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Where is Stock Market Liquidity Now Heading?

(July 15, 2007)

Dear Subscribers and Readers,

In the stock market – just as in life – the quest to keep up with everyone else is not only imperative for the quest for “alpha,” but is also a necessity for survival.  Since the beginning of this century, we have witnessed an explosion of the influence of the financial sector – not just in the value of all financial companies but also in the number of instruments and financial asset classes that can now be traded with relative ease, such as REITs, emerging markets, and more importantly, many new kinds of derivative instruments.  This continuing trend of the increasing influence of the financial sector did not come about merely because of the huge amount of liquidity that was dumped into the markets in 2001 and 2002 (and which the central banks have still yet mopped up) – but mostly because of three things: financial liberalization, increased computing power, and the continuing quest to hedge as many types of risks as possible (and on the flip side, to expand the “efficient frontiers” of hedge funds and high net worth individuals alike).

One manifestation is the explosion of the currency, interest rate, and credit default swaps markets.  Following is a semi-annual chart showing the notional amount (in US$ billions) outstanding in the currency & interest rate swaps and the credit default swaps markets from 1H 1997 to 2H 2006, courtesy of the ISDA:

Total Currency & Interest Rates Swaps and CDS Outstanding (US$billions) (1H 1997 to 2H 2006)

Over the last ten years, the currency and interest rates swaps market has grown nearly ten times – increasing from a total notional amount outstanding of $28.7 trillion to $285.7 trillion.  At the end of the 20th century, the credit default swaps (CDS) market did not even exist.  From a total notional amount outstanding of $630 billion in 1H 2001, the CDS market has grown to a $34.4 trillion market in just six years.  Given the continuing increase in cheap computing power and cheap bandwidth (see our June 24, 2007 commentary “The Times They Are a-Changin” for our views on how this will impact our lives in the next decade), and given the continuing emphasis on more financial education in our colleges today, the trend of an ever-expanding financial sector should continue to grow for the foreseeable future.

For subscribers who prefer to not spend their Sundays reading technical papers on the CDS or the CLO markets, I would – again – highly recommend reading Robert Shiller's book on hedging risks in the 21st century, entitled “The New Financial Order.”  Another excellent book on modern finance that this author is currently reading is the just-released “Capital Ideas Evolving” by Peter Bernstein.  Both of these books are very well written and are easy to understand.  For those who do not have a background on modern financial/portfolio theory, I would highly recommend reading an earlier book (published in 1992) written by Peter Bernstein on this subject, entitled “Capital Ideas.”  Incidentally, we have just published a book review on “Capital Ideas” in our “Favorite Books” section of our website.

As I have mentioned before – primarily because of the continuing exponential pace of change we are witnessing in both the domestic and international stock markets – what you see on this website in a few years will most likely not resemble the content that you are seeing here today.  Sure, the Dow indices and the sentiment charts will still be here, but we will most likely be more actively covering the international markets as well as the derivative (and even virtual) markets.  Because of this, we are currently evaluating many global data vendors in order for us to improve our service going forward.  However, the data and software does not come cheap – and thus we would like to get as many new subscribers as possible over the next couple of months.  Subscribers and readers, please continue to support us by letting your friends know about our site and asking them to subscribe if they are interested!  Rex and I will fully appreciate your help.

As an aside: For a “dislocation” technology in the restaurant industry, look no further than the Microsoft “Surface” technology – which is simply an amazing piece of technology.  At first glance, kids will simply think of this as a cool technology to view photos or transfer videos, but give it a couple of years and many restaurants will start utilizing this technology as part of their food/drink ordering and clean-up system.  Besides having the ability to order food or drinks, the “Surface” will know what you are drinking and will ask you if you need a refill when your cup is half-empty.  Once all your plates are empty or nearly empty, the “Surface” will also alert the busboy so he can come and remove your dishes.  At the same time, you will be able to start ordering desserts as well, or of course, pay for your meal (either through your credit card or through Paypal).  In five years, the number of waiters needed in the restaurant industry will be halved, and 15% tips will no longer be needed (assuming a reasonable 40% decline in cost each year, these US$10,000 machines/surfaces will only cost US$750 by the end of 2012).  What outsourcing or off-shoring cannot do (i.e. displace workers whose jobs tend to be localized), technology will.

Let us know begin our commentary by providing 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.

As of Sunday evening on July 15th, we are still neutral in our DJIA Timing System (subscribers who want to go back and review our historical signals can do so at the following link).  While it would have worked out well if we had continue to hold our long position since May 8th, we decided to exit our position at that time since there were many signs – including most of our valuation, sentiment, and liquidity indicators – that the rally was getting tired.  We continue to stand by this position, as – despite the stock market rally over the last two weeks – there continues to be signs of declining liquidity.  This includes the failure of the NYSE A/D line to surpass its all-time high last Friday, as well as the continuing signs of stress being witnessed in the junk bond and the CMBS market (besides the continuing mess in the subprime market), as well as the huge reliance on the Yen carry trade to fund a broad range of investments around the world.

In our last weekend commentary on July 1st, I stated: “However, we currently do not plan to go short in our DJIA Timing System – not even in the midst of the latest Bear Stearns hedge fund crisis – at least not until we see a brief but weak rally in the stock market.  We also would prefer to see a Dow Industrials reading in the 13,800 to 14,200 area before shorting, but this point, we cannot be “greedy,” so this author may actually end up on initiating a 50% short position in our DJIA Timing System should we see an unsuccessful retest of the previous all-time high, assuming that the rest of the market (and the Dow Transports) remains weak.  Should we decide to go short, we will inform our subscribers by emailing you a real-time “special alert.”  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 still near its most expensive level since May 2006, despite the weakness of the stock market over the last few weeks.   Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially 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.

Based on the above statement, we are now getting close to initiating a 50% short position in our DJIA Timing System.  Since the subject of this commentary is about U.S. stock market liquidity, let us now start with that.  Folks who have continued to monitor central bank developments (not just the Federal Reserve, the ECB, or the Bank of Japan, but also the People's Bank of China, the Bank of England, the Reserve Bank of Australia, and the Bank of Korea as well) will know that the central banks of the world have continued to tighten “primary liquidity” over the last few weeks.  As late as last Friday, the People's Bank of China took the unprecedented step of selling US$13 billion worth of 3-year bills to four commercial banks (these banks are obliged to buy the bills) at a yield of 3.6% - with the intent of draining more liquidity from its financial system.  Another 27 basis point rate hike by China over the next month or so is now inevitable.  Even the Bank of Japan is expected to raise rates at the conclusion of its next policy meeting on August 23rd.

Within the United States, the continuing decline of “primary liquidity” can be witnessed in the continuing decline in the St. Louis Adjusted Monetary Base, which we had last mentioned in our June 3rd commentary, as part of our update on our MarketThoughts “Excess M” (MEM) indicator.  As I mentioned in that commentary, I still believe it is a relevant indicator, even in today's globalized world of financial flows.  Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages).  The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve.  One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base.  By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and ultimately, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity).  On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking.  If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing.  Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3.  Instead, M-3 is directly affected by the ability and willingness of commercials banks, hedge funds, private equity funds, and foreign central banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has stopped publishing M-3 statistics, this author has revised our MEM indicator accordingly.  Instead of using M-3, we are now using a monetary indicator that most closely resembles the usefulness of M-3 – that is, a measurement that tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy.  We went back and found one measurement that is very close – that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 that the Fed is still publishing on a weekly basis).  That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator.  Following is a weekly chart showing our “new: MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-2 outside of M-1 plus Institutional Money Funds (April 1985 to Present) - Speculators have gotten much more aggressive despite the dismal growth in *primary liquidity* and a tightening ECB, Bank of England, and Bank of Japan. Investors should continue to tread carefully, especially in areas where the Japanese carry trade has been a very popular trade. Moreover, this indicator of speculation vs. liquidity in the markets is now at its most dire signal since January 2002. 4) Markets did well during 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade! But now, the BoJ is tightening as well...

Since our June 3rd discussion revolving around our MEM indicator, it has continued to decline – signaling a further deterioration of prime liquidity vs. “secondary” liquidity.  That is, while foreign investment banks, commercial banks, hedge funds, and private equity funds are still busy creating liquidity, the Federal Reserve itself has continued to remove liquidity from the global financial system.  This is evident by the dismal 1.6% growth in the St. Louis Adjusted Monetary base over the last 12 months.  At this point (similar to the 1995 to 1998 period), the world is being “held ransom” by both the Bank of Japan, the Japanese Ministry of Finance, and the Japanese retail investor, as these parties are now playing the role of “liquidity provider of last resort” in the form of the Yen carry trade.  However, since Japan runs a current account surplus, it is to be noted that Japan is thus not a natural exporter of their currency (unlike the U.S.).  Moreover, the Yen carry trade – by any measure – is now way, way, overstretched.  That is – if this continues – at some point, there would be a liquidity squeeze in Yen – not unsimilar to what occurred during the Fall of 1998 (when the Yen appreciated over 10% in an hour). 

The Yen carry trade, however, can go on indefinitely until one of the two following occurs: 1) Both Japanese private pension funds and Japanese retail investors have exhausted their savings, or 2) For some reason, the Japanese repatriate their savings, by selling foreign assets and reinvesting their savings into domestic savings accounts or domestic assets instead.

At this point, the urge to invest in foreign assets is still strong among the Japanese, despite the continuing unfolding of the subprime mess here in the US (it is now known that many buyers of these CDOs were actually European and Asian institutional investors who bought the paper simply because they were triple A rated).  However, as I mentioned in our latest mid-week commentary, the subprime mess is still not close to being over, and the jury is still out on whether it is going to morph into some kind of “systemic event” in the future.  What is evident – at this point – is that investors' risk appetite is now slowly fading, as evident by the recent increase in spreads in both the junk bond and the CMBS market.

Let us first take a look at the high yield market.  As I mentioned in our latest mid-week commentary, the spread between the Lehman CCC index and the Lehman Treasuries Index rose a whopping 67 bps from the end of May to the end of June – rising from 4.01% to 4.68% (note that high yields encompass all debt that are rated BBB- or lower, and so CCC represents only the riskiest portion of high yields, if we exclude D rated issues).  Since the end of June, junk bond yield spreads have continued to increase, as represented by the following chart showing the credit default swap spread for the five-year CDX.NA.HY index (which represents 100 high yield components traded in North America).  The following chart is courtesy of

Credit default swap spread for the five-year CDX.NA.HY index  

For those who want to read more about credit default swaps or the various credit default indices, I would highly recommend going to the Markit website.  Besides this website, I would also highly recommend getting the sixth edition of John Hull's book “Options, Futures, And Other Derivatives” – which is a great layman's introduction of the derivatives industry.

As for the CMBS market, we are also now witnessing an increase in credit default swap spreads, as evident by the following chart showing the three-year CMBS credit default swap spreads of 25 BBB rated issues traded in the North American market:

Three-year CMBS credit default swap spreads of 25 BBB rated issues traded in the North American market

A similar situation is occurring in the U.S. leveraged loan market.  Spreads on the LCDX index (click on the following link for a primer on the LCDX index), have doubled from approximately 100 basis points to 200 basis points as of Friday at the close.  Coupled with the fact that junk bond spreads are also now blowing out, private equity deals are now getting much more difficult to complete as before, especially given higher valuations in the stock market and continuing tightening from most major central banks in the world today.  Given all of this, and given that $87 billion flood of new junk bond issues over the next six months – it looks like junk bond and leveraged loan spreads will continue to have an upward bias at least for the rest of this year.  More importantly, given that high yields and U.S. equities had a 0.6 correlation over the last 16 years, my guess is that the stock market will have a tough summer and Fall as well.

In the meantime, as long as the flood of earnings reports do not disappoint, the stock market is still most likely “safe,” for now.  The major reports to watch this week are:

Tuesday: CSX, INTC, JNJ, KO, MER, STT, and YHOO

Wednesday: ABT, BLK, EBAY, JPM, LUV, MO, PFE,  UTX, and WM


Friday: C, CAT, SLB, and WB

More importantly, we know that the flood of earnings reports will peak by late July.  This is important for stock market liquidity, as insiders are typically not allowed to sell any shares during the two weeks (before and after) surrounding the reporting of its earnings numbers.  This means sometime starting in early to mid August, there is a strong likelihood that insider selling will start flooding the market, especially if the stock market continues to hold at current levels or rally into August.  Should the stock market rally into August, there is a high probability that we will then initiate a short position in our DJIA Timing System – given what we had just discussed regarding the continuing deterioration of general market liquidity.

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 January 2005 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2005 to July 13, 2007) - For the week ending July 13, 2007, the Dow Industrials rose 295.57 points while the Dow Transports rose 138.39 points - marking two consecutive weeks of rises in the two popular Dow indices. In retrospect, the oversold condition of the Dow Transports (when it had its weakest weekly close since the week ending April 13th), along with the record short interest, marked for a great setup for a rally over the last two weeks. More importantly, the Dow Transports also closed at an all-time high on Friday, something it has not done since June 1st. However, the Dow Utilities is still lagging badly, and given that the NYSE A/D line did not confirm the all-time highs in the many indices this month, this author will most likely not get back in on the long side anytime soon. As of May 8th, we have trimmed our 100% long position in our DJIA Timing System to a completely neutral position at a DJIA print of 13,299, and will continue to remain so unless the market declines to a more oversold situation sometime this Summer/Fall.

For the week ending July 13, 2007, the Dow Industrials rose by a whooping 295.57 points while the Dow Transports rose 138.39 points – with both Dow indices closing at an all-time high last Friday.  What a different two weeks make – as we had been “lamenting” on our July 1st commentary on the fact that the Dow Transports had just had its lowest weekly close (on June 29th) since April 13th.  In retrospect, the immensely high short interest (see our July 1, 2007 commentary “High Short Interest the Achilles' Heel of Bears” and the somewhat oversold condition of the stock market was a major catalyst for the stunning two-week rally.  However, the latest all-time highs in both the Dow Industrials and the Dow Transports is still not being confirmed by the Dow Utilities, as it is still 3.8% below its all-time high of 535.72 made on May 21st.  For now, 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 continue to rally into early/mid August, and assuming that out liquidity indicators continue to deteriorate.  Again, should we decide to go short, we will inform our subscribers via a real-time “special alert” through email.

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 23.7% to 24.7% for the week ending July 13, 2007 – the most optimistic level in over six weeks.  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 July 13, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 23.7% to 24.7% - representing the most overbought reading since June 1st. This latest jump in sentiment - while it is not at a hugely overbought level - suggests the investors are at their most optimistic in over six weeks, and thus this is no time to initiate a long position. In fact, should the market rally more over the next three to four weeks, there is a good chance that we will initiate a short position come mid to late August 2007.

Given that this reading is now at its most overbought level in six weeks, readers should be very hesitant about initiating any long positions here.  The perfect setup for an initiation of a 50% short position in our DJIA Timing System would be a further 3% to 5% in this reading – accompanied with a DJIA level of over 14,000.  Moreover, we do not plan to go long the stock market again until his reading has gotten to a more oversold level, such as what we experienced during the April 2005 (8.5%), the October 2005 (11.6%), and the June 2006 (1.7%) bottoms.  For now, we will remain neutral in our DJIA Timing System, but should we witness some kind of spike (in the 3% to 5% range) over the next few weeks in this indicator, and should this be accompanied a DJIA level of over 14,000, and a Barnes Index reading of over 70 (which has occurred already), then we will probably initiate a short position in our DJIA Timing System.

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:

ISE Sentiment vs. S&P 500 (November 1, 2002 to Present) - The 20 DMA of the ISE Sentiment (note that a significant number of historical readings in 2007 were revised by the ISE a couple of weeks ago) hit a level of 147.7 last Friday, and is now at its most overbought level since the first week of January 2007. Meanwhile, the 50 DMA rose to a 5-month high reading of 139.7 last Friday. Even though the absolute readings in these two moving averages are still relatively low - given the relentless run-up in both the 20 and 50 DMA since March, my guess is that the market will most probably correct and continue to struggle throughout the summer, especially as stock market liquidity tends to dissipate after the end of earnings report season. More importantly, we will need to see a significantly more oversold reading in this indicator before we will go long in our DJIA Timing System yet again.

Over the last week, the 20-day moving average of the ISE Sentiment rose substantially – rising over 10 points from 137.6 to 147.7 – and is now at its most overbought reading since January 2007 (when the ISE Sentiment Index closed at 148.4 on January 3rd).  Should the 20-day moving average penetrate the 148.4 level, this will result in the most optimistic reading since May 30, 2006 – which is relatively bearish from a sentiment/contrarian standpoint.  Should the ISE Sentiment Index continue to rise in the coming days, and should this be accompanied by a DJIA level of over 14,000, and a Barnes Index reading of over 70, then we will most likely initiate a short position in our DJIA Timing System.  The bottom line is that unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.

Conclusion: Over the last two weeks – even as the U.S. and global stock markets have continued to rally – the evidence continues to pile up warning of an imminent liquidity crunch sometime over the next six months – as exemplified by the continued blowout in spreads in the subprime, high yield, CMBS, and leveraged loan markets.  As the Bank of England, the European Central Bank, the People's Bank of China, and even the Bank of Japan continue to tighten, this will also have a depressing effect on liquidity sooner or later.  While many investors can still find solace by borrowing either the Japanese or the Swiss currency, folks should understand that the Swiss Central Bank has also been on a tightening cycle – raising its overnight rate from 0.75% to 2.5% over the last two years – with rates expected to rise to 3% by the end of this year.  Meanwhile, even the Bank of Japan is expected to raise its overnight rates from 0.50% to 0.75% at the end of its next policy meeting on August 23rd.

In our July 1st commentary, I stated: “However – even though both our liquidity and breadth indicators continue to deteriorate – folks who are bearish here should be very vigilant when it comes to shorting individual stocks, given the record-breaking jump in short interest over the last three to four months.  While there are valid explanations for this jump (valid explanations that won't add much fuel for the bull's case), the sheer increase in short interest is nothing to sneeze at – and we will not know for sure just who or which entities were responsible for this jump until it is too late.  I urge you to please stay tuned, as always.”

Given the immense increase in short interest from mid April to mid June, a huge short-covering rally was going to materialize sooner or later – but the question now is: What kind of short interest numbers will see in the upcoming July NYSE report, which is scheduled to be released later this week (the NASDAQ report should be released during the week after)?  Should short interest have decreased over the last four weeks, then we will most probably go short in our DJIA Timing System sometime during early to mid August, assuming that the stock market continues to rally into that timeframe.  Should short interest have increased further, then we will most probably not consider shorting until later in August – after the August short interest numbers have been released.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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