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Reflation Soon?

(January 13, 2008)

Note: As many of my subscribers may know, I am also a co-author of The Retirement Advisor, a monthly publication geared towards more conservative investors who do not want to time the markets and who are more interested in issues of asset allocation, retirement, savings vehicles (such as CDs), and mutual funds.  For those who are interested, I want to offer our January 2008 issue as a sample.  In this issue, aside from a summary of our portfolios' performance in 2007, we also discuss where one can get the highest CD rates, a sound withdrawal strategy from your retirement portfolios, as well as a summary of the various mutual fund families we discussed in 2007 (two of our recommended mutual funds were named Morningstar's “Fund of the Year” in their respective categories).  Subscription information is outlined at the back of the newsletter as well as on our website.

Dear Subscribers and Readers,

As all of my subscribers should know, we made a very substantial change in our DJIA Timing System last Wednesday morning, covering our 50% short position that we had initiated on October 4, 2007 at a DJIA print of 12,630 at a 1,326-point profit.  At the same time, we initiated a 50% long position.  Following is an update on our six 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 on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 23.70 points as of Friday at the close.

Our decision to reverse our 50% short position and go 50% long was discussed in our Tuesday evening commentary.  Aside from a severe oversold condition in the U.S. stock market, there were also numerous signs of capitulation, such as rumors of an inevitable bankruptcy in Countrywide Financial and a Tuesday afternoon decline that was exacerbated by AT&T announcement that implied a substantial economic slowdown.  I also discussed (and as alluded to in our November 11, 2007 commentary) that should the S&P 500 decline to or below the 1,375 level, there was a good chance that the Federal Reserve will orchestrate an inter-meeting rate cut, a la the “Bernanke Put.”  While we did not get a surprise rate cut, we did witness many similar developments.  For example, on Thursday, Fed Chairman Ben Bernanke issued a statement indicating that the Fed stood ready “to take substantive action” in order to prevent the economy from falling into a recession.  Even William Poole – the St. Louis Fed President who is traditionally a hawk – recently came out with remarks that were uncharacteristically dovish.  For Bernanke, this was a dramatic departure, as unlike Alan Greenspan, Bernanke has tended to make decisions by committee and consensus so far in his tenure as Fed Chairman.  More importantly, this should also provide tremendous confidence to the markets going forward – as the markets have traditionally looked much more kindly on a leader/dictator (a la JP Morgan, Paul Volcker, and Greenspan) as opposed to a ruling committee on Fed policy during times of crises.  Finally, talks of a Countrywide “bailout” started to become rampant on Thursday afternoon.  By Friday morning, the deal was already sealed.  In a “special alert” to subscribers on Thursday afternoon, I stated:

Today was an important today.

From Bernanke's statement today, we now know the "Bernanke Put" has a strike price of 1,375 on the S&P 500. This is the level which I have been discussing since early November, and is also a good support level which represents the bottom in early March 2007.

Secondly, not only will the Countrywide buyout (assuming it goes through) remove a substantial amount of "systematic risk" from the financial system, it will also remove a significant competitor for bank deposits (CFC and ETFC have been upping their deposit rates in order to remain liquid). This will lower rates on the short end of the curve immediately.  Now, as the Fed again cuts rates, this will reliquify the entire system as the yield curve further normalizes.

I think the financials have, in general, bottomed out here, assuming the CFC transaction goes through.

There is now no doubt that the Federal Reserve is doing all it can – with the help of the private sector (the ones that still have cash, such as JPM and BAC) and sovereign wealth funds – to defend 1,375 on the S&P 500 and to actively remove as much “systematic risk” as it possibly can.  For now, and assuming that the JP Morgan's acquisition of Washington Mutual goes through, it does look like that liquidity conditions are gradually loosening.  This is being confirmed by the decline in the “TED spread,” 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 1994 to the present:

5-Day Simple Moving Average of the TED Spread (January 1994 to Present) - The TED spread hit a 20-year high in mid December, but has since declined back to the 1.4% level. Should the Fed ease by 50 basis points on January 30th, there is no doubt this will ease back to below the 1.0% level. The decline in the TED spread not only suggests that liquidity issues are now gone, but most probably that we have witnessed (or about to witness) a significant low in the U.S. stock market.

Given that the TED spread was at a 20-year high as recently as three weeks ago (the highest since October 1987), and given the Countywide buyout and the impending Washington Mutual acquisition, there is a good chance that we have already seen the high in the TED spread for this cycle.  Moreover, should the Fed cut by 50 basis points (or more) in the upcoming Fed meeting on January 30th, there is no doubt that this will ease back to below the 1.0% level.  Assuming that the Washington Mutual acquisition goes through, and assuming that both Citigroup and Merrill Lynch is able to secure the necessary capital that the Wall Street Journal has advertised over the next couple of days, there is a good chance that we have already or will see a low in the financial sector during the upcoming week.  For those that are already holding C or MER, the greatest risks (at least in the upcoming week anyway) will be dilutive in nature – as opposed to liquidity or even credit risks.  Interestingly, despite a 246-point down day on the Dow Industrials last Friday, financial stocks actually closed positive for the day.

Speaking of liquidity, I also want to discuss stock market liquidity, or as we have mentioned before, our “cash on the sidelines” indicator.  This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge of how oversold the US stock market really is – as well as how sustainable a current rally may be.  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 (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to January 2007 (updated with January 11th data for the month of January):

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to January 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash.  2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio rose to 23.41% at the end of last week, due to the latest surge in money market fund assets and the recent decline in the S&P 500, and hitting a high not seen since April 2003 (and nearly on par with October 1990). Over the longer run, a reading of over 20% is on the high side and should be supportive for stock prices over the next 12 to 24 months. That being said, that does not mean that this ratio cannot go higher - but chances are that the market will be higher for the rest of 2008.

As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 23.41% - a level that has not been seen since the end of April 2003, and on par with the reading at the end of October 1990.  While this ratio is not a great timing indicator, what it does show is the amount of “fuel” for a sustainable stock market rally going forward.  Moreover, such a reading is very high on a historical basis and should be supportive for stock prices over the next 12 to 18 months.  Even though the stock market can do anything over the short-run, my guess is that there is a maximum downside of only 5% from current levels – barring the failed acquisition of Washington Mutual or a less than 50 basis point rate cut from the Fed on January 30th.  Moreover, the Fed will also need to address the dismal growth of the St. Louis Adjusted Monetary Base (the 10-week moving average of the St. Louis Adjusted Monetary Base is up a mere 1.6% over the last 12 months).  However, unless we witness a collapse of the banking sector such as what we witnessed in the early 1980s (note that this ratio spiked quite dramatically from January 1981 to late 1982), chances are that stock prices will be higher 12 to 18 months from now.

Over in the Pacific area, we have also been witnessing a significant amount of capitulation in the form of a crashing Nikkei.  In fact, since the Nikkei topped out on July 9, 2007, it has declined over 22% in the space of six months.  As of Friday, the Nikkei closed at 14,110.79, its lowest level since November 15, 2005.  Moreover, the Nikkei is now 16.12% below its 200-day moving average, as shown in the following daily chart (showing the Nikkei vs. its percentage deviation from its 200-day moving average from January 1995 to the present):

Daily Chart of the Nikkei vs. its % Deviation from its 200 DMA (January 1995 to the Present) - Last Friday, the Nikkei hit a bear market low of 14,110.79 - or 16.12% below its 200 DMA. Based on this statistic, the Nikkei is now at its most ovesold level since March 11, 2003!

Based on this statistic, the Nikkei is now at its most oversold level since March 11, 2003.  In addition, over the last 13 years, virtually all declines in the Nikkei (with the exception of the post-911 decline) have stopped when the Nikkei reached a level that is close to 20% below its 200-day moving average – recession or no recession.  Given that more than 50% of stocks on the Tokyo Stock Exchange are now trading below book value, and given the severe Japanese underweighting of many international mutual funds here in the US, my guess is that the Nikkei is now in the midst of bottoming out.  I continue to believe that Japanese small caps are approaching a significant buying point – and may come as early as this week. 

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 January 11, 2008) - For the week ending January 11, 2008, the Dow Industrials declined 193.88 points while the Dow Transports declined 72.79 points. While this author is now bullish on the major US market indices, that view is based on two overriding ideas: 1) The hugely oversold condition and potential *capitulation* in the US financials and consumer discretionary sectors, and 2) Our view that the Fed will adopt a more accommodating stance going forward. In the meantime, the technical damage is still with us, although the chances of at least a short-term bounce here remains very high. Should the Dow Transports (which has been the leading index since this bull market began in October 2002) break its Tuesday closing low of 4,146.46 on a closing basis, then we may have to rethink this scenario. Bottom line: Subscribers should continue to be cautious.

For the week ending January 11, 2008, the Dow Industrials declined 193.88 points while the Dow Transports declined 72.79 points.  In last weekend's commentary, I stated: “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.” 

The Dow Industrials broke its November 26th closing low sooner than we had anticipated.  Combined with the NYSE 10-day ARMS Index reading of 1.84 last Tuesday and the many Fed's accommodative signals late last week, this was enough to get us to cover our 50% short position in our DJIA Timing System and to go 50% long at the same time.  In the meantime, however, the technical damage is still with us (although the Dow Transports is still above its August 11, 2006 low of 4,141.62).  While this will take at least a few weeks to repair, I am currently comfortable with our 50% long position.  Moreover, chances are that we will shift to a 100% long position should we see more weakness in Monday's trading – especially since quarterly contributions for calendar-year defined benefits pension plans are due on January 15th, which would in turn provide more liquidity for the U.S. and global stock markets.  However, should the Dow Transports break its Tuesday closing low of 4,146.46 and its August 11, 2006 closing low of 4,141.62 in a substantial way, then we will have to seriously rethink our bullish scenario.

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 10.3% to 3.9% for the week ending January 11, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending January 11, 2008, the four-week MA of the combined Bulls-Bears% Differentials declined a whooping 6.4% - from 10.3% to 3.9%. This reading is now very oversold and is on par with the readings we got in early September and early December, when it reached lows of 2.6% and 4.7%, respectively. Moreover, the 10-weem MA (not shown) is now at 6.7% - representing the most oversold reading since late August 2006. Given the postive divergences we witnessed at the end of last week, I expect the market to enjoy a substantial bounce over the next few weeks. At this point, we will stay 50% long in our DJIA Timing System, potentially moving to a 100% long position sometime this week.

With the reading at 3.9%, the four-week MA is now very oversold, and is on par with the readings that we got during early September and early December of last year.  Given this and other factors we have previously discussed, not only did it make sense to cover our 50% short position in our DJIA Timing System, I am also now comfortable with a 50% long position in our DJIA Timing System, and potentially go 100% long sometime this week if we get the right conditions.

However, the big news last week was the prevalent pessimism in the AAII survey – with a Bulls-Bears% Differential of -39% for the week.  This weekly reading is now at its most oversold since the November 15, 1990 weekly reading, when it registered a reading of -43%, and prior to that, the October 19, 1990 weekly reading when it registered -54%, coinciding with a multi-year buying point for the U.S. stock market.  On a longer-term basis, the oversold condition in the AAII survey can also be witnessed by tracing out its 52-week moving average, as shown in the following chart from July 1988 to the present:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (July 1988 to Present) - The 52-week moving average of the AAII Bulls-Bears% Differential touched a low of 0.8% in the latest week, representing the most oversold level since May 2003, and prior to that, August 1994..

As shown on the above chart, the 52-week moving average of the AAII Bull-Bears% Differential readings touched a multi-month low of 0.8% in the latest week, representing the most oversold reading since May 2003, and prior to that, August 1994.  Make no mistake: From a sentiment standpoint, we are now approaching a multi-month buy signal.

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 3-month low of 113.9 on December 5th, the 20 DMA of the ISE Sentiment staged a brief bounce and is now back at the 115.0 level. Both the 20 DMA and the 50 DMA are now oversold. More importantly, the latter is now at a level consistent with various market bottoms over the last 18 months. Given the positive divergence that we witnessed in the markets last week, and given the oversold condition per the ARMS Index and this sentiment indicator, I believe that there is little downside here. For now, we will stay 50% long in our DJIA TIming System, and look to go 100% long, perhaps as early as this week.

With the 20-day moving average of the ISE Sentiment Index declining to 115.0 and the 50-day moving average to 117.8 in the latest week, the ISE Sentiment Index is now severely oversold.  More importantly, the ISE Sentiment Index has now “sold off” to a level that is consistent with various market bottoms over the last 18 months.  Given the positive divergences that we witnessed last week, and given the oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, I believe there is limited downside from current levels, although I would not be surprised if we retest 1,375 on the S&P 500.  For now, we will stay with our 50% position in our DJIA Timing System, and possibly go 100% long sometime this week.

Conclusion: Since the beginning of this year, many “pundits” who were previously bullish or optimistic on the U.S. stock market has now turned decidedly bearish.  Not only can this be witnessed in the mainstream media, but also in the latest 2008 Barron's Roundtable as well (interestingly, Bill Gross and Marc Faber – who were bearish in January 2007 and who were the only ones that “got it right” – are now relatively bullish on the U.S. stock market).  The argument usually goes something like this: “Since the end of World War II, the U.S. stock market has declined anywhere from 15% to 30% during a recession, and so we have more downside to go in this cycle.”  I would argue otherwise.  First of all, there are not enough cycles since the end of World War II to constitute even a weak sample, statistically speaking (in other words, every economist who cite this as a reason has just failed high school statistics).  Second of all, the period since October 2002 is unlike any we have witnessed in modern history – in that the U.S. economy is no longer the driver of global economic growth.  Rather, China, India, and other large emerging market countries are now “doing the driving,” especially on the infrastructure side, and to a lesser extent, consumer spending.  If the U.S. economy had entered into a recession only ten years ago, then there would be no doubt we would have had our bear market already, as the energy, materials, and industrials sectors would have collapsed along with the financials and consumer discretionary sectors.  On the other hand, I believe that the financials and consumer discretionary sectors have already discounted a mild recession for 2008.  Unless we are entering a global recession (global GDP growth is still projected to be over 3.5% this year), then chances are that we are now approaching a significant low for the S&P 500.

Moreover, we will most likely shift from a 50% long position to a 100% long position in our DJIA Timing System sometime early this week.  Should the Dow Industrials continue to weaken during Monday's trading, we will most likely go long on Monday, right before the Citigroup earnings announcement on Tuesday morning.  Given the dramatic spike in new 52-week lows on both the NYSE and the NASDAQ Composite last week, and given the positive divergence towards the end of last week, my sense is that this is now a good time to “bottom fish” various individual stocks, although I would still hesitate if a stock remains technically weak.  Finally, given the significant “cash on the sidelines” that we are seeing in both retail and institutional money market funds, I believe any rally that emerges from current levels will be sustainable at least for 3, and possibly 6 months.

Signing off,

Henry To, CFA

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