An Update on Global Liquidity and Commodities
(February 25, 2007)
Dear Subscribers and Readers,
Just a couple of announcements to kick off our weekend commentary. First, the second issue of “The Retirement Advisor” (a newsletter catering to baby boomers which I am proud to be a part of) has been posted and sent to subscribers last Wednesday. For those who want to get a free sample of “The Retirement Advisor” newsletter, you can do so at the following link. Second, for readers who are avid followers of investor sentiment – specifically the Rydex Cash Flow Ratio, I would highly recommend reading the latest “Chart Spotlight” published on Decisionpoint.com regarding the Rydex Cash Flow Ratio. In a nutshell, owner of the website and author Mr. Carl Swenlin asserts that the Rydex Cash Flow Ratio is no longer as efficient a sentiment indicator as it once was – as the onset of “ETFs and other products are siphoning bullish funds from Rydex and other mutual fund groups.” On the other hand, the Rydex bear funds are still the perfect vehicles for speculators who want to maintain a short position in the market, as investing in these bear funds allow you to be leveraged short in the stock market while maintaining limited downside. Therefore – going forward – we will continue to keep watch on the amount of bearish assets in the Rydex mutual funds, as opposed to taking the Rydex Cash Flow at face value. Again, nothing is obvious when it comes to the stock and financial markets.
In last weekend's commentary, I had this to say about the subprime market: “Despite the continued and recent strength in the stock market, two of the weakest sectors within the stock market have been the semiconductor industry and the subprime lenders … for subprime lenders, it is definitely too early to say the industry has bottomed. Sure, there has been a shakeout among the smaller subprime lenders as their credit lines were cut – but readers should keep in mind that this has occurred while both the U.S. and global economies are still awashed in liquidity. Therefore, don't expect the Federal Reserve to come in and save these lenders (by cutting rates), unless there is a high probability the subprime lending industry would pose a risk to our financial system. If anything, it now looks like that the major central banks are still continuing to tighten, as exemplified by the recent messages coming out from both the European Central Bank and the Bank of Japan. At this point, however, I do not believe there will be any “spillover effects” from the troubles in the subprime industry. That being said, I will continue to monitor developments in this industry and report back if my assessment changes.”
The subprime industry took another hit last Wednesday, as Novastar revealed a downside earnings surprise on Tuesday evening and projected that the company will not have any “taxable” income for the year 2007 to 2011. The company is also expecting to rescind its status as a REIT as it is expected to continue to struggle for the foreseeable future. As of Sunday afternoon on February 25, 2007, the industry still does not look like it has hit a bottom yet. In fact, the next market that could “go down in flames” is the Alt-A market. As a response to the current woes in the subprime market, one of the biggest players in this market, FirstFed Financial (FED), closed down more than 5% last Friday. At this point, however, I still do not expect the woes in the subprime and the Alt-A market to spill over into the broader economy, but like I said last week, I (and I am sure our subscribers will do the same) will continue to monitor developments in this industry and report back if our assessment changes.
Before we continue with the rest of our commentary, let us 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 1,262.48 points
2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,142.48 points
Given the recent upside surprises in both the Euro Zone and Japan - not to mention the continued strength in the Nordic countries and in the majority of emerging markets around the world, chances are good that the U.S. stock market will continue to strengthen in the weeks and months ahead. As of Sunday afternoon on February 25, 2007, 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 (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel (Intel is now close to two generations ahead of AMD), GE, and American Express. We are also bullish on Yahoo, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been overblown. We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials. We also continued to be very bullish on good-quality and growth stocks in general. In terms of individual countries, we continue to be bullish on both the Taiwanese stock market and the Taiwanese dollar.
As subscribers should know, however, we never get complacent about our positions – and besides watching the current carnage in the U.S. subprime market, I am also keeping an eye on the Indian equity market and economy. In both our commentaries and discussion forum over the last three to six months, I have discussed the fact that the Indian equity market was one of the most expensive markets in the world, and given rising inflation – along with a crumbling physical infrastructure – a decline in Indian equities was inevitable sooner or later. Moreover, as the Bank Credit Analyst had just reported, “With the P/E ratio at 22 (among the highest globally, [Indian] stocks offer very little valuation cushion to protect against deteriorating monetary conditions and slowing growth. More technically, the advance/decline line for the Indian stock exchange has peaked, which typically serves as a warning signal for a rollover in share prices. Banking issues appear most vulnerable as they are directly exposed to rising interest rates and the ensuing slowdown in credit demand.” Readers please stay tuned.
In last weekend's commentary, I stated that there were many factors supporting the current bull market in U.S. stocks – including “indicators such as 1) the amount of money market funds vs. the S&P 500 market cap, 2) equity and equity mutual fund holdings as a percentage of total household assets, 3) mutual fund inflows/outflows data per AMGdata.com, 4) short interest outstanding on the NYSE and the NASDAQ, 5) relative valuations of U.S. equities vs. U.S. bonds, international stocks, real estate, and commodities, and so forth … The potential long-term bullishness inherent in these indicators is also being confirmed in our most popular sentiment indicators – those being the American Association of Individual Investors (AAII) and the Investors Intelligence Surveys.” Not surprisingly, we got some pushback with some of the above reasons – with some skeptics (if there were no disagreement, then this would not be a market!) stating that they could find “many instances” where the stock market declined anyway even though bond yields were low, etc.
My initial reaction to that would be: Yes, I will definitely like to see some past examples when U.S. stocks declined substantially even as U.S. commercial real estate and UK, Western Europe, and Asian stocks were selling and staying at comparatively higher P/E ratios (the U.S. REIT equivalent of the P/E ratio is now higher than that of the S&P 500). If there were such past instances at all (and I don't think there has been any such cases), then the “warning shot” for the U.S. stock market would have come from the markets that were more speculative and had a higher valuation first (such as the Nikkei in early 1990 and emerging markets in 1997/1998). With the exception of the subprime market and the Indian stock market, there has not been any broad sell-offs in any of the more speculative asset classes just yet (the Chinese stock market “bubble” will probably rise further than anyone would think possible until it tops out). Secondly, I realize that U.S. stocks have sold off even as bond yields were much lower than the dividend or the earnings yield of the Dow Industrials or the S&P 500. In fact, at the bottom of the May 1946 to June 1949 bear market in stocks, the earnings yield of the Dow Industrials was close to 18%, while bond yields were only 2.5% or so. One can also draw a similar conclusion if one uses the Great Depression and World War II period from 1932 to 1945 as an analogy. Conversely, bond yields continued to rise during the late 1970s, even though they were already twice as high as the dividend yield of the S&P 500 as early as 1972. My point is: Relative valuation models that look at stocks vs. bonds (such as the so-called “Fed Model”) only works in certain environments – such as an environment of relatively low and stable consumer price inflation. This has been the environment through most of the 1980s and the 1990s, and is still the environment we are currently in. More importantly, I do not expect this environment to change anytime soon.
Look – as a financial market analyst and investor, I only like to deal in probabilities. As I stated before, I realize that there are no certainties either in the stock market or in life in general – but one thing I won't do is to put my investing money in low probability events – such as a deflationary bust or a “new era” of stagflation such as what the U.S. endured during the 1970s. In February 2000, I made the decision to sell all my technology holdings (including sending out several emails urging my friends and associates to sell their stock holdings as well) because there was ample evidence that a major top was forming. Today, we have seen no similar evidence (not by a long shot). As I am writing this, the Advance/Decline lines for the NYSE (all issues), the NYSE (common stocks only), the S&P 500, the S&P 400, and the S&P 600 are all near all-time highs. So are many international markets – not just in the developed world, but the developing world as well. Moreover, the most recent run-up in REIT prices has just not been confined to the U.S., but it is evident around the world as well. At this point, breadth remains healthy, and chances are that the U.S. stock market will continue to rise in the coming weeks and months.
More importantly, while primary liquidity (those being directly created by Central Banks such as the Federal Reserve, the Bank of Japan, the European Central Bank, or the Bank of England) has definitely been shrinking over the last 12 to 18 months, subscribers should know that overall liquidity is usually created by the financial sector's willingness to borrow and for entrepreneurs, investors, and speculators to take on additional risks, i.e. the classic money multiplier effect at work. In earlier times, many companies and individuals (and even sovereign countries) depended on the generosity of banks such as the Rothschilds, the Barings, and Morgans – and later the Chase Bank, Citigroup, Bank of America, and Wells Fargo. As long as these banks did not run into trouble and call in their loans or tighten their lending practices, then all was fine. Today, the center of power has shifted from banks to hedge funds and private equity funds. As long as hedge funds and private equity funds don't liquidate all their holdings tomorrow, then global liquidity will remain ample, and given the more than $160 billion sitting on the balance sheets of private equity funds (not to mention the $25 to $30 billion liquidity injection that the “Big Four” Chinese banks received prior to their IPOs earlier last year), the global liquidity environment should be relatively benign for the foreseeable future.
Moreover, one important indicator of global liquidity – that of foreign dollar reserves held in the custody of the Federal Reserve banks, is still growing at a relatively decent rate. As we first stated in our May 1, 2005 commentary, ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard as opposed to the Gold Standard that has been in place since the end of World War I. Therefore, as world trade expanded, the demand for dollar has continued to increase - and with it, the continuing increase of foreign dollar reserves held at the Federal Reserve Banks. It is interesting to note that various financial crises or economic recessions (see chart below) have usually occurred when the annual change of dollar reserves is slowing down or experiencing negative growth. Following is the chart showing the level of foreign reserves vs. the annual change in foreign reserves January 1982 to February 2007:
Note that the growth rate has been as high as 36% as recently as August 2004. Since August 2004, the annual growth of foreign reserves held in the custody of the Federal Reserve banks has slowed dramatically but is still at a relatively high rate of approximately 16%. Again, any decline in global liquidity going forward would most likely show up in this indicator first. The decline in the stock market in 1990, the 1997 Asian Crisis, the 1998 emerging market and LTCM crises, and the 2001 recession and dramatic drop in the stock market had all been preceded by dramatic declines in foreign reserves. As of today, we have witnessed no such dramatic declines – and thus global liquidity remains ample for now.
I now want to devote some space to the discussion of commodities – specifically the CRB Index and the CRB Energy Index. As regular readers may recall, we have not discussed commodities in awhile – especially commodities in the context of the movements in our MarketThoughts Global Diffusion Index (MGDI). For newer subscribers who are not familiar with our MGDI, I will begin with a direct quote from our May 30, 2005 commentary outlining how we constructed this index. Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages."
However, we have since revised our MGDI by incorporating the leading indicator readings for the Chinese economy as well. This makes sense, as the Chinese economy is now the fifth largest economy and has been responsible for much of the world demand growth in commodities over the last few years. Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the CRB Index and the YoY% change in the CRB Energy Index from March 1990 to December 2006 (the January 2007 reading will be updated and available on the OECD website early next month). In addition, all four of these indicators have been smoothed using their three-month moving averages:
The strength of the MGDI is essential to keeping our U.S. economic slowdown scenario alive – as a slowing global economy in the midst of a U.S. economic slowdown can mean many negative feedback loops around the world's economies which could in turn induce a classic U.S. economic recession. More importantly, the historical rate of change (second derivative) in the MGDI has lead or tracked the year-over-year change in both the CRB Index and the CRB Energy Index very closely. Given that both the change and the second derivative of the MGDI has continued to trend down over the last few months, my guess is that energy and commodities in general will underperform over the next 9 to 12 months.
Let us now discuss the most recent action in the U.S. stock market via 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 February 23, 2007, the Dow Industrials declined 120.09 points while the Dow Transports rose 52.96 points – marking the first weekly divergence between the two popular Dow indices since the week ending January 5, 2007. Given that all three of the Dow indices made simultaneous all-time highs as late as the week before last, and given that the Dow Transports has been the leading index since the cyclical bull market began in October 2002, my guess is that the latest decline in the Dow Industrials is only temporary. That is, we should be see higher prices in the weeks and months ahead.
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 a new rally high of 31.0% for the week ending February 23 2007. 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 four-week MA of this indicator has been rising consistently since early August – although it did dip slightly from mid November to mid December. As of last Friday, the four-week MA hit a high of 31.0% - the most optimistic reading since late December 2005. While such a reading is still uncomfortably high, readers should note that this is due to the Market Vane's Bullish Consensus readings more than anything else – and is not being confirmed by other sentiment readings such as the ISE Sentiment Index.
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 been rising relentlessly since late September (bottoming at 101.5), after dipping slightly from mid November to mid December, is now again declining (and has been doing so since the end of January). This latest decline is encouraging for the stock market bulls, as it allows the stock market to work off some of its short-term overbought conditions. Again, there is no guarantee that the stock market won't endure a further correction from current levels (as it did last week), but the outlook for equities is bright for the weeks and months ahead.
Conclusion: This author continues to be bullish on U.S. equities in general, especially U.S. large caps and large cap growth stocks. While there are certain sectors that we need to keep an eye on (such as the U.S. subprime industry, the U.S. Alt-A industry, and the Indian stock market), things in general are still looking bright over the next six to nine months. Looking at history and evaluating the different probabilities suggests that using relative valuations are still the best way to value the U.S. stock market – and will continue to remain so for the near future. For now, we remain 100% long in our DJIA Timing System.
Henry To, CFA