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The State of U.S. Households' Balance Sheets – a Third Quarter Update

(December 10, 2006)

Dear Subscribers and Readers,

I hope that none of you was caught the wrong way in the U.S. Dollar Index trade last Friday morning.  The recent slide in the U.S. Dollar Index was definitely overdone, and as I have mentioned before in my commentaries over the last two weeks, I now believe that the U.S. Dollar will generally outperform most major currencies (with the exception of the Chinese Renminbi, most “emerging Asian” currencies, and possibly the Japanese Yen) in 2007.

The reversal of the U.S. Dollar against most major currencies on Friday was also accompanied by more bullish news for the dollar.  Note that I do not mean Secretary Hank Paulson's interview on CNBC about the need for a “strong dollar” (he has mentioned this many times before).  What I mean is that over the week ending last Tuesday, the commercials continued to increase their short position on Euro futures contracts.  As a result, the net short position of Commercials is now at a new 52-week high.   Following is a chart showing the net positions of commercials, large speculators, and small speculators vs. open interest for the Euro, courtesy of

The net positions of commercials, large speculators, and small speculators vs. open interest for the Euro 

Not coincidentally, the net long position of small speculators is also at a new high.  Given that small speculators have historically acted as great contrarian indicators, and given that commercials are usually the “smart money,” there is a good chance that the Euro reversal on Friday morning was legitimate – signaling that the U.S. dollar has probably bottomed and should rally into the end of this year and beyond into 2007.

Let us now do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 922.48 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 802.48 points

As of Sunday afternoon on December 10th, 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 (which is now also expanding in China), 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, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been way overblown.  We are also very bullish on good-quality, growth stocks.

In last weekend's commentary, I discussed that the ISM Manufacturing Index is a coincident indicator, and not a leading indicator.  Therefore, folks who are “relying” on the ISM, GDP, and consumer confidence numbers in order to predict the stock market going forward is playing a fool's game.  Moreover, manufacturing makes up slightly less than 20% of the U.S. economy, and according to the creators and keepers of the ISM Manufacturing Index, a PMI in excess of 42% is generally indicative of an expansion in the overall economy.  Therefore, the 49.5% November reading is not indicative of a contraction in the U.S. economy at all.  In fact, according to the ISM, it equates to an approximate 2.4% increase in U.S. GDP.  This view was vindicated when the latest ISM Services Index for November hit a level of 58.9, up from 57.1 in October and handily beating expectations of only a 56.0 reading.

Okay Henry, but the ISM Services Index is also a coincident indicator.  What makes you think that we are heading for a soft landing, aside from the fact that the stock market is still going up?

In last week's commentary, I stated that:  “… subscribers may remember that the U.S. stock market (as well as major stock markets around the world) did experience a significant peak on in early May of this year (during which time we were short via our DJIA Timing System) – a decline which did not end until mid-August for the most part.  For the four months ending August 2006, mutual fund outflows from domestic equity funds were the highest four-month running total since the end of October 2002 (when the last cyclical bear market ended).  If there had not been ample private equity buyouts or company buybacks, the Dow Industrials would have most likely gone down another 1,000 points before stabilizing.  As it turned out, the “professional investors” were buying hands over fist while retail investors were bailing out in anticipation of the four-year Presidential cycle low and the annual October low.  As for the world of economic leading indicators, the ECRI Weekly Leading Index had already started deteriorating in early August – suggesting that the U.S. economy was about to dramatically slow down.  In other words, both the stock market and the ECRI Weekly Leading Index had successfully foreseen a mediocre GDP growth of 2.2% in the third quarter and the latest sub-50 reading in the ISM PMI.

In other words, I dispute the views by many popular commentators that the stock market is irrational, as I believed that the stock market (at least retail investors) had properly discounted the current economic slowdown during the four months ending August, when the amount of mutual fund outflows hit a record not seen since the four-month period ending October 2002.  Moreover, all this current talk of market manipulation, etc, is moot – as everything this author is seeing and hearing is that both the hedge funds and retail investors are underinvested in the U.S. stock market.  At the same time, many of the world's stock markets (the UK, Germany, France, Hong Kong, India, Brazil, Australia, etc., with the exception of Japan and South Korea) are still trading at or near all-time highs – suggesting that the probability of “manipulation” or “irrationality” is very much a moot point (let's face it, it is very hard to “manipulate” all the stock markets in the world at the same time).

As for other leading indicators besides the U.S. and the world's stock markets, I rely on the “Weekly Leading Index” (WLI) published by the ECRI for signs of a U.S. slowdown or recession.  And right now, the annual rate of growth of the ECRI WLI is at a 26-week high at 1.8% - suggesting that while U.S. economic growth is definitely sub-par going forward, the possibility of a recession is currently very small.  The economic slowdown scenario is also being confirmed by the latest UCLA Anderson School Forecast.  Quoting from the LA Times article:

Despite the housing downturn, the California and U.S. economies are headed for a "soft landing" because trouble in one sector alone is not enough to trigger a recession, UCLA economists said in a quarterly forecast to be released today.

California could have a soft landing — slowing growth but without recession — as long as its economic woes are limited to the housing sector, economist Ryan Ratcliff said in the UCLA Anderson Forecast outlook.

"The question for how bad this thing is going to get over the next two years is whether or not something else comes along and becomes the double whammy," he said.

Leamer's national forecast devotes 14 pages to explaining why several economic models foresee recession. Then, in the final page and a half, the forecast says such models are wrong because "they can't seem to be taught that something is very different this time." In recessions, Leamer said, the manufacturing sector declines, along with construction, and the combined job and productivity losses cause recession. What's different this time, he said, is that construction is poised for a downturn, but manufacturing is "still on its knees in a deep trough." Outside manufacturing and construction, job losses in past recessions have been minimal. And, without a substantial decline in manufacturing jobs, Leamer said, "there cannot be enough job loss to qualify as real recession." His conclusion: "The models say 'recession'; the mind says 'no way.' I'm going with the mind."

Before you say that economists are always wrong and thus the UCLA Anderson School Forecast must be wrong as well, please note that the UCLA Anderson School was one of the first to forecast the 2001 recession – in December 2000 as a matter of fact, when it was still very unpopular to do so.  It also had an excellent track record in predicting the seriousness of the downturn in California in the early 1990s, and the subsequent strong rebound since 1993.  In other words, the track record of the UCLA Anderson School Forecast has been excellent, and there is every reason to think that the current slowdown call is “on the mark” – especially given that this author's indicators are also saying “slowdown and not recession” as well!

Let us know get on with your commentary.  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 and subsequently in our September 24, 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 third quarter of 2006:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 3Q 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! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.2 today...

As you can see on the above chart, the net worth of U.S. households again hit a new high during the third quarter of 2006, up from $53.29 trillion to $54.06 trillion – a $770 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 no doubt in this author's mind that we have already seen the bottom in both the Dow Jones Industrial Average and the S&P 500 on October 10, 2002, and that the market should continue to rally from current levels, unless there is 1) a major policy mistake by the Fed, 2) a rise of protectionist sentiment in Congress, 3) a major war in the Middle East, or 4) a threat of the Bush tax cuts of 2001 and 2003 being rolled back.

On a year-over-year basis, the net worth of American households grew 6.9%, just slightly under the 54-year geometric year-over-year average of 7.4%.  While this growth is definitely decent – especially in light of the “crash” in the housing markets, the one notable trend that I am continuing to worry about 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.”

However, 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 also why both Alan Greenspan and Ben Bernanke has been very careful in the current hiking cycle (which most probably has already ended), in that they were 1) very transparent with their views and made sure all rate hikes were communicated in advance, 2) very careful and incremental – by choosing incremental 25 basis point hikes as opposed to the rate hike cycle during 1994 to 1995 when Greenspan hiked by 75 basis points during one meeting.  Bottom line: The United States (and even more so, the United Kingdom since it does not have a great agricultural, technology, or entertainment industry such as what we have in the U.S.) today is more dependent on asset appreciation and the financial sector than ever – and both the Federal Reserve and the central banks of the world will continue to do what they can to uphold this trend going forward.

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 – which should come at the May 9, 2007 meeting.

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 asset 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 24.64% of total financial assets and 14.88% of total assets owned by households – which are at levels (with the exception of the bottom in late 2002, early 2003, and the second quarter of 2006) 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 3Q 2006) - 1) As a percentage of total household assets, equities *only* make up 14.88% - slightly below its 54-year average of 15.22% and at a level (ex. the bottom in 2002, early 2003, and 2Q 2006) not seen since the fourth quarter of 1994. 2) As a percentage of total financial assets owned by households, equities *only* make up 24.64% - slightly above its 54-year average of 23.64% and at a level (ex. the bottom in 2002 and early 2003) not seen since the second quarter of 1995 (and actually below that of the 2Q of 2006).

While the market has definitely enjoyed a substantial rally since the end of the third quarter (the S&P 500 is up 5.5% since September 30th), it is to be noted that based on mutual fund inflow information, retail investors in general are still avoiding domestic and domestic large cap equities.  While no reliable 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.  Again, let me put this more bluntly: We are still 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).

On the Japanese Stock Market

Given that the Nikkei and especially Japanese small caps (as a whole, Japanese small caps are down more than 25% this year) have underperformed almost every other stock market this year, readers may be wondering if it is currently a good time to buy Japanese equities.  My conclusion: While I am also watching Japan and am also looking for an entry point, I will not buy any Japanese equities at this stage, given that:

  1. The over-eagerness of the Bank of Japan to hike: Most of the current growth in the Japanese economy has come from exports and capital spending.  Consumer spending still remains dismal, and if it hadn't been a slight bout of rising prices in China in 2005 and the declining Yen, there is no doubt the Japanese economy would still mired in a deflationary environment today.

  2. The historical tendency of Japanese corporations is to focus on empire building and providing lifetime employment rather than focus on the bottom line, and given the recent capital spending boom over the last couple of years and decreasing profit margins, there is a good chance that Japanese corporations are reverting to their old bad habits.

  3. The recent regulation in the consumer finance industry – when lawmakers imposed a maximum legal limit that consumer finance companies can charge at 20%, as opposed to the 29.2% that consumer finance companies have been charging.  Based on various estimates, as many as ten million customers could lose access to their credit lines, forcing them to rely on loan sharks or family help instead.  In the short-run at least, this will curb consumer-spending growth considerably.

  4. Expectations for the Japanese equity markets are still high.  Moreover, since the end of the Bank of Japan's quantitative easing policy in March and the subsequent wounding down (which effectively ended a couple of months ago), there still has not been a “general washout” or “capitulation” of Japanese equity investors or even sentiment.  Given the historical correlation between the year-over-year rate of growth (or second derivative) in the Japanese monetary base (which is now very negative) and the year-over-year growth in the Nikkei (which was still at 5.5% at the end of November), there is still a lot of downside risk for the Nikkei if the two indices converge to each other, as shown below:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to November 2006) - 1) Note that Japanese money growth has been plunging since the end of 2003 - with the latest Y-O-Y increase registering a highly negative reading of -22.3%. Such dismal growth will most likely mean a continuing consolidation in the Nikkei. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) has plunged since February 2006 - resulting in the lowest reading in recorded history (just slightly lower than Jan 2001)! 3) Momentum of the Nikkei still SIGNIFICANTLY diverging from monetary growth...

Despite all the above negatives, however, Japanese equities still remains an attractive asset class, given that earnings yield are currently over 4% vs. a domestic corporate bond yield of approximately 2%, and given that corporate earnings are still growing at double-digit rates.  On a purchasing power parity basis (especially against the Euro), the Yen is also very undervalued.  Moreover, real estate prices in Japan in the three largest cities appreciated during 2006 for the first time in 16 years, while bank lending also started rising earlier this year for the first time in 10 years!  Finally, it should be noted that Japanese individuals collectively represent one of the biggest savings pools in the world.  Starting from October 2007, the Japanese government shift approximately US$1.7 trillion from the postal savings system to quasi-private accounts – thus allowing individuals (who currently have approximately 50% of their savings in cash) to more easily invest in their own domestic markets and even into the global markets.  Bottom line: The Japanese stock market continues to be on my watch list, but it is not a “buy” just yet.

Let us now shift back to the U.S. stock market and 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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to December 8, 2006) - For the week ending December 8, 2006, the Dow Industrials rose 113.35 points while the Dow Transports rose 12.95 points. Since the mid November highs, the Dow Transports has been the weaker Dow index, and the action over the latest week is no different. Going forward, the Dow Transports is definitely the index to watch - especially given the recent strength in oil prices. While the two popular indices are still somewhat overbought, readers who are long should continue to hold on for now - and not try to be *cute* in timing any subsequent corrections - as I believe that both of these indices are still in intermediate uptrends. However, should the Dow Transports continue to be weak, then it may be time to start cutting your weak positions.

For the week ending December 8, 2006, the Dow Industrials rose 113.35 points while the Dow Transports rose 12.95 points.  As mentioned on the above chart, the Dow Transports is definitely the weaker index – and it should continued to be watched.  For now, however, the intermediate uptrend remains intact, although in the short-run, the stock market is still vulnerable to a further correction – especially given the onslaught of IPOs and secondary offerings right before Christmas.  Also, unless the Dow Transports decline below its November 3rd low of 4,612.69 (we are currently 107 points away), however, there is still no cause for alarm just yet.  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 27.0% for the week ending December 8, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending December 8, 2006, the four-week MA of the combined Bulls-Bears% Differentials declined from 28.5% to 27.0%. Given that the breadth of the stock market has been quite weak and given that this indicator is still overbought, readers may want to wait for better prices before initiating new positions here. The intermediate-term trend, however, remains up.

As mentioned on the above chart, the four-week MA of this indicator has been effectively rising non-stop since early August – although it did managed to dip slightly over the last few weeks.  This reading is still overbought, suggesting that 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 coming days (this week sounds like a good candidate for a further correction given that many offerings should be priced this week ahead of the Christmas holidays).

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:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - After rising relentlessly from late September to mid November, the 20 DMA of the ISEE Sentiment has finally pulled back and was essentially flat last week - rising from 137.1 to 137.2. Moreover, the 50 DMA has caught up - as the 20 DMA is now only 1.1 points above the 50 DMA. This is definitely a well-needed *rest,* and suggests that stocks should continued to be purchase *on the dips* in general.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment has been rising relentlessly since late September (bottoming at 101.5) until the middle of last month – topping out at 146.5.  Since then, it has retraced some of its rise – and is now sitting at 137.2, slightly up from a reading of 137.1 on December 1st.  Meanwhile the 50-day moving average is still rising, coming in at a reading of 136.1 as of the close last Friday.  The latest pullback in the 20-day moving average was definitely a well-needed rest for bullish sentiment and given that the 50-day moving average has also now caught up with the 20-day moving average, this suggests that stocks should continued to be bought in any corrections in the coming days.

Conclusion: Based on the asset holdings of U.S. households, and based on the fact that U.S. households have been favoring international equities as opposed to domestic equities, one can reasonably conclude that U.S. equities in general are still very underowned, especially large caps and growth stocks.  Going forward, they should continued to be bought – although this author would definitely continue to watch for any signs of potential downside risks (such as a threat of a potential roll-back of Bush's 2001 and 2003 tax cuts).  Moreover, our economic slowdown scenario for the U.S. continues to remain in place.  In the very short-run, the U.S. stock market is still overbought and it is probably still in a corrective phase.  The “onslaught” of offerings this week (ahead of the Christmas holidays) should also continue to put pressure on stocks in the very short-run.  However, even though both the market and 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.  Again, we remain 100% long in our DJIA Timing System and do not intend to shift to a less bullish stance for now.

As for the Japanese stock market, it will most likely be a “buy” sometime in 2007.  For now, it will just be on my watch list – and I will alert our subscribers should I see any profit opportunities (or a good chance of outperforming the U.S. stock market) in the Japanese equity market going forward.

Signing off,

Henry To, CFA

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