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Spain – the Weakest Link – A Redux

(September 9, 2007)

Dear Subscribers and Readers,

Let us begin our commentary by first providing 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.

As of Sunday evening on September 9th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link).  At this point, we are still not looking to go long in our DJIA Timing System just yet, as we believe that there is a good chance of a retest of the mid-August lows – as we have already discussed in many of our past commentaries.

I want to begin our commentary by providing an update on the “MarketThoughts Global Diffusion Index” (MGDI).  We first featured the MGDI in our May 30, 2005 commentary – with our last update coming in our February 25, 2007 commentary.  For our newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD).  Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages.  More importantly, the MGDI has historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI on two occasions – first by incorporating the leading indicator for the Chinese economy, and second by dropping the one for Turkey.  The first revision is obvious; as China is now the fourth largest economy in the world and actually has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth this year is expected to surpass that of the US).  The second revision is less obvious.  While Turkey is by no means a small or marginal country, many of the readings over the last six months have been very unreliable – and so we have chosen to drop Turkey in our MGDI instead.  This is rather unfortunate, but it is better to omit certain data points than to incorporate unreliable data.  

Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the CRB Index and the YoY% change in the Dow Jones Industrial Average from March 1990 to July 2007 (the August 2007 reading will be updated and available on the OECD website in early October).  In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the CRB Index & the CRB Energy Index (March 1990 to July 2007) - The deviation of the change in the Dow Jones Industrials and the annual and the rate of change (second derviative) in the MGDI suggests that the U.S. stock market should at least take a further *breather* before resuming its rally. More importantly, this weaking in the MGDI suggests that global economic growth should weaken over the next three to six months.

Quoting our February 25, 2007 commentary, “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.”  Ominously, as the above graph suggests, global economic growth (OECD + China) is now trending down – suggesting that the chances of a U.S. recession has just gotten a little bit higher (although we are still not looking for one at this stage).  More importantly for now, a slowing global economy will reveal the weakest links in the global economic system – or as Warren Buffett would put it, we are now going to find out who has been swimming without his trunks now that the tide is receding.

While it is now obvious that the U.S. housing/subprime markets were one of the weakest links in the system (now that they have both peaked) – one of the markets that have not been given as much ink is the Spanish economy and her housing market.  We first discussed the Spanish economy in our June 29, 2006 commentary (“Spain – One of the Weakest Links in Europe).  In that commentary, we asserted that the latest boom in Spain was not sustainable, given that the boom was built on, among other things:

1) A housing bubble.  While housing prices in the US have only risen about 40% from 1995 to 2004, Spanish housing prices rose nearly 100% during that same timeframe – surpassed only by the UK housing bubble out of the world's major OECD countries.  Moreover, this housing bubble has created an Anglo-Saxon type of boom within the broader economy, as folks took advantage of higher housing prices for consumption purposes.  Since the end of 2004, housing prices in Spain has continued to rise.  In fact, the divergence between housing appreciation and income growth in Spain surged to an all-time high during the second quarter of 2007, as shown in the following chart (showing housing prices as a percentage of gross household income) courtesy of Reuters EcoWin:

Spain, Housing Market Indicators, Price of housing/gross household income

2) A current account deficit that was not sustainable.  In fact, aside from the US, Spain runs the largest current account deficit – in absolute terms – out of all countries around the world.  As a percentage of GDP, Spain's current account deficit is now in the neighborhood of 9% to 10% of GDP, which, aside from Latvia (which is running an astonishing current account deficit equivalent to 26% of its GDP!) and New Zealand, is also the highest out of all major countries in the world today.  The following chart, courtesy of Reuters EcoWin, shows Spain's current account deficit (as a percentage of GDP) along with its 12-month change (in EUR billions) from 1994 to the present:

Spain: Current Account (% of GDP) and 12-Month Rate of Change

Note that Spain hasn't run a current account surplus since August 1998.  Moreover, it current account deficit has not improved since early 2003, and in fact, had continued to deteriorate significantly over the last three years.

Over the last six months – just like in the US – there have been ample evidence that the Spanish housing boom is now effectively over.  Quoting a September 7, 2007 UK Telegraph article on the subject:

In a sure sign that the supply of houses is outstripping demand in overcrowded tourists resorts, more than 300 estate agent offices have closed this year on the Costa Blanca alone, property experts said yesterday. More are believed to have closed in other regions along the coast  … During the last decade vast swathes of the Spanish coastline have been developed in a construction boom that has made the nation one of the fastest growing economies in Europe. Spanish house prices have risen by more than 200 per cent in that period, encouraging many overseas investors - a large number of them British - to purchase property with the promise of short-term financial rewards.

But in the second quarter of this year the rise in house prices dipped below the rate of inflation for the first time in 10 years … Last year more than 800,000 homes were built in Spain, more than in Britain, France and Germany combined.

Earlier this year the Organisation for Economic Co-operation and Development said that Spanish house prices were so over inflated that during 2007 the country would see "an abrupt adjustment in which prices will plunge".  The Spanish government said this week that the housing boom was coming to an end, bringing with it a rise in unemployment due to the expected further decline in new construction contracts being awarded.  In a bleak assessment of Spain's prospects, the Socialist government admitted that the country faced an uncertain future.

Moreover, similar to the adjustable-rate mortgage market in the US, the most recent housing bubble in Spain had been fueled by the availability of cheap credit – as the interest rate on residential mortgage payments is for the most part tied to a floating exchange rate.  As the following table illustrates, the interest rate of the typical Spanish residential mortgage loan is tied to the Euribor (plus some spread) – which is in turn directly tied to the overnight rate as set by the European Central Bank.

Spain: Typical Residential Mortgage Loans

The above lending structure for residential housing fueled the Spanish housing bubble considerably given that the European Central Bank slashed its overnight rates to all-time lows in early 2003.  Moreover, the ECB did not start its latest hiking campaign until late 2005 – but by then, it was already too late – the Spanish housing bubble was already in full swing.  Today, however, cheap credit is no longer available, as the Euribor has now risen from a low of 2% in early 2004 to 4.75% as of last Friday, as shown by the following chart:

Euro Zone, Interbank Rates, EURIBOR, 3 Month, End of Period, EUR

Unlike most adjustable-rate mortgages taken out in the US (where there is fixed “teaser rate” period), most Spanish mortgages reset once very month.  Given the ECB's hiking campaign since late 2005, and given the recent turmoil in the credit markets, the Euribor approximately doubled in less than two years.  For those Spaniards who took out 30-year mortgages over the last few years, this implies their mortgage payments have essentially doubled – as the bulk of the mortgage payments (for mortgages that are relatively young) usually go towards paying interest as opposed to paying down the principal.

The $64 billion question for Spain is now: Will this entail a classic slowdown or will this turn into a recession for Spain, or perhaps even a full-fledged financial crisis?  Given all the evidence that this author has seen so far, I would rate the chances of a recession in Spain sometime in the next 12 to 18 months as being over 50/50.  The big difference between the Spanish and the US economy is that the Federal Reserve is now turning dovish (and should cut the Fed Funds rate by 25 basis points on their next scheduled meeting on September 18th), while the European Central Bank is still thinking of hiking rates over the next few months!  More importantly, it is essential to keep in mind that the European Central Bank typically makes monetary policy – for the most part – for the bigger economies within the Euro Zone, such as Germany, France, and Italy.  That is the main reason why the ECB had been so reluctant to hike rates to keep the Spanish housing bubble in check in 2003 or 2004 – and why it will be reluctant to cut rates in order to ease any problems in the Spanish economy going forward.  Unlike in the US (where the Federal Reserve tends to make monetary policy for the biggest states, such as California, Texas, New York, Florida, and Illinois), however, there is not much labor mobility within the Euro Zone to take advantage of diverging economic conditions or labor markets – and so any slowdown or recession within a particular country such as Spain will be rather painful for the local population.

Finally, the skeptic in our readers may ask: Spain has been persistently running a current account deficit since 1999.  Sure, the bursting of the Spanish housing bubble and the stubborn hawkishness of the ECB may result in a economic slowdown, but would the current account deficit have any significant impact on the Spanish economy?

This is a very good question.  First of all, it is important to keep in mind that the current account deficit is not only a manifestation of a country that is importing more than it exports, but also a manifestation of the amount of foreign investments entering versus leaving the country.  In today's world of globalized and 24-hour trading, that also means much of what foreigners have invested into Spain over the last 7 to 8 years – investments in private equity and real estate notwithstanding – can leave the country at a moment's notice, a phenomenon termed “capital flight.”  In other words, running a current account deficit is only sustainable if 1) the country that is running the current account deficit remains attractive to its foreign investors, whether it is because of higher-than-expected economic growth, a booming stock market, or a booming real estate market, 2) the country that is running the current account deficit has ample reserves to “defend” its currency should foreigners leave the country and/or speculators attack its currency, such as what occurred in Thailand, Indonesia, South Korea, and Hong Kong in 1997/1998.  Interestingly, 2) is also applicable to Spain – as, even though it has joined the Euro, the lender of last resort within Spain is still its own central bank, even though it has no control over its own interest rates.  In other words, if the Spanish banking/financial system experiences a run and needs emergency borrowing, it cannot turn to the ECB – but rather, its own national central bank.  This is why it is important for the central bank of Spain to maintain an adequate amount of reserves, even though the country has already joined the Euro.

Indeed, one of the “Asian Tigers” – South Korea – had also been running a current account deficit since 1994, and yet the Asian Crisis did not hit them until late 1997:

South Korea: Current Account (% of GDP) and 12-Month Rate of Change

Just like Spain today, the current account deficit in South Korea – especially in 1996 – was not sustainable, and yet, the country did not collapse until late 1997/early 1998.  One reason was that growth was still acceptable as late as 1996.  Another reason was the fact that global growth, for the most part, was still humming along.  That is, both “the Street” and the general population was willing to “look the other way” – until the Thai Baht was devalued on July 2, 1997.  However, for those who have been keeping track of South Korea's foreign reserves, it was obvious that things were not going well by late 1996, as reserves had, by then, declined nearly 20% from its peak in early 1996, as shown in the following chart:

South Korea: Reserves, Total, USD

In other words, there was already capital flight by late 1996 – and while the central bank of South Korea was not telegraphing that fact, it was obvious that they were trying to defend their currency from both investors who were trying to withdraw capital from the country and the speculators who want to take down the Korean Won.  Fast forward to today – where there is a good chance we may now be seeing the same thing, but only in Spain:

Spain, Reserves, Reserve assets total, EUR

Amazingly, reserves held by the Spanish central bank are now at its lowest level since early 1987 – and has declined more than 80% from its peak in 1998.  More importantly, it had resumed its decline after a short recovery during the latter parts of 2005 to the first month in 2007.  Indeed, while it is not obvious on the chart (given the scale on the y-axis), central bank reserves in Spain declined a further 15% from January of this year to the end of August.  Given the current structure of the Euro Zone's banking system, Spain may eventually be forced to ask the IMF or the World Bank for emergency loans, as the European Central Bank is strictly forbidden from bailing out its member states, unless there are clear signs that the crisis will spread to other member states within the Euro Zone.

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 September 7, 2007) - For the week ending September 7, 2007, both the Dow Industrials and the Dow Transports declined substantially - with the former declining 244.36 points and the latter 145.82 points for the week. While the Dow Industrials is still (slightly) above its weekly close on August 17th, the Dow Transports has now completely retraced its rally from the August 17th close, and is, in fact, 0.7% below its August 17th close. This latest action suggests that the Dow Transports is still exhibiting relative weakness versus the Dow Industrials (as it has been for weeks now). Note that the Dow Transports has nearly always been the stronger index over the last few years - as it has always led the Dow Industrials on the upside and had also risen more than the Dow Industrials during that period. As such, the relative weakness of the Dow Transports during the last 7 weeks is not a very good sign.

For the week ending September 7, 2007, the Dow Industrials declined by 244.36 points while the Dow Transports declined by 145.82 points.  As mentioned on the above chart, while the Dow Industrials is still slightly higher than its close from three Fridays ago, the Dow Transports is actually 0.7% below its close from three Fridays ago.  In fact, the Dow Transports experienced its lowest weekly close since January 26, when it closed 4,713.01.  At the time, the Dow Industrials closed at 12,487.02.  Given that the Dow Transports has nearly always been the stronger index – as well as a leading indicator – ever since the cyclical bull market began in October 2002, subscribers should continue to be cautious here.

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 again decreased (for the 5th week in a row) – from last week's 4.9% to 2.6% for the week ending September 7 , 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending September 7, 2007, the four-week MA of the combined Bulls-Bears% Differentials again decreased (its 6th consecutive weekly decrease) - this week from 4.9% to 2.6% (the most oversold reading since late June 2006). While this reading is now more oversold than both the April 2005 and the October 2005 bottoms, this author would prefer this reading to reach an even more oversold level, or a reading of 2% or less. Such a reading may come as early as this week, but bottom line: Until these readings reach more oversold levels - there is still no major capitulation, and as such, we will continue to remain neutral in our DJIA Timing System.

Note that the four-week MA is now at its most oversold level since the week ending June 30, 2006.  This reading is now close to the oversold reading similar to what we experienced during the June 2006 (1.7%) bottom.  However – given the current turmoil in the world's credit markets as well as the deterioration in the MGDI, I am still reluctant, and thus would like to see a more oversold reading in this indicator before going long in our DJIA Timing System.  Again, readers should keep in mind that sentiment is mostly a secondary indicator and is only meant as a confirmatory signal for other more important indicators, such as breadth and volume of the stock market, as well as liquidity and credit availability.  For now, these latter indicators are still not flashing buy signals, and as such, we will continue to hold off.  Given the bearish readings in our most popular sentiment indicators, however, it will not take much for us to go long once our liquidity and most of our technical indicators are “in place.”  For now, we are still not there yet.

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.  For the history buffs out there, you may notice that we have extended our study period further back from November 1, 2002 to May 1, 2002.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting a 14-month high of 152.9 in late July, the 20 DMA of the ISE Sentiment readings has literally gone into freefall - falling to a low of 99.9 on August 28th, which, along with the late March lows, was the most oversold level since November 4, 2002. Meanwhile, the 50 DMA rose to a 5-month high reading of 140.9 on July 19th, before finishing at 124.4 on Friday. Interestingly, while the 20 DMA is still severely oversold, it has risen quite a bit over the last couple of weeks, despite a weak market. More importantly, the ISE Sentiment Index reached a level of 154 last Friday, despite the severe decline on that day. Given this and the fact that the 50 DMA is still yet at an oversold level - my guess is that the market will need to at least retest the mid August lows before it can put in a sustainable bottom.

Over the last couple of weeks, the 20-day moving average of the ISE Sentiment actually experienced a significant resurgence – rising from 100.5 to 113.7 last Friday.  Indeed, while the absolute level of the 20-day moving average is suggesting that retail sentiment is still very bearish (and therefore bullish from a contrarian standpoint), the uptick over the last two weeks – despite the mediocre conditions in the market – suggests that the bottom may not be here just yet.  Moreover, the 50-day moving average is still not close to being very oversold, and chances are that we will need at least a couple of more weeks to see an oversold reading in the 50-day moving average.  Until or unless the 50-day moving average decline to a similar level we witnessed during recent bottoms (approximately 115), we will continue to avoid a long position our DJIA Timing System.

Conclusion: In conclusion, the “take-aways” for our latest weekend commentary are the following: 1) Going forward, global economic growth, as indicated by the “MarketThoughts Global Diffusion Index” should slow down over the next three to six months – and as such, my guess is that more of the “weakest links” in our global economic system will reveal themselves going forward.  In particular, this also suggests further weakness in the U.S. stock market, or at the very least, sub-par appreciation in the DJIA/S&P 500 for the next three to six months; 2) One of the weakest links in the world, not just in the Euro Zone, continues to be Spain.  Moreover, given that the ECB continues to remain hawkish, and given the significant deterioration in the Spanish current account deficit and in its central bank reserves, there is a good chance that some kind of economic turmoil will hit Spain over the next 12 to 18 months, whether it is a recession or a full-blown financial crisis; and 3) We will continue to remain neutral in our DJIA Timing System, and that, for now, we will just take it one day at a time, and be glad that we have not been caught in the latest downdraft and volatility.

Signing off,

Henry To, CFA

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