Tactical Trade on the U.S. Dollar?
(September 16, 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 16th, 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. As always, should we decide go long in our DJIA Timing System, we will email all our subscribers on a real-time basis informing of the change, but as of today, we do not expect this to happen anytime soon.
Before we jump into the subject of our commentary, I want to discuss a contrarian indicator that we utilize at turning points in the market: That of mutual fund inflows and outflows. As long-time subscribers know, the latest mutual fund inflows/outflows data is released by www.amgdata.com every Wednesday night. By looking at mutual fund inflows/outflows, one can – often times – spot a changing trend in the market from a contrarian standpoint. That is, during months when inflows are abnormally high (such as January to March 2000, or January 2004), there is a reasonable chance that the market is reaching a significant top, while during months when we see outflows, there is usually a good chance that the market is nearing a bottom, such as during August 1998 or during the fateful period of June 2002 to October 2002. In interpreting these numbers, this author usually likes to look at pure mutual fund flows, as opposed to fund flows including ETF flows.
There is a good reason for doing this. Keep in mind that holders of mutual funds usually represent investors that are not active in trading (i.e. 401(k) and 403(b) account holders, defined benefit plans, etc.) and thus are not as apt to keep up with the financial markets or the economy. In other words - to the extent that they try to time the markets by redeeming their mutual funds - they are usually dead wrong. On the contrary, while not all folks who trade ETFs may be professional investors or hedge fund managers, many of these folks are more knowledgeable about the markets and why it is moving, and therefore are better market timers in general than mutual fund holders. In other words, for contrarian-timing purposes, it is more reliable to look at mutual fund excluding ETF inflows/outflows rather than total inflows/outflows. Moreover, it is important to keep the size of the mutual fund and the ETF market in perspective. According to ICI, total equity mutual fund assets were US$6.4 trillion at the end of July 2007, while total balanced mutual fund assets were US$688 billion. Assuming that 60% of all balanced mutual funds are invested in equities (which is a conservative assumption), that means that is approximately US$413 billion of equity assets held in balanced funds. In total, that is US$6.8 trillion of equities held in U.S. mutual funds. Compare this with ETF assets - where we have $315 billion in domestic equity ETFS and $147 billion in global equity ETFs. In other words, equity ETF assets still make up less than 7% of all equity mutual fund assets in the US. At this point, “throwing away” ETF inflow/outflow is still a relatively safe bet.
So Henry, what are your mutual fund inflow/outflow indicators telling you now? And how did mutual fund outflows during August of this year compare to past historical outflows? Is this indicator telling us that we may have a significant bottom in place?
First of all, a disclaimer. The official mutual fund inflows/outflows data for August will not be released until two weeks from now, so all the August numbers that we are currently citing are just estimates. However, using the weekly data from www.amgdata.com, we can make a good guess. According to www.amgdata.com, equity (domestic and global) mutual fund outflows (again, excluding ETF flows) were approximately US$9 billion in August. Following is a monthly chart (courtesy of Reuters EcoWin) showing mutual fund inflows/outflows from January 1995 to August 2007 (note that the August 2007 number is just an estimate at this time):
As mentioned on the above chart, the estimated net outflows from U.S. equity mutual funds during August is approximately $9 billion – representing the highest outflow since June 2006 – the last time that the S&P made a significant bottom. More importantly, aside from the June 2006 outflow, U.S. equity mutual funds have not previously witnessed another outflow since February 2003, when U.S. mutual fund holders redeemed $11 billion from equity mutual funds. In an ongoing cyclical bull market (such as during the end of summer last year when this author went long in our DJIA Timing System), this would have been a strong signal to go long – but as I have mentioned many times before, we are now witnessing the end of a variety of bull markets in the financial markets today. No, not the equity kind, but we are now witnessing the end of a cyclical bull market in structured finance, in REITs, in private equity funds, and potentially in hedge funds as well. As I have mentioned before, we have had a genuine credit crisis for the last six weeks and we still do – and a genuine credit crisis usually ends with some sort of capitulation by investors as they dump every liquid asset they could get their hands on, including, of course, equities (note that “Black Swans” usually occur more frequently during times of credit contraction). For now, I do not believe the mid August decline represented capitulation, and given the mediocre breadth and volume we have witnessed in the rally of the U.S. and global equity markets (with the exception of the Chinese and Hong Kong stock markets) since mid August, my guess is that we are due for a retest of the mid August lows sometime over the next few weeks.
Moreover, as I am typing this, the FTSE 100 is down more than 1% on the catastrophic developments over the weekend in the UK – as doubts grew that the 8th largest bank and 5th largest mortgage lender in the UK, Northern Rock, will survive as an independent going concern. In a demonstration of early 20th century “laissez faire” central banking, the Bank of England has refused to step in and mediate or expedite any takeover attempts by potential private sector bidders, as it believes that “the market will take care of itself.” Case in point: Lloyds TSB was mulling a bid for Northern Rock as early as the beginning of last week, but the deal fell apart when the Bank of England refused to lend monetary support to the deal – as the BoE did not want to “subsidize” the bailout of a private bank. Given the money markets are still closed, chances are that no bidders would show up now unless there is a fire sale of Northern Rock's assets. Moreover, since Friday morning, more than 2 billion pounds (or 7% of the deposit base) at Northern Rock has been withdrawn or transferred to other financial institutions. Chances are that this will rise going forward, given the disastrous news over the weekend and the fact that 10 billion pounds are held in postal accounts at Northern Rock (it usually takes a week or so for the paperwork to go through to withdraw funds from these postal accounts). This is perfectly understandable – as the UK's Financial Service Authority will only guarantee 100% of deposits up to ₤2,000, and 90% up to ₤32,000. For those with deposits over ₤32,000, you are out of luck if Northern Rock goes under (the Northern Rock customers who were laughing at the queues on Friday are not feeling so amused now). Whether this current crisis will emerge into something bigger remains to be seen – but if the Bank of England continues to sit on its hands, then it may very well will. For what it's worth, GaveKal is now calling this the biggest disaster for the UK financial system since Black Wednesday of 15 years ago.
Let us now shift to our major topic of this commentary and discuss the U.S. Dollar Index. Over the last two and a half years, we have – off and on – gotten bullish in the U.S. Dollar Index (see our May 1, 2005 and November 12, 2006 commentaries). While the official calls that we made in our commentaries were, for the most part, correct and tradable on the long side in the short-run – in retrospect, the “bullish dollar” call was far too early and had not pan out over the longer-run. At this point, however, we still stand by our original thesis – that over the longer-run, while most Asian currencies should out perform the U.S. Dollar (not only because of higher economic growth in Asia ex. Japan, but also because of the differences from a purchasing power parity standpoint), things are not so clear in either the UK or Euroland. I have discussed our many reasons before, but among them are: 1) deteriorating demographics, combined with the lack of a coherent immigration policy of young and enthusiastic talent with good education, 2) lack of structural reforms, 3) housing bust in Spain, along with the fact that both the UK and France's economic boom over the last few years have, in no small part, been helped by rising housing equity in both countries, 4) the fact that much of Euroland (especially Germany) is the marginal manufacturer in the world – and therefore, at the first sign of an economic slowdown, European exports will come to a screeching halt, and 5) a hugely overvalued currency from a power purchasing parity standpoint, as exemplified by the wave of UK tourists doing their Christmas shopping at Macy's during 2006.
However, over the short-term, this author is still not willing to go long the U.S. Dollar yet. The reasons is that the growth in foreign reserves held in the custody of the Federal Reserve has continued to increase exponentially over the last six months, signaling that there is still “too much U.S. Dollars” in the system. For readers who have not been with us for long, we first discussed the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index in our May 1, 2005 commentary. In that commentary, I stated:
Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.
Since our May 1, 2005 commentary, this inverse relationship has more or less still hold true, as evident by the following monthly chart showing the annual change in the U.S. Dollar Index. vs. the annual change in the rate of growth (second derivative) in foreign reserves:
Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that while the recent change in the growth of foreign reserves has slightly decreased (while the U.S. dollar has decreased significantly on a year-over-year basis), the divergence between the rate of growth in foreign reserves and the decline of the U.S. dollar index is still not wide enough for us to bet on the dollar one way or another. However, historically, the action in the U.S. Dollar Index and our foreign reserves indicator does not diverge for long – suggesting that the U.S. dollar should rise at some point, unless foreign reserve growth accelerates from here. We will update our readers once the above chart flashes a “buy” on the U.S. dollar index.
Another way to spot a good entry point on the U.S. Dollar Index is to keep track of its percentage deviation from its 200-day simple moving average. This is one the advantages of using an overbought/oversold indicator on a major currency – and especially the world's reserve currency – as major currencies usually do not gap up or gap down in a major way. That is, along as there are no abnormally sinister forces in the market place (such as Japanese housewives speculating on foreign currencies) – buying the dollar index when it is oversold (e.g. when it is trading at 5% below its 200-day moving average) has usually been a profitable endeavor, as long as one is not heavily leveraged. Following is a daily chart showing the U.S. Dollar index from December 1985 to the present:
As mentioned on the above chart, the U.S. Dollar Index closed at a level that was 3.61% below its 200 DMA last Friday. While – by this measure – the U.S. Dollar is now oversold relative to readings over the last nine months, there have been cases over the last five years when the U.S. dollar has gotten much more oversold, such as during July 2002, May 2003, January 2004, and December 2004 – when the U.S. Dollar Index declined to as low as 8% to 10% below its 200 DMA. While I am not looking for similar oversold readings this time around, I would definitely like to see this reading hit, at a minimum, 4.5% below its 200-day moving average, similar to the (tradeable) reading that we got on December 1, 2006. Before we decide to go long the U.S. Dollar Index, however, I would also like to see a greater divergence in the rate of annual growth in foreign reserves held in the custody of the Federal Reserve and the year-over-year decline in the U.S. Dollar Index, as discussed in the former chart. Subscribers please stay tuned/
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 July 2005 to the present:
For the week ending September 14, 2007, the Dow Industrials rose by 314.67 points while the Dow Transports rose 102.33 points. As mentioned on the above chart, while the Dow Industrials managed to retrace all (and more) of its decline from the week prior, the Dow Transports was unable to do so, as it was only able to retrace 70% of the decline from the week prior. More importantly, the Dow Transports is still a whooping 2.5% below its most recent closing high on September 4th, even as the Dow Industrials is only 6 points away from its September 4th high as of Friday at the close. 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 – for the first time in six weeks – increased from last week's 2.6% to 4.9% for the week ending September 14, 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:
Note that at its most oversold level on September 7th, the four-week MA was at its most oversold level since the week ending June 30, 2006. However – given the current turmoil in the world's credit markets, and the inevitable slowdown of the U.S. economy for the second time during this cyclical bull market (the annual change in the ECRI Weekly Index is now just one reading away from going negative) 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 (along with the lack of capitulation) 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:
Over the last three weeks, the 20-day moving average of the ISE Sentiment actually experienced a significant rally – rising from 100.5 to 119.0 as of 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 three weeks – despite the mediocre breadth and volume 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 another couple of more weeks before we will see an oversold reading in the 50-day moving average. That is, 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: While there are now increasing signs that the market is close to hitting bottom, subscribers should keep in mind that we are still in the middle of a credit squeeze – and that, not coincidentally, “Black Swans” tend to occur more frequently during times like this more so than others (the collapse of “Northern Rock” is one example). While U.S. equities are still decently valued based on the latest quarterly earnings reports, our inclination is to continue to be cautious in this environment – especially given that we had not witness a credit squeeze since the dark days of the Global Crossing and WorldCom bankruptcies in 2002. In other words, since that time, many investors (including many folks who I speak to on a daily basis) have now gotten very complacent – and it is times like this when one should be careful.
We also remain bullish on the U.S. Dollar against the Euro and the Pound over the long-run, although we may continue to see short-term weakness given the inevitable cut in the Fed Funds rate on September 18th and given the possible repatriation of capital from the U.S. by foreign banks to cover their U.S. subprime losses, thus further pressuring the U.S. Dollar. For now, we will continue to stand pat on the U.S. Dollar Index, but will inform our investors once we change our mind and decide to go long.
We will also continue to remain neutral in our DJIA Timing System. 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.
Henry To, CFA