A Bleak Christmas, Indeed
(December 7, 2008)
Dear Subscribers and Readers,
Let us now 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 3,536.58 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 3,227.58 points as of Friday at the close.
I apologize for our commentary's “dark” title this week, but there's no getting around it. As indicated by the ECRI and the Conference Board's economic leading indicators more than six months ago, the latest spike in jobless claims is far from a surprise. The Lehman bankruptcy and the decline in the stock market during October virtually assured a much higher-than-expected spike in jobless claims. Given the latest readings of the ECRI's Weekly Leading Index, I continue to stand by my “base case scenario” that the unemployment rate will peak between 8% and 9% by the end of 2009.
The latest spike in jobless claims finally aroused the Congress to act and put together an “ad hoc” rescue package for automakers – a temporary “stop gap” (albeit with strings attached) to keep them running until at least March 2009. This should give the new Obama administration enough time to access the situation and to devise a longer-term solution. As I previously mentioned, the bankruptcy of one of the Big Three automakers would wreck havoc not only in the auto & auto parts industry, but also on the real economy as well. Should that occur, we will no doubt see an unemployment rate of over 10% by the end of 2009, potentially accompanied by “soup kitchen” lines and riots in certain parts of some major cities. Credit spreads would rocket higher – undoing several months of Fed easing and making the Fed's job of reflating the economy virtually impossible – unless the Fed is willing to make direct purchases of corporate bonds, non-agency MBS, and CMBS. As the US tax base shrinks, the budget deficit would also spike higher – which would hamper the federal government's ability to reflate the economy by cutting taxes or providing other forms of “fiscal stimulus.”
Thankfully, the latest jobless claims aside, we are now seeing some stabilization in various components that make up the US economic leading indicators. For example, US private housing permits peaked at 2.3 million units during September 2005. Since then, it has literally crashed to only 730,000 units (as of October 2008) – which is on par with similar troughs in late 1974/early 1975, late 1981, and early 1991, as shown in the following chart courtesy of the Federal Reserve:
Note that authorized building permits are now running significantly below the natural rate of growth, or what is needed to satisfy the long-term household formation trends of the US. More importantly, both the national 30-year fixed and 30-year fixed jumbo mortgage rates have declined 70 to 80 basis points over the last four weeks, after the Feds indicated that they would be purchasing $500 billion in agency mortgage-backed securities and $100 billion in agency debt:
This decline in mortgage rates should put a cushion under authorized building permits for the foreseeable future. In addition, the US Treasury has indicated that it is working on a plan to bring down mortgage rates still further – possibly to the 4.5% area for first-time homebuyers. This should go a long way towards mitigating further declines in authorized building permits – removing a significant drag on both the US economic indicators and the US economy going into 2009.
At the same time, the Federal Reserve has been “busy” (an understatement) trying to reflate the economy via other means – from lowering the Fed Funds rate to just 1% (with another to come on December 16th) to backstopping Citigroup and creating a new facility to provide support for the asset-backed securities markets. Encouragingly, while the “shadow banking system” is still not functioning well (and probably won't until housing prices start to stabilize), we know that the traditional measurement of the money supply, the year-over-year growth of M-2, has risen from its trough of 4.6% in late August to 7.4% in late November, as shown in the following chart:
As the traditional measurement of money supply, M-2, is an important component of the US economic leading indicators, there is good reason to believe that the US economic leading indicators will start to stabilize, if not increase again. Encouragingly, the most recent ECRI Weekly Leading Index reading actually perked up for the week, although it is still far away from reversing its cyclical downtrend.
At this point – assuming the Big Three automakers are rescued by Congress – neither the Federal Reserve nor the US government is impotent in reversing the most violent decline in the US economy since the beginning of the Great Depression. At the end of August 1931 (two years after the beginning of the 1929 crash), the Dow Jones Industrial Average sat at 139.41, down by more than 60% from its peak on September 3, 1929, but still more than 200% above its cataclysmic low trough of 41.22 at the close on July 8, 1932. As documented by Henry Villard of the University of Minnesota in a 1937 Journal of Political Economy article (and others since, including Milton Friedman and Ben Bernanke), the month of September 1931 marked a watershed event in the US and global economy, as the British devaluation and departure from the gold standard reversed gold inflows into the US – thus shrinking the domestic money supply. The Federal Reserve – in an effort to stem the outflow of gold – raised the discount rate from 1.5% to 3.5% in early October. This confluence of events set off a severe banking crisis and a decline in the Dow Industrials. While bank failures across the country averaged 100 a month during 1930, it rose to a monthly average of 320 from September 1931 to February 1932. The Dow Industrials, meanwhile, declined 30% during September 1931 – its worst monthly decline in history as the country crashed into the Great Depression. While the US and global economy is infinitely more complex than it was in the 1930s, the Federal Reserve and the US government also have their disposals a much greater set of tools available to stem further decline in the US banking system and economy. Neither the US or global economy is constrained by the gold standard any longer. Finally (and most encouragingly), unlike the 1930s, the major economies of the world (with the glaring exception of Germany) are now much more willing to work with the US to combat this financial crisis.
With the wide variety of tools available to global policy makers – and given their willingness to use these tools – I expect the global reflation effort to succeed (at least in the developed economies, and other major countries such as China, Brazil, and India) sometime in 2009. As I mentioned in our commentary two weeks ago, I also expect a tremendous amount of productivity/Schumpeterian Growth forces in the US to be unleashed within the next 5 to 15 years, as the Obama administration increases funding to our scientific (such as the NIH) and engineering institutions and as venture capital funds start to take more risks again. Make no mistake: With Wall Street and the global hedge fund industry in tatters, many of our smartest students – in lieu of seeking a Wall Street career - will choose to stay in their respective fields or go on to get their PhDs in a scientific or engineering field. Over the long-run, having a sound scientific base is the key to achieving productivity and sustainable growth.
As I mentioned in our commentary two weeks ago, no analysis of the stock market is complete without a discussion on valuations. Driven by the unprecedented liquidation of global equities and other risky assets over the last two months, the dividend yield of the S&P 500 exceeded the ten-year Treasury yield last month and has since risen again. The last time we have witnessed such a positive yield spread was July 1958 – or more than 50 years ago – as shown in the following monthly chart:
Given the such compelling valuations– and given the unprecedented global reflation efforts on the part of our policy makers – I sincerely believe that this is now the buying opportunity of our generation. Once the money and financial markets right themselves, the investment bankers and the venture capitalists (the conduits for investment capital) should come back with full force. The Y-gens would subsequently experience their own “bull market of their lifetimes.” For now, however, we should be prepared for a very bleak Christmas and for the unemployment rate to continue to rise into the end of 2009.
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 March 2003 to the present:
For the week ending December 5, 2008, the Dow Industrials declined 193.62 points while the Dow Transports declined 78.87 points. Over the short-term, resistance levels for the two Dow indices are 8,830 and 3,513, respectively. More selling will come at the November 4th peak of 9,626 and 4,072, respectively, should we witness ongoing strength in the two Dow indices this upcoming week. With the Federal Reserve's backstop for Citigroup and the bailout of the Big Three automakers, global liquidation pressures should ease this upcoming week. While there are still landmines in various emerging market countries and individual stock investments, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis, given the most compelling valuations in the US equity market in decades and the emerging innovative/Schumpeterian growth forces that will inevitably be unleashed in the next 5 to 15 years. We will remain 100% long in our DJIA Timing System (we would've moved to 150% long but the rules of our System does not allow us to do that).
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 -13.8% to -18.2% for the week ending December 5, 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 four-week moving average of our popular sentiment indicators declining to -18.2%, this indicator has again declined to a very oversold level (in fact, the 10-week MA is now at its most oversold level since early September 2002). Again, given the inevitable rescue package for the Big Three automakers, and combined with the compelling global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, I highly believe this is the buying opportunity of our generation, even though we could possibly retest our most recent lows at some point in the next couple of months. 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:
Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early October, both the 20 DMA and the 50 DMA have. Moreover, the 20 DMA is still above the 50 DMA, signaling that the uptrend in sentiment remains intact. Historically, a reversal of the ISE Sentiment index from an immensely oversold level has been the best indicator of an upcoming rally. Combined with the oversold level in our other sentiment indicators, extreme valuations and oversold levels in the equity markets, as well as unprecedented global bailout package, and assuming that the G-20 countries commit to more easing policies going forward, I believe the stock market is now presenting itself as a once-in-a-generation buying opportunity. As long as one is under the age of 60 and is in a reasonable state of health, then one should be buying US equities aggressively with one's long-term savings.
Conclusion: While the latest jobless claims may be a surprise to some analysts, whether the US equity markets will rally or decline going forward will depend on the administration and Congress' response to the number and the financial crisis. Unlike the 1930s – when the Federal Reserve was more rigid (and when the rest of the world did not cooperate) – there is now an almost limitless amount of tools that global policy makers can use to stem the bleeding in the global financial markets and economy, including buying equities outright should that ever be needed. With the inevitable bailout of the Big Three automakers, it looks like credit conditions will continue to ease over the next few weeks. Moreover, outstanding loans and leases held under bank credit have also continued to grow. While there will be ongoing liquidation pressures stemming from tax loss selling and hedge fund redemptions, I expect these forces to be relatively benign. More importantly, the compelling valuations in the US equity market are now too much to ignore. For those with a long-term timeframe, this represents the greatest buying opportunity of our generation.
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 still bullish on gold miners – specifically, the GDX. We will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA