical overvaluation!” Following is a monthly chart courtesy of Decisionpoint.com showing the historical P/E ratio of the S&P 500 from January 1925 to August 2006. Note that there has been many multi-month periods (as mentioned above) where the P/E ratio of the S&P 500 has hovered at or near the historical overvalued measurement of 20 or over:
Interestingly, today's P/E ratio of approximately 18 or so represents the most undervalued reading (okay, the undervalued label is stretching it a little bit but you know what I mean) since late 1995/early 1996 – suggesting a propensity for the market to move significantly higher (10% to 15%) over the next 12 to 18 months based on the elevated P/E ratio of the S&P 500 over the last 15 years or so.
However – and more importantly, the valuation of U.S. stocks relative to many other asset classes such as U.S. bonds, global real estate, global bonds, global equities, and commodities is now at its lowest level at least since the major bottom in October 1990. Unless the U.S. economy is heading into a deflationary bust (which is a low probability event as long as the Fed is finished with its series of rate hikes and as long as there is no major terrorist attack in the U.S. or Western Europe), the relative valuation of U.S. stocks as measured against other financial or even physical asset classes has always been a much better timing indicator (over the next 12 to 24 months) vs. historical valuation ratios such as the P/E ratio of the S&P 500. Moreover, as I have discussed many times before, U.S. equities are also very underowned and underloved – as evident by the Fed's Flow of Funds data on the balance sheets of U.S. households, mutual fund outflows out of domestic equities from May to August (the most since the four-month period ending October 2002), and the fact that there has not been much hedge fund speculation in U.S. equities in recent years. As for U.S. growth stocks, it is interesting to note that the famous “Value Line Ranking System” (a system based on buying good-quality, growth stocks and which has overperformed the marketing significantly since inception in 1965) has actually underperformed the market for the last consecutive five years – an occurrence which is totally unprecedented (again, never say never in the stock market). This and the relative valuation indicator suggests to me that U.S. large caps and U.S. growth stocks will most probably overperform most asset classes (including cash) for the rest of this year and even into Spring of 2007.
The fact that U.S. equities are underowned and underloved is also apparent in our most popular sentiment indicators – those being the American Association of Individual Investors (AAII) and the Investors Intelligence Surveys. I have not covered them on an individual basis since the beginning of this year (rather, these two indicators have been combined with the Market Vanes Bullish Consensus to come up with a combined indicator) so I want to provide a quick update. However, instead of providing the reader with weekly readings, I want to show both surveys on a 52-week moving average basis in order to smooth out any spikes or “seasonal effects” (along with giving the reader a longer-term perspective). Let's first start with the American Association of Individual Investors (AAII) Survey. During the latest week, the 52-week moving average of the Bulls-Bears% Differential declined from 7.0% to 6.4% - the lowest reading in three weeks. More importantly, the 52-week moving average of the AAII survey most recently bottomed at 6.1% in early August 2006 – which in turn represented the most oversold reading since June 2003. Following is the 52-week MA of the AAII survey vs. the weekly closes of the Dow Industrials from July 1988 to the present:
As mentioned on the above chart, the 52-week MA of the AAII Bulls-Bears% Differential most recently hit a low not seen since June 2003. Moreover – excluding the spike lower in the latter parts of 2002 and early parts of 2003, the 52-week MA of the AAII Bulls-Bears% Differential is at its most oversold level since March 1995 – and we know what happened afterwards.
As for the 52-week MA of the Investors Intelligence Bulls-Bears% Differential – it is definitely not as oversold as the AAII survey on a historical basis – but please note that it has also just hit a low not seen since July 2003, as illustrated by the following weekly chart:
Again, while the 52-week MA of the Investors Intelligence Bulls-Bears% Differential isn't as oversold as the 52-week MA of the AAII survey, the fact that it is now giving us a reading which hasn't been seen since July 2003 should definitely be very encouraging to the bulls.
In the early part of this commentary, I also discussed that the breadth of the market has significantly improved during last week. This is important, as this has been the one thing that has given the bear case some validity since the rally in mid August (even though I had pounded the table that we were early in a large cap bull market and thus breadth just wasn't that important at that point). The following chart showing the NASDAQ Daily High-Low Differential Ratio (number of new highs minus number of new lows divided by the number of issues traded on a daily basis) vs. the NASDAQ Composite illustrates the huge improvement in breadth perfectly:
As mentioned on the above chart, the NASDAQ High-Low Differential Ratio hit a level of 3.22% last Thursday – the highest reading since May 10th. This is definitely very encouraging, as this is the one thing that have made the bear's argument look credible since the rally from mid August. The fact that this has dented the bear's argument suggests that 1) bears should now cover their shorts (which could potentially be huge since both NYSE and NASDAQ short interest are at all-time highs), and 2) retail investors who are still on the sidelines waiting for a “better entry” may now be induced to buy individual stocks. Moreover, once the Fed starts cutting rates (and it could come as early as January 31, 2007), then cash will no longer be as attractive an option as it is today for the retail investor. Bottom line: The rally from the mid-August bottom is still alive and well.
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 October 1, 2003 to the present:
For the week ending October 6, 2006, the Dow Industrials rose 171 points while the Dow Transports rose 116 points. For the first time in six years and eight months, the Dow Industrials closed above its all-time January 14, 2000 high of 11,722.98. But more importantly (at least in the immediate sense), the action in the Dow Transports had also been very encouraging – as its high of 4,630.48 last Thursday represented the highest close since July 19, 2006. For the bears who had been pointing out to the weakness in the Dow Transports as “evidence” that this rally was not sustainable, the action of last week in the Dow Transports was particularly discouraging (and thus encouraging for the bulls). The rally in the Dow Transports and in the NASDAQ Daily High-Low Differential Ratio late last week suggests this rally still has further to go. Therefore, we remain 100% long 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 21.4% in the week before last. As of the week ending October 6, 2006, the four-week moving average of these sentiment indicators is at 20.4%. 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 mentioned on the above chart, the latest dip from 21.4% to 20.4% represented a “well-needed” rest – as this indicator has been rising relentlessly since its bottom in late June (aside from a slight dip in early August). Could we see some consolidation or even a correction in the Dow Industrials of 250 to 400 points here? Definitely (especially in light of the most recent news of the nuclear testing conducted by North Korea) – but given that this indicator is still not at a very overbought 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.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. 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:
As one can see from the above chart, the 20-day moving average of the ISE Sentiment has reversed back to the upside from 101.5 to 108.2 in the latest week, while the 50-day moving average is again at a level not seen since the recording of this indicator – declining yet further from 111.2 to 109.1. The fact that the shorter-term moving average has reversed back to the upside while the 50-day moving average is so oversold suggests that the market has already bottomed and is preparing itself for a further up move over the next few months.
Conclusion: In last weekend's commentary, I had stated that:
While the breadth of the stock market continues to be a red flag, my overall view of the market and the sectors we like does not change from what we have already discussed over the last three to four weeks. That conclusion is: U.S. large caps and growth stocks continue to be the most attractive asset class in the world today – and while some conservative investors would opt for sitting in cash today (which makes sense since it is yielding at over 5%), I believe that that “parking in cash” mentality will start to change once the Fed starts cutting the Fed Funds rate – perhaps as early as January 31st of next year. As for the chances of a recession in the U.S., I do not believe it will occur – barring a major terrorist attack on U.S. soil or an oil embargo from Iran (the chances of the latter happening is next to nil as well).
As of last Friday at the close, the breadth of the market is no longer a red flag – given the improvement in breadth on the NASDAQ Composite and given the huge rally in the Dow Transports last week. Moreover, both the S&P 400 and S&P 600 are still in a solid uptrend. The only red flag is the Philadelphia Semiconductor Index, as it actually closed down slightly last week. However, this author believes that semiconductors are a good buy on purely a fundamental basis – no matter what the technicals are currently saying. To me, there is no question that the Philadelphia Semiconductor Index would close above 500 at some point over the next few months. Based on this assumption, this author will continue to remain fully-invested in both U.S. large caps and U.S. growth stocks.
Henry To, CFA