Identifying Short and Long Term Trends for 2008 - Part II
(January 6, 2008)
Dear Subscribers and Readers,
It is great to be back in Los Angeles and in “full force” – as we try to tackle what I believe will be the toughest market environment in five years over the next 3 to 6 months. I hope all our subscribers had a great New Year's – don't forget to go back and skim over your New Year's Resolutions every now and then!
In Part I of this commentary, we discussed our 2008 domestic equity outlook, as well as more thoughts on both the US energy supply/demand and demographical issues going forward. There were three main themes in our domestic equity outlook: 1) We haven't seen the worst of the latest “credit crunch” just yet, and that interestingly, the whole episode continues to be a sad “slow motion train wreck” which has been well-documented in advance and probably preventable in retrospect. Denial, at this point, is still in full bloom; 2) Once the latest correction is over, we will see new leadership – within the US, this author is now looking for the health care, consumer staples, and to a lesser extent, technology to outperform going forward, and 3) I believe there will be a great buying opportunity sometime over the next six months – which will coincide with a kind of “capitulation low” that we haven't witnessed since March 2003.
In this commentary, I will expand on our themes and discuss the foreign equity markets as well as the U.S. Dollar Index. Before I do that, however, I want to 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 1,155.82 points as of Friday at the close.
A great way to start off with our discussion on the foreign equity markets is to first review our Global Overbought/Oversold model. 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), and this is what we are going to do in this instance. 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. We also added the CRB Total Return Index since our August 2nd commentary. Following is our Global Overbought/Oversold Model as of the end of December 2007 (note that this does not take into account last Friday's global decline):
In Part I of this commentary, I discussed that Japanese small caps may be a buy at some point this year. This is confirmed by the oversold condition as implied by the Global Overbought/Oversold Model. Specifically, Japanese small caps are now oversold (below the 15th percentile, or approximately one standard deviation below the average) on both a 3-month and 6-month basis. A further decline in January would also put Japanese small caps into oversold territory on both a one and two-year basis – suggesting that it is now time to take a hard look at Japanese small caps. Another country to keep in mind is Ireland. It is now very oversold on a 3, 6, and 12-month basis. Moreover, the Irish financial system remains sound, and the weakness in its housing sector has gone on for longer than the US housing sector. From a valuation standpoint, Irish equities are now trading at a forward P/E not seen since the mid 1980s – when interest rates were nearly three times higher than today's. Within Ireland, my current pick is Allied Irish Bank ADR (AIB) – I will appreciate it if subscribers can send in any of their “Irish ideas.”
As for the UK and most other European stock markets, I am still staying away from them at this point, given the fact that the ECB has their hands tied (labor unions are asking for significant pay raises in the middle of a global credit crunch) and given the overvalued Euro on a purchasing power parity basis. Moreover, while real housing prices in the US appreciated about 50% from 1997 to 2005, they actually rose significantly more in countries on the “Continent,” with the UK seeing a 125%, Spain 120%, and France 80% appreciation during the same time period. Interestingly, while there are only about half a million excess homes in the US housing inventory, there are approximately one million in Spain alone. Coupled with rising wages and a Central Bank that is still hanging out to its tightening bias, there is no doubt that corporate profits in Western Europe should exhibit lower-than-expected growth this year.
As far as emerging markets goes, I believe the “decoupling” thesis is being strongly tested today – especially in light of the recent assassination of former Pakistani Prime Minster Benazir Bhutto, and the subsequent weakness in the Pakistani stock markets. At this point, the jury is still out, but I sincerely do not believe that emerging markets can effectively decouple from the weakness in the US stock market going forward, especially since the current weakness is being accompanied by a weakening Japanese, South Korean, and Western European economy.
Let us now discuss the U.S. Dollar Index. We last discussed the U.S. Dollar Index in our November 4, 2007 commentary (“The Various Bear Markets”). At the time, and subsequently in our commentaries and in our discussion forum, I had mentioned that a good buying point was only several weeks away. Now, I believe we will not see a good buying point until the February to March period at the earliest. I will get to the reason why in a second. For now, let us just take a look at a couple of indicators on the U.S. Dollar Index that I track on at least a weekly basis. One of the indicators is the growth in foreign reserves held in the custody of the Federal Reserve. While the growth in foreign reserves has decelerated over the last few months, it has continued to increase, 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 continued to slow down over the last couple of months, 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:
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 also been declining – 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 continues to slow down in the weeks ahead, and assuming that the U.S. Dollar Index remains weak, I believe the above chart will flash a “buy” on the U.S. Dollar Index sometime during the February to March period. 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, as along as there are no abnormal 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:
As mentioned on the above chart, the U.S. Dollar Index closed at 4.81% below its 200 DMA last Friday. While – by this measure – the U.S. Dollar is now 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, December 2004, or for that matter, just two months ago on November 30, 2007 – when the U.S. Dollar Index declined to as low as 8% to 10% below its 200 DMA. While the U.S. Dollar Index does not need to decline to 8% to 10% below its 200 DMA before I will go long, I would prefer to see the U.S. Dollar Index to make a lower low (below the 73 level) before going long – as well as accompanied by a greater divergence in the rate of annual growth in foreign reserves held in the custody of the Federal Reserve.
As far as the February to March timeframe goes, I believe that will be the time when the majority of investors start to discount a US recession – while at the same time, continue to discount decent growth for the Euro Zone, and perhaps the UK as well. This will also be the timeframe when the European Central Bank starts to realize that they will need to slash rates – and quickly – in order to avert a recession in the Euro Zone. As far as the UK is concerned, it is definitely way behind the curve (just like the Northern Rock “rescue”) in terms of its easing campaign – by the time this is all over, we may actually see the Bank of England easing more aggressively than the Fed, given that its economy is way more leveraged to the financial and housing sector, versus the US economy. Subscribers please stay tuned.
Let us now discuss the most recent action in the US stock market. Friday's action was nothing short of ominous. Aside from being a 90% downside day, we also saw a significant knock-down in the technology sector. This is the sector where many (smart) mutual fund managers and analysts have been bullish on over the last six months – and had been the main sector where they have been bullish on over the last several weeks, despite the continuing deterioration in the financial and consumer discretionary sectors, as well as the broader stock market. We also witnessed a new 52-week low in the Dow Transports, and a slightly lower low in the NYSE Common Stock Only Advance-Decline Line. Moreover, liquidity has tended to be more bullish during December and the first two weeks of January as the IPO and secondary offering calendar winds down. Given that the IPO backlog is now at a high $37 billion (versus $21 billion at this time last year) – investment bankers/underwriters will do all they can to push these shares out as long as the markets don't collapse (by far the biggest is the upcoming Visa IPO). Moreover, once “earnings season blackouts” are again lifted by late January, there is a good chance insider selling will ramp up again – again, as long as the markets don't collapse. Either way, liquidity will continue to be challenging going forward.
No matter how you look at the market, however, it is starting to get oversold. For example, the NYSE ARMS Index – an indicator that has aided me immensely in calling for oversold bottoms since we began writing our commentaries, just hit a of 4.23 at the close on Friday, the most oversold daily reading since the 15.77 reading on February 27, 2007 (and prior to that, March 24, 2003, when the it hit a reading of 5.01). Following is a daily chart showing the 10-day and 21-day MA of the ARMS Index vs. the daily closes of the Dow Industrials from January 2003 to the present:
As of Friday at the close, the 10-day and the 21-day NYSE ARMS Index closed at 1.66 and 1.37, respectively. Make no mistake: We are now seeing very oversold readings on the NYSE ARMS Index – readings that we haven't witnessed since early March 2007, and prior to that, August 2004. Unfortunately, this oversold condition isn't being confirmed by the NYSE Common Stock Only McClellan Summation Index, the VIX, or the percentage deviation of the either the Dow Industrials or the S&P 500 from their 200-day moving averages just yet. At the very least, I want to see another 3% to 5% decline in both the Dow Industrials and the S&P 500 over the next couple of weeks, as well as a VIX reading approaching the 30 level, before covering our 50% short position in our DJIA Timing System. Even should we cover our position, however, I most probably will not go long until (as we have mentioned before) I see more capitulation, such as 1) A high profile bankruptcy, whether it comes in the form of a domestic automaker, a national homebuilder, or a poorly-run bank that have originated a “generous” amount of subprime mortgages, 2) New highs in corporate bond, CMBS, and emerging market bond spreads, 3) Record high mutual fund redemptions on the part of retail investors, or 4) A dramatic decline in NYSE and NASD margin debt.
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 January 4, 2008, the Dow Industrials declined a whooping 565.69 points while the Dow Transports declined 365.18 points. For the Dow Industrials, this was the worst start since the year 1932. More ominously, the Dow Transports closed at a new low of 4,260.39, or a low not witnessed since September 11, 2006 (when the Dow Industrials closed at 11,396.84). The Dow Transports is more than 20% below its mid July highs and remains the weaker index – and given that it has been the leading index since this bull market began in October 2002, chances are that the Dow Industrials will break its November 26th low (currently only 57 points away) sometime over the next couple of weeks. 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 12.5% to 10.3% for the week ending January 4, 2008. 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 reading at 10.3%, the four-week MA is now oversold , although still not as oversold as it was during early September or early December of last year. This author would like to see sentiment decline back to those levels before we cover our 50% short position in our DJIA Timing System, especially given the strong downside breadth and the technical damage incurred last week. For now, we will stay with our 50% 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:
With the rise of the 20-day moving average of the ISE Sentiment Index to the 123.0 level over the last several weeks, the 20 DMA of the ISE Sentiment Index, while still oversold, is not yet at a level consistent with various market bottoms over the last 18 months. Again, given the strong downside breadth we saw last week, and given the lack of a “fully oversold condition” in this indicator and other sentiment indicators, I believe there is further downside to go. Again, until we get that oversold reading, I will not cover our 50% short position in our DJIA Timing System just yet.
Conclusion: As we move forward into 2008, two of the more attractive foreign equity markets, in this author's eyes, are the Japanese (especially Japanese small caps) and the Irish equity markets, from a fundamental, as well as a sentiment basis. While the global credit crunch will still no doubt do damage to these markets assuming the US stock market continues its decline over the next couple of months, my guess is that these markets will outperform going forward. I continue to be relatively bearish on the UK and the majority of the Western European markets, and am wary of the “decoupling thesis” of the emerging markets, especially the “BRICs.” As far as the U.S. Dollar Index is concerned, I believe we will see a huge buying opportunity at some point during the February to March timeframe – we will continue to update our subscribers on both our foreign equity and our US Dollar thesis going forward.
As for the US stock market, the strong downside breadth and the technical damage done to the equity markets last week is too strong to ignore – and most likely, we will see the Dow Industrials break its November 26th lows over the next couple of weeks, especially since U.S. market liquidity will no doubt be more challenging as insider selling restrictions are lifted and as the IPO calendar start ramping up later this month. While the US stock market is now getting very oversold, I am still wary of going long in a substantial way, until I see “greater capitulation” all around. For those subscribers who are looking to “bottom fish” various individual stocks, I would not do so here until we see a positive divergence in breadth (such as a new low in the major indices which is not accompanied by a new low in the NYSE CSO A/D line), since technically weak stocks such as these tend to be the last stocks to bottom in any major correction. However, given the significant “cash on the sidelines” that we are seeing in both retail and institutional money market funds, I believe there will be a great buying opportunity sometime in the next six months. For now, we will remain 50% short in our DJIA Timing System, and will most likely not cover unless the Dow Industrials decline another 3% to 5% over the next couple of weeks. Subscribers please stay tuned.
Henry To, CFA