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The Various Bear Markets

(November 4, 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 360.90 points as of Friday at the close.

In this weekend's commentary, I am going to highlight the various major bear markets in the US today and give a sense to when we will buy into some of these asset classes.  Hopefully, this will prepare our subscribers for the buying opportunities once they arrive.  We will then end this commentary with our usual discussions on the US stock market and the sentiment indicators that we track on a weekly basis.

One of the major bear markets in the world today is, no doubt, the bear market in global financial stocks (e.g. Citigroup made a fresh four-year low and Merrill Lynch made a fresh 2 ½ year low last Friday), as well as the structured finance market and the private equity industry.  Since these topics have already been discussed extensively by both and the mainstream media, we will refrain from speaking about these in this commentary.  Rather, I want to begin this commentary with the topic of US REITS.

We first discussed the overstretched valuations in US REITs in our February 1st commentary (coincidentally, 7 days before the ultimate peak in US REITs).  In that commentary (“REIT Market Overheating?”), I concluded that “… given the rich valuations in the REIT market today, subscribers should be very cautious – as it probably will not take much for anything to act as a catalyst for a major peak in the REIT market.”  To give readers a sense of how overvalued US REITs were,: At the end of January 2007, the spread between REIT dividend yields and the 10-year Treasury yield was at approximately negative 1.4%, compared to an average 0.5% positive spread during the 1990 to 1997 period and the 1.4% positive spread during the 1998 to 2006 period.  Moreover, the spread between REITs and 10-year Treasuries have never traded at such a negative spread before.  During the last US REIT bull market that peaked in mid 1997 (REITS would decline 18.8% in 1998 and 6.5% in 1999), the spread declined to “only” negative 80 basis points.  By all historical measures, US REITs were priced at their richest in history at the end of January 2007, just 8 days before the ultimate peak.

According to the FTSE NAREIT All REIT index, US REITS were down 2.4% at the end of October on a year-to-date basis, after outperforming the S&P 500 for six consecutive years from 2000 to 2006.  By contrast, the S&P 500 was up 10.9% on a YTD basis, for a return differential of a huge 13.3%!  There is no doubt that US REITs are currently in a bear market after peaking in early February of this year.  The $64 billion question is, as always, when would REITs present a good buying opportunity?

Let us start with the dividend yield on the FTSE NAREIT Equity REIT Index.  As of the end of October, equity REITs yielded 4.17%, just 12 basis points below the 10-year Treasury yield at the close on Friday, and up from a yield of 3.40% at the end of January.  However, the spread of negative 12 basis points is slightly “misleading,” as 10-year yields have declined substantially since the end of January, from 4.83% to 4.29% at the close on Friday.  Common sense would dictate a higher “yield cushion,” given that REITs are now officially in a bear market.  Over the last 24 months, 10-year yields have traded in a 102 basis point range of 4.28% to 5.30%.  Assuming that subscribers are happy with a yield that is comparable to 10-year Treasuries (such a scenario would involve betting on higher rental growth and higher real estate prices going forward), I believe subscribers should at least settle for a 5.00% yield.  Moreover, given that the rental market in New York and San Francisco continues to be weak, an optimistic projection would be for a 10% growth in rental income over the next two years.  To get to a 5% yield point, and assuming a 10% growth in general rental income, the FTSE NAREIT All REIT Index would need to decline a further 10% over the next two years in order to meet our buying point.

Note that our above scenario represents out most optimistic projections.  Firstly, it does not assume that the US economy will slide into a recession, as a recession typically has widespread repercussions in the REIT market, such as declining rents, lack of access to borrowing, and higher borrowing costs for “lesser-quality” REITs.  Secondly, as I have mentioned before (and as shown in the following chart courtesy of the monthly NAREIT REITWatch publication), the spread between equity REIT yields and ten-year Treasury yields has historically traded at some kind of spread.  During the early to mid 1990s, the average yield spread was 50 basis points.  From 1998 to 2006, the average yield spread rose to 140 basis points, as a result of 1) investors shifting money from REITs into technology stocks from 1998 to 2000, and 2) as investors pulled back from taking general risk during the 2001 to early 2003 period.

Monthly Equity REIT Dividend Yield Spread (January 1990 - September 2007) 

Given that REITs are now currently in a bear market, it would not surprise me if REITs again trade at a spread of 150 basis points to 10-year Treasury yields sometime the next few years, especially if the US enters a recession.  Even if the US does not experience a recession going forward, it is still reasonable to assume that REIT investors would like to see some kind of spread before investing in REITs again.  To that end, I believe a 50 basis point spread is reasonable, and actually, relatively conservative.  Assuming a 10-year Treasury yield of 5% sometime over the next two years, a two-year rental growth rate of 10%, and a 50 basis point spread between REIT and ten-year yields would result in a 16% to 18% decline in the FTSE NAREIT All REIT Index over the next couple of years, as opposed to the 10% “optimistic” scenario that I had outlined previously.  My guess is that this is the most likely scenario, and should provide a good risk-adjusted return for long-term investors.  For more conservative investors or older retirees, I would simply demand a higher spread before buying.  If it never goes there, then so be it.  To that end, I believe a 100 basis point spread is reasonable, which would imply a 25% decline from current levels over the next couple of years assuming my relatively optimistic assumptions hold true.  If rental income growth slows further going forward, or if 10-year yields spike to 6%, then all bets are off.

I now want to discuss another bear market that we have been experiencing – the bear market of the U.S Dollar Index.  We last discussed the U.S. Dollar Index in our September 16, 2007 commentary (“Tactical Trade on the U.S. Dollar?”).  In that commentary, I stated:

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.

I continue to stand by this thesis.   Moreover, we are now starting to see some strains on the UK economy, given that UK economic growth has been so leveraged to the growth of the financial sector and the boom in the UK housing market over the last five years.  There is no doubt that the Bank of England will need to lower rates possibly as soon as February of next year in order to combat lower economic growth and high credit costs.  But more importantly, I believe the current fallout in the credit markets will have a bigger impact on the UK economy as opposed to the US economy, especially given that the UK housing boom has been much more violent than the US housing boom in recent years.

In our September 16, 2007 commentary, I also stated that over the short-term, I was still not willing to go long the US Dollar Index just yet (a view that has had luckily worked out in our favor).  One major reason was the growth in foreign reserves held in the custody of the Federal Reserve had continued to increase substantially increase over the last six months, signaling that there was 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 has held.  More importantly for us, the growth in foreign reserves has slowed down over the last six weeks, 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:

Annual Change in U.S. Dollar Index vs. Annual Change in Rate of Growth in Foreign Reserves (Monthly Chart) - The divergence between the annual change in the dollar index and the second derivative (rate of change) in foreign reserves is now getting *long in the tooth,* suggesting that sooner or later, it will be wise to go long the U.S. Dollar Index.

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 aside from the decline in the growth of foreign reserves, the U.S. Dollar Index has been decreasing significantly as well – meaning that the divergence between the rate of growth in foreign reserves and the decline of the U.S. Dollar Index is now getting rather “long in the tooth.”  Assuming that foreign reserve growth continue to slow down in the weeks ahead, there is a good chance that the above chart will flash a “buy” on the U.S. Dollar Index sometime in the next several weeks.  We will update our readers once we get to a good buying point.

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 of the major 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 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 and its percentage deviation from it 200 DMA from December 1985 to the present:

USD Index vs. Percentage Deviation from its 200 DMA (December 1985 to Present) - The percentage deviation of the USD Index from its 200 DMA hit a level of negative 6.42% last Friday. While this reading is definitely very oversold relative to the readings we have seen over the last 2 1/2 years, it still isn't as oversold as readings of years past, such as the -9.50% reading in January 2004 or the -8.57% reading during the depths of the Russian and LTCM crises in October 1998. Even though amount of foreign reserves in the custody of the Fed is no longer rising at a rapid pace, this author would still like to be careful and wait for a more oversold situation before going long, along with a confirmation of a higher shortgage of U.S. dollars in the market.

As mentioned on the above chart, the U.S. Dollar Index closed at 6.42% below its 200 DMA last Friday.  While – by this measure – the U.S. Dollar is now extremely oversold relative to readings over the 2 ½ years, there have been cases over the last ten years when the U.S. dollar has gotten more oversold, such as during October 1998, 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.  Should the U.S. Dollar Index decline to 8% to 10% below its 200-day moving average, then we will definitely go long the U.S. Dollar Index in some shape or form, but should this reading be accompanied by a greater divergence in the rate of annual growth in foreign reserves held in the custody of the Federal Reserve, then the U.S. Dollar Index, in short, will be as close to a “screaming buy” as you will see in any asset class this year.  Subscribers please stay tuned.

As for the U.S. stock market, this author still does not believe we are at a buying point just yet, given the lack of an oversold condition in many of our technical indicators, such as the NYSE ARMS Index, the NYSE McClellan Oscillator, new highs vs. new lows on both the NYSE and the NASDAQ Composite, and a lack of bearish sentiment in our sentiment indicators.  At the very least, I want to see the Dow Industrials – one of the strongest U.S. market indices over the last few months – decline to below its 200-day moving average before buying (the Dow Industrials is currently still 3% above its 200 DMA, as can be seen on our MarketThoughts charts page).  Given that we are still not close to being oversold on any of our technical indicators, I will refrain from providing more charts at this point – but as always, I will continue to keep our readers up-to-date should the US or global stock market continue to decline 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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2006 to November 2, 2007) - For the week ending November 2 2007, the Dow Industrials declined 211.60 points while the Dow Transports declined 64.22 points - with both indices giving up nearly all of their gains from the prior week. As we have mentioned numerous times, over the last 3 months, the Dow Transports has persistently been the weaker index. For example, the Dow Transports has only able to retrace 17% of the decline from mid July to mid August, leaving the index still about 11.8% from its all-time high (the Dow Industrials is only 4% from its all-time high). Given the recent action of the Dow Industrials, however, it now looks like that the Dow Industrials is now following the Dow Transports down as well, which isn't surprising given that the Dow Industrials has been the leading index since this bull market began in October 2002. Subscribers should continue to be cautious here.

For the week ending November 2, 2007, the Dow Industrials declined 211.60 points while the Dow Transports declined 64.22 points, with both Dow indices giving up nearly all their gains 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 17% of its decline from July 19th.  More importantly, the Dow Transports is still about 11.8% below its all-time high, while the Dow Transports is only 4% from its all-time high.   Given the weakness of the railroad loadings that we discussed a couple of weeks ago, 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.

Interestingly, the Dow Utilities was only one point away from closing at a new all-time high last Wednesday, but to the detriment of the bulls, has pulled back 1.7% by Friday's close, even though long bond yields declined.  The failure of the Dow Utilities to close at a new all-time high means that since the Dow Utilities hasn't closed at a new high since May 21st, or over five months ago.  Given that historically (aside from the early 2000 peak), the Dow Utilities has led the overall stock market by 3 to 12 months over the last 25 years, this is an ominous sign for the bulls.

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 26.8% to 24.9% for the week ending November 2, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending November 2, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased slightly from 26.8% to 24.9%.  The reading of 29.0% two weeks ago represented its most overbought level since late February, or right before the 500-point decline in the Dow Industrials due to initial subprime concerns. Given its still overbought conditions, and coupled with the 90% downside day in the stock market last Thursday, this author believes that there is a good chance we will revisit the mid August lows - despite the immensely oversold reading we witnessed two months ago. I also prefer to see this reading reach a more oversold levels than what we witnessed during mid August, as I did not see major capitulation during the mid August lows, and as such, we will continue to remain 50% short in our DJIA Timing System.

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 90% downside day last Thursday and the continuing weakness in the US financials, the inevitable slowdown of the U.S. and UK 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 (CMBX credit spreads made a new high last Friday), 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.  Given that this sentiment indicator is still at an overbought level,  we will stay with our 50% short position in our DJIA Timing System for now.

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:

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 fell to an extremely oversold level 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 hit a 5-month low at 114.7 on October 2nd, before finishing at 133.5 on Friday. However, the subsequent bounce since the mid August lows has been weak and narrow in scope, and more ominously, both the 20 and the 50 DMA are no longer oversold. Coupled with the 90% downside day last Thursday, this author believes that the 20 DMA (and thus the the stock market) will spike down again before we can claim *capitulation,* and so we will continue to remain 50% short in our DJIA Timing System for the time being.

Over the last 10 weeks, the 20-day moving average of the ISE Sentiment rallied significantly – rising from 100.5 to 141.7 as of last Friday.  More importantly, the absolute levels of both the 20-day and the 50-day moving averages are suggesting that retail sentiment is no longer bearish, and given this and the 90% downside day on the NYSE last Thursday – my guess is that we will revisit the August lows at some point over the next 3 to 6 months.  Moreover, we will not go long in our DJIA Timing System again until both the 20 and the 50-day moving averages are again at oversold levels.

Conclusion: While REITs have been mired in a bear market since February of this year, this author believes that there is further downside to go.  At the very least, subscribers should expect another 10% decline sometime over the next 12 to 24 months.  More importantly, subscribers should not think about investing in REITs again until the FTSE NAREIT All REIT index declines a further 16% to 18% from current levels.  For more conservative investors or older retirees, a better long-term buying point would be at around 25% below current levels, assuming both rental income growth and long term interest rates remain steady going forward.

As for the U.S. Dollar Index, we are now approaching a good buying point, especially if we see another spike down in the U.S. Dollar Index or if we see a continued slowdown in the foreign reserves growth rate over the next four to six weeks.  We will continue to update our readers on the U.S. Dollar Index, but my guess is that there will be a buying point sometime in the next four to six weeks.

For now, we will also remain 50% short in our DJIA Timing System.  The most important time of this week will be Wednesday after the close, when Cisco (CSCO) reports quarterly earnings.  Given that the technology sector has been the sector “holding this market” up in many ways, the market could set itself up for some disappointment should Cisco fail to beat its earnings estimates.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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