Yield Spreads Telling a Different Story
(October 28, 2007)
Dear Subscribers and Readers,
Note: Please participate in our latest poll. The question is: What is the probability of a US recession in the near future? Comments are also welcome, as always.
Let us begin our commentary by first providing an update on our four 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.
4th signal entered: 50% short position October 4, 2007 at 13,956, giving us a gain of 149.30 points as of Friday at the close.
As I mentioned in several posts in our discussion forum over the last 5 days, I was fortunate enough to be invited to the American Funds Institutional Forum in downtown Los Angeles last Monday and Tuesday. The American Funds family is the largest mutual fund family (in terms of assets under management, ahead of Vanguard and Fidelity) and has one of the most accomplished investment track records over the last 40 to 50 years.
In terms of their outlook on the markets, they made three key points. While they maintain that they're long-term investors, many of their managers are now becoming worried about the domestic equity outlook, after having been strongly bullish for the last five years. Two reasons were cited: 1) A dramatically slowing economy over the next 6 to 9 months, accompanied by much greater uncertainty in the financial markets than they have seen over the last five years, and 2) they believe that no matter who gets elected in the next Presidential election, taxes will be raised, and historically, this has not been bullish for equities.
Another major key point is that they continue to be more bullish on international equities than they are with US equities, given that many emerging markets still have a lot of ground to make up in terms of both GDP per capita and market cap per capita. Until or unless they see another new technology paradigm favoring the US (such as the PC or internet revolution in the 1980s and 1990s, respectively), they will continue to be more bullish on international equities in general. They are also overweight Continental Europe ex UK, as valuations remain decent and as profits still have a lot of room to grow given the push for more reforms in the Euro Zone. They are also significantly underweight the UK, given its heavy dependence on the financial sector and the UK housing market.
The final key point is that they continue to be bullish on energy prices (they have been heavily invested in energy for the last few years). While alternative energy will one day have a significant impact on energy supply (whether it is solar, nuclear, etc), they believe that alternative energy investing is more hype than reality at the moment. Moreover, many energy companies are still not confident that high oil prices are here to stay, and therefore, they have continued to be cautious in R&D and exploration spending – thus putting a ceiling on higher supply going forward. American Funds has two oil analysts, and both of them continue to forecast higher crude oil prices over the next few years. One of those analysts believes that $200 a barrel sometime at the end of this decade is now highly possible.
Given our current 50% short position in our DJIA Timing System, we fundamentally agree with American Funds' cautious outlook over the next 6 to 9 months (subscribers can review our historical signals at the following link). In our October 7, 2007 commentary (“Global Economy Now Slowing Down”), I articulated our initial reasons for establishing a 50% short in our DJIA Timing System. Again, many of these reasons – with the exception of the continuing strength in both the Shanghai and the Hong Kong stock markets – are still valid. Even within the Hong Kong stock market (the strongest developed market during 3Q), the number of new highs made a peak early this year, and has been consistently making lower highs since. Within the U.S. stock market, we are still witnessing major divergences, including lower highs in the NYSE A/D line, the non-confirmation of the all-time highs in the Dow Industrials and the S&P 500 by the Dow Transports, Dow Utilities, the American Exchange Broker Dealer Index, and the Russell 2000 Index, as well as lower highs in both the NYSE and the Dow Industrials McClellan Oscillators. Moreover, even within the UK stock market – one of the most liquid and international exchanges in the world today – breadth has been consistently weakening, as shown by the following chart courtesy of Reuters EcoWin:
As can be seen in the above chart, the 21-day simple moving average of the London Stock Exchange's A/D line peaked back April and has been consistently making lower highs for the last 6 months. Moreover, nearly each major peak over the last 4 years in the FTSE 100 has also been accompanied by a non-confirmation of the 21 DMA in the LSE A/D line. Given that LSE breadth peaked out in April, and more importantly, given that it has been consistently making lower highs since February 2005, my guess is that equities on the London Stock Exchange is now due for a breather, especially given the market and the economy's leverage on the financial and housing sectors in the UK. Given that the London Stock Exchange is one of the biggest exchanges in the world in terms of market cap (with a market cap of over US$4 trillion), my guess is that any weakness in the London Stock Exchange will not bode well for the U.S. stock market either, especially companies within the U.S. financial sector.
As for the US market, most eyes are now on the Fed meetings on the 30th and the 31st. The Fed is expected to lower the Fed Funds rate by 25 basis points, with another 25 basis point cut at the next meeting on December 11th. However, while further cuts in the Fed Funds rate make good headlines, it is to be noted that the Fed still remains relatively tight by historical standards, as demonstrated by the abysmal growth in the St. Louis Adjusted Monetary Base (the only liquidity indicator that is directly controlled by the Fed) over the last six months. This was last mentioned in our July 15, 2007 commentary as part of our update on our MarketThoughts “Excess M” (MEM) indicator. 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:
- 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.
- 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 that 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-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:
Since our July 15th 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 creating liquidity (although this is slowing down as well), the Federal Reserve itself has continued to restrain liquidity from the global financial system, despite a lower discount and Fed Funds rate since July 15th. This is evident by the dismal 2.0% growth (a rate that is below that of inflation) in the St. Louis Adjusted Monetary base over the last 12 months.
Another indicator of deteriorating liquidity is the blowout of credit spreads in the U.S. markets over the last few months. With the rally off the mid August lows, one would think that credit spreads have settled down since then, but that has not been the case. Following is a chart showing investment grade and high yield corporate spreads (option-adjusted) from January 2003 to the present, courtesy of Merrill Lynch:
As mentioned on the above chart, both investment grade and high yield corporate spreads (as exemplified by the Merrill indices) have spiked up again since the mid to late August lows in the stock market, despite the stock market rally over the last six weeks. More importantly, investment grade yield spreads have risen about 60 basis points since the late February lows while high yield spreads have risen about 250 basis points since the June lows. In other words, no amount of rate cuts would bring back the LBO market of six months ago anytime soon, given that lenders are continuing to get more cautious, not less.
The general blowout in yield spreads can also be witnessed in the most recent spike in credit default swap spreads in the commercial mortgage backed securities market, as illustrated by the recent rise in CMBX index spreads (the securitization.com website has a good primer of the CMBX indices) . Following is a daily chart showing CMBX AAA, A, and BBB-rated CMBX spreads from July 2006 to the present, courtesy of Reuters EcoWin:
Note that with the exception of the CMBX AAA-rated index, both the A-rated and the BBB-rated index has seen spreads spike to new highs – surpassing the spreads that we witnessed during the August “general credit crunch.” At this point, we still do not know whether this is the result of general deteriorating liquidity conditions or a slowdown in the commercial real estate market. But whatever it is, it does not bode well for either the US stock market or the economy going forward.
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 2006 to the present:
For the week ending October 26, 2007, the Dow Industrials rose 284.68 points while the Dow Transports rose 65.61 points, with both Dow indices retracing about half of their declines from the prior week. Again, while the Dow Industrials has made fresh all-time highs since the decline from its July 19th top, the Dow Transports has continued to struggle, and has only been able to retrace just 25% of its decline from July 19th. More importantly, the Dow Transports is still about 10.5% below its all-time high. Given the weakness of the railroad loadings that we discussed above, and 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.
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 decreased slightly from last week's 29.0% to 26.8% for the week ending October 26, 2007. As one can easily see, the latest AAII readings, while oversold, are still not having a significant impact in this sentiment study just yet. 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 weakening breadth of the U.S. and UK stock market, the inevitable slowdown of the U.S. economy due to the lingering concerns over subprime resets and Alt-A loans, the deteriorating credit conditions as exemplified by the continuing blowout of credit spreads, and the weakening global leading indicators that we had mentioned in previous commentaries (in particular, the weakening signals coming out from the Euro Zone, the UK, and Japan), I am still inclined to think that the U.S. stock market will retest its mid-August lows before embarking on a more sustainable path upwards. Now that the above indicator has spiked up substantially (it is now at its most overbought level since late February, right before the 500-point decline in the Dow Industrials due to initial subprime concern), and given that this and the all-time highs in the Dow Industrials has not been accompanied a corresponding confirmation in breadth and in other major indices, we will stay with our 50% short position in our DJIA Timing System. Should the Dow Industrials rise to the 14,150 to 14,500 area immediately before the October 31st Fed decision, there is a good chance that we will shift to a fully (100%) 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 May 1, 2002 to the present:
Over the last 9 weeks, the 20-day moving average of the ISE Sentiment rallied significantly – rising from 100.5 to 141.5 as of last Friday. More importantly, the absolute level of the 20-day moving average is suggesting that retail sentiment is no longer bearish, and given this and the continued mediocre breadth and volume conditions in the market – my guess is that we will revisit the August lows at some point over the next 3 to 6 months. Moreover, should the 20-day moving average and the Dow Industrials continue to rally into the Fed decision this Wednesday, and should this be confirmed by our other sentiment indicators, relatively weak breadth, and lack of confirmation in other major market indices (such as the Dow Transports, the Dow Utilities, the American Exchange Broker/Dealer Index, the Russell 2000, and so forth), then there is a good chance that we will go fully (100%) short position in our DJIA Timing System.
Conclusion: Not only does U.S. stock market breadth continue to remain weak, we are now also witnessing deteriorating breadth on the London Stock Exchange as well, as illustrated by the lower highs in the London SE A/D line going back to April of this year. Moreover, despite the recent cut in both the discount and the Fed Funds rate, the growth of primary liquidity, as illustrated by the St. Louis Adjusted Monetary Base, continues to be dismal, and this continued deterioration in liquidity is now showing up in another blowout in credit spreads across the board (note that the ABX indices are also making new lows as we speak).
For now, we will also continue to remain 50% short in our DJIA Timing System – but as we mentioned in this commentary, should the market continue to rally (preferably to the DJIA 14,150 to 14,500 area) going into Wednesday's Fed decision, we will shift to a fully (100%) short position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA