Divergences Still Abound
(December 6, 2007)
Dear Subscribers and Readers,
There is an ancient Chinese proverb that goes something like this: “It is better to be a dog in a peaceful period than be a man in chaotic times.” Obviously, the English translation of this proverb is much less stylish, but you get the idea. This ancient proverb can be extended into this corollary: “It is better to be an average man in American than be a highly intelligent and resourceful man in China.” Of course, this saying had only been true for the last 200 years, and over the last few years, it has increasingly become more obvious that this saying no longer holds much water. The rollout of 4G wireless services – as exemplified by Sprint's WiMax and Verizon's LTE network – over the next 2 to 4 years, as well as an increasingly English literate Chinese workforce will further increase the competitiveness of Chinese labor versus American workers. A high school tutoring service based in India, TutorVista, has already signed up over 10,000 US and 1,000 UK subscribers. Unlike many US on-site tutoring services that charge $40 to $60 an hour (or other remote tutoring services that charge $20 to $30 an hour), TutorVista charges only $99 a month, for as many 45-minute sessions as the student wants.
To take this analogy further, it is obvious that the latest “government-induced” subprime bailout plan (along with the unprecedented amount of rate cuts during the 2001 to 2002 aftermath of the technology bubble) can only have a chance of succeeding because of the US Dollar's status as the world's dominant currency – not only for trading purposes but also for the United States' status as a safe haven as well as its many attractive assets, such as Manhattan/West Los Angeles real estate, Google and Apple common stock, and a generally talented labor force. Even the biggest skeptic on the American economy has to admit that from World War II onwards, the sheer size of the American economy relative to the rest of the world made her the dominant force – so dominant that it could dictate monetary policy to the rest of the world. Case in point: When Charles de Gaulle pulled out of the London Gold Pool in 1968 and asked to redeem payments for gold instead of US dollars, the London Gold Pool was disbanded, and three years later, President Nixon simply closed the gold window. This is the luxury, ladies and gentlemen, of being the predominant military and economic power of the modern world.
While I don't believe any currency will supplant the U.S. Dollar anytime soon (and even if there is, neither the Euro and the Yen will be frontrunners), there is now no doubt that the power to dictate economic of monetary policy by the US government or the Federal Reserve is no longer as great as it once was. Before you say that this is good for our humility, you should keep this in mind: This also means that the power to bail out US consumers or act as a lender of last resort to the financial system as a whole is no longer a unilateral decision. Just 10 years ago, a tanking U.S. Dollar would be somebody else's problem, but 10 years from now, it may just be our problem, especially if China, India, and Brazil can “prove” that their economies can “decouple” from the US in the inevitable slowdown over the next 3 to 6 months. If indeed they can, that this will no longer mean that the US can dictate economic or monetary policy to the rest of the world, hampering the success of any loose monetary policy initiative or government intervention to jump start economic growth going forward.
This is further compounded by the fact that foreigners now own the greatest amount of US assets in history, as a percentage of total US net assets. The details of the “subprime bailout” plan not withstanding (it will be announced later today), I do not believe the markets have yet currently priced in such a “strait jacket scenario” for the US economy just yet.
Turning the topic of this commentary, one thing that that we had mentioned as a non-confirmation of the current rally as the start of a sustainable rally is the weakness of the NYSE CSO A/D Line ever since peak in mid July. Not only did it fail to confirm the new highs in the Dow Industrials and the S&P 500 (not shown) in early October, it has continued to grow weaker over the last six weeks. Even with the 700-point rally in the Dow Industrials since last Monday's close, the latest rally in the NYSE CSO A/D line has failed to impress (following is a daily chart showing the NYSE Composite Index versus the NYSE CSO A/D line, courtesy of Decisionpoint.com):
Under normal circumstances, we usually use our monthly Global Overbought/Oversold Model as cues to either go long in a substantial way or cut back on long positions (overbought indicators are notoriously bad timing indicators), but in this instance, we are going to use this to show the various divergences among the different country stock indices instead. This model was first discussed in our August 2nd commentary. As we mentioned in that commentary, 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. Following is our Global Overbought/Oversold Model as of the end of November 2007 (note that we have also added the CRB Total Return Index in this model since our August 2nd commentary):
As can be seen in the above table, while many markets remain relatively strong or neutral on a 3-month basis, there are many markets that have remained weak despite the latest rally since November 26th. This includes a couple of “commodity countries” (those being Australia and Canada), various Western European countries such as Ireland, Belgium, and Sweden – and surprisingly, Singapore and Taiwan. The weakness in Taiwan reflects continuing weakness in the semiconductor industry, while the weakness in Australia and Canada reflects the ongoing weakness in commodities, or more specifically, the materials sector. The lack of breadth in the global markets in the latest rally suggests something is amiss – especially in markets (such as Australia and Canada) which have been leading the commodity and global boom since late 2002. This is not unlike the weakness in the NYSE CSO A/D line that we mentioned earlier. The global credit crunch is now taking its toll.
Utilizing the same methodology we used to construct the global overbought/oversold model, I have also constructed s similar model for the ten major sectors of the S&P 500. Note that similar to the MSCI data we used for the above model, this also utilizes price indices only, as opposed to total returns (which include dividends paid as well as capital appreciation):
Interestingly, aside from the consumer discretionary and the financial sectors (and perhaps telecom services, but that sector makes up only 5% of the S&P 500 market capitalization), the remaining sectors of the S&P 500 still remain neutral to even overbought, especially on a six-month and 12-month basis. More importantly, in the last three instances when financials have corrected to the current extent (those being October 1990, August 1998, and September 2002), all the other sectors within the S&P 500 – including consumer staples and health care – have also sold off in a major way. Moreover, even though financials are now very oversold as shown on the above table, subscribers should note that from peak to trough, financials have “only” declined 18%, versus the peak-to-trough declines of 44% for the period ending October 1990, 23% for the period ending August 1998, and 30% for the period ending September 2002. Could this time be different? Or are investors already discounting the successful implementation of both the “Super SIV fund” and Hank Paulson's “subprime bailout” plan? Readers please stay tuned, but my guess is that this current rally is still merely a result of the severe emotional swings of investors and traders alike – and does not signal the beginning of a new bull market upswing.
Henry To, CFA