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Still Not Too Late for a Rescue

(January 18, 2009)

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 3,890.78 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 3,581.78 points as of Friday at the close.

Last Friday, the Bureau of Labor Statistics reported what we have been fearing for months – that the US is now close to a deflationary spiral, as the CPI (Consumer Price Index) declined by 0.7% (on a seasonally-adjusted basis) in December, with the CPI for Urban Wage Earners and Clerical Workers declining by 0.9%.  On a year-over-year basis, these two indexes (the CPI-U and the CPI-W) increased by 0.1% and decreased by 0.5%, respectively.  As we discussed in our June 15, 2008 commentary (“The Capitalist and Productivity Engine”), consumer price inflation – within a disciplined and well-communicated monetary framework – is driven by productivity growth (or lack thereof) over the long run.  With US households losing a combined US$10 trillion in net worth over the last 15 months (and with global households losing a lot more), deflation in the CPI will continue to rule the day, as both global aggregate demand and global liquidity continue to shrink.  This is being confirmed by the cyclical low in the ECRI Future Inflation Gauge, and the continued weakness in the OECD (and Chinese, Russian, and India) leading indicators.

In a well-functioning capitalist financial system/economy, the $825 billion Obama fiscal stimulus should make a tremendous impact on GDP growth and employment, as the combination of tax cuts and infrastructure expanding is transmitted through the economy – which in turn is transmitted into the banking system as a basis for more commercial and consumer loans.  This is the classic money multiplier effect (which we all learned in high school economics) at work.  Of course, our modern financial system is much more complicated than that.  Over the last five years, the pace of financial innovation has been unprecedented, with the “shadow banking system” (this term courtesy of PIMCO's Paul McCulley) such as the structured finance market dominating the pace of liquidity creation and cheap financing.  Until the Federal Reserve or the US administration steps in to boost the asset-backed securities market, all we have to work with is our banks.  And for now, this multiplier mechanism is still not functioning well.  That is, the $825 billion Obama fiscal stimulus will not have much of an impact on GDP growth (especially if US consumers save their rebates or tax cuts) until our banks or asset-backed securities market is functioning again.

Make no mistake: we are now seeing early signs of deflationary spiral.  For the first time since the Great Depression, companies (such as AMD, Caterpillar, and YRC Worldwide) are cutting wages of their salaried workers.  A poll by Watson Wyatt suggests that 5% of its 117 companies surveyed had already reduced salaries, while 6% plan to do so in the next year.  As wages are cut and as unemployment levels rise, debt repayments will be more difficult, resulting in more delinquencies and bad loans.  This is a death knell for a debt-driven economy such as the United States.  Thankfully, a deflationary spiral or depression is still not inevitable at this point, as core inflation (CPI less food and energy) and the Cleveland Fed's Median CPI is still positive on a year-over-year basis (shown in the following table):

The Cleveland Fed's Median CPI is still positive on a year-over-year basis...

As this commentary's title suggests, the US and global economy is at a crossroads.  With the Europeans and Japanese still fumbling through this economic crisis (culminating in the ECB's hugely misguided 25 basis point hike in July of last year) – and with US consumers and the rest of the world deleveraging – there are only two parties with sizable reserves to stem the collapse in global aggregate demand and to stop the ongoing deflationary spiral.  Those are: 1) US policy makers, which encompass the Federal Reserve, the President and the US Treasury, the FDIC, and Congress, and 2) the Chinese government, the People's Bank of China, and Chinese consumers.  With US consumers deleveraging, other parties will have to “take up the slack” by running either budget deficits (in the case of the US government) or current account deficits (in the case of Chinese or other consumers) in order to revive economic growth later this year and in 2010.

So Henry, what kind of policy responses do you believe the Feds or the Chinese would implement over the next few months?

With the rescue of Bank of America last Friday, the immediate crisis in the US financial system is over for now.  The $20 billion preferred equity injection would increase the bank's Tier 1 ratio from 9.15% to 10.70%.  Combined with the Fed's backstop of $118 billion in toxic assets, Bank of America's capital position should be sufficient to withstand any further losses over the next couple of quarters.  The qualifier in the previous sentence is “for now.”  Investors are now projecting further losses in the global diversified banks for the rest of the year.  Taking this into context, the extreme loss in confidence and the indiscriminate selling of global bank stocks is totally understandable.  The UK government – taking last week's indiscriminate selling as a cue – has announced a new rescue package that provides protection against future defaults as long as financial institutions are willing to lend more money.  The UK government also announced a scheme to purchase up to £50 billion of AAA-rated asset backed securities, while the Bank of England has been authorized to purchase up to £50 billion in private sector assets.  As soon as Obama is inaugurated as President on Tuesday, his advisors, the Federal Reserve, and the FDIC will be working around the clock with Congress to set up a broader rescue plan for the US banking system (make no mistake: the UK rescue will not work unless a similar plan in the US goes into effect).  I expect such a plan (whether it is in the form of a RTC-style fund or a systemwide backstopping of the banking system) to be announced as early as next weekend, and to be implemented no later than the end of February.  In the meantime, I expect the Federal Reserve to continue to support the US housing markets by buying GSE mortgage-backed securities, and I don't expect them to stop until the 30-year conforming, fixed mortgage rate target declines to 4.5% or below.  Assuming the US administration announces some kind of universal “backstop” for the US banking system by next weekend, I expect bank lending to increase immediately, as there are tons of cash on commercial banks' balance sheets (shown in the following monthly chart):

Cash Assets vs. Monthly % Change of Cash Assets in US Commercial Banks(January 1988 to December 2008) - The increase in banks' cash assets is unprecedented, as the amount of cash held by US commercial banks increased by 240% year-over-year in December, and topped $1 trillion for the first time in history...

As shown in the above chart, the amount of cash assets held by commercial banks increased by 240% on a year-over-year basis in December 2008.  The amount of cash assets is currently at US$1.01 trillion, up from just $297 billion as of December 2007.  With the universal backstopping of the US banking system, as much as $300 billion of this cash hoard would be available for lending immediately.  More importantly, the $825 billion “Obama fiscal stimulus” would also have a greater impact on GDP growth, as a well-functioning financial system will allow the “multiplier effects” of the fiscal stimulus to work to its fullest extent.

As for the Chinese, I expect the People's Bank of China to ease again sometime next month, followed by at least one more easing in March or April.  I also expect the Chinese government to ease retail gasoline prices, as Chinese consumers are now paying the equivalent of $80 to $90 a barrel.  Given the government's history of taking incremental steps, I don't expect any implementation of social safety nets just yet to spur domestic spending/consumption, but if the global economic indicators do slow further over the next couple of months, I expect the Chinese government to announce a larger fiscal stimulus package (which would also help in lessening social tensions).  Over the long run, I fully expect the Chinese government to implement some social safety nets and to invest more in alternative energy research, as the Chinese realize that neither the US consumer nor the US scientific/venture capital community can “go it alone.” 

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports(July 2006 to January 16, 2009) - For the week ending January 16th, the Dow Industrials declined 317.96 points, while the Dow Transports declined 313.11 points. The stock market is now at a crossroads, with the Dow Transports (which has been one of the leading indexes throughout the October 2002 to October 2007 bull market) just 5.3% above its November 20, 2008 bear market low of 2,988.99. While the rescue of Bank of America on Friday stemmed the selling pressure for now, any action over the next week or so will be driven by the actions of the Obama economic team, including talk of a RTC-style fund to absorb toxic assets or a system-wide *backstop* of banks' balance sheets. The $825 billion Obama fiscal stimulus is not enough - and neither can the US rely on the Europeans or the Japanese to lift the global economy out of recession. With the immense amount of capitulation and very compelling valuations across the world - I believe we are still in the midst of one of the greatest buying opportunities of our generation, but should the latest plans fail out to stem the liquidation in financial stocks once and for all, there's a chance we could break the November 20, 2008 lows. For now, we will maintain our 100% long position in our DJIA Timing System, but will continue to be cautious on the stock market until we see some stronger policies from US policy makers.

For the week ending January 16, 2008, the Dow Industrials declined 317.96 points while the Dow Transports declined 313.11 points.  With the market waiting for a system-wide bailout of the US banking system, and with the Dow Transports just 5.3% above its November 20, 2008 bear market low, the stock market is now at a crossroads.  While the rescue of Bank of America rescue last Friday has put a floor under the market for now, investors are now screaming for a much broader rescue – something akin to the RTC-style fund to absorb toxic assets or a system-wide backstop of banks' balance sheets.  With tax-loss selling and hedge fund liquidation now over, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending) once/if any broad rescue plan is announced.  That said, while there are still landmines in various emerging market countries (such as most of central and eastern Europe) 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 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 from -8.8% to -8.7% for the week ending January 16, 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 January 16, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios increased slightly from -8.8% to -8.7%. While, the latest rise in bullish sentiment is a good sign for the bulls (as the market has typically performed well when this sentiment indicator reverses from an extremely oversold condition), most of the upcoming week's market action will again be news-driven. Until we get some concrete news of a systematic-wide bailout, sentiment can indeed get darker again, but for now, we will remain 100% long in our DJIA Timing System.

With the four-week moving average of our popular sentiment indicators having reversed from a historically oversold condition, chances are that the stock market will continue to rally, as the stock market has typically performed well when this sentiment indicator reverses direction from an extremely oversold condition.  That said, this week's market action will again be news-driven, given ongoing jitters about the global banking system and fourth quarter earnings reports.  For now, we should continue to be cautious, but given the end of tax-loss selling and hedge fund liquidation, the upcoming release of the remaining $350 billion in TARP funds, 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 still believe we are in the midst of the biggest buying opportunity of our generation.  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 its most recent high on January 8th, the 20 DMA of the ISE Sentiment has endured a quick correction. The uptrend in bullish sentiment is still intact, however, although the 20 DMA is now getting overbought relative to its readings over the last two years. However, relative to levels over the last five years, both the 20 and the 50 DMAs are still at neutral levels, signaling that bullish sentiment still has potential to rise. With the immense liquidation in the global stock market in the last three months, my sense is that the selling pressure in the US stock market has peaked, but until we get some concrete news of a systematic-wide bailout, we could see more weakness in the short run.

Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early to mid October, both the 20 DMA and the 50 DMA have reversed convincingly to the upside.  Historically, a reversal of the ISE Sentiment index from an immensely oversold level has been the most powerful indicator for an upcoming or a continuation of a rally.  That said, the 20 DMA of the ISE Sentiment Index is now getting slightly overbought (relative to its readings over the last two years) – suggesting that the market could experience some short-term weakness next week, especially with the lingering concerns of the global banking sector.  However, as I have mentioned before, as long as one is under the age of 60 and is in a reasonable state of health, I believe US equities are still a great buy at current levels.

Conclusion: With the US stock and financial markets now at a crossroads, and with the UK government leading the way, I expect the Obama administration to come in this week with all guns blazing – starting with more concrete plans on how to spend the remaining $350 billion TARP funds, and ending with an announcement of a broader plan to bail out the US banking system.  With global economic leading indicators still heading south – and with the OECD economies plunging into deflation – there is no time to lose.  Given the immense amount of cash sitting on the sidelines (including the amount of cash assets on commercial banks' balance sheets), any official government “backstopping” of the US banking system would create an immediate incentive for fresh lending.  Such a move would also bring a lot of risk capital back into the financial markets – starting with the corporate bond market, and moving on to the high yield and equity markets.  However, subscribers should be very selective if buying individual stocks, given the ongoing deleveraging phase in the OECD economies.  As I mentioned before, subscribers will also need to be very careful with buying “yesterday's winners,” as the stock market's “favorites” tend to change in a new bull market.

Assuming a system-wide bailout of the US banking system is announced, I expect a dramatic easing of global liquidation pressures, although there are still further “shoes to drop” – primarily in Central & Eastern Europe, and in the commercial real estate market.  For those with a long-term timeframe, the stock market still represents the greatest buying opportunity of our generation.  I am still 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.  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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