The Period of Maximum Danger
(July 20, 2008)
Dear Subscribers and Readers,
Let us begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 675.43 points as of Friday at the close.
7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 366.43 points as of Friday at the close.
Don't get me wrong, I am a great fan of the concept of “market efficiency,” especially as it relates to the large capitalization (over $5 billion) stocks in the U.S. stock market. Except for a few funds such as Growth Fund of America, American Funds Fundamental Investors, Dodge & Cox, CGM, Davis NY Venture, Neuberger Berman Partners, Columbia Value & Restructuring, Eaton Vance Large Cap Value, Calamos Growth, Janus Twenty, Fidelity Contrafund, Fidelity Growth Company, Fidelity OTC, T. Rowe Price Spectrum Growth, and the Vanguard PRIMECAP funds (keep in mind that there are more than 1,500 distinct mutual funds in the U.S. large cap space), it is difficult to find any funds that have outperformed the index by a significant margin over the long-run (10 to 15 years) and also over the last three to five years. Note that as recent as 12 months ago, Bill Miller's Legg Mason Value Fund would've still been on this list. Moreover, 15 years can hardly be considered as the “long-run,” as the benign disinflationary/deflationary cycle that began in 1982 (and that many money managers had gotten used to, including Miller) lasted for more than 20 years.
Of course, even the concept of “market efficiency” in US large caps break down every now and then. For example, the potential impact of FAS 140 on the GSEs was well known (for the last four months) by money managers, the regulators and the GSE executives prior to the latest plunge in the stock prices of both Freddie Mac and Fannie Mae (in a nutshell, this new accounting standard would “force” the GSEs to put all its $5.1 trillion in guaranteed mortgage debt on their balance sheets, requiring them to raise more than $75 billion in order to meet its minimum regulatory capital requirements). And yet, the market chose not to focus on the issue until Lehman Brothers analyst Bruce Harting (who has been bullish on the GSEs for nearly the last decade) reversed his bullish stance and wrote a piece on this issue on July 7th, triggering the latest downward spiral and the “late night scramble” by the Treasury, Federal Reserve, and Congress to put a “backstop” on both agency MBS and agency debt.
As I discussed in last week's commentary (“The Lender of Last Resort”), the US stock market most likely made an intermediate bottom last week in light of the “bailout” of the GSEs. Assuming Congress provides a good-sized lifeline to the GSEs (my sense is that we need a minimum lifeline of $500 billion; $300 billion isn't going to cut it), we should see at least a two to three-month rally from current levels, especially given the recent “cooling down” in crude oil prices. As an aside, I highly believe that the latest decline in crude oil prices is self-reinforcing – as the refiners should increase their inventories (i.e. what shows up on the official EIA stats) as carrying costs of crude oil comes down. Moreover, my sense is that approximately around $20 of the current price in crude comes from the following two factors:
- Many producers simply don't have enough credit or “the guts” to hedge their production going forward. Crude oil in the ground isn't going to help you much if oil spikes to $200 a barrel in the next six months and the CEO/CFO has to take a huge accounting loss at the end of the year. This could actually be a potentially debilitating event, as many grain elevators found out (many of them went bankrupt because of their hedging practices) when grain prices shot up earlier this year.
- Many investment banks that have traditionally “taken the other side” of the long speculators and long commodity funds have been taken out of the markets, not only because of the volatility, but more importantly because of hugely impaired balance sheets. For all we know, the prop desks at the major investment banks were long commodities simply because they need as many “quick bucks” as they can to make up for the write-downs and the loss of revenues from their other businesses. Given the latest rise in the shares prices of financial stocks last week, my sense is that investment banks will start taking relatively more risk in the near future – starting with providing liquidity to oil producers by shorting crude oil. This trade is now particularly simply to justify given that the commodity is now in contango and given the sheer number of “dumb indexers” on the long side.
More importantly, the latest decline in crude oil and natural gas prices will not only provide more liquidity to US consumers, but will also allow the Federal Reserve, for the first time since the August to October 2007 period to provide more primary liquidity to the financial markets. As covered in our October 28, 2007 commentary (“Yield Spreads Telling a Different Story”) and subsequent commentaries, we know that while the Fed has aggressively lowered overnight rates and created various “liquidity facilities” to the US commercial banking system and the major primary dealers, it has actually acted with relative restraint when it came to overall liquidity (especially compared to the Greenspan Era) as demonstrated by the abysmal growth in the St. Louis Adjusted Monetary Base (the only liquidity indicator that is directly controlled by the Fed) over the last 12 months:
Most likely, the Fed has been draining liquidity (by selling Treasuries to the public) on the one hand, while swapping illiquid instruments in return for Treasuries with the various commercial and investment banks on the other. However, as shown in the above chart, the year-over-year change in the St. Louis Adjusted Monetary Base (four week moving average) bottomed out at 0.70% in early May (note that the green line showing the change in monetary base has been advanced by 12 weeks) and has since ticked up to 1.87% on July 16th. Bottom line: The Federal Reserve has started to become much more accommodative over the last 12 weeks. Assuming that crude oil prices continue to correct from current levels, the Fed should become even more accommodative going forward. This is another bullish development for the US stock market.
Furthermore, while it is dangerous to buy stocks in a very oversold market that is trending down, subscribers should also note that once the inevitable reversal comes along, the resulting rally could be ferocious and devastating for those on the short side. We know that the NASDAQ Composite was at a historically oversold condition per our commentary last weekend. Not surprisingly, we are now also witnessing a very oversold condition in the NYSE as well, as illustrated by the following chart showing the NYSE McClellan Oscillator (ratio-adjusted so it can be comparable across time) and the NYSE McClellan Summation Index (also ratio-adjusted), courtesy of Decisionpoint.com:
As can be seen on the above chart, the NYSE McClellan Summation Index (Ratio-Adjusted) touched the -1,200 last week – an oversold level not witnessed since September 1998, right in the midst of the Brazilian, Russian, and LTCM crises. Not coincidentally, the stock market bottomed with an inter-meeting emergency 25 bps rate cut from Alan Greenspan, and a major bailout of LTCM. Over in Asia, the slide in Hong Kong stock prices ended when the Hong Kong Monetary Authority engaged in a two-week war with short-sellers by buying up more than US$15 billion of shares on the Hong Kong Stock Exchange. Again, given the bailout of the GSEs, the recent correction in oil prices, and the severe oversold conditions in the US stock market, we should be witness at least another two to three-month rally. At the very least, I want to see the NYSE Summation Index move back to the zero line (the read line).
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 July 2006 to the present:
For the week ending July 18, 2008, the Dow Industrials rose 396.03 points while the Dow Transports rose 227.28 points. In retrospect, the non-confirmation of the Dow Industrials by the Dow Transports on the downside last week provide to be a precursor of a significant reversal in the broad market, with the Dow Industrials rising 3.6% for the week. More importantly, the Dow Transports is still holding up very well, as it is now only 8% away from its all-time high (versus 18% for the Dow Industrials). In addition, given the recent deleveraging by the airlines (and thus newfound pricing power) and the continuing bottlenecks in the US transportation infrastructure, I expect the Dow Transports to remain resilient, especially as the growth in global demand for oil now seems to be calming down. Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I expect both the Dow Industrials and US stocks in general to embark on a sustainable rally over the next two to three months. For now, we will remain 100% long in our DJIA Timing System – and will only seek to pare back our position if the market becomes more overbought or if our sentiment indicators become overly bullish again.
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 again from last week's reading of -15.9% to a historically oversold reading of -21.7% for the week ending July 18, 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 latest decline in the four-week MA, this sentiment indicator is now at its most oversold level since the week ending March 14, 2003 – right at the beginning of the stock market's major four-year bull run. Moreover, over the last ten years, the only other period where we saw more (but just slightly) oversold readings was July 2002 – which in retrospect turned out to be a major low for many US and global stocks. Combined with severe oversold condition in the US stock market, the sheer amount of investable capital sitting on the sidelines, the record amount of short interest, and the backstopping of the GSEs by the Feds) this reading should be good for at least a two to three-month bounce in the US stock market. For now, I am very comfortable with our 100% long in our DJIA Timing System, and will only pare back our position should the stock market or should our sentiment indicators get overbought once again.
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:
While the ISE Sentiment Index has bounced substantially since its mid March lows, the 20 DMA of the ISE Sentiment Index has now worked off a significant chunk of its short-term overbought conditions (in fact, the 20 DMA just made a three-month low while the 50 DMA made a two-month low). More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years. Given this, the probability for much further downside is minimal, and is thus conducive to a sustainable rally over the next several months.
Conclusion: The early sell-off in global stock prices last week most probably represented an intermediate term bottom for the US and most other stock markets around the world. Assuming that Congress creates a lifeline for the GSEs (again, I want to see something significantly higher than the $300 billion lifeline now mentioned), and combined with the fact that the Federal Reserve is now again directly injecting liquidity into the financial markets (as evident from the recent spike in the US monetary base), this intermediate bottom should give rise to at least a two to three-month rally going forward. I also expect both agency spreads and junk bond yield spreads to compress over the next few months – but should they fail to come down, I would not be surprised if the US Treasury decides to intervene in the debt markets by purchasing agency mortgage-backed securities in order to compress general credit spreads and bring down mortgage rates. It is going to be a rough, but exciting ride over the next several weeks.
Finally, there remains a substantial amount of investable capital that remain interested in recapitalizing global financial institutions – whether it is in the form of private equity funds, Japanese financial institutions, or US institutional and retail investors. Aside from US equities (mainly technology and biotechnology firms), I continue to like Japanese equities (especially Japanese small caps), Taiwanese, Hong Kong, and South Korean equities. In the meantime, I still do not expect a sustainable bottom in emerging market equities, although I do expect some kind of general bounce over the next few months. For now, we will stay with our 100% long position in our DJIA Timing System, and will only seek to pare back our long position once the stock market gets overbought again. Subscribers please stay tuned.
Henry To, CFA