A Worrying Headwind for the U.S. Stock Market
(May 28, 2007)
Dear Subscribers and Readers,
First of all, I hope everyone is having a great Memorial Day Weekend and that you have had time to give “thanks” to those heroes who fought to turn back Nazism, Communism, and other “ism-s” in the 20th century which have killed millions of innocent lives all in the name of ideology. As anyone who reads our commentaries and who invests in the stock market can attest to – life is a constant struggle. Sometimes, we compete with our neighbors, and sometimes we embrace them. There is no one mechanism for making this world a perfect place – and if someone claims there is, you better find a way to lock him/her into a lunatic asylum, where he can do no damage. The Ponzi scheme artist who promises a 20% monthly return from trading currencies is one example (I've actually had decently smart people who approached me and ask if 20% consistent monthly returns are possible – the quick answer is no, you do the math). Life would not be fun if it were not for our day-to-day and month-to-month struggles.
Speaking of “struggling,” there is no doubt that the folks who have been consistently shorting the U.S. and the world's stock markets (with the exception of the Venezuela market, homebuilders and subprime lenders, and Japanese small caps during 2006) have most probably struggled greatly over the last four years or so. There is a reason why out of the 9,000 hedge funds or so out there, probably less than 100 of them are dedicated short bias hedge funds. Going forward, I believe dedicated short-sellers will continue to struggle in the months or years ahead. I know, I know – this somewhat contradicts the title of this commentary – but I will illustrate why later in this commentary. Before we go ahead with our commentary, I want to alert our readers to the May/June commentary written by Bill Gross of PIMCO. It is a must-read, as always. Besides the fact that Mr. Gross and PIMCO has now “capitulated” to the bullish side, there are of course other things worth mentioning in the article as well:
- The topic of capital vs. labor, or more specifically, the “ascendance” of capital over labor – as we have discussed in both our discussion forum and our commentary over the last 12 to 18 months. Aside from the fact that both Chinese and Indian urbanization and industrialization have now added over a billion workers to the global labor force, the triumph of technology, as demonstrated by a technological S curve acceleration – is also a significant contributor to this phenomenon. Readers with good memory will also recall that we have discussed the concept of the “S curve” in our May 14, 2006 commentary.
- Given decent valuations around the world today (with the exception of the Chinese stock market), the only things that could derail this unprecedented global boom is bad fiscal and trade policy (stemming from calls for protectionist interests, for example), an ongoing severe deflation in the U.S. housing market, or higher-than-expected inflation in the world's major economies, causing further tightening by the world's central banks. The threat of higher inflation going forward is real – as Chinese export prices have been (and still are) rising – given the rise of the Chinese Renminbi and higher Chinese labor prices. Moreover, the world's central banks' ability to control inflation using short-term rates is as diminished as ever, given the ability of hedge funds, private equity funds, and good old-fashioned commercial banks to create their own liquidity nowadays (especially via the use of derivatives). Quoting the article: Importantly, special consultant to PIMCO Alan Greenspan has pointed out that the process of transitioning hundreds of millions of workers from planned economies to a market environment may peak in the next 2-3 years in terms of its rate of growth, reducing the disinflationary impact.
- The search for alpha continues. Quoting Mr. Gross: Now, however, a growing number of investors are trying to “be like Yale or Harvard” by moving toward more diversified asset allocations, and that includes the holders of over 50% of outstanding U.S. Treasuries, Chinese and Petrodollar central authorities among them. A day after our Forum's conclusion, for example, China eased investment restrictions in order to allow its commercial banks to buy stocks abroad. Even without a buyers' strike or a dramatic reversal of the U.S. current account deficit though, Treasury yields (and other widely held G-7 government issues) will lose some of their caché over the next few years and real yields may rise somewhat. In other words, the day of timing the market or timing cycles – especially when you are managing half a trillion dollars in bonds – is over. Going forward, all anyone wants to invest in will be absolute return strategies – via some kind of global strategic/tactical asset allocation. This could mean benchmarking your pension portfolio to some kind of long duration benchmark via derivatives or swaps, and using the remaining cash to generate “alpha” either in small caps or emerging markets or other non-conventional asset classes such as old violins. And for those who just want “beta” exposure, now is still a great time to get exposed – and again, via some kind of global strategic/tactical asset allocation.
- Given the search for alpha by every fund that is imaginable (e.g. the Chinese authorities, Japanese retail investors, and so forth) – many of these funds have or will shift their holdings in government bonds (such as US Treasuries) into other asset classes, such as equities, commodities, real estate, and infrastructure. Going forward, this will have the effect of raising yields all across the free world (as we have already seen over the last couple of months). PIMCO itself is now eyeing local currency fixed income markets – where spreads in Brazil, for example, are still as high as 500 basis points, compared to only 75 basis points in U.S. denominated Brazilian bonds.
On a more immediate basis, this re-allocation by PIMCO and other bond managers will continue to put pressure on U.S. Treasuries. Going forward, I believe a ten-year yield of 5% is inevitable sometime during this summer. As I am finishing up this commentary, Japan also surprised with a lower-than-expected unemployment rate and higher-than-expected household spending, thus also putting pressure on Japanese government bonds. All this will in turn put pressure on U.S. equities, especially given that they are still very overbought on a short to intermediate term basis. In the longer-run, the move by PIMCO into “riskier” assets is not only a reflection of a new-found stability in the global economy – but also because “the quest for alpha” is all anyone is concerned about today – no matter what one's “beta measure” is. This is true now for endowments, foundations, pension funds, and hedge funds alike – and pretty soon, for retail investors as well as we are now witnessing an expansion of 401(k) options into “absolute return strategies” such as carry trade funds, long-short equity funds, and so forth.
Now, let us continue the rest of our commentary. First of all, following is an update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
While equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S. equities are now at its most expensive level since May 2006. Combined with the fact that the stock market is now overbought on both a short and intermediate basis, and given that there are now many divergences in place (such as the non-confirmation of the Dow Industrials by the Dow Transports on the upside, the weakness in the NYSE McClellan Oscillator and Summation Index, the new highs vs. new lows on both the NYSE and NASDAQ, etc.), my guess is that both the U.S. stock market and the global stock markets (especially China) will have a tough time this summer. In terms of liquidity, stocks are also not too attractive at this point, as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th. Should the U.S. stock market continue to rally further in the coming days or weeks, then we may actually initiate a 50% short position in our DJIA Timing System.
In a recent research publication on U.S. defined benefits pension plans – another must-read – McKinsey & Company discusses the tumultuous changes that are already going on in the defined benefits plan industry, with an emphasis on the asset management side. Not only with this shift (after all, the DB industry has a whooping $2.3 trillion in assets) have a significant impact on asset managers, but will also have an impact on all investors around the world. Quoting the McKinsey report:
- At least $1 trillion … will be invested in entirely different products and solutions by 2012. This will be the result of the changing behaviors of five key plan sponsor segments, each of which will take separate paths and embrace different product solutions to transform the market over the next 3 to 5 years.
- These changes … will have a profound influence on the sources of private-sector DB industry growth and profitability. By 2012, we expect to see changes in several areas:
- Plan sponsors will adopt entirely different approaches to portfolio construction, based on a risk-driven framework;
- Allocations to domestic active long-only equities will plummet by two-thirds, with long-duration fixed income, hedge funds, and private equity picking up most those losses;
- Risk-management solutions, using derivatives and balance sheet capabilities, will be just as important as long-established asset management products.
- Finally, a three-way race between asset managers, insurers, and investment banks will be in full swing by 2012. No single type of firm currently possesses the requisite set of skills to provide comprehensive solutions to DB plan sponsors – as such, we expect to see players from all three sectors making the necessary strategic moves to build, joint venture or acquire them over the next 3 to 5 years.
Historically, the majority of U.S. plan sponsors have opted for a “traditional” 60/40 mix of equities and bonds – a strategy which has historically worked well until the bear market of 2000 to 2002 – when plan sponsors found out their assets and liabilities were really grossly mismatched. The combination of this “lesson” – along with regulatory forces (the Pension Protection Act of 2006 and FAS 158) and other demands of the marketplace has meant that this traditional mix is no longer sufficient or tolerated by CEOs or CFOs. Following is an exhibit (straight from the McKinsey report) showing the external forces that are driving the current changes in the DB industry:
As a participant in both the DB and the DC pension plan industry, I can definitely attest to this (please see our August 13, 2006 commentary “The New Pension Legislation and a Challenging Market” for a refresher). Going forward, the main goal of plan sponsors will be to minimize the volatility of pension funding statuses – and at the same time, achieve excess returns (or “alpha”) by continually diversifying into new asset classes, such as local emerging market securities, real estate, infrastructure (October 20, 2006 commentary “The World of Private Infrastructure Investments”), hedge funds, or private equity funds. In terms of minimizing the volatility of pension funded statuses, plan sponsors can best do this by “matching” assets to liabilities (i.e. make sure that assets move with liabilities as closely as they can) – either by buying long duration bonds or getting exposure to some kind of long duration fixed income benchmark via swaps or other derivatives (especially if a pension plan has a particularly long duration, since most long duration bond funds max out at around a duration of 10 or so). That is, instead of using the traditional “risk free asset” as the benchmark of performance (such as three-month treasury bills) – pension plans are using their own liabilities as the benchmark. This makes perfect sense – and is one reason why the “high-risk” workers that are saving for retirement are those that are investing in money market or stable value funds, not those that are investing in equities, domestic or otherwise.
As more DB pension plans adopt this view, the obvious first loser is those group of long-only equity mutual funds that have consistently underperformed their benchmarks – be it the S&P 500, the MSCI EAFE, or the Russell 2000. On a less obvious level, the exodus of pension plans away from these long-only mutual funds (and into long duration assets, hedge funds, or private equity funds) will also create a significant headwind for U.S. equities. Assuming half of the $1 trillion are ultimately invested back into the world's equity markets (which is probably an overly optimistic number), this still means an annual outflow of $100 billion from the world's equity markets. This trend has already started and is now accelerating – and this is one reason why I am envisioning a tough summer for the bulls this year.
Given that this is more or less a zero sum game, this shift in pension plan asset management practices will also create huge opportunities for those with the necessary skill sets and who can recognize these upcoming trends. For example, the entry of pension funds into new asset classes has created a significant amount of liquidity into asset classes that are traditionally not that liquid – such as real estate, farmland, wine, private companies – and get this – even old violins. Going forward, there will be many new niches waiting to be filled – whether you are a talented art appraiser, a biochemist, or even a film critic that has the ability to predict box office successes. From a more traditional standpoint, the most successful investor going forward will be one that is comfortable with investing globally – as well as being able to gain “alpha” with various derivative strategies. That PhD in economics or political science that you obtained outside the United States may actually be very worthwhile after all.
I will update our readers on the latest technical and valuation indicators in our Wednesday night commentary. Over the next few days, I would dearly love for our readers to read both the latest PIMCO article and the McKinsey study on the defined benefit pension plan industry, should you have the time (registration is free on the McKinsey website).
For now, let us 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 January 2005 to the present:
For the week ending May 25, 2007, the Dow Industrials declined 49.25 points while the Dow Transports declined 66.13 points. Since late April, the Dow Transports has been the weaker index. More importantly, the Dow Transports has historically led the Dow Industrials higher since the beginning of this cyclical bull market in October 2002. Moreover, it is important to remember that the Dow Transports has still not surpassed its all-time high of 5,243.60 made on April 25th . This “divergence” is a good confirmation signal that the market is now getting weaker (this is consistent with the divergences being seen in the NYSE McClellan Oscillator and in NYSE and NASD new highs vs. new lows). Even should the Dow Transports confirm on the upside by rising to an all-time high this week, we will continue to maintain our completely neutral position in our DJIA Timing System and will probably initiate a 50% short position in our DJIA Timing System should the Dow Industrials hit the 13,800 to 14,200 area in the coming weeks.
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 increased from last week's 23.3% back to 23.7% for the week ending May 25, 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 I mentioned last week, my guess is that keeping a close watch on our most popular sentiment indicators is no longer that relevant – given that significant tops do not necessarily need to be preceded by highly overbought sentiment indicators. However, what is necessary is at least a moderately overbought condition in the market. This is where we are now – and should this sentiment indicator experience a spike over the coming week (accompanied by new all-time highs in the Dow Industrials), then there is a chance that we will initiate a short position in our DJIA Timing System. Moreover, we will most likely not go long again unless these indicators again reach an oversold signal at least consistent with what we witnessed during the April 2005 and October 2005 corrections.
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:
While the 20-day moving average of the ISE Sentiment (at a current reading of 133.9) is still not close to overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) is getting “long in the tooth” in the short-run. Should this experience some kind of spike in the coming days, and should this be accompanied by a DJIA reading in the range of 13,800 to 14,200, then we will most likely initiate a short position in our DJIA Timing System. Moreover, unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.
Conclusion: As discussed in this commentary and in our older commentaries over the last 12 to 18 months, the “quest for alpha” is still the main theme for virtually all institutional investors – and retail investors should not be surprised to find similar “absolute return” strategy funds in their 401(k) options going forward. As funds like PIMCO continue their respective quests for more alpha going forward, yield spreads all across the world will continue to compress – while assets/indices which were not tradable or which were not liquid just 12 months ago will find themselves tradable, for the first time in financial history.
As defined benefits pension plans embrace liability-driven investing (or “LDI” for short), the exodus from under-performing mutual funds will turn into a rout – and many mediocre money managers will find themselves out of work. The advent of LDI and other alpha strategies will complete the job that index funds began 30 years ago – making underperforming fund managers accountable for their mistakes or missteps. Moreover, the continuing maldistribution of income will not only be evident in U.S. society, but in the financial industry as well. On a short to intermediate term basis, this exodus of funds from the mutual fund industry will also be a huge headwind for U.S. stocks over the next five years – as approximately US$1 trillion is estimated to shift from mutual funds into other strategies, such as LDI, immunization, hedge fund, and private equity fund strategies.
Combined with the fact that the market is now overbought, and given the many divergences we are seeing – as well as “capitulation” of many mainstream market commentators, and I will have to conclude that U.S. stock market investors will have a tough time during this summer. At this point, we will thus stay completely neutral in our DJIA Timing System – and may actually even initiate a 50% short position in our DJIA Timing System should the market continue its rally over the coming days or weeks. Subscribers please stay tuned.
Henry To, CFA