Our Reasons for Turning Neutral on the U.S. Stock Market
(June 1, 2008)
Dear Subscribers and Readers,
I want to begin our commentary by reiterating the purpose of the MarketThoughts.com DJIA Timing System as well as our most recent signal to shift from a 100% long position to a completely neutral position on May 22nd at a DJIA print of 12,640. We covered most of our reasons in a broad manner in our “special alert” to subscribers on May 21st, but we will get into more details in this commentary. Suffice it to say, our stance remains the same as it was on May 21st.
Let us begin our commentary with a review of our 8 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;
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively.
We will update the performance of our DJIA Timing System after the end of this quarter. As of today, the performance of our DJIA Timing System is still beating the Dow Jones Industrial Average on both an absolute and a risk-adjusted basis over the last one, two, and three years and since inception.
The disease of the “two-armed economist” inherent in all financial market newsletter writers is unavoidable. Trying to forecast movements in the stock market or other financial instruments in general is a tricky and virtually impossible business over the long run. That is why – at least in my train of thought – I always engage in scenario analysis, and is constantly revising my “most likely” forecast on a day-to-day basis or as new information comes in. As has been quoted many times before, John Maynard Keynes, in responding to a criticism of his changed stance on monetary policy during the Great Depression is supposed to have said: “When the facts change, I change my mind. What do you do, sir?” That is why so many writers incorporate qualifiers into their commentaries when writing of a particular event that the writers believe may occur. The cynic in us would say that this allows newsletter writers to claim that they were right no matter what the stock market does.
It is difficult for me to avoid this type of “writing style” in our newsletter, since I am constantly reviewing my scenarios and adding new ones, as well as revising the probabilities attached to each scenario. It is especially difficult given the current market environment – as the probability of the “worst case scenario” has dramatically increased over the last 9 months, despite the Fed's intervention which eliminated a significant chunk of the tail risk in the U.S. banking system when it made its balance sheet available to the 23 primary dealers, including Bear Stearns. This is the major reason why we instituted on DJIA Timing System in the first place. That is, we wanted to find a way to communicate to our readers our position on the stock market in a concise and effective manner, with no ambiguities. While one of our aims is to educate our readers on the U.S. and global financial markets, much of these efforts would be futile if our subscribers could not make profitable investments or avoid a significant amount of the “tail risks.” Having the DJIA Timing System would tie us down to a clear position in the U.S. stock market – and would also force us to be more disciplined and responsible for our words and actions.
As we have mentioned before, there were many reasons for our latest shift in our DJIA Timing System from a 100% long position to a completely neutral position on May 22nd. For those who did not get a chance to read our “special alert” sent to subscribers on May 21st, I urge you to do so now. For those who would like more details, I am now going to give you a point-by-point view of the indicators that we are currently tracking.
As we mentioned in our May 21st special alert, liquidity in the stock market is now waning. For example, primary liquidity – as evident in the growth of the St. Louis Adjusted Monetary Base (the only monetary measurement that the Fed directly controls) – has been growing at a negligible pace and is now down again after rising by a minuscule rate during late March to early April. The 52-week change in the ten-week moving average of the St. Louis Adjusted Monetary Base is now at 1.04%, the lowest reading since the 1.02% reading on February 27, 2008, and prior to that, the 0.24% reading on February 21, 2001. While the banking system should benefit from the steeper yield curve, all the recent cuts in the Fed Funds rate won't do much for the American consumer if the banks are not lending – and are instead, tightening terms in consumer and home equity lending. However, as I have reiterated in the past, the Fed is not impotent. Surely, the U.S. stock market and the U.S. economy would've suffered a great deal more if it hasn't been for the Fed's easing campaign and other liquidity easing policies since the beginning of this year. The Fed definitely “cushioned the blow” from the unwinding of the subprime/housing bubble, but given the recent trend in the St. Louis Adjusted Monetary Base (and other indicators which I will talk about), the stock market is definitely not out of the woods yet.
Stepping away from primary liquidity, we know that lending in the commercial banking system has remained, for the most part, robust ever since the credit crisis began. Part of this has to do with the immense recapitalization of commercial banks such as Citigroup, Wachovia, and Washington Mutual – an act that allowed these banks to continue lending despite their subprime losses. Another part of this has to do with the many lending commitments that these banks had made with U.S. corporations during the previous boom – many banks are now “on the hook” to lend to cash or liquidity-strained corporations even though they do not want to. On the consumer side, commercial bank lending is no doubt being reined in as we speak. Following is a monthly chart showing the year-over-year change in loans and leases held under bank credit of the U.S. commercial banks from January 1948 to May 2008:
As mentioned in the above chart, U.S. commercial bank lending is still relatively high – with a year-over-year growth of around 9.6%. However, it is to be noted that this reading is now at its lowest level since September 2004. More importantly, the global asset-backed market – the major liquidity creator over the last few years – is still effectively shut. Until the issuance of asset-backed securities and commercial mortgage-backed securities start to grow again (unlike the MBS market, there are no GSEs such as Freddie and Fannie that can provide liquidity in these markets by buying these instruments), liquidity will continue to be tight for both consumers and corporations alike.
From a stock market specific standpoint, many stock market liquidity issues that I track, such as the amount of insider buying, secondary offerings and company buybacks, and the amount of investable capital sitting on the sidelines have also been deteriorating. For example, after being very active in the second half of last year, many sovereign wealth funds have now refused to participate in any significant recapitalizations in the Western financial system over the last few months, forcing many of these entities (such as AIG and RBS) to seek funds by selling debt and equity in the secondary markets, sometime at great discounts. Not only has this significantly diluted existing investors, but it has also taken liquidity away from many institutional balance sheets. At the same time, many of these financial institutions are still in “balance sheet building mode,” and are not utilizing this newfound capital to do any new lending. In the meantime, many of these sovereign wealth funds are instead choosing to invest in their own domestic economies, thus putting further pressure on commodity prices, which are consequently straining the balance sheets of consumers all around the world.
Moreover, from an institutional standpoint, many U.S. defined benefits pension funds, endowments, and foundations are still overweight U.S. equities – and are continually seeking to not only “diversify” away from U.S. equities, but also equities in general into bonds (mainly asset-liability matching strategies), real estate, commodities, hedge funds, infrastructure funds, and so forth. This is what I am currently seeing – and is also a point that Mohamed El-Erian (co-CEO and co-CIO of PIMCO and former President of Harvard Endowment) mentioned in his most recent Barron's interview and in his new book “When Markets Collide.” Following is (courtesy of Barron's and “When Markets Collide”) a typical portfolio allocation that El-Erian recommends for institutional investors:
Given that the typical institutional portfolio has around 35% to 50% allocated to U.S. equities, any short-term buying power coming from institutions – short of a significant pension contribution from GM, IBM, or GE – should be minimal at best. More importantly, investors such as Mohamed El-Erian are regarded as leaders and shrewd investors by the investment management industry and by institutional investors. Given that CalPERS is essentially holding the same view (they are still actively “diversifying away” from U.S. equities into international equities and other asset classes such as infrastructure investments, hedge funds, etc.) and given that CalPERS is also regarded as a leader by other pension funds, my sense is that this trend will hold for the foreseeable future. Bottom line: Institutional investors are no longer a source of liquidity for the U.S. stock market – and may actually be actively taking liquidity away from U.S. stocks as we speak.
In our May 18, 2008 commentary (“The Message of the NYSE A/D Line”), we asserted that the weak breadth in the stock market coming off of the mid March lows (as evident by the dismal action of the NYSE Common Stock Only Advance/Decline Line) should be expected, given the continuing deleveraging in the U.S. economy. We also stated that this was not without precedent, as the NYSE A/D line was also very weak coming off of the October 1990 lows, as the smaller and weaker firms of the U.S. economy go out of business due to a weaker economic environment and lack of financing options. However, the much larger companies, such as those within the Dow Jones Industrial Average or the S&P 500 should not only be relatively immune (especially since nearly 50% of their net income now come from foreign economies) but should also benefit from this deleveraging, as a significant amount of competition from the much smaller firms should go away.
Unfortunately, the NYSE CSO A/D line has continued to weaken since our May 18th commentary. More ominously, even the A/D line for the components within the Dow Jones Industrial Average has gotten progressively weaker (note the lower high in the DJIA A/D line despite the higher high made since late February), as evident in the following chart courtesy of Decisionpoint.com:
Given this ominous divergence in the DJIA A/D line vs. the Dow Industrials, we are simply not comfortable in staying invested in our DJIA Timing System for now.
As we stated before, the Federal Reserve's actions since mid January of this year (starting with my belief that the announced acquisition of Countrywide by Bank of America was “encouraged” by the Fed and others) has taken a tremendous amount of “tail risk” off the table for the global financial system – culminating with the announcement of the Primary Dealer Credit Facility and the “backstopping” of the Bear Stearns' acquisition by JP Morgan. The European Central Bank was very active as well – as it had put its own balance sheets at risk over various European mortgage securities since late last year.
Unfortunately, short of coming into the markets and buying lower-quality mortgages, corporate bonds, or even equities of the components of the S&P 500 or equity futures of major global equity market indices, the world's major central banks are now effectively out of the picture. Not only had the Fed stretched its “legal authority” with the Bear Stearns rescue (as stated by Paul Volcker in early April), but rising headline inflation all across the world means the Fed has its hands tied with respect to further easing monetary policy to deal with deflationary pressures in the housing market and in consumers' balance sheets. There are two points to be made about investors' psychology here. First, we had two brushes with a market crash - one in mid January and one in mid March. On both occasions, the Federal Reserve came in and helped save the day (the first by easing the Fed Funds rate by 75 basis points and the second by creating the PDCF and helping to rescue Bear Stearns). The latter was especially potent with the Fed using half of the Treasuries sitting on its balance sheet as collateral. Congress then responded on its own with the passing of the fiscal stimulus. While Congress can still do more to “jump start” the U.S. economy, Congress' hands are also effectively tied given the continuing rise in energy prices, headline inflation, and a projected $400 billion budget deficit. In fact, Fed Funds futures are now pricing in a better-than-even chance of a 25 basis point hike in the Fed Funds rate by the October 29th meeting.
There is no doubt that investors are now starting to feel that both the Fed and Congress – in light of all the severe restraints – can do little to “backstop” the stock market the next time it declines below the psychologically important levels of mid January and mid March. In other words, both the “Bernanke put” and the “Congress put” for the S&P 500 and for financial and consumer discretionary stocks in general are no longer in place. If so, then investors may “pre-empt” others by selling first the next time the stock market exhibits a great deal of weakness. The mid January and mid March declines are still close enough in investors' memory to trigger such a reaction. In addition, it is difficult to ignore the lack of buying power among institutional investors and the lack of interest in equities among retail investors. In fact, many retail investors who have been recently laid off are no doubt taping into their retirement accounts to fund their living on top of what they are receiving in unemployment benefits.
Second, it is also no secret that the stock market generally does not act well to rising inflationary pressures (although over the long-run, the relationship between inflation and stock prices has been shaky – as in the 1960s, inflation was generally regarded as a good thing for stocks). While the potential for rising headline inflation is embedded in the “seven points” (such as projected productivity growth, the freedom to trade around the world, and the governments' ability to protect private wealth from confiscation) that I discussed in our April 27, 2008 commentary (“Reflections and Black Swans”), it is also dependent on the population's confidence in the Federal Reserve and other central banks to “anchor” inflation to a relatively low level over the long run. To a certain extent, it is also dependent on the flexibility of the domestic labor market. This is why the ECB is scared stiff of inflation right now – the “second round” effects is coming home to roost as the unions now demand significant wage increases even though the global and European economies are slowing down. We currently have no problems with such “second round” effects, but again, human psychology is very tricky to predict. Should the Fed's ability to suppress inflation be ever questioned by investors, then not only will we witness a self-fulfilling prophecy in the form of rising inflationary pressures – but in the more immediate term, a potential sell-off in the U.S. equity markets. Recent comments by PIMCO's Bill Gross and Mohamed El-Erian have only added further fuel to this potential inflationary fire. With the Fed and Congress effectively out of the picture, and with the possibility of a rise in inflation expectations among both institutional and retail investors, my sense is that potential tail risks have again risen over the last few weeks.
Over the longer-run, however, I continue to believe in the integrity of our capitalist system to continue to innovate and to increase productivity and thus reduce headline inflation from current levels. For the first time in history, alternative fuels, technologies (plug-in hybrids, cellulosic ethanol, etc), and materials (carbon nanotubes, etc.) are now in place to significantly reduce domestic crude oil demand over the long run. While such technologies won't be commercialized until 2010 at the earliest, my sense is that these are real technologies that will most likely end the “bubble” once and for all in various commodities sometime early in the next decade. In the meantime, I would wait until our intermediate indicators get into “oversold territory” before I can justify a 50% or a 100% long position within our DJIA Timing System.
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 May 30, 2008, the Dow Industrials rose 158.69 points while the Dow Transports rose 292.40 points. As I mentioned in the above chart, the Dow Transports is now a mere 8.95 points away from surpassing its all-time closing high made on July 19, 2007, while the Dow Industrials is still 10.8% away from its all-time closing high. However, while the Dow Transports has been a leading indicator of the broad market since October 2002, it is to be noted that it has been nearly a year since the Dow Transports has made a new all-time high – and as such, any surpassing of its all-time closing high, without increasing technical strength in the broad market or in the A/D line of the Dow Industrials, should be viewed with some suspicion. Furthermore, the forward P/E of the railroads, which has been a major source of strength for the Dow Transports, is now trading at the high-end of its historical range at 16. While I continue to believe that the intermediate bottoms made on January 22nd and March 17th will hold, I now prefer to stay on the sidelines and wait for the market to get into oversold territory before again going long within 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 decreased from last week's reading of 13.7% to 9.7% for the week ending May 30, 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:
Note that the latest decline in this sentiment indicator represents the first decline in ten weeks. In addition, last week's reading of 13.7% represented the most overbought condition since mid November of last year. While last week's reading is not overbought relative to readings we have witnessed over the last few years, it is definitely of concern, given the tremendous rise in sentiment since mid March, and given the deteriorating breadth in the stock market. For now, I am still more comfortable with a neutral position in our DJIA Timing System, and will most likely not establish a long position again until we witness more oversold readings in this sentiment indicator.
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. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. 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 both the 20-day and 50-day moving averages of the ISE Sentiment Index reversing from historic oversold readings in such a dramatic way since mid March, and with the 20 DMA stalling over the last couple of weeks – and accompanied by a technically weak condition – I will continue to stay on the sidelines for now.
Conclusion: The liquidity, psychological and technical situation for the U.S. stock market has deteriorated significantly since our last “full blown” weekend commentary published on May 18th. As a result, we decided to shift from a 100% long position in our DJIA Timing System to a completely neutral position on May 22nd, and will continue to stay on the sidelines unless we get a more oversold condition in the U.S. stock market. At this point, I do not have a “target price” for either the Dow Jones Industrial Average or the S&P 500, but at the very least, I would prefer to see a DJIA print of 12,000 before we even consider of going on the long side again.
Henry To, CFA