Looking for a Market Catalyst
(November 11, 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.
First of all, I would like to welcome our new subscribers to the MarketThoughts family. Since the end of last month, traffic to our website has increased over 40% on a daily basis. Participation in our MarketThoughts.com discussion forum has increased as well. I am especially happy about the latter since many of my best ideas come from you, our subscribers, and having a forum to discuss and swap trading and investment ideas (or to air concerns about my commentaries) is essential – especially as the world's financial markets continue to become more globalized and sophisticated by the day. Again, I just want to say “thank you” for all your ideas, time, and participation. Without you, there will be no MarketThoughts.
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 913.26 points as of Friday at the close.
As of Sunday evening, November 11th, we continue to remain 50% short in our DJIA Timing System. Aside from the NYSE McClellan Summation Index, the NYSE ARMS Index, and the S&P 500's percentage deviation from its 200-day moving average, many of our technical indicators are now approaching a “fully oversold” status. However, subscribers should keep in mind that during the midst of a panic, stock prices tend to experience their greatest declines towards the end of the panic (the most extreme case was October 19, 1987, when the Dow Industrials declined 22.6% (even though the market had already reached a highly oversold level the previous Friday), and would ultimately decline a further 7% on October 20th before reversing to close 6% higher than the previous day's close.
Given our quick gains in our short position in our DJIA Timing System over the last couple of weeks, and given the current oversold conditions in the stock market, my current goal is to cover our short position in our DJIA Timing System should one of the following two conditions be met over the next few days (warning: A major rally on Monday would invalidate this position):
- An intraday decline in the Dow Industrials of more than 400 points;
- An intraday NYSE ARMS Index reading of 2.5 or higher.
Should we decide to cover our 50% short position in our DJIA Timing System (to essentially go neutral), we will, as always, send a real-time email to our subscribers informing you of such a decision. Note that the two previous conditions are merely “guide posts” at this point, and should not be construed as “set in stone.” The shift in our position will not be official until an actual email goes out.
Before we go on to the “gist” of our commentary and discuss potential market catalysts for a stock market reversal, subscribers should remember that a sustainable stock market rally could only emerge out of a “reasonably” oversold condition. The term “reasonably oversold” is different for every market and time period. For example, during the current bull market that began in October 2002, the market had been able to enjoy a sustainable rally subsequent to every 7% to 9% correction in the S&P 500, as evident by the subsequent higher highs in most major market indices (including the Philadelphia Bank index and the American Exchange Broker/Dealer Index) , as well as the NYSE A/D line. Given the market action over the last few months, however, it is obvious that the mid August lows were not sufficiently oversold to attract enough buyers for a sustainable rally going forward. That is why – especially over the last couple of weeks – I have stated that there was a good chance that we will revisit the mid August lows. As of Sunday evening, November 11th, I still stand by this position, but as I have mentioned before, there is a good chance we will cover the 50% short position in our DJIA Timing System should we: 1) experience an intraday decline of more than 400 points in the Dow Industrials, or 2) experience an intraday NYSE ARMS Index reading of 2.5 or higher.
Aside from the mid August lows, this author would also like to see more oversold readings in the global stock market, especially the UK market, and any other markets that are heavily tilted towards the financial sector (such as Switzerland and Hong Kong). An appropriate indicator for the various stock markets around the world that we have developed is our “global overbought/oversold indicator” – an indicator that we first discussed in our August 2, 2007 commentary (actually, it placed in the beginning of a guest commentary from Bill Rempel). In that commentary, I stated that the purpose of the model is to help our subscribers keep track of all the international market indices and new international ETF products being developed out there today. The inner workings of this global overbought/oversold “model” are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility.
Let us go back and review our Global Overbought/Oversold Model as of August 15, 2007:
All the percentile rankings highlighted in yellow in the above table represent rankings below the 15th percentile – which is consistent with a reading that is more than one standard deviation below the mean (note that this is a true standard deviation calculation based on historical data and does not assume that returns are normally distributed). That is, relative to the historical % deviations of the same country or region, the current % deviation is more oversold than 85% of its readings going back to December 1998. Not surprisingly, there were many cells highlighted in yellow at the most recent bottom on August 15th – with the bulk of these being in the developed countries, and Latin America. On a trailing one-month basis ending August 15th, the only investable countries (both developed and emerging) that were up were Jordan (+0.3%), Venezuela (+0.4%), and Morocco (+2.7%).
The month-end updates for August, September and October of our “Global Oversold/Overbought Indicator” can be found in our September 2nd, September 30th, and November 1st commentaries, respectively. Let us now fast forward to November 9, 2007:
Note that the number of cells that are highlighted in yellow (readings that more oversold than 85% of all readings going back to December 1998) is much less than what we witnessed at the last bottom on August 15th. More specifically, there are only 5 countries/regions that are oversold on any of the timeframes that we track – those being the MSCI World Index, North America, Belgium, Ireland, and Sweden. Moreover, there are countries in the Asian Pacific, Latin America, or in the Emerging Markets category that are currently oversold. The countries in those regions that come the closest to being “oversold” are (in order): Mexico, Chile, Pakistan, Japan, and Pakistan.
At the very least, this author wants to see a “yellow reading” in either the United States or the UK stock market before we could claim the market is “fully oversold” – i.e. oversold enough for a sustainable, global, stock market rally going forward. For now, we will remain 50% short, but will most likely cover our short position should the market continue to sell off during the upcoming week.
In terms of “cash on the sidelines” as an impetus for a sustainable rally going forward, one measure that has been particularly useful is the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500. I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to October 2007:
While the ratio between money market fund assets and the market cap of the S&P 500 is not a great timing indicator – what it does show is the amount of “fuel” for a sustainable stock market rally going forward. Note that the October 31st ratio of 20.32% is now at its highest since October 2003. Such a reading is relatively high on a historical basis and should be supportive for stock prices over the next 12 to 24 months. However, over the short-run, the stock and financial markets can do anything. For example, it is interesting to note that this ratio hit a high reading of 19.45% on August 31, 2001, and yet, this ratio continued to hit highs after highs as investors fled into money market assets in the midst of the September 11th attacks, the Enron scandal, the Worldcom, and Global Crossing bankruptcies, etc. This ratio would ultimately not top out until September 30, 2002, when it hit a 20-year high reading of 27.69%. Finally, subscribers should also note that money market fund assets have been growing at over 30% in recent weeks – a rate that is definitely not sustainable – especially since the Fed (despite slashing the Fed Funds rate by 75 bps over the last couple of months) remains relatively tight, as evident by the dismal growth of the St. Louis Adjusted Monetary Base over the last 12 months. In other word, while it is likely that stock prices will be higher 12 to 24 months from now, it is not a given, and will highly depend on the viability of both the US and European financial sectors going forward.
At this point, I don't see any immediate catalysts for a sustainable stock market rally just yet, especially since both the Dow Industrials and the S&P 500 is still at least a few percentage points from reaching a “fully oversold” status. From an economic standpoint, the most important releases will be the PPI and retail sales numbers this Wednesday, along with the CPI this Thursday. I know what many of you are saying now – that these numbers are manipulated – but whatever flaws these construction methods do have, they will undoubtedly be watched by many economists and hedge fund managers alike, as these will determine what kind of bias the Federal Reserve will have going forward. On the UK side, the main focus will be the release of the quarterly inflation report this Wednesday – as like their brethren in the US, many investors are now anticipating the Bank of England to cut rates sooner or later (perhaps as soon as February of next year). My guess is that these inflation numbers on both the US and the UK side will either be neutral or surprise on the upside. Ultimately, they may not matter too much, as there is no doubt that – given rising commodity prices over the last six weeks – the November numbers will be higher.
On the earnings side, the biggest earnings reports this week are Blackstone (Monday after the close), Fortress Investments and Macquarie Bank (Tuesday, but time not supplied), Home Deport, Wal-Mart, and Vodaphone (Tuesday, before market opens), Macy's (Wednesday, but time not supplied), NEC Corporation (Wednesday, before market opens), Petsmart (Wednesday after the close), and BEA Systems and Starbucks (Thursday after the close). Given the prevalent pessimism surrounding the homebuilding and home improvement industry, and especially given the relentless decline in the stock price of Home Depot since mid July, the stock market could be in for a positive surprise on Tuesday morning. However, unless the U.S. stock market decline another few percentage points tomorrow morning, I will still be reluctant to call for a reversal at this point.
Another potential catalyst (and one that many hedge fund and private equity fund managers are hoping for) is a surprise easing of the Fed Funds rate – but even here, the case for a surprise ease is very weak. In our November 1, 2007 commentary, I mentioned “it is still too early to glean the “strike price” of the “Bernanke Put,” assuming that they are more reluctant to further cut rates going forward. Looking at their most recent record going back to mid August, the “strike price” is probably in the range of an S&P 500 level of 1,400 to 1,475, but as I mentioned before, the Fed is probably willing to give the market more “leeway” as long as GDP growth (or GDP growth estimates) don't go below the zero line, in light of everything that has happened since ((a housing market that is still in trouble, made worse by record oil prices, multi-year low USD, etc.). Moreover, much of the rest of the world is still in a tightening mode (the European Central Bank would have raised rates already if the Euro wasn't already at such a high level, given its higher-than-expected inflation reading yesterday), given that consumer price inflation is still rising in much of the world today.”
Given that the U.S. Dollar has since continued to decline since that commentary, my guess is that the “strike price” of the Bernanke put (which is really a moving target that even Bernanke himself is not sure about) is lower than what we initially outlined. My current guess is that it is in the 1,300 to 1,375 range, and only if we are far away from a scheduled Fed meeting. Moreover, it is important to remember that even during the days of the Fed easing in Fall 1998, the surprise rate cut did not come until October 15, 1998, a full six weeks after the market has already declined 20% and made a bottom on August 31st. Since the current Fed most likely don't want to be cast as “bailing out the financial industry,” my guess is that they will tread much more carefully this time around, and avoid a surprise easing as much as they could.
Moreover, as outlined in the following figure (courtesy of Barclays Capital), it looks like that the voting members of the FOMC next year will be more hawkish than the current voting members of the FOMC. The table shows both voting and non-voting members who had requested a discount rate cut prior to the October 31st Fed meeting:
Furthermore, the current Philadelphia Fed President (who is not a current voting member but will be one next year) had indicated that he would have been reluctant to vote for easing by 25 basis points during the last Fed meeting, and that he believed more economic data was needed before he would vote to ease. In his mind, he had already discounted a Q4 2007 GDP growth rate of 1.0% to 1.5%, and that only a further downside slide in his leading indicators would convince him to cut rates further. This suggests that the FOMC will be more reluctant to cut rates preemptively as a response to a financial market dislocation come 2008 – although, as we all know, there are still seven weeks until the end of this year, and seven weeks could be an eternity when it comes to the financial markets.
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 November 9, 2007, both the Dow Industrials and the Dow Transports experienced more than a 4% decline, with the former declining 522.36 points while the latter declined 198.83 points. More ominously, the Dow Transports actually made a new 2007 low, and is now at its lowest level since December 29, 2006. Again, the Dow Transports has continued to struggle relative to the Dow Industrials, and is now more than 15% below its all-time high (vs. the Dow Industrials which is “only” 8% below its all-time high). Given that the Dow Transports has nearly always a leading indicator since the cyclical bull market began in October 2002, subscribers should continue to be cautious with regards to both the Dow Industrials and the broader market.
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 24.9% to 19.7% for the week ending November 9, 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 the latest decline in the four-week MA is mostly due to the latest decline in the AAII bulls-bears differential readings. More importantly, however, even with the latest decline, the four-week MA is still significantly higher than its most recent bottom on September 7th (when it reached 2.6%), signaling that sentiment has not turned “pitch dark” just yet. Given the current downtrend in the stock market, as well as the continuing weakness in the US financials and consumer discretionary sectors, 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 (corporate bond and 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 at a neutral level at best, we will stay with our 50% short position in our DJIA Timing System for now, but again, we will not hesitate to cover our short position and go neutral should the opportunity present itself during the upcoming week.
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:
With the latest weekly decline of the 20-day moving average of the ISE Sentiment Index from 141.7 to 135.4, the 20 DMA is now officially in a downtrend. More importantly, the absolute levels of both the 20-day and the 50-day moving averages are suggesting that retail sentiment is definitely not oversold, thus signaling further downside in the US stock market. While we will not hesitate to cover our short position in our DJIA Timing System should we experience: 1) A 400-point intraday decline in the Dow Industrials, or 2) An intraday reading of 2.5 or over on the NYSE ARMS Index, we will most likely 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 there is a chance that the market could rally this week, my sense is that we are not at a sustainable bottom yet, given that the market is still at least a few percentage points away from being “fully oversold,” and given the lack of a catalyst over the next week or so (with the exception of a potential upward surprise from Home Depot). More importantly, we continue to believe that the chance of a preemptive ease by the Fed is relatively low at the moment, and will at least involve a further decline in the S&P 500 to below 1,400 before we will even consider such a scenario. Moreover, as we move into 2008, this chance will continue to get smaller, given the generally higher “hawkishness” of the 2008 FOMC voting members versus the 2007 voting members.
We also have not forgotten the U.S. Dollar Index. While we are now closer to a good buying point, I still want to see another spike down in the U.S. Dollar Index before I would consider a long position in the US Dollar Index. Moreover, this will need to be accompanied by 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 three to six weeks.
For now, we will also remain 50% short in our DJIA Timing System, but will not hesitate to cover and stay neutral in our DJIA Timing System should the right conditions emerge in the upcoming week. Subscribers please stay tuned.
Henry To, CFA