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Liquidity Still a Headwind

(June 28, 2009)

Dear Subscribers and Readers,

The FHFA House Price Index (formerly the OFHEO House Price Index) is the broadest (in terms of geography) publicly available measure of the movement of single-family housing prices in the US – and is “designed to capture changes in the value of single-family homes in the U.S. as a whole, in various regions and in smaller areas.”  Unlike the Case-Shiller indexes (which cover only major metropolitan areas), the FHFA HPI is “based on transactions involving conforming, conventional mortgages purchased or securitized by Fannie Mae or Freddie Mac.

The following quarterly chart shows the value of real estate assets held by households (courtesy of the Federal Reserve's Flow of Funds) as a percentage of their total assets vs. the quarterly changes in the FHFA HPI from 2Q 1975 to 1Q 2009:

Real Estate held by Households and Nonprofits as a Percentage of Total Assets vs. the Quarter-to-Quarter Change in the FHFA House Price Index (2Q 1975 to 1Q 2009) - With the growth in housing prices (per the FHFA HPI) having come down significantly in recent quarters (and more so if you utilize other housing market indices, such as the Case-Shiller indices), real estate as a % of household assets has now declined to 27.70% at the end of 1Q 2009. However, this is still above the 34-year average of 25.03% - suggesting that there is still further downside for real estate prices (at least on a relative basis).

During the 4th quarter of last year and the 1st quarter of this year, housing prices (those that are covered by conforming mortgages) remained steady, even as the global equity markets plunged to multi-year lows (in the case of Japan, a new 25-year low).  As a result, the value of real estate held by households and non-profit organizations as a percentage of total assets actually increased over those two quarters.  At the end of 1Q 2009, the percentage of total assets held in real estate by households and non-profits sat at 27.70%.  Even though this percentage has declined from its record-high of 30.50% (set in the 3rd quarter of 2005), it is still 2.63% above its 34-year average.  With the 30-year fixed mortgage rate still sitting at 5.51% - and with the mortgage financing available to only highly credit-worthy borrowers with 20% down – probability suggests that US housing prices in general are still on a downtrend.  I am not looking for any sustainable strength in the national housing market until 2010 at the earliest.

Let us now continue our commentary by reviewing our 9 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 3,733.61 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 3,424.61 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.

With housing and commercial real estate prices still a major headwind across the world (with the major exception of Chinese real estate prices), global policy makers will need to continue with their accommodative fiscal and monetary policies for the foreseeable future.  As we covered in our June 18th commentary, one major central bank that has maintained its pace of asset purchases (known as “Quantitative Easing”) is the Bank of England.  From mid March to the present, the Bank of England has consistently purchased between 6 to 7 billion pounds in Gilts, commercial paper, and corporate bonds on a weekly basis – effectively monetizing these debts and creating money “out of thin air” in the process.  For the week ending June 25th, the Bank of England purchased another 6.4 billion pounds (US$10.5 billion) in debt.  The following weekly chart (showing the weekly as well as the cumulative asset purchases made by the Bank of England since early March) illustrates the consistency of these weekly purchases:

Central Bank Reserves Supplied Via Asset Purchases by the Bank of England (in Sterling millions)

Even though the Bank's QE program is quite small (with a current limit of 125 billion pounds, which could be raised to as high as 150 billion pounds if needed) relative to the Federal Reserve's asset purchases, it still helped ease monetary conditions in the UK on a marginal basis.  That said, the Bank of England has already purchased 99.1 billion pounds in debt.  At the current rate, the Bank's QE program (if not raised to 150 billion pounds) will be prevented from purchasing more assets in as little as four weeks.  Even if the limit is raised to 150 billion pounds, the Bank of England's quantitative easing program could grind to an abrupt halt in as little as two months.  With the little political support for an expansion of the Bank of England's quantitative easing program, UK policy makers could run into a liquidity headwind later this summer.

With UK policy makers projected to run into a liquidity headwind later this summer, global financial markets will be more dependent on the Federal Reserve (especially with the Bank of Japan paring back its liquidity programs).  While the Fed still has ample “fire power” (e.g. in the latest FOMC statement, the Fed stated it will be purchase up to $1.45 trillion in agency MBS and debt by the end of this year – meaning it could purchase an additional $891 billion of agency MBS and debt over the next six months), the pace of its asset purchases has slowed over the last five weeks, as shown in the following chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - Even though the Fed purchased a significant amount of Treasuries and agency securities during the middle of June, the Fed's purchases have stalled over the last five weeks compared to where they were in April - suggesting that the Federal Reserve is not being as accommodative as it was during the early March to mid May period...

With the average 30-year fixed mortgage rate still at a relatively elevated 5.51%, and with the savings rate spiking up to 6.9%, the Federal Reserve will probably need to quicken its pace of asset purchases in order to increase global liquidity.  With systemic risks still present in Central and Eastern Europe (analysts are now speculating that Bulgaria will be the next country to turn to IMF aid) and over the longer-run, US commercial real estate, my sense is that global liquidity conditions will stay relatively challenged as we had head into the Fall (i.e. Autumn).  As the second-quarter earnings reports and third-quarter earnings projections roll in over the next few weeks, I expect investors to become more cautious and thus for the stock market correction to continue in the short-run.

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 June 26, 2009) - For the week ending June 26th, the Dow Industrials declined 101.34 points, while the Dow Transports rose 43.30 points. From the March 9th bottom till now, the Dow Industrials and Dow Transports are up 29% and 52%, respectively. While the Dow Industrials surpassed its early May high three weeks ago (although only just marginally), the Dow Transports is still significantly below resistance . The short-term outlook for the market is now tited towards the down side, as the potential Latvia devaluation, the lack of central bank liquidity creation, and the deterioration of the commercial real estate market hang over the horizon. However, the intermediate term uptrend probably remains intact. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending June 26, 2009, the Dow Industrials declined 101.34 points while the Dow Transports rose 43.30 points.  With the two Dow indices having risen by 29% and 52%, respectively, from their early March lows, and with liquidity headwinds and systemic risks rising over the last four weeks, we decided to reduce our risk exposure by paring back our 125% long position to a 100% long position in our DJIA Timing System on the morning of June 8, 2009.  We will continue to keep track of the amount of central bank liquidity creation, 2nd quarter earnings reports (along with 3rd quarter earnings projections) and the systemic risks emanating from Eastern Europe, as we feel that these three issues pose the most downside risk to the U.S. stock market throughout the summer.

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 a reading of 1.0% to 0.0% for the week ending June 26, 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 June 26, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 1.0% to 0.0% - after rising for two consecutive weeks. While this reading has been on an uptrend since March, it still remains oversold on a historical basis. However, in order to control for risk, we decided to par back our 125% long position to 100% long in our DJIA Timing System on the morning of June 8th. For now, we will remain 100% long in our DJIA Timing System.

The 4-week MA experienced its first decline after rising for two consecutive weeks.  While the 4-week MA is still oversold on a historical basis, it has increased very quickly since the early March lows.  Combined with the impending liquidity headwind, the systemic risks stemming from Central and Eastern Europe, and potential jitters from 2nd quarter earnings reports, I expect the stock market correction to continue in the short-run.   While I believe the world's central banks are still committed to reflating the global financial system should the financial markets exhibit another bout of weakness, there is no doubt that paring back our 125% long position in our DJIA Timing System to control for risk was the right move.  For now, we will remain 100% long in our DJIA Timing System, and will most likely not ever shift back to a 125% long position unless the Dow Industrials break the 7,000 level and approach the early March lows.

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) - With the dip to below 120 last week, the 20 DMA is no longer at an overbought level. While this suggests that the rally should continue over the next several months, there are some short-term but significant obstacles that the market needs to deal with - including 2nd quarter earnings and earnings projections. Because of these ST obstacles, we have decided to reduce our 125% long position to just a 100% long position in our DJIA Timing System on the morning of June 8th in order to control for risk.

After consolidating in the 127 to 137 range over the last three months, the 20 DMA actually spiked below this range to close at 119.1 for the week.  With this downward spike, this indicator is no longer at an overbought level.  Despite this, there are still some short-term but significant obstacles that the market needs to deal with.  Unless this reading declines to a more oversold level, probability suggests that the market should continue to correct in the short run.

Conclusion: With real estate assets still making up a higher-than-average proportion of household assets, probability suggests that both residential and commercial real estate will continue to be headwinds for the US economy over the next six months.  With the Bank of England now running up against its 125 billion pound asset purchase limit, and with the Federal Reserve now slowing down on their asset purchases, the US financial markets could run into a serious liquidity headwind sometime this summer, especially if we experience a financial dislocation coming out of Central & Eastern Europe or in US commercial real estate.  Again, I expect a further correction in the global equity markets in the short-run.  That said, I still expect the global equity markets to rise later this year, as global central banks will no doubt return to a more accommodative mode if equity and commodity markets experience a weak summer.  2010 will be trickier, as consumers and corporations around the world will continue to rebuild their balance sheets.  On a country-specific basis, I expect most of Asia and Brazil to continue to outperform (with a focus on domestic-orientated stocks).  While this is still too early to say, I expect the next US bull market to be driven by technology and biotechnology stocks.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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