Relative Valuation Still On the Side of Equities
(November 5, 2006)
Dear Subscribers and Readers,
Let us now do some “laundry work” before we get to the gist of our commentary. 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 601.04 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 481.04 points in the black. Real-time “special alert” emails were sent to our subscribers informing them of these changes. Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.
As of Sunday afternoon on November 5th, 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 (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, and American Express. We are also bullish on both Yahoo and Amazon. We are also very bullish on good-quality, growth stocks. We are no longer as bullish as Sysco, given its recent run-up since early August and given the inevitable rise in its food costs on the back of the current strength in the agricultural commodities. At this point, the breadth of the market is still strong – despite last week's correction. Even should breadth top out here, the major market indices typically should still have four to six months to run being forming a significant top (based on action in a typical bull market). Moreover, many of the major hedge funds out there are underinvested and underexposed to U.S. equities in general – and as the end of 2006 approaches, many of these hedge funds will be in an unenviable position of trying to beat the S&P 500 – by either buying “high beta” stocks (such as growth stocks) or by leveraging up on S&P 500 futures.
So again, while it may be tempting to take quick short-term profits here, I urge our readers not to get “cute” and to try to time this market on a short-term basis. I assure you – no trader on the face of this Earth can do this successfully on a consistent basis – not Jesse Livermore, not Bernard Baruch, not George Soros, Stanley Druckenmiller, and not even Steve Cohen of SAC Capital – who have actually just recently sworn off short-term trading (effectively forever) in his fund.
Let us now get on with our commentary. Speaking of relative valuations, one of the best ways of timing the market on a short to intermediate term basis (assuming that we are in an environment of low and stable inflation) is through various “tactical asset allocation” models that attempts to gauge relative valuations between various financial assets by looking at earnings yield or bond yields. As I mentioned in our July 9, 2006 commentary, historical valuation indicators such as P/E ratios are lousy timing indicators. On a traditional valuation basis (P/Es), everyone and his neighbor know that the U.S. stock market is now overvalued, but unless the world going to hell in a hand-basket (e.g. when real interest rates – nominal interest rate minus inflation – went sky-high such as during the early 1930s and the 1970s), it is usually a good bet to use alternative financial assets such as bonds or even real estate when trying to gauge the “proper value” for equities.
In the most recent past, the Barnes Index (please see our March 30, 2006 commentary for a description) has served us especially well in this regard, and this author will continue to use it going forward as a relative valuation tool between equities and bonds. Following is the chart courtesy of Decisionpoint.com plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:
As subscribers can see from the above chart, the Barnes Index – despite the huge decline of the bond market last Friday – actually declined two points in the latest week. The Barnes Index is now trading at its lowest level in a month, and is actually lower than where it was in mid July. As can be witnessed in the above chart, major tops in the stock market only occurs when it is preceded by a Barnes Index reading of at least 75 (e.g. early 1973), and in most cases, a Barnes Index of 90 or over (such as 1981, early 1984, early 1990, and early 2002). In some cashes, the Barnes Index can rise to significantly higher levels before we see a major top in the stock market (such as August 1987 when it rose above 150, April 1998 when it rose above 200, and early 2000 when it rose above 350).
As this author has mentioned many times before, I would not be too worried until the Barnes Index approaches the 75 level or over. And given the still-bearish sentiment among retail investors, and given that the dividend payout ratio is historically low (i.e. U.S. corporations have a much higher capacity to pay dividends than ever before) – I would not be surprised if the market does not top out until the Barnes Index approaches the 100 level or actually rises above it.
Obviously, however, not everything is going to be “smooth-sailing” from this point onwards. As I mentioned in our October 26, 2006 commentary, the latest rise of metals prices continues to bother me (some of which are at fresh all-time highs). For subscribers who keep a close eye on the commodities market, you may also know that the grains market – such as corn or soybeans – are now enjoying their best bull runs since the 1970s. Corn has been especially doing well, as ethanol production from corn is expected to top 2.15 million bushels this year, or 20% of production. The amount of ethanol production from corn is also up 63% in the last two years – but more importantly, many investors still have no plans to curtail the construction of more ethanol production plants despite the latest rise in corn prices. As a matter of fact, 48 of them are still under construction, compared to 106 that are already operating. Many analysts are estimating that – given a continuous amount of government subsidies and incentives – it will take a corn price of over $4 per bushel in order to curtail corn ethanol production.
At this point, there is nothing much the Fed can do in curtailing the rise in base metals or agricultural commodities – short of pushing the U.S. into a full-blown recession. The more efficient way to curb metal or commodity prices in general is for China to continue to curtail credit growth or speculation in its economy, but it is a stretch to believe that the Chinese government will continue to push for restraint going forward. The next five years will all be about more efficiencies both in the energy and the agricultural sector as the U.S. (both public and private) increases its funding to the alternative energy sector and as we try to adopt more advanced genetic-engineering techniques to increase efficiencies in the production of corn and soybeans. The $64 trillion question is: Can this be done?
My guess is “yes” – but it will be more of a decade long story rather than merely a five-year story. In a recent commentary on solar energy, Matt Simmons of Simmons & Company International states that ever since 1982, the price of solar energy has generally declined 7% on an annual basis – or other words, 85% on an absolute basis. In order for solar power to be widely adopted (even in places like sunny California or sunny Australia), however, the price of solar will still need to decline another 50% in order to be competitive with traditional fossil fuels. And while the 7% annual price decline has held steady on a historical basis, Mr. Simmons believes that there will need to be a “genuine breakthrough” in solar technology before that can occur. In other words, the current technology in the solar industry has hit a wall – as evident by the lack of price declines during 2005 and earlier this year. As for corn, subscribers may not remember this but as late as 1970, U.S. corn production only amounted to 4.1 billion bushels with an average yield of 71.6 bushels per acre. For comparison purposes – in 2004, U.S. corn production totaled 11.8 billion bushels at an average yield of 160.4 bushels per acre. While this gain looks impressive on the surface, subscribers should know that this only equates to an average efficiency gain of 2.4% per year (leading to 12 to 13 billion bushels of production annually by 2010). Again, just like the progress being made in solar energy, the efficiency gains made in corn do not seem to be too remarkable going forward, and just like solar energy, there will need to be some technology breakthroughs in agricultural production as well in order to curtail prices for the near future. It is definitely going to be a struggle for both producers and consumers alike but this author remains very optimistic – given the amount of both public and private funding increases we have seen over the last 12 months. Let's face it: Many of these VC companies were burned big time during the early 2000s. Assuming that they have learned their lessons, they definitely would not be funding many of the current alternative energy companies if they did not like their technologies. Over the next 6 to 12 months, I will strive to attend some of these conferences in the SoCal area and then report to all of you on what I find. It will definitely be a very interesting learning experience!
But Henry, why are you worried about the recent rise in non-energy commodities given their relative lack of impact on the broader U.S. economy (relative to crude oil or natural gas)?
I am worried simply because we are not totally out of the “inflation woods” yet – despite the benign readings we have seen from the ECRI Future Inflation Gauge over the last few months. Sure, there are many things going for lower inflation in the months ahead – such as a slowing U.S. economy, a significantly lower ISM manufacturing survey reading (to the point where the Fed has traditionally cut rates), weakness in the housing market, and a continuous deflationary force coming out of China, Vietnam, India, and even Japan. However, given that the unemployment rate has just declined to a five-year low of 4.4%, and given that labor costs have recently “enjoyed” a huge uptick, the Fed may now be having second thoughts. And should gold and silver, base metals, and agricultural commodity prices continue to surge going into Thanksgiving, the Fed may ultimately “surprise everyone” by adopting a more hawkish tone than what is currently implied by the Fed Funds futures.
While a 25 basis point rise in the Fed Funds rate to 5.5% may not amount to much, it is difficult to see the Fed stopping after only one more hike. More importantly, any further rise in short-term interest rates may put a significant dent in the LBO (leveraged buyout) market, as many LBO firms are now heavily relying on the collateralized loan obligation market to fund their operations. Given that private equity investors and company insiders (which include company share buybacks as well as M&A activity) were single-handedly supporting the stock market while individual investors were capitulating from late May to August, any cash or credit crunch in the LBO market will have severe implications. Will a further rise to 5.5% in the Fed Funds rate be the death knell for private equity or LBO activity? Most probably not. But given that collateralized loan obligations are floating securities tied to LIBOR or prime, a further rise to 5.5% coupled with the Fed's intention to further hike rates could definitely be a blow to the private equity or the LBO market.
Let us now shift away from the U.S. stock market for a moment and discuss the Japanese stock market, or more specifically, the Nikkei. As I have mentioned over the last few months, the time to go long Japanese stocks in general still has not arrived yet – mainly because 1) The substantial decline of the Japanese monetary base, and 2) Japanese financials have been severely underperforming. As of this evening, my stance on Japanese stocks in general has not shifted, as the latest growth of the Japanese monetary base for October was again very dismal. Following is a chart showing the year-over-year growth and the year-over-year rate of growth (second derivative) of the Japanese monetary base vs. the year-over-year change in the Nikkei from January 1991 to October 2006:
As can be seen on the above chart, the growth in the Japanese monetary base over the last few months has been very dismal any way you look at it. Given the historical positive relationship between the growth of the Japanese monetary base and the performance of the Nikkei, this definitely does not bode well for Japanese stocks going forward. Again, I still would not buy the Nikkei or the Japanese market unless we again see an increase in the Japanese monetary base or unless this divergence has been resolved. Readers please stay tuned.
The historic decline in the Japanese monetary base is also of interest to us in another way – as a significant decline in this over the last 30 years has generally led to some kind of financial crisis somewhere in the world. The optimists in us will say that we have already experienced this “dislocation,” as many stock markets over the world experienced a significant peak in May and proceeded to decline (or even crash) over the subsequent two to three months. That may very well be the case. But until I get further confirmation (i.e. a positive rate of growth in the Japanese monetary base), I am definitely still on my guard – especially given that the European Central Bank (an area of the world where there is still relatively cheap money) is still continuing its series of rate hikes. For now, however, the market is still in an uptrend – and readers should continue to hold on to their “favorite stocks” and “favorite sectors” as long as they are still performing well and as long as their fundamentals still look positive going forward.
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 November 3, 2006, the Dow Industrials declined 104 points while the Dow Transports declined 136 – finally breaking the five-week upside streak of both of the popular Dow indices. While the severe underperformance of the Dow Transports is definitely a red flag (especially in the absence of rising crude oil prices), it is still not much of a worry at this point. However, this weakness in the Dow Transports (along with the general weakness of the Dow Transports since early July) should continue to be monitored. For now, this merely looks like a corrective phase in both the Dow Industrials and the Dow Transports. We continue to remain 100% long in our DJIA Timing System, given that the intermediate trend remains up and given that we expect the Dow Industrials to reach a higher level by the end of this year than the level it closed at last Friday. 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 28.0% for the week ending November 3, 2006. 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:
With the exception of the week ending September 29, 2006, the four-week MA of this indicator has been rising relentlessly since early August – and has again risen in the latest week despite it already being in overbought territory the week before. Readers who have been looking to initiate new long positions in the stock market should continue to wait until after this indicator has experienced more of a correction in the upcoming weeks.
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 reversed back to the upside four weeks ago (from 101.5 to 108.2) and has risen further to 138.1 in the latest week (up from 134.4 the week before). Meanwhile the 50-day moving average also reversed on the upside from an extremely oversold level of 109.1 four weeks ago to the current reading of 121.5. The fact that the shorter-term moving average has reversed back to the upside and has now crossed above the 50-day MA suggests that the market has already bottomed and that the intermediate uptrend remains intact. However, given the recent relentless rise in the ISEE sentiment and given the latest correction in the stock market, bullish readers should definitely be concerned about initiating long positions here. Anyone that wants to initiate long positions in the stock market should wait until we see some kind of dip in ISEE sentiment – at least in the 20-day MA.
Conclusion: The long-awaited correction in the stock market finally occurred last week, and given the recent rise in bullish sentiment, it looks like that the correction should have further to go before making a significant bottom. However, even though sentiment is still too overly bullish on a short-term basis, the intermediate term trend remains up – as we are nowhere close to any kind of exhaustion yet. Moreover, the relative valuation of the stock market – compared to bonds, and even real estate and commodities – is still low on a historical basis. From this standpoint, we are definitely nowhere close to a top (although the readings in the Barnes Index can just spike higher if the bond market just collapses from here). As I have mentioned many times before in both our commentaries and in our discussion forum, predicting a top is definitely the most difficult practice in the field of the investing. It is not a science, but an art. It simply cannot be done on a consistent basis. Nevertheless, typical signs I look for include the following:
- Sustained period of bullish sentiment - especially on the part of retail investors. Note, however, that sentiment does not have to be very bullish on the day of the top. As a matter of fact, bullish sentiment tends to have already topped out prior to the actual top of the major stock market indices (not everyone cannot be treated as a contrarian indicator!);
- Sustained period of huge money inflows to domestic equities - which is basically a confirmation of bullish sentiment of retail investors. Based on the evidence I have seen, retail investors are still shifting money away from domestic equities on a relatively consistent basis;
- Relative overvaluation compared to other financial assets, such as bonds and CDs;
- Amount of leverage in the system - as exemplified by NYSE margin debt and the commitment of traders reports;
- A drop in liquidity - as evident either by continued Fed tightening or divergences from other stock market indices or international/emerging markets. This can also be witnessed in the deterioration of our popular breadth indicators, such as NYSE operating company A/D line, the McClellan Summation Index, new highs vs. new lows, and so forth. In fact, divergences among the major stock market indices or breadth indicators have historically been the most reliable predictor of a major top in the stock market (the Dow Industrials or the S&P 500).
As I have said over the last few months, investors should now overweight U.S. domestic large caps and growth stocks – as opposed to cyclical stocks and anything that has to do with commodities. Again, we remain 100% long in our DJIA Timing System and do not intend to shift to a less bullish stance for now.
Henry To, CFA