Numerous Positive Divergences Now Evident
(February 22, 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 4,806.33 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 4,497.33 points as of Friday at the close.
Based on the pure mechanical (and short term) interpretation of the Dow Theory, the technical condition of the stock market now looks downright ominous, as both the Dow Industrials and the Dow Transports pierced their respective bear market lows at the close last Friday. But over a longer-term timeframe, the concurrent declines last Friday are far from ominous. For example, while the Dow Industrials did pierce both its recent bear market and its October 2002 low (the nadir of the last bear market) last Friday, this isn't the case for the Dow Transports. Sure, the Dow Transports did make decline below its recent bear market low, but it is still 39% above its March 2003 low – suggesting that both global trade and the continuing influence of global Ricardian growth remain intact (although it no doubt has been damaged by the pullback of the US consumer). More importantly – as I discussed in our original “primer” on the Dow Theory and in subsequent commentaries and posts on our discussion forum – the concept of valuations override virtually every other technical signal that emulates from the Dow Theory. While new concurrent lows by the Dow Industrials and the Dow Transports would have been a very bearish sign during the 2000 to 2002 bear market (when valuations were still overly high), I would argue that such is not the case today.
In fact, the price-to-book ratio of the Dow Industrials is now at a mere 2.000 – its lowest level in over 20 years (lower than where it was during the October 1990 bear market low)! Given the decade-low valuations in the stock market, the amount of bearish sentiment on Wall Street, the aggressive policies of global policymakers to “get ahead” of the financial crisis, and the amount of cash (earning virtually zero interest) on the sidelines, and the many positive technical divergences within the US stock market (much of what I will discuss in the latter part of this commentary), I believe we now have a great setup for at least a “swing trade” in the US stock market. Such an opportunity does not come often, and we intend to take advantage of this rare condition by breaking with tradition and going 125% long in our DJIA Timing System at some point in the next few days. As we have done in the past, I will send a personal email to your mailbox (in real-time) informing of our entry point once we have decided to do so. Even though we would be utilizing leverage (which I never like to do under any circumstances), subscribers should note that a 125% long position isn't overly aggressive. Even if one gets caught with a 125% long position during a market crash, it is by no means catastrophic for one's portfolio. We will attempt to limit the risk of this additional 25% long position (should it come to pass) by quickly paring it back on any rally over the next few weeks.
More importantly, US corporations are still projected to add value over the course of this year, even though by all accounts, real US GDP is set to experience its first calendar-year year of negative growth since 1991 (and measuring by the magnitude of the decline and in the spike in unemployment, our worst recession since 1982). While we all know that Standard & Poor's is too optimistic with their earnings projections of $66.60 a share for 2009, the book value of both the S&P 500 and the Dow Industrials would still rise as long as earnings remain in positive territory. The more bearish (both top-down and bottom-up) analysts are, at this point, still calling for a $50 to $55 in earnings for the S&P 500 this year – suggesting that the price-to-book ratio of the Dow Industrials will decline further this year if the Dow Industrials remains at its current level.
In addition, there is a good chance (with the glaring exception of the European Central Bank and the German government) that policy makers around the world are now starting to “get ahead” of the financial crisis. For example, there is now credible talk that Citigroup (the weakest of the banks with only a 1.5% tangible common equity ratio, compared to 2.6% for Bank of America and 2.7% for Wells Fargo) is currently negotiating with the Obama administration to make its tangible equity position stronger by converting the government's stake in preferred equity into common equity. At the same time, Citigroup will also seek others (such as the Abu Dhabi Investment Authority) to do the same, and to separately issue more common equity to both existing and new shareholders. Not only will this strengthen Citigroup's common equity position, it will also increase its overall capacity to lend – as well as eliminate $3.4 billion of preferred dividends that the company is now paying under the TARP. I expect some kind of announcement on Citigroup to be made in the next couple of weeks. Before then (most likely this week), I expect the US Treasury to clarify its timeline and plans to “stress test” and recapitalize the US banking system – which would provide some reassurances for investors who have been spooked of talk regarding nationalization.
Over in the UK, the government has decided to utilize the nationalized Northern Rock as a vehicle to provide more liquidity to the British mortgage market. In return for an injection of £3 billion, Northern Rock will aim to make as much as £14 billion of new loans over the next two years. While £14 billion over two years is not a significant amount in of itself, it would definitely help on the margins – especially when combined with other schemes such as the Bank of England's quantitative easing scheme, the British fiscal stimulus plans, and the recent devaluation of the Pound Sterling.
Over in Asia, the largest nations out of the 13 members of the Association of Southeast Asian Nations have agreed to enlarge a common regional funding reserve to $120 billion from $80 billion. Called the “Chiang Mai” initiative, this pool provides ASEAN countries a funding source in the face of capital flight or currency attack, and is essential for governments struggling to borrow money in the global debt market for basic operational needs. More importantly, ASEAN members have also agreed to ease the rules guarding access to the funds. Previously, only countries that have sought IMF aid will have access to the funds. This rule is no longer in place, and will thus allow ASEAN countries to gain immediate relief from the global financial stress (especially Indonesia).
Finally, Dubai – where many of its companies have seen their CDS trade at Icelandic levels in the last few weeks – was “bailed out” by the UAE central bank this weekend. In return for 4% annual interest, Dubai will obtain an immediate lifeline totaling $10 billion. Under the agreement, Dubai will eventually obtain a total of $20 billion in low-interest loans from the UAE central bank – a lifeline that will allow Dubai to satisfy its funding and repayment commitments for the rest of 2009.
Let us now quickly discuss the technical condition of the US stock market. In a recent report, Lowry's (one of premier and the oldest technical service available – it has been in service since the 1930s) reported that last Tuesday was the fifth 90% downside day since mid January. Since the bear market began in late 2007 (these are my words, not Lowry's), the market has at least temporarily stopped declining after a cluster of four or five 90% downside days. If recent trends play out again, then we are definitely due for a rally, especially given the oversold conditions in the stock market, as shown in the following chart (showing the percentage of stocks above their 20, 50, and 200-day exponential moving averages) courtesy of Decisionpoint.com:
As shown in the above chart, the percentage of stocks on the S&P 500 that are trading above their 20-day EMAs were only 9% last Friday – its lowest level since early December of last year. More importantly, we are now also seeing numerous positive divergences, as indicators like the NYSE Common-Stock Only Advance/Decline Line (shown the following chart courtesy of Decisionpoint.com) are still higher than their November 20, 2008 lows – thus failing to confirm the Dow indices on the downside:
In addition, the number of new 52-week lows is nowhere close to where its level back in early October and late November of last year (as shown in the following chart, again courtesy of Decisionpoint.com) – suggesting that selling power on both exchanges (this is also the case on the NASDAQ Composite) is dissipating, even though the two Dow indices are making new lows:
With the most attractive valuations in over two decades, the oversold condition in the stock market, and numerous positive divergences (including the higher highs in the McClellan Summation Index), I believe this is now a good time for a swing trade on the long side. Doing so right now is also advantageous, as many institutional investors (such as pension funds) are now seriously underweight their target equity allocation, and will most probably rebalance back into equities (from mostly fixed income) over the next few months. We would also look to take advantage of any snap back rally with an additional 25% in our DJIA Timing System over the next few days – thus bringing it to a 125% long position.
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 February 20, 2009, the Dow Industrials declined 484.74 points while the Dow Transports declined 258.41 points. With the latest decline in both Dow indices, both the Dow Industrials and the Dow Transports have made new bear market lows. While this is usually an ominous sign, I believe the current decline “lacks teeth,” given that: 1) the Dow Transports is still 39% over its March 2003 low, and 2) valuations in the US stock market is now arguably the cheapest in two decades. As I mentioned before, the US financial system (in the form of banks' shares, corporate spreads, and securitized spreads) has been screaming for assistance. Now is the time for the Feds to be much more transparent and proactive in order to find a systematic solution, once and for all. My sense is that this will come as early as this week, if not in the next few weeks. Once that is settled, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending). Because of this, we will look to go 125% long in our DJIA Timing System, up from our current 100% long position.
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 declined from -13.8% to -16.2% for the week ending February 20, 2009. 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:
While the four-week moving average of our popular sentiment indicators sinking to -16.2%, this reading is now at its most oversold level since early December of last year. More importantly, this indicator is also now near historically oversold level, suggesting that the market could snap back higher at any time. My sense is that we would get more clarifications on the US Treasury's bank recapitalization scheme (along with specific plans on what the government will do with Citigroup) over the next couple of weeks. Combined with the inevitable rebalancing into equities by institutional investors, my sense is that the market could very well embark on a rally very soon. Given the very attractive global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, we should definitely be more bullish than most.
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 its most recent low on February 4th, the 20 DMA has bounced back up strongly to a level of 127.0, a high not seen since January 15th. While the rising bullish sentiment in this indicator isn't confirming the the bearish sentiment within our other sentiment indicators, it is nonetheless still trading at an oversold level (relative to readings over the last five years). As a result, the ISE Sentiment reading is not an obstacle to a snapback rally in the stock market. Assuming that the US Treasury clarifies its bank recapitalization plan over the next couple of weeks, equities should rally strongly over the next few weeks. As I have mentioned in a previous commentary, 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 good long-term buy at current levels.
Conclusion: Sustainable, and snapback rallies in the stock market are typically preceded by positive divergences within the technical condition of the stock market. Combined with the most attractive valuations in two decades, the sheer amount of investable capital on the sidelines, the overly bearish sentiment, and the aggressive policies of the Obama administration to counter the financial crisis, I believe the conditions for a significant snapback rally is now in place. As a result, we will “break with tradition” and go to a 125% long position in our DJIA Timing System sometime in the next few days (a real-time email will be sent informing you of our decision). Make no mistake: We have always been very conscious of risk and will continue to be. We believe we are minimizing our risk by: 1) limiting the additional long position to only 25%, such that a further 30% or even a 40% decline should not cause long-term damage to our performance, 2) limiting our holding period to only a few weeks – but maybe longer if the market exhibits strong breadth and volume on any snapback rally, and 3) implementing this position ahead of institutional investors who will no doubt rebalance into equities over the next two to three months. While some of my “capitulation indicators” are still not flashing a “once-in-a-generation” oversold reading, they have come close. With the US Treasury set to provide further clarifications on its bank recapitalization plans, subscribers should start thinking about what individual stocks to buy, and in what industries, etc. Also, within one's global equity portfolio, I highly recommend an overweighting of US equities and emerging markets at the expense of international developed (mostly Western European and Japanese) equities for the next 12 months. 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 some clarification is provided regarding the bailout of the US banking system, 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 one of the best buying opportunities of our generation. I am still constructive on US and Chinese equities. Unfortunately, I am no longer overweight in Japanese equities, as both the Japanese government and corporate CEOs have shown continued reluctance for structural reforms. Subscribers please stay tuned.
Henry To, CFA