Contrarian and Sentiment Indicators
(February 10, 2008)
Dear Subscribers and Readers,
I want to begin our commentary by reviewing our 7 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 447.87 points as of Friday at the close.
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 467.13 points as of Friday at the close.
Before we go on with our commentary, it is important to remember that ALL of our above signals – similar to the majority of our past signals – were initially met with wide skepticism and sometimes, even anger. For example, when we effectively went 100% long in late September 2006, we were met with emails and messages questioning why we would go long given the “impending four-year cycle low,” “bearish looking charts,” etc. This was again the case when we established a 50% short position in early October 2007. At that time, many folks were looking for a “blow off top” to end this bull market in light of the beginning of the Fed easing cycle. 225 basis points later, all the major equity market indices are lower than where they were in early October of last year. Today, the situation is no different. Many folks who missed the subprime crisis and its potential/current impact on the equity markets are now calling for more downside – not only in housing but in the equity markets as well. However, it is important to remember that – even if one can get the timing of the subprime/housing crisis correctly (and this is a big “if” not only for most retail investors, but for many Wall Street strategists and analysts as well), it does not translate to an automatic “tell” on the equity markets.
Henry, why do you say that? Doesn't a recession or a credit crisis automatically translate into a bear market for stocks?
As I have mentioned in our commentaries over the last several weeks, it is important to keep in mind that the latest bubble has been in U.S. housing and structured finance products that were related to U.S. housing. Undoubtedly, this can also be extended into residential (and some commercial) real estate in other parts of the world, such as the UK, France, Australia, Spain, India, and so forth. The point is: Unlike the late 1990s – when the bubble was centered on U.S. large cap growth stocks (technology as well as others like Home Depot, Wal-Mart, etc.), the current bubble was centered on something else. That means the “2000 to 2002 playbook,” or following the path of the 2000 to 2002 bear market, at least when it comes to predicting the future path of U.S. equities, is non-sensical. More importantly, similar to the aftermath of the 1990s large cap growth bubble, the Fed is now utilizing monetary policy to target the subsequent economic weakness, as opposed to policies that directly address the housing bubble. We can argue the pro/cons and the effectiveness of this policy all day, but it is important to remember that: 1) In the tradition of the Greenspan Fed, the Bernanke Fed does not consider the “most likely” scenario when it comes to implementing policy, but a “worst-case scenario” that has a reasonable chance of occurring. Hence, in the midst of a credit crisis, the Fed will always accommodate market participants and will more often than not surprise by easing more than market participants expect; 2) To the extent that the Fed bails out market participants, its target is generally the average U.S. consumer, and not overstretched folks who bought houses and paid more than they can afford via exotic means. This has the effect of “cushioning” the U.S. economy without posing “moral hazard” problems or “socializing losses” further down the road. Most likely, this will also mean any “excess liquidity” will flow to asset classes that were generally not in bubble territory during the last few years (such as U.S. equities), similar to the performance of U.S. REITs during the 2000 to 2002 bear market in stocks (REITs rose 26.4%, 13.9%, and 3.8% during the 2000, 2001, and 2002 calendar years, respectively). While I am not predicting a 20% rise in U.S. equities in 2008, subscribers should keep in mind that U.S. equities (excluding energy and materials), as we have discussed many times before, are still one of the most undervalued asset classes in the world, especially compared to government bonds, commodities, and global REITs (one can still find some value in private real estate). Combined with the fact that the U.S. dollar is also very undervalued, especially relative to the Euro, British Pound, and Australian dollar, the global allure of U.S. equities will get stronger as global estate comes down in price and as the global economy starts to slow down. While the short-term is “anything goes,” I would not be surprised if the Dow Industrials hits the 20,000 level in four to five years time (this translates to an 11 to 14% annualized return over the next four to five years, which in actuality, isn't that aggressive) as global capital rotates to U.S. equities going forward.
As far as the possible impact of a recession on U.S. equity prices, we had discussed this in last weekend's commentary (“Looking Beyond a Recession”). Specifically, if we follow the timeline of the late 1990 to early 1991 recession (which in many ways, is more comparable to today's economic environment than the 2001 recession), the Dow Industrials or the S&P 500 should bottom out during the first month of the first quarter that the U.S. experience negative GDP growth. Assuming we experience negative GDP growth during this quarter, and assuming that the U.S. only experiences a mild recession,, then the stock market, in all likelihood bottomed out in late January. This assertion is made all the more conceivable given that information travels much more quickly than it did in the pre-internet days of the early 1990s. If the U.S. does indeed experience a recession this year, it would definitely be the most anticipated recession in U.S. history.
Let us now take a look at a contrarian/sentiment indicator that we have discussed in the past – but which we have not updated as frequently for our readers. Newer readers may not know this, but the Conference Board's Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint. While it has always been significantly better in calling bottoms during a bear market, it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market – with one of its most successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90. During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points. More recently, the Consumer Confidence Index gave us a “strong buy” signal during October 2005, and foretold the beginning of a bear market with its “rounding top” during the first half of 2007. Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to January 2008:
The last time the Consumer Confidence Index gave us such an oversold reading was at the end of October 2005 – the Dow Industrials would go on to rally over 15% over the next 12 months. The fact that this reading is now at a similar level to that of the October 2005 (not to mention the October 2001 reading) suggests that subscribers who are still cautious should start to think about implementing long positions in the stock market, if they had not done so already. This signal is especially powerful given the once-in-a-decade/generation oversold readings that we saw in the stock market (as exemplified by the new 52-week high/low readings, the NYSE ARMS Index, % of stocks above their 200-day EMAs on both the NYSE and the NASDAQ, etc.) during late January.
Another sentiment indicator – the insider buy-to-sell ratio, most recently at 1.44 for the month of January – is now at its highest reading since 1994/1995 – immediately before the tremendous “bull run” we experienced during the late 1990s. Prior to 1994/1995, the only instances when we experienced similar (bullish) readings in the insider buy-to-sell ratio was late 1990 (right at the bottom of the late 1990 to early 1991 recession) and early 1988, or immediately after the October 1987 crash. Following is a chart, courtesy of Bloomberg, showing these instances as well as the amount of short interest on the NYSE:
Given the recent popularity of 120/20 and 130/30 funds, the recent spike in the NYSE short interest should be taken with a grain of salt – at least in terms of its predictable powers of the stock market going forward. However, one thing is undeniable: Company insiders have historically been “correct” on the future direction of the U.S. stock market when they have acted in such a bullish manner. Even with the aggressive company buyback programs over the last few years, company insiders have never bought this much shares relative to how much they are selling since 1995. Again, while the stock market can “do anything” over the next few months, I continue to be long-term bullish on the U.S. stock market, especially in selected companies within the consumer discretionary, financial, health care, and technology sectors.
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 February 8, 2008, both the Dow Industrials and the Dow Transports declined – with the former declining a whooping 561.08 points and the latter declining 95.69 points. While the Dow Industrials managed to give up all its gains from the week prior, the Dow Transports continued to exhibit relative strength, declining only 2% for the week (note that it rose more than 7% in the week prior). Again, the strength of the Dow Transports over the last four weeks is very telling (especially in light of a strengthening oil price last Friday), as the Dow Transports has been the leading index since this cyclical bull market began in October 2002. Coupled with the severe oversold condition in the U.S. and global stock markets three weeks ago there is a very good chance that we have already seen a bottom on January 22nd, even though retail investors should continue to be jittery over the next several months. For now, we will stay 100% long in our DJIA Timing System.
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 finally bounced - increasing from last week's -8.4% to -8.1% for the week ending February 8, 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:
Even with the slight bounce in the latest week, the four-week MA is still (excluding last week's reading) at its most oversold level since April 2003. Moreover, the 10-week MA (not shown) again declined – from last week's 1.8% reading to 1.4% this week – its most oversold level since May 2003. Given this and other factors we have previously discussed, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should the fiscal stimulus be not implemented in time for the checks to start arriving by May,
More significantly, we continue to witness persistent pessimism in the AAII survey. Four weeks ago, the AAII survey flashed a bulls-bears % differential reading of -39% - its most oversold reading since the week ending November 15, 1990, when it registered a reading of -43%, and coinciding with a multi-year buying point for the U.S. stock market. Since then, the AAII readings have continued to be pessimistic (which is bullish from a contrarian standpoint). On a longer-term basis, the oversold condition in the AAII is also evident from its 52-week moving average, as shown in the following chart from July 1988 to the present:
As shown on the above chart, the 52-week moving average of the AAII Bull-Bears% Differential readings touched a multi-month low of -2.4% in the latest week, which is even more oversold during the March to April 2003 lows (when it bottomed out at -1.6% in the week ending April 4, 2003), and is now at its most oversold level since April 1994 (when it bottomed out at -2.5%). Make no mistake: From a sentiment standpoint, we are now approaching or have already witnessed 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:
With the 20-day moving average of the ISE Sentiment Index remaining steady at 97.9 (its most oversold level since October 30, 2002) and the 50-day moving average declining to 109.1 in the latest week, the ISE Sentiment Index is now extremely oversold and has “sold off” to a level that is close at or close to the October/November 2002 lows. Given the capitulation bottom that we saw on January 22nd, and given the immensely oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, I believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500. For now, we will stay with our 100% position in our DJIA Timing System, and will most likely only scale back if we get a spike in our most popular sentiment indicators.
Conclusion: With the vast majority of our contrarian/sentiment indicators are now hitting multi-year lows, and given the Fed's accommodative stance and the immense amount of cash currently on the sidelines (which we have discussed in our last several commentaries), chances are that we witnessed a significant bottom on January 22nd. While anything can happen in the short-run, we believe that there is a little downside in U.S. (and Japanese) equities at current levels. For long-term investors, the market continues to be a “buy.” Subscribers should remember that over the long-run, the danger continues to be an overweight of cash in your liquid portfolio – which, as modern history have demonstrated – is a sure way to the poor house over the long-run.
Again, many folks had conveniently forgotten that we just had a bubble in U.S. housing, not in U.S. equities. Since the Federal Reserve, the Administration, and Congress are essentially targeting the “average American” when it comes to Fed easing and the fiscal stimulus – as opposed to extended/subprime U.S. homeowners, it is not inconceivable to see some of this “excess liquidity” spill over into the U.S. equity markets – similar to what housing experienced during the last easing cycle from early 2001 to mid 2003, even as U.S. stocks continued to deflate. For now, we will stay with our 100% long position in our DJIA Timing System. I also continue to be bullish on U.S. consumer discretionary and certain financial shares (please see Rick Konrad's latest guest commentary for some suggestions on the consumer discretionary/retail side). We will only look to par down our positions should our most popular sentiment indicators start to get overbought, or should liquidity levels start to wane. Finally, given the tremendous valuations (not to mention its hugely oversold condition) we are now seeing in the Japanese stock market, I think it is now time to start nibbling on Japanese equities, especially Japanese small caps.
Henry To, CFA