The Message of the MarketThoughts Global Diffusion Index
(March 9, 2008)
Dear Subscribers and Readers,
I realize that this is a tough time for many subscribers who are currently long the U.S. stock market. I continue to believe that we are now close to the bottom of have already experienced a bottom in the U.S. stock market during the intraday lows of January 22nd, given:
- The severe oversold conditions as exemplified by the NYSE ARMS Index, the new highs vs. new lows on both the NYSE and the NASDAQ, the % of stocks above their 200-day EMAs on both the NYSE and the NASDAQ, and the very decent valuations among many of the S&P 500's components, especially relative to U.S. Treasuries, TIPS, commodities, and even REITs.
- The severe pessimism among retail investors, as exemplified by the 17-year lows in the AAII Bull-Bears Differential readings, the record low ISE Sentiment readings, the 10-day MA reading of 0.85 on the equity put/call ratio (the most oversold reading since January 18, 2007, and prior to that, August 19, 2004), and the lowest consumer confidence level (as published by the Conference Board) since March 2003.
- The unprecedented sources of capital sitting on the sidelines that are set to tack on more risk as soon as the most severe problems of the credit crisis are solved. In particular, the amount of money market assets as a percentage of the S&P 500's market cap is now at a high not seen since July 1982 (surpassing the February 2003 high) – not to mention the fact that there is also an unprecedented amount of global capital that was not available for investment in February 2003, let alone July 1982 (immediately preceding the biggest market bull in modern history).
More importantly, not only has the Federal Reserve committed to a continuance of the current easing cycle (as articulated in our commentaries over the last couple of months) it has now also committed to the accommodative policy for longer than previously expected – a policy articulated by Timothy Geithner, President of the NY Fed and Vice-Chairman of the Federal Reserve, last Thursday. This is an important development. In a speech in December of last year, Paul Tucker (member of the Monetary Policy Committee and the BoE) discussed the so-called "reaction function" which helps determine rates and monetary policy. One of the more "inputs," aside from the current policy rate, is a reasonable expectation of where rates could be further down the road. In other words, in order to induce the financial sector to start expanding the balance sheets again, the Fed will need to reassure financial participants that they will keep rates low for the foreseeable future - as opposed to quickly raising them once the current crisis is over and once spreads have come down (which was the market's expectations before Geithner's Thursday speech). That is, in addition to a bailout, the financial sector wants something close to a free lunch further down the road - which is not unreasonable to expect given that we're currently still in the deleveraging process. Judging by Geithner's recent speech, it is now doubly obvious that the Fed is trying to induce the financial sector to start expanding its collective balance sheets again. Moreover, given the continuing spike in credit spreads and the widening in agency spreads late last week, it is now obvious that the liquidity situation is getting rather acute – and that in all likelihood, the “neutral” monetary policy rate is now significantly below 2%, as originally articulated in our February 17, 2008 commentary (“Taylor Rule Targeting a Fed Funds Rate Below 2%?”), and recently by Paul McCulley from PIMCO. While the 75 basis point FFR cut on March 18th is now a given, don't be surprised if the Fed overshoots that and cuts by 100 basis points instead. We are living in interesting times, indeed.
Before we go to the rest of our commentary, let us now review 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 736.31 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 178.69 points as of Friday at the close.
While I am not happy with our performance in our DJIA Timing System over the last couple of months, I continue to have confidence in our position. Moreover, our long-term track record remains sound, as demonstrated in our signals going back to both 2006 and the inception of the system (I will provide an update on inception-to-date performance later this month).
Let us now get on with our commentary. We last discussed the MarketThoughts Global Diffusion Index (MGDI) in our December 9, 2007 commentary (“Global Economic Growth Continues to Disappoint”) – arguing that global economic growth will continue to slow down in the months ahead, as implied by the MGDI readings from last December. To recap, we first featured the MGDI in our May 30, 2005 commentary. For 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 CRB Index and the CRB Energy 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 has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth last year surpassed 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. So what are the latest readings telling us?
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 CRB Energy Index from March 1990 to January 2008 (the February readings will be updated and available on the OECD website in early April). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Note the divergence of the year-over-year change in both the CRB Index and the CRB Energy Index vs. that of the MGDI (and its second derivative) since September of last year. Given the historical (positive) correlation with OECD growth and the rise in commodity and energy prices since the fall of the Berlin Wall, there is no reason to expect this continued divergence. At this point – it is reasonable to believe that the bulk of the recent rise in commodity and energy prices have been due to short-term supply issues, short-covering, and the panic over the 1970s concept of “Stagflation,” which few professional economists and forecasters actually understand. As I have mentioned before, as Jack Treynor discussed in his 2003 paper “A Theory of Inflation,” lower interest rates should eventually lead to lower oil and other commodity prices – to the extent that commodity price inflation is being caused by supply constraints. Why is this the case? Consider a present value or IRR study on a new drilling and development project in the deepwater parts of the Gulf of Mexico. If the planner decides that low interest rates are here to stay, then future projections of both crude oil prices and profits do not need to be as high to make the project feasible to executive management. In such a scenario, oil companies will choose to increase expenditures for exploration and drilling projects, which will in turn increase both reserves and production going forward. Furthermore, given that crude oil prices are now over $100 a barrel, and given that many participants are now projecting demand to continue to grow steadily going forward, many participants – such as venture capitalists, private equity firms, and scientists – are now seriously devoting significant resources and time to the alternative energy sector. This is exemplified by the recent “doctrine” on the natural resources sector by Russell Read, the Chief Investment Officer of CalPERS, as mentioned in our last weekend's commentary. All of these will act as deflationary force on commodity and energy prices over the long-run.
As an aside, for those who are continuing to look for continuing inflationary pressures (or stagflationary pressures) in the U.S. economy over the next 12 months, it is to be noted here that the ECRI Future Inflation Gauge for the US just hit a new cycle low for the month of February. At the same time, its Future Inflation Gauge for the Euro Zone is continuing to experience very high readings – which somewhat justifies the ECB's tough stance given its sole mandate to target inflation within the system. More importantly, despite decent economic growth from 2003 to 2006, both consumer prices and labor costs have continued to remain steady. Now that the economy is stalling – and given our very flexible labor markets – it does not make too much sense to expect a wage spiral – thus driving long-term inflation higher – going forward. On the other hand, despite a slowing economy, much of the Euro Zone's labor force (which is highly unionized) have been and are still calling for substantial wage increases. At this point, the divergence in the Fed's and ECB's monetary policies continue to make sense, although I continue to believe that the ECB should ease at some point later this year.
Let us now take update 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 February 2008:
The last time the Consumer Confidence Index gave us such an oversold reading was at the end of March 2003 – the Dow Industrials would go on to rally nearly 30% over the next 12 months. The fact that this reading is now at a similar level to that of March 2003 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.
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 March 7, 2008, the Dow Industrials declined 372.70 points while the Dow Transports declined 60.34 points. For the first time in three weeks, the Dow Transports exhibited greater strength than the Dow Industrials. More importantly, this also resulted in a non-confirmation of the Dow Industrials on the downside (since it broke its January 18th closing low) by the Dow Transports, as the latter is still more than 7% above its January closing low, despite the failure of the Delta-Northwest merger and record high crude oil prices. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, this latest development suggests that the recent weakness in both the Dow Industrials and the broad market is overdone. 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 declined from last week's reading of -5.0% to -7.0% for the week ending March 7, 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:
Given the severely oversold condition in this sentiment indicator, and given that there is a good chance it bottomed out at -8.4% five weeks ago, my sense is that the broader market has either bottomed out or will bottom over the next couple of weeks. Given the readings of this sentiment indicator, the relatively successful rescue of Ambac late last week (not to mention the announcement of the many insider buys last Friday), 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 Fed back away from its aggressive easing campaign.
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 declining to 88.9 and the 50-day moving average declining to 97.9 in the latest week, the ISE Sentiment Index again has again hit a record low for the week – i.e. even more oversold than where they were at the October 2002 lows. Given the historically oversold condition of the stock market, the severely pessimistic sentiment on the part of retail investors, the unprecedented amount of capital sitting on the sidelines, and the promise of more Fed easing, I continue to believe we have already witnessed (or are witnessing) 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 only scale back if the Fed backs away from its easing campaign or if the monoline rescue fails to go through.
Conclusion: Given the severe divergence in the change in the MarketThoughts Global Diffusion Index versus the change in the CRB and the CRB Energy Indexes, it is a matter of time before commodity and energy prices top out – especially after the short-term supply issues dissipate. Moreover, to the extent that the Fed's easing campaign can lower companies' borrowing and financial costs going forward, this should be long-term deflationary for commodity and energy prices – given the efficiency of the U.S. capitalist system to translate lower financing costs into new exploration activities or financing activities in the alternative energy sector.
For now, we continue to be bullish on the U.S. stock market, given that the vast majority of our contrarian/sentiment indicators have been hitting multi-year lows day after day, and given the Fed's continuing accommodative stance, the relatively successful Ambac “rescue” (and the subsequent amount of insider buying announced last Friday) and the immense amount of cash currently on the sidelines. 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 especially, the market continues to be a “buy.”
Henry To, CFA