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Is the Market Rally Sustainable?

(April 5, 2009)

Dear Subscribers and Readers,

Let us now begin our commentary by reviewing our 8 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 4,154.41 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 3,845.41 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a gain of 767.59 points as of Friday at the close.

In his seminal book, “The Great Illusion,” published in 1909, Sir Norman Angell asserted that the fears of a war between the UK and Germany was unfounded – even though the UK and Germany was engaged in a naval arms race at the time – as all the major powers in Europe were too dependent on each other for exchange and cooperation for economic growth and prosperity.  From Angell's standpoint, a major war in the region was simply inconceivable.

John Maynard Keynes, who started work at the UK Treasury immediately after the war broke out (and who wrote the prophetic “The Economic Consequences of the Peace” and “The General Theory of Employment, Interest, and Money”) also did not foresee the “The Great War.”  While Keynes was not involved in politics at the time, there was no doubt that Keynes should have sensed it earlier than most, as Keynes has been speculating in the stock market – which provided an early warning – since 1913.  Interestingly, although Archduke Ferdinand was assassinated on June 28 1914, Keynes did not mention the deteriorating international conditions in his letters until a month after the assassination.  On August 1st, Germany invaded Belgium, and on August 4th, the UK declared war on Germany.  As one of Keynes' biographers, Robert Skidelsky, discussed, war was not expected, as “Keynes and his friends, like Angell, were rationalists and meliorists.  They were aware of dark forces lying in wait to ambush civilization, but believed they would be scattered by ‘automatic' economic progress.  In the years before the war Keynes and his friends were caught up in a cultural renaissance.  These things occupied the foreground of their consciousness; the atavistic posturings of the statesmen seemed to be ‘the amusements of the daily newspaper', as Keynes later put it.”

The irrationality of World War I would manifest itself in a major way at the Versailles Conference in 1919.  The French and the British, screaming for blood and reparations from Germany, and focusing on future national security and borders, were far from concerned about rebuilding Germany to ensure future European cooperation and prosperity.  20 years later, Europe would be mired in another major, and as Winston Churchill labels it, an “unnecessary war.”  Today, with the US nuclear weapons pile able to destroy the world many times over, and with the aging of the world's general population (not to mention China's “one child policy”) I highly doubt even irrational men would even dare to fight a major war today, but as events in the financial markets over the last decade have demonstrated, the dominance of human irrationality in times of greed or fear has never changed, and probably never will.

From February 14, 2000 to April 2, 2000, I sent a series of emails to my friends and colleagues (which can be found here) discussing the irrationality of stock market investors and why stocks will reach a major peak sooner rather than later.  I do not need to go into details here, but when investors slap a multi-billion market cap on stocks with no revenues, and when the one-day dollar trading volume of a certain stock (JDS Uniphase) exceeds the value of the daily US GDP, chances are that we were in a mania.  Unfortunately – even with the subsequent collapse of internet and telecom stocks, the bankruptcies of Enron, Worldcom, and Global – investors learned next to nothing about managing risk and following a sound investment strategy.  Five years later, Americans were back to speculating in housing, with institutional investors blindly investing in structured securities such as CDOs, asset-backed securities, mortgage and commercial REITs, and multi-billion leveraged buyouts that were done at the top of the market.  In the wake of the technology analysts' scandal (with Henry Blodget as one of the main characters), the forced separation of sell-side analysts and investment bankers resulted in the near-destruction of the sell-side analyst model (sell-side analysts are now being paid only 10% to 20% of what they were used to).  In the wake of the accounting scandals and collapse of Enron, Worldcom, and Global Crossing, Congress enacted the Sarbanes-Oxley Act.  While the majority of the US population and some analysts (who should really know better) have screamed for blood and punishment in light of the global financial crisis, the Administration has so far (rightly) resisted this idea – calling for Reform first and foremost instead.  From both a principal and practical standpoint, it makes little sense to “punish” the banks or the bankers at this point, as the vast majority of those who benefited from the housing bubble have already left or resigned from the industry, while those remaining behind have certainly learned the lessons, and are just responsible for picking up the pieces.  Any “punishment” would simply further damage the financial system and impede economic recovery – which perversely would allow the folks who walked away with their millions to purchase cheap assets down the road.  Furthermore, with the implosion of Lehman Brothers, and the near-death experiences of Merrill Lynch, Morgan Stanley, and Citigroup, I seriously doubt “moral hazard” would be a major issue in the next decade or two.  The financial crisis in the last 18 months will be implanted in our collective minds for years to come.

But of course, what makes sense from a moral and practical standpoint does not matter a whole lot – especially in a political charged environment, as history has demonstrated.  Many economists who never foresaw this crisis are still asserting that larger tax cuts would boost the US economy more than infrastructure spending, even though their conclusions were never tested under a system where both the financial and consumer sectors were actively deleveraging (more than likely, the majority of the tax cuts would go into debt repayments or savings accounts instead).  Similarly, the call for protectionism is even more preposterous.  The domestic economy cannot create more jobs with higher tariffs any more than New York can if it put up trade barriers with New Jersey or California.  The global economy thrived after World War II because of cooperation and reconciliation.  The global economic order – grounded in the Bretton Woods monetary system – provided sustainable economic growth and worked decently well while it lasted (for a generation).  Finally, for those who would like nothing more than for the “free markets” to sort this mess out, look no further than one of the manifestations of this ideology when taken to the extreme – namely, Enron's role in the California's electricity markets in 2000.  If the Federal Reserve had not stepped in, many of us would not be reading this right now, as we would be spending our time trying to get our money back from our (bankrupt) brokerages or (collapsed) money market funds instead.

Again, what makes moral and practical sense may not matter in the current emotionally and politically charged environment.  The majority of the baby boomers cut their teeth during the late 1970s and 1980s – in a period of unprecedented global prosperity fueled by the withdrawal of the public sector from our daily lives – especially in issues such as financial deregulation, privatization of government-owned industries, our national healthcare policies, and even our military.  Up until 2000, baby boomers generally believed in limited government and individualism – as these fueled both their balance sheets and income levels in the preceding 20 years.  With the technology crash and the collapse of Enron in the early 2000s, chinks started appearing in the “free markets” armor.  The subprime crisis that began in early 2007 – which subsequently morphed into a global financial crisis, and evolved into a global recession – has struck another huge blow to the baby boomers' beliefs of free markets and global capitalism itself.  Already, most of the G-20 countries are calling for substantial regulation of global banking leverage ratios, and the hedge fund and private equity industries.  The oldest baby boomers are also just now beginning to retire (although a significant number of baby boomer retirements would be delayed for several more years as they rebuild their savings lost in the last two years).  As the baby boomers retire, they will demand increased security and economic stability, or in other words, tougher regulations and government involvement.

Perhaps as important, subscribers should not forget that the second most powerful demographic cohort – Generation Y – has never really experienced the wealth generated by deregulation or limited government since they graduated from college (the oldest Gen-Y'er graduated in 1999).  So far, all they have experienced is scandal after scandal – all perpetrated in an environment where there was a lack of regulatory rules or a lack of regulatory enforcement.  In the meantime, hedge fund and private equity fund managers experienced a many-fold increase in their compensation while middle-class real income levels have declined since 2000.  CEOs were paid substantial bonuses even as they underperformed.  Here too, there is not much resistance to increased government involvement or regulations going forward – especially given the popularity of the Obama administration and a willingness to cooperate with our Western European counterparts among members of Generation Y.

After arguably swinging to one side of the “free markets” pendulum (at least to its most extreme since the early 1930s, and in terms of government spending as a percentage of GDP, since the late 1960s), I fear that the pendulum will swing to the extreme end of the other side.  This is not an unreasonable conjecture.  As seen in the below chart (courtesy of, of all places), US government spending stood at just slightly below 20% of GDP in 2007:

U.S. Government Spending as a Percentage of Gross Domestic Product 1980-2007

Contrast this to over 50% of GDP for France government spending and over 40% for Germany.  With the US consumer making up about 70% of GDP and still actively deleveraging, and with companies still reluctant to invest, there is a strong likelihood that public sector involvement in all aspects of our economy will increase going forward.  Moreover, with the baby boomers aging and demanding more stability and security, and with a renewed commitment to repair our crumbling infrastructure (such as highways, power lines, bridges, dams, etc.), I do not see this trend ending anytime soon.  While I don't believe US government spending will increase to 40% of GDP, I would not be surprised to see a structural (and sustainable) rise to 25% or even 30% of GDP in the next decade.

Whether the current stock market rally represents something more sustainable (i.e. the beginning of a multi-year bull market) or merely a bear market rally (e.g. the bear market rally rally from May 1970 to January 1973 within the 1966 to 1974 secular bear market) will depend on continued US innovation and the long-term ability of our country to generate more wealth.  Should the public sector become a much larger part of our economy, US corporate profits may suffer as public investment “crowds out” private consumption and investment.  On the other hand, one could also argue – as Felix Rohatyn has in his new book “Bold Endeavors: How Our Government Built America, and Why It Must Rebuild Now” – that public funds are needed to repair significant parts of the nation's infrastructure, as well as build new ones, such as a nationwide broadband network or a new power grid.  No matter what path this nation takes, it is going to be a very interesting one, indeed.

In the meantime, the current stock market rally is still far from running out of steam.  For example, corporate bond spreads are starting to narrow, while interest rates for jumbo mortgages are starting to decline.  As I have mentioned, upside volume and breadth over the last four weeks have been the most impressive since this bear market began in late 2007 – suggesting genuine demand for stocks.  In addition, unlike the rally coming off the October 9, 2008 bottom, the current rally has not been driven by short covering, as evident in the following chart (showing NYSE Short Interest vs. the Dow Industrials from mid November 2000 to mid March 2009):

NYSE Short Interest vs. Dow Jones Industrials(November 15, 2000 to March13, 2009) - For the two months ending March 13, 2009, total short interest on the NYSE increased by 2.8 billion shares to a six-month high of 16.2 billion shares. Thus, unlike the rally coming off the October 9, 2008 low (which coincided with a dramatic decrease in short interest), this current rally is not driven by short-covering, and suggests that the current rally is much more sustainable than any rally since September of last year.

As mentioned in the above chart, the latest rally has not been accompanied by a decline in short interest, confirming that the current rally has not been driven by short covering, but by genuine investment demand from institutional and retail investors.  Interestingly, total NYSE short interest actually increased by a whopping 2.8 billion shares over the last two months.  The same type of phenomenon is also evident in the NASDAQ Composite short interest numbers.

Note that the amount of cash on the sidelines, relative to the market cap of the S&P 500, is still near a record high, as shown in the following chart:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap(January 1981 to March 2009) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market which would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio spiked to another all-time high at the end of February, due mainly to the recent decline in the S&P 500. Since then, this ratio has declined to 51.19% - but is still much higher than the highs set in the bottom of the previous bear markets in October 2002 (27.68%) and month-end July 1982 (27.95%). This ratio is definitely supportive for stocks for the rest of 2009.

With many institutional investors (such as pension funds, endowments, and foundations) now underweight stocks, we should see at least some rebalancing back towards equities over the next several months.  For now, we remain bullish on the US stock market, and thus will remain 125% long in our DJIA Timing System.

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 April 3, 2009) - For the week ending April 3rd, the Dow Industrials rose 241.41 points, while the Dow Transports rose 200.37 points. Both Dow indices have now risen four weeks in a row - although they are still below recent resistance levels. However, there is no doubt about the strength of the rally over the last four weeks, as both upside breadth and volume have been the most impressive since the bear market started in late 2007. More importantly, the Dow Transports managed to hold above its March 2003 low of 1,942 (if the March 2003 low did not hold, we will most probably experience a far greater-than-expected global recession). In addition, until the financial system is working again and until the US housing market stabilizes, the Obama administration will continue to find ways to revive the financial markets. The current rally looks sustainble - but whether it will be sustainable in the weeks ahead will depend on investors' reaction to 2Q earnings. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending April 3, 2009, the Dow Industrials rose 241.41 points while the Dow Transports rose 200.37 points.  The two Dow indices have now risen four weeks in a row.  As mentioned before, the rally in the last four weeks was certainly nothing to sneeze at, as both upside breadth and upside volume was at their most impressive levels so far in this bear market.  More importantly, the Dow Transports managed to hold above its March 2003 lows at its lowest level – suggesting that the global economy is still holding up relatively well (and as confirmed by the recent rally in commodity prices).  Given the many positive divergences we have discussed, the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system, I expect the current rally to continue for the next several months.  Should there be any further need for capital, I continue to expect the US Treasury to stand by the terms of its February 10th “Financial Stability” plan, and with the Feds now providing support for the TALF and the PPIP, I also see a significant increase in bank lending.  Because of this, we will maintain our 125% long position 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 a reading of -21.7% to –15.5% for the week ending April 3, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending April 3, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -21.7% to -15.5%. Meanwhile, its ten-week MA (not shown) has also reversed from a historcal oversold reading of -18.9% (lowest since August 2002!) to -18.4% - suggesting that sentiment has reversed from its very bearish readings. Subscribers should note that any reversal from historically oversold readings is usually a precursor to a significant rally. We will remain 125% long in our DJIA Timing System, and are now looking for a continuation of the rally over the next several months.

With the four-week moving average rising over 10% in three weeks, there is no doubt that this sentiment indicator has now reversed to the upside.  Given this development there is a very good chance the market will continue to rally, as the most bullish signal has typically occurred when sentiment indicators such as this reverses from a historically oversold level.  Moreover, one of its components, the AAII Bears reading, spiked to a whopping 70% five weeks ago, which is the most bearish reading since the survey began in 1987.  With the world's governments committed to reliquifying the global financial system, and coupled with the inevitable rebalancing into equities by institutional investors, my sense is that the market could sustain its rally over the next several weeks to several months.  We will remain 125% long in our DJIA Timing System, for now.

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 low on February 4th, the 20 DMA of the ISE Sentiment has bounced to its highest level since Octobrer 2007. While the 20 DMA has now become overbought relative to its readings over the last two years, it is still oversold relative to its longer term readings. Moreover, the 20 DMA is now trading authoritatively above the 50 DMA - signaling that the market is still biased towards the upside. With the immense liquidation in the global stock market in the last five months, my sense is that the selling pressure in the US stock market has peaked. Now that we have received concrete details on the TALF and PPIP, we should see a continuation of the rally over the next several months.

Since its most recent low on February 4th, the 20 DMA has bounced to its highest level since October 2007.  While this sentiment indicator is now at a level that is overbought relative to its readings over the last two years, it is still somewhat oversold relative to its longer-term readings.  More importantly, the 20 DMA is now trading authoritatively above its 50 DMA – suggesting that both bullish sentiment and the stock market are still biased towards the upside.  As a result, the ISE Sentiment reading is also supportive for a sustainable rally in the stock market over the next several weeks to several months.

Conclusion: While the current stock market rally should continue for the next several weeks to several months, whether we have begun a new multi-year bull market is still up in the air, given the ongoing deleveraging in US consumers' balance sheets and the global pressure for more regulations within both the US and UK financial sectors.  As US consumers continue to rebuild their savings over the next several years, there is a good chance that public sector spending will increase – possibly to 25% or even 30% of US GDP – especially as the baby boomers' faith in the concept of “free markets” and limited government involvement start to wane as they get older.

In the meantime, as I mentioned two weeks ago, I expect levered beta strategies to come back into vogue as global policy makers go “all out” to cushion or stop the deleveraging in the financial markets.  Consequently, I expect financial stocks, consumer discretionary stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis for the next several months.  Starting in 2010, however, this trend should change yet again, as consumers and corporations around the world start to rebuild their balance sheets once again.  Whatever future growth we achieve will need to come mostly from Schumpeterian growth, while true alpha would mostly be extracted from “exotic beta” strategies such as microcap stocks, foreign small cap stocks, private equity, and private real estate strategies.  As the US Treasury and the Fed continue to find ways to reliquify the asset-backed markets and our financial institutions (through the Fed's stress tests), I expect CDS spreads to narrow and for the structured finance indices to start their recovery.  Such a scenario would not only benefit the asset-backed markets, but the stock and bond markets as well (especially the balance sheets of major financial institutions).  With the darkest sentiment in decades and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System on February 24th.  We will sell this additional 25% long position once the market rally starts to lose steam.  For those with a long-term timeframe, the stock market still represents one of the best buying opportunities of our generation.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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