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A Golden Opportunity?

(November 2, 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 2,856.99 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 2,537.99 points as of Friday at the close.

As we have covered before, each new week brings another round of monetary easing from the Federal Reserve and other central banks.  On Monday, the Bank of Korea unexpectedly cut its policy rate by 75 basis points.  On Wednesday, the People's Bank of China followed with a 27 basis point cut – its third cut in just two months.  Ditto the Federal Reserve, which cut the Fed Funds rate by 50 basis points to 1.00% - matching a half-century low, last set in 2003.  On Friday, the Bank of Japan finally capitulated, cutting its policy rate by 20 basis points to 0.30%, its first cut in seven years.  More significantly, the BoJ introduced a temporary measure (similar to the Fed's) to allow the central bank interest payments on excess reserves. This will allow the BoJ to better control the policy rate while flooding the system with more liquidity.  Finally, on the monetary policy front, the Reserve Bank of India also unexpectedly cut its repo rate by 75 basis points to 7.50% this weekend.

With the unprecedented easing and the many unconventional policies coming from central banks and finance ministries over the last 12 months, we are now possibly seeing a thaw in the commercial paper (witness the bounce in the amount of financial and asset-backed commercial paper outstanding last week).   More significantly, the Federal Reserve followed up with another surprise (and unprecedented move) last week – by creating USD swap lines with the central banks of Brazil, Mexico, South Korea, and Singapore.  This is a truly unprecedented move, as this means the Federal Reserve is effectively backstopping the financial systems of Brazil, Mexico, South Korea, and Singapore.  There are three immediate implications: 1) This move proves that the USD is still the sole reserve currency of the world; 2) For the first time ever, the Fed is providing lifelines to "non-white" EM countries, signaling that as long as one has been fiscally conservative, it will get a helping hand from the Fed; 3) Both the Fed and the IMF have learned significant lessons from the IMF "bailouts" during the Asian Crisis. Today, emerging markets countries such as Brazil have become very important players of the global economy.  In essence, the Fed is acknowledging that there will be very significant ramifications should these countries ever go down.

Make no mistake: The Fed is hell-bent on stopping deflation dead in its tracks before it can gain a foothold in the global economy.  My sense is that the Federal Reserve will cut by 25 basis points at its December 16th meeting and then cut by 25 basis points again at the January 28, 2009 meeting.  At a Fed Funds rate of 0.50% to 0.75%, however, it becomes problematic for money market funds to cover their costs and still provide a positive yield to their investors (especially those that cater to retail investors, as the average retail money market fund has an expense ratio of 0.55%). At a Fed Funds rate of below 0.50%, we could see widespread liquidation of money market funds as it is no longer profitable for institutions to manage them. Such a scenario is counter-productive as money market funds provide substantial liquidity to the commercial paper and the asset-backed markets.  Fortunately for the Federal Reserve, this does not mean we are “at the end of the road” once the Fed Funds rate hit 0.50%.  Assuming this (along with other liquidity provisions and recapitalizations in the banking sector enacted thus far) is not sufficient to turn around the credit/equity markets, I expect to see the Fed to start intervening in longer-maturities of the Treasury market, as Chairman Bernanke outlined in his now-famous (and grossly misunderstood) 2002 speech on fighting deflation.

I also expect the GSEs to ramp up their purchases in the GSE mortgage-backed securities market and for a permanent increase in the agency conforming limit to $729,750 (now set to expire in December 2009). Finally, I am assuming that another round of "fiscal stimulus" is inevitable at this point. From an international perspective (again, assuming the credit/equity markets do not turn around), I expect the Federal Reserve to create larger swap lines to Australia, New Zealand, Denmark, Norway, Sweden, the UK, Switzerland, the Euro Zone, and Canada in addition to those that were created back in late September.  Following its actions from last week, we should also see larger swap lines to South Korea, Singapore, Mexico, and Brazil.  As India is now forced to cut rates, I also expect the Fed to create a swap line with the Reserve Bank of India should the Indian Rupee ever come under attack, as that is the one remaining 800-pound gorilla in the room (most likely, the Fed is going to ignore Russia).

If these swap lines aren't sufficient (which I seriously doubt), then the Fed will most probably intervene in the foreign debt market by purchasing the sovereign debt of other developed countries, as well as the sovereign debt of Korea, Mexico, Brazil, Singapore, and India. This will help bring down sovereign spreads all across the world (and importantly, the large EM markets) and flood the world with USD-denominated liquidity (note that the sovereign debt market is several times the size of the domestic government bond market – a fact which gives the Fed a lot of scope to expand global USD-denominated liquidity and to fight global deflation).  If all else fails, the Federal Reserve – with the Congress' stamp of approval – could start buying corporate bonds and equities in the open market to create further liquidity.  Combined with the Treasury's current plan of recapitalizing the banking sector (and potentially life insurance companies) – as well as another shot of fiscal stimulus down the road – I find it highly unlikely that the 1930s-style of a deflationary bust can ever set foot in the United States or in the majority of the world's countries.

In light of the global “all-out” war on deflation (the South Koreans just announced a US$10.8 billion fiscal stimulus package as I am typing this), it is difficult to envision gold prices weakening much further from current levels.  Furthermore, subscribers should note that even the Reserve Bank of India is now getting on the monetary easing “bandwagon.”  Given that Indian citizens are responsible for much of the world's gold consumption on average (through the purchase of gold jewelry), it is imperative for the Indian economy to continue to grow in order to support gold prices.  In addition, despite the recent relative strength of gold prices relative to other metals, gold (in terms of its percentage rise since January 1, 2003) is still lagging that of copper, tin, and lead prices.  Finally, the non-commercial position in COMEX gold (following exhibit courtesy of Goldman Sachs and COMEX) has also been vacillating at near its August 2007 levels, just immediately preceding the last major gold rally from $650 an ounce to nearly $1,000 an ounce earlier this year.  From a contrarian standpoint, this should at least provide a cushion for gold prices in the days ahead:

COMEX non-commercial positions vs gold px - Gold has responded well after bottoming at 300 kt level

Note that this author isn't going to buy any gold here, as gold prices had not been hit as much as other asset classes in the recent global liquidation/panic.  The “golden opportunity” that I want to discuss is the gold miners – or more specifically, the GDX ETF.  Given the recent decline in fuel prices and the strength in the U.S. Dollar (note that much of the gold miners' production are overseas), the cash cost of mining gold should decline across the board in the fourth quarter (this decline should more than offset the weakness in the prices of the “bi-products” that come with mining gold such as copper and nickel).  In reality, the prices of gold miners (as exemplified by the GDX) has plunged, as hedge funds and retail investors alike liquidated equities in the materials and mining sector over the last four months, despite the fact we never saw a corresponding decline in gold prices.  This intense liquidation has resulted in the GDX/Gold price ratio declining to its lowest level since late 2000, as shown in the following weekly chart courtesy of

Market Vectors Gold Miners (GDX)

As an aside, this author went heavily long gold mining stocks (both the majors and the juniors) in late 2000, when both the XAU and the HUI declined to an all-time low level of 40.  To this day, I still remember reading the many messages that the die-hard goldbugs posted on the Yahoo! Message boards.  One author that I distinctly remember stated that he had sold all his gold mining shares after a decade-long holding period, and that it represented “the total capitulation of a goldbug.”  As it turned out, many of the gold mining shares that I had bought in late 2000 came from folks who had held to their shares for 10, if not 20 years.  While we will never get such a buying opportunity again, my sense is that the latest sell-off will provide a decent opportunity for those who want to go long the GDX. 

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 April 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (April 1, 2003 to October 31, 2008) - For the week ending October 31st, the Dow Industrials rose 946.06 points (its best-performing week in 34 years), while the Dow Transports rose 437.39 points. Immediate resistance levels are the Dow Industrials' and the Dow Transports' October 13th close of 9.387.61 and 4,042.79, respectively. Last Monday, the Dow Industrials closed at its lowest level since April 1, 2003. While the Dow Transports also exhibited a great deal of weakness last Monday, it still closed 57% above its April 1, 2003 level last Monday. With global policy makers adopting a more shareholder-friendly *bailout approach,* and with more global central bank easing along the way, there is a good chance that global equity markets have made a solid bottom early last week. Coupled with the immense amount of capitulation and very decent valuations across the world - I expect both the broad market and the Dow Industrials to enjoy a rally lasting into Christmas. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending October 31, 2008, the Dow Industrials rose a whooping 946.06 points (its largest percentage weekly increase in 34 years), while the Dow Transports rose 437.39 points.  Despite the extreme weakness in the stock market over the last six weeks, the Dow Transports is still trading at its November 2005 levels.  The Dow Industrials, on the other hand, is substantially weaker (at its September 2003 levels), despite last week's rally.  Given the radical (and shareholder-friendly) policies that global policy makers have adopted to jump start the financial and equity markets – my sense is that the stock market has made a solid bottom as long as both the European Central Bank and the Bank of England follow through with more rate cuts this week – with a promise of more to come.  For now, we will remain 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 increased slightly from -21.5% to -20.7% for the week ending October 31, 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 October 31, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios increased slightly from -21.5% to -20.7%. Subscribers should note that this indicator is still at a historically oversold level (the ten-week MA, not shown, is now more oversold than it was at March 2003) , and has probably as well. Historically, a reversal from a very oversold sentiment level has been one of the most reliable signals preceding and accompanying a major rally.  While sentiment can indeed get darker, my sense is that the market has hammered out a capitulation bottom. For now, we will remain 100% long in our DJIA Timing System.

With the four-week moving average of our popular sentiment indicators reversing from a historically oversold reading of -21.5% (note that the ten-week moving average, not shown, is now at its most oversold level since September 2002, after having pierced the oversold levels of March 2003), chances are that the stock market has hammered in a bottom as long as the European Central Bank and the Bank of England follow through with interest rate cuts and commit to an aggressive easing schedule going forward.  Combined with the depressed global valuations, the recent correction in commodity prices, the sheer amount of global investable capital sitting on the sidelines, unprecedented global bailout packages, these latest readings should be sufficient for a meaningfully rally in US and global equities potentially lasting into Christmastime.  For now, we will remain 100% long in our DJIA Timing System.

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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting its most oversold level in six months a few weeks ago, the 20 DMA of the ISE Sentiment Index has reversed to the upside, and is in the process of breaking back above its 50 DMA. More importantly, relative to levels over the last five years, both the 20 and the 50 DMAs are still at very oversold levels, signaling that sentiment is much closer to a bottom than a top. Given the immense selling in the global stock market in the last three weeks - combined with unprecedented public policy action all over the world - my sense is that the stock market has hammered out a capitulation bottom and should rally into Christmastime.

Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early October, the 20 DMA has reversed to the upside – and is now close to rising above the 50 DMA.  Moreover, as discussed in the last three weeks, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are still at oversold levels that are synonymous with a tradable bottom in the stock market.  Combined with the extreme valuations and oversold levels in the equity markets, as well as unprecedented global bailout package, and assuming that the Bank of England and the European Central Bank cut rates this week and commit to a more aggressive easing schedule; I believe the stock market has already hammered out a bottom.

Conclusion: Since our last weekend's commentary, the G20 countries have continued to adopt more innovative and aggressive policies to fight the global deleveraging – with South Korea unexpectedly cutting rates by 75 basis points last Monday and unveiling a US$10.8 billion fiscal stimulus package earlier today.  The 75 basis point cut in South Korea's policy rate was swiftly followed by a US$30 billion “backstop” from the Federal Reserve.  In implementing this, the Federal Reserve also created similar swap lines with the central banks of Mexico, Brazil, and Singapore – making the Federal Reserve the de-facto “central bank of central banks.”  This was followed by a 20 basis point cut by the Bank of Japan on Friday, and a 50 basis point cut by the Reserve Bank of India over the weekend.  Going forward this week, I expect both the Bank of England and the European Central Bank to cut policy rates by at least 50 basis points – and to commit to more easing for the rest of the year.  I also expect to see a rescue of GM by the US government over the next few weeks – and for the stock market to continue to rally into Christmastime.

Going forward, I continue to be constructive on US, Japanese, and Chinese equity prices in the longer-run, as the world starts to focus on sustainable, Schumpeterian Growth vs. Ricardian Growth over the next few years.  Over the intermediate term, I am bullish on gold miners – specifically, the GDX.  For now, we will stay with our 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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