Global Economic Growth Continues to Disappoint
(December 9, 2007)
Dear Subscribers and Readers,
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 330.42 points as of Friday at the close.
Before we go on to the “gist” of our commentary, I want to devote a few paragraphs to the state of our infrastructure in the US – an issue that we first discussed in our October 20, 2006 (“The World of Private Infrastructure Investments”). Aside from infrastructure demand in the booming parts of Asia (it is estimated that Asia will need to spend US$200 billion a year on infrastructure in order to maintain its current growth rates), there is no doubt that US infrastructure (such as roads, rails, airports, pipelines, dams, etc.) is also in dire need of upgrading or maintenance – as demonstrated by the I-35W bridge collapse in Mississippi on August 1, 2007. According to the American Society of Engineers' 2005 report card, approximately US$1.6 trillion is needed to bring our infrastructure up to “acceptable standards.” Following is a few examples demonstrating the sorry state of our infrastructure in selected States:
- Massachusetts: 36% of all bridges in this State are structurally deficient or functionally obsolete. In order to maintain the state's roads and rails at current levels, the State will need to spend $15 to $19 billion on maintenance alone over the next 20 years.
- Texas: Only 6 staff members are available to inspect over 7.500 dams on a regular basis. At the current rate, there will be some dams that will never be inspected in the next three centuries.
- New York: Due to aging water pipes, the State estimated that over one billion gallons of drinking water is lost every month. Not only do leaks result in water loss, they can also allow toxins and other chemicals to enter the state's drinking water.
- Louisiana: 31% of all bridges in this State are structurally deficient or functionally obsolete.
- California: 37 levees from are at risk of failure – far more than in any other State. Moreover, the levees that have been studied so far make up only a small part of the entire system. An additional 10,000 miles of levees still have not been inspected.
As I mentioned in our October 20, 2006 commentary, the time is getting ripe for a boom in private structure investments – especially if State budgets become severely constrained in the upcoming economic slowdown – thus forcing States to privatize or seek private capital to fund infrastructure investments (such as toll roads, bridges, parking garages, etc). An additional tailwind for a boom in private infrastructure investments will come if raw material prices start to decline – a trend which we are starting to witness already (base metal prices have peaked, although steel and cement prices have yet to follow). Finally, should construction spending and employment decline next year on a weaker housing and commercial real estate market, there will most likely be a huge push to create construction jobs by providing incentives to the private sector to fund infrastructure spending – especially since most parts of the world are still awash with capital. The biggest obstacle is mostly political in nature. From an investment standpoint, infrastructure investments are close to a “no-brainer,” given infrastructure's attractiveness for diversification purposes, especially for those investors with a long-term investment horizon (such as pension plans and sovereign wealth funds). We will continue to stay abreast of this asset class going forward.
Let us now get back to the subject of this commentary. As of Sunday evening, December 9th, we remain 50% short in our DJIA Timing System. As we discussed in our commentaries over the last couple of weeks, there are several reasons for our continued bearish stance – and those arguments remain in place, despite the stock market rally that we witnessed over the last few days. For example, as we mentioned in last weekend's commentary, TrimTabs, one of the most bullish publications (and who also “got it right” during the 2000 to 2002 bear market) over the last few years (including during the summer correction of 2006) has continued to be bearish on the US stock market, citing, among other factors, a) a decline in personal income growth, leading to less discretionary spending and less savings going into brokerage and retirement accounts, b) an IPO and secondary offering backlog totaling over $35 billion, one of the largest backlogs we have seen in this bull market, despite the fact that many large companies are choosing to list on other non-US exchanges, and c) a virtual freeze on cash acquisitions, given the recent LBO cancellations and lack of new LBO announcements (which is not surprising given the current credit crunch). This continues to hold true as of tonight. Moreover, the BLS is notorious for overstating employment gains during the transition to an economic slowdown/recession (and vice-versa when the economy is emerging out of recession). According to TrimTabs, employment growth over the last two months is probably 200,000 less than the official numbers from the BLS.
Furthermore, as we also mentioned last week, the NYSE Common Stock Only Advance/Decline Line did not confirm the new highs in the Dow Industrials or the S&P 500 in early October – a development that has not occurred since the bull market began in October 2002. In fact, the NYSE CSO A/D Line had already topped out in early July – three months prior to the most recent high. A non-confirmation of the NYSE CSO A/D Line of a new high in either the Dow Industrials or the S&P 500 usually signals selectivity, or in other words, a lack of general buying power. Over the last 50 years, such non-confirmations have always resulted in a correction in the Dow Industrials or the S&P 500 of 12 % or more – and sometimes, much more, such as during the 1973 to 1974 bear market or those fateful two months from late August to late October 1987. In other words, this is a classic warning sign of, at the very least, a more severe-than-normal stock market correction. If this were your typical “10% bull market correction,” then in all probability, there would not have been such a flagrant non-confirmation by the NYSE CSO A/D Line. Following is a three-year chart (courtesy of Decisionpoint.com) showing the NYSE CSO A/D Line and the NYSE Composite:
More ominously, the latest uptick in the NYSE CSO A/D line has been rather muted despite the impressive gains in both the Dow Industrials and the S&P 500. Furthermore, this weakness in the A/D line is also confirmed by the weakness in the NYSE CSO A/D Volume Line (which is the cumulative daily differences in NYSE CSO Advancing Volume and NYSE CSO Declining Volume) – suggesting that the most recent rally is very weak from both a breadth and a volume standpoint.
Of course, the Dow Industrials and the S&P 500 could always retest or even surpass their highs until we see a more severe decline. But given this continued weakness in breadth, the continuing credit crunch in most of the world's financial markets, the lack of “teeth” in the White House's subprime “bailout” plan, my guess is that both forward earnings and the stock market will continue to be weak over the next several months. Should the Dow Industrials move higher over the next several weeks, and should we continue to see a negative divergence in terms of weak breadth or a lower low in the NYSE CSO A/D line, there is a good chance we would shift to a fully (100%) short position in our DJIA Timing System.
Speaking of the general credit crunch – while CMBS, ABX, and credit spreads in general have eased over the last couple of weeks, the same cannot be said for the “TED Spread.” The TED spread is defined as the difference between the three-month LIBOR rate and the yield of the three-month Treasury bill, and is usually interpreted as the willingness of banks to lend to high-grade corporate borrowers or fellow banks. Following is a chart showing the TED spread (smoothed on a five-day basis) from January 1983 to the present:
While it is not obvious from the above chart, it has usually been a great time to buy stocks after a spike in the TED spread, such as during the July 1984, October 1987, December 1990, October 1998, and October 1999 spikes. However, there have been exceptions, such as during May 1987 and during the most recent spike in late August of this year. While the stock market did initially rally subsequent to the May 1987 and the August 2007 spikes, the market would eventually turn lower (the former much lower). In other words, a spike in the TED spread is not in itself a buy signal. Rather, the TED spread is a reflection of general credit conditions – conditions that also have an impact on the stock market. Should a spike in the TED spread (in our case, a new 20-year high in the TED spread) be not accompanied by a genuinely oversold condition in the stock market, chances are that the stock market will eventually fall further, as exemplified by the May 1987 and the August 2007 spikes. Given that the TED spread is now at a 20-year high, and given that the stock market did not get that oversold during the latest decline in late November, my guess is that the major market indices will eventually break their November 26th lows – whether it is later this month or early next year.
As implied by the title of this week's commentary, I would now like to update our subscribers on the latest readings in our “MarketThoughts Global Diffusion Index” (MGDI) – which we last discussed in our November 18, 2007 commentary (“Should We Even Pay Attention to Financial Stocks?”). As we discussed in that and in our October 7, 2007 commentary, given that as much as 50% of profits within the Dow Industrials and the S&P 500 is derived from outside of the US, we would never have gone short in our DJIA Timing System if we had believed that profit growth from outside the US would “make up” for an earnings slowdown or decline within the US. This was what happened in the US during 2Q 2007, as virtually 100% of year-over-year profit growth came from outside of the US, while domestic earnings remained stagnant. However, as we discussed in our October 7, 2007 commentary, there was a strong chance that much of the world's economy was slowing down as well, as implied by our MGDI indicator. If that was the case, then chances were that earnings expectations for many US companies would be coming down for the foreseeable future as well.
In our November 18th commentary, we concluded that global economic growth will continue to slow down in the months ahead, as implied by our latest MGDI readings. So what are the latest readings telling us? To recap, we first featured the MGDI in our May 30, 2005 commentary. For our newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for the 25 countries in the Organization for Economic Co-operation and Development (OECD). Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages. More importantly, the MGDI has historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI on two occasions – first by incorporating the leading indicator for the Chinese economy, and second by dropping the one for Turkey. The first revision is obvious; as China is now the fourth largest economy in the world and actually has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth this year is expected to surpass that of the US). The second revision is less obvious. While Turkey is by no means a small or marginal country, many of the readings over the last six months have been very unreliable (and have continued to be) – and so we have chosen to drop Turkey in our MGDI instead. This is rather unfortunate, but it is better to omit certain data points than to incorporate unreliable data.
Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the CRB Index and the YoY% change in the Dow Jones Industrial Average from March 1990 to October 2007 (the November 2007 reading will be updated and available on the OECD website in early January, but it should also be lower, given the dismal performance of the global stock markets during November). In addition, all four of these indicators have been smoothed using their three-month moving averages:
As we discussed in our February 25, 2007 commentary, “The strength of the MGDI is essential to keeping our U.S. economic slowdown scenario alive – as a slowing global economy in the midst of a U.S. economic slowdown can mean many negative feedback loops around the world's economies which could in turn induce a classic U.S. economic recession.” Ominously, as the above graph suggests, global economic growth (OECD + China - Turkey) has continued to decline since our last update on November 18, 2007 – suggesting that not only the chances of a US recession have risen (the ECRI's Weekly Leading Index is now at its lowest level since November 2002), but that a severe slowdown in many Western European countries and Japan is now very real. Should this slowdown persist for the next few months, then foreign corporate growth could start becoming a headwind – as opposed to being the significant tailwind that it has become over the last 12 months.
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 December 7, 2007, the Dow Industrials rose 253.86 points while the Dow Transports rose 215.06 points. From the bottom at the November 26th close, the Dow Industrials and the Dow Transports have rallied 6.9% and 11.2%, respectively. Despite this impressive rally, the fact remains that with both the Dow Industrials and the Dow Transports closing below their August 16th closes (the latter actually closed at a low not seen since September 2006) on November 26th, the technical damage has already been done. More ominously, the Dow Transports is still more than 10% below its mid July highs – and given that it has been the leading index since this 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 from last week's 5.4% to 4.7% for the week ending December 7, 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:
With the decline over the last two weeks, the four-week MA is now as oversold as it was during the summer 2006 and the late February/early March 2007 correction. However, even though sentiment has now turned quite dark, subscribers should keep in mind that the sentiment indicators is mostly meant to be a secondary tool, as these surveys simply cannot take into account the action of all US and global stock market investors. Given the weak buying power leading up to the early October highs, and given that the uptick in both the NYSE CSO A/D and A/D Volume Lines remains weak, chances are that we should at least see a retest of the November 26th lows, if not a further correction from those levels. For now, we will stay with our 50% short position in our DJIA Timing System, but we will not hesitate to go 100% short should the market continues to rally over the next couple of weeks on relatively weak breadth and volume.
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 decline of the 20-day moving average of the ISE Sentiment Index to 114.7 in the last two weeks, the 20 DMA of the ISE Sentiment Index is now very oversold. More importantly, the absolute level of the 20 DMA is now at a level that is consistent with various market bottoms over the last 18 months. This, along with our other sentiment indicators, suggest the potential of a further rally in the next couple of weeks – but should both upside volume and breadth fail to confirm any new highs in the major market indices going forward, there is a good chance that we will ultimately see a more severe correction over the next several months.
Conclusion: The weight of the evidence continues to suggest that we will at least retest the November 26th lows, especially given the continued weakness in our MGDI readings, suggesting that foreign profits may not be as much of a tailwind for corporate earnings as they have been over the last 12 months. Should the market continue to rally on relatively weak breadth and volume, however, then there is a high possibility of a more severe correction going forward – a correction that could potentially take us down to the early March 2007 lows in both the Dow Industrials and the Dow Transports. Moreover, the more I read and study the Administration's “subprime bailout” plan, the less I think it will have any impact (either short-term or lasting) on either the stock market or the economy – making it “too little, too late” – as subprime resets are set to peak in March 2008. For those subscribers who are looking to “bottom fish” various value stocks (such as Sears Holdings, Sprint, Citigroup, Freddie Mac, Home Depot, Dell, First Marblehead, Discover Holdings, etc.), I would not do so here until we have at least seen a retest on a positive divergence in breadth, since technically weak stocks such as these tend to be the last stocks to bottom in any major correction. Again, my sense going into 2008 is that volatility will be here to stay, at least until the second quarter of 2008. There are several implications: 1) A buy-and-hold strategy will continue to be frustrating, unless your definition of “buy-and-hold” means buying and holding for a few months, at the most, 2) There is a good chance that the signals in our DJIA Timing System will be more frequent, especially if we believe that the Dow Industrials will stay in a trading range for the foreseeable future (the jury is still out here), 3) at some point, we may see a general washout in the market that we haven't seen since the beginning of this bull market, as more traders and retail investors are “weeded out” of the stock market because of the upcoming whiplashes and volatility, and 4) A long strategy purely based on momentum or relative strength may not work as well as it has over the last five years.
As for the US Dollar Index, I will provide you with a more detailed update in next weekend's commentary, but for now, I still believe we will see more spike down in the U.S. Dollar Index – and I would not consider a long position in the US Dollar Index until this occurs. 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 between now and March 2008.
For now, we will also remain 50% short in our DJIA Timing System, but will not hesitate to shift to a 100% short position should the major market indices continue to rally on weak breadth/volume. Subscribers please stay tuned.
Henry To, CFA