Dow's Longest Winning Streak Since Summer 1955 – What Now?
(May 3, 2007)
Dear Subscribers and Readers,
I hope you have all enjoyed both Rick's and Bill's guest commentaries during the last two weekends. I apologize for my absence during those times – but I promise you that I will again be at “full speed” during the upcoming weekend. At the same time, however, I would like to continue to solicit different views and opinions from our readers and other guest writers on the web – so don't be surprised if we publish another guest comment at some point. For those writers who would like to get a comment published on our website, please feel free to contact us. Now, as we enter the “seasonally weak” six months of the year, it is always a good time to stand back and engage in a lot of reflection, especially since the bulls have been on a rampage (with the exception of two weeks during late February and early March) since the summer of last year. As I have mentioned over the past two weeks, the current rally off of last summer's lows has not been relegated to the U.S., but is actually global in nature. Once this trend ends (and it will at some point), then it can and will get brutal.
Before I go further into the commentary, I want to bring a couple of things to our readers' attention. The first one is geopolitical and demographical in nature, and has been mentioned on and off in our commentaries and in our discussion forum over the last couple of years. For those who haven't been following European demographics – in particular, France – one should definitely read the following cover story on the European version of Times Magazine from two weeks ago:
The article – entitled “The French Exodus” – tells the story of a country (in this case, France) witnessing talent flight. In many ways, “talent flight” is more damaging to an economy than mere capital or financial flight, as the talent pool in any one country represents a long-term investment in that particular country. Whether the cover story in the Times article is a contrarian indicator no one knows at this point, but with the upcoming run-off in the French Presidential election only three days away, what we are currently seeing could be a turning point (for the better) for France the country and her economy. There are reasons to be optimistic, as the first round of the election saw the virtual destruction of the Communists, the Anti-Globalization, and the Greens Party. It also looks like that Ms. Royal will most probably not generate enough support to form a majority government – which is good since we already know her policies to be socialistic in nature and will only push France deeper into its current economic hole. For now, it remains to be seen if Nicolas Sarkozy will be astute enough to implement more liberal economic policies for France, but like I said, I remain optimistic. While Mr. Sarkozy has called for protectionist and government intervention policies in the past as Finance minister, readers should not forget that Margaret Thatcher had also espoused such policies during their bid to be elected as the new Prime Minister of Great Britain in 1979. At this point, all Mr. Sarkozy is concerned about is getting elected on a majority platform – and after that, he will be free to implement his policies any way he wants, as long as he makes the appropriate political maneuvers. Readers please stay tuned.
The second item is the most recent article on a NY Fed study on “Hedge Fund Risks” that were published yesterday. That particular article begins with the following paragraphs:
One measure of hedge fund risk suggests parallels with the financial crisis sparked in 1998 by the collapse of industry giant Long-Term Capital Management, according to research released on Wednesday by the Federal Reserve Bank of New York.
Hedge fund returns have become much more correlated of late, meaning managers are generating similar gains and losses in similar market conditions, according to a study by Tobias Adrian, an economist at the bank. That also happened before LTCM collapsed in late 1998, he said.
However, Adrian also noted a big difference between then and now. Today, the increased correlation of hedge fund returns has been driven by an overall decline in the volatility of returns in financial markets, the economist added.
The implication of this article is wrong at worst and misleading at best. Indeed, if one has read the original paper (which I would highly recommend doing at the following link), one would most likely come up with the completely opposite conclusion – that being that the latest increase in correlation among hedge funds is not a big thing to worry about, as the latest correlation statistics have more to do with historically low absolute volatility as opposed to higher covariances (for a review of how to calculate the correlation coefficient, please see the following link) – which played a significant role as a trigger for the 1998 Brazilian, Russian, and LTCM crises. In other words – at this point in time – there is no substantial evidence that hedge funds as an industry are invested in the same trades, as opposed to early 1998 when many hedge funds and prop desks were invested in the same types of trades which LTCM was involved in. The only exception is most probably the Yen carry trade – although the biggest player in the Yen carry trade thus far is either the Japanese institutional or the Japanese retail investor.
Of course, given that the investments of the typical Japanese investor do not show up in hedge fund correlation statistics, it is still probably a good time to be cautious on the markets, especially since the market is now very overbought in the short-run and especially as the Yen carry trade has become even more overstretched since the last time we gave our subscribers an update.
The short-term overbought nature of the U.S. stock market (and most other major global markets as well) is reflected in the fact that the Dow Industrials has now been up 21 out of the last 24 trading sessions – rising approximately 7.5% in the process. As discussed in the following article, such as streak has not occurred since the summer of 1955. As a matter of fact, the last streak took place during the trading sessions from May 31, 1955 to July 6, 1955, as shown on the following daily chart:
As mentioned on the above chart, the streak that ended on July 6, 1955 culminated in a two-day “blow off” of approximately 3% in the Dow Industrials – leading to a short-term top and a subsequent two-month consolidation period before we saw another push higher during September 1955. The subsequent rally ended in the midst of news about the infamous Eisenhower heart attack – resulting in a substantial one-day decline of 6.5% on September 26, 1955. If we witness the same kind of timeline, then this author will most likely trim our 100% long position in our DJIA Timing System if either of the following occurs:
- A one-day rally of over 200 points in the Dow Industrials either today or this Friday;
- A one-day reading of over 200 in the ISE Sentiment Index either today, this Friday, or anytime over the next week or so.
In the longer-run, however, such a streak is nothing to fret about, as such an overbought condition usually signals market strength, especially in light of decent valuations and ample global liquidity. At this time, I do not expect the “trimming” of our position to be anything other than a quick tactical allocation in order to squeeze some “alpha” in our returns.
Besides the short-term overbought condition in the global markets, this author is also somewhat worried about short-term liquidity, as both the Bank of England and the European Central Bank is still on a tightening path and as China continues to clamp down on stock market speculation in their domestic markets. More importantly – one of the main supply sources of liquidity – the Japanese carry trade investors, may again be getting too “carried away” (excuse the pun), as the Euro-Yen cross rate is now becoming very overbought. Following is a daily chart of the Euro-Yen cross rate vs. the percentage deviation from its 50 DMA (the latter which is used to illustrate the overbought condition of the Euro-Yen cross rate):
As discussed on the above chart, the Euro-Yen cross rate hit a high of 3.1% above its 50 DMA and 6.5% above its 200 DMA last Monday – representing a very overbought Euro vs. the Yen. More importantly, the Pound Sterling – despite threats of more hikes going forward – has failed to confirm the Euro on the upside. During the latest multi-month rally in the Euro, the Pound Sterling has always confirmed. The latest non-confirmation is not only a red flag for the Euro bulls, but also for speculators that are now involved in the Yen carry trade as well. The situation is now getting more precarious by the day.
As for the long-run – as this author has mentioned before – I do not anticipate shifting to a more long-term bearish stance until we see a higher valuation in the S&P 500, as exemplified by the readings in the Barnes Index. As I stated in previous commentaries, we have been utilizing the Barnes Index (please see our March 30, 2006 commentary for a description) as a measure of relative valuation between the two most important asset classes with money managers and investors today – that of 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:
At the most recent peak, the Barnes Index rose to a high of 67.60 in early May 2006, as we discussed in our May 7, 2006 commentary (“Playing the Probabilities”). At the time, I stated: “In our past commentaries, I discussed that we will not enter the “dangerous zone” (the zone when cash/bonds start to become attractive relative to equities) until we hit the 65 to 70 level on the Barnes Index. As of last Friday at the close, the Barnes Index finally entered the “dangerous zone” when it registered a reading of 67.60 … Of course, a huge decline isn't imminent here – especially given the fact that the market has gone on to make higher highs until the Barnes Index touch the 90 level (or even higher such as August 1987, April 1998, and January 2000) in 1981, 1983 and 1990. But today's reading of 67.60 is consistent with the level made in the 1973 top, as well as the January 1980 top (which occurred in conjunction with the top in gold and silver prices). One should at least expect a significant correction here – especially given the continuing rise in long bond yields and the fact that Fed still has at least one more Fed Funds rate hike to go on May 10th.”
In retrospect, we did manage to get our “significant correction” – and the Barnes Index has been instrumental in calling that. As of yesterday at the close, however, the Barnes Index closed at 58.80 – still too far on the low side to be calling a significant top just yet, although we would not rule out some kind of correction or consolidation over the next few weeks.
For now, however, we remain 100% long in our DJIA Timing System, as we believe that the market's intermediate term trend remains up – given decent valuations, decent breadth (we have been anticipating large cap outperformance for awhile now so we are willing to tolerate some short-term divergences) and volume, and relatively neutral sentiment. The stock market also remains well supported by private equity buyouts, although insider selling should pick up significantly starting next week. Again, we will consider trimming down our 100% long position in our DJIA Timing System should 1) the Dow Industrials experiences a one-day rally of over 200 points in the next two days, or 2) the ISE Sentiment Index registers a one-day reading of over 200 over the next couple of weeks. Stay tuned for further updates.
Henry To, CFA