Where is the “Bernanke Put?”
(July 5, 2009)
Dear Subscribers and Readers,
On June 23rd, the 33rd semi-annual edition of the top 500 list of the world's most powerful supercomputers was published at the 2009 International Supercomputing Conference at Hamburg, Germany. Most notably, the top 500 list is still dominated by Intel-based systems (although many of the top-performing systems utilize IBM's “Blue Gene” processors), with IBM a distant second, and AMD third. From a geopolitical standpoint, 58.2% of the top 500 supercomputers (by supercomputing power; note that the NSA – which houses some of the most powerful systems in the world – has stopped reporting since 1998) are located in the US, with 8.8% of the supercomputing power located in the UK, 6.0% in Germany, 4.6% in France, and 4.2% in China. Japan – which created and housed the most powerful supercomputer in 2002 (named the “Earth Simulator”), is now only in 6th place – housing just 3.0% of the world's supercomputing power.
Aside from providing the most up-to-date supercomputing statistics, the semi-annual list also publishes the historical progress of global supercomputing power – as well as a reasonably accurate projection of what lies ahead. Following is a log chart summarizing the progression of the top 500 list since its inception in 1993, along with a ten-year projection:
Today, a typical desktop with an Intel or AMD processor operates at 10 gigaflops (note that we choosing to ignore the GPU in our graphics processor from our calculations) – or the equivalent of an “entry-level” supercomputer on the top 500 list in 1998. In three to four years, a typical desktop should reach 100 gigaflops, or the equivalent of the most powerful supercomputer in the world in 1993. On the highest end, IBM is aiming to construct a Blue Gene/Q supercomputer with a targeted performance of 20 petaflops (or 20 million gigaflops) for the National Nuclear Security Administration by 2011. Code-named “Sequoia,” this supercomputer will possess the combined performance of all the supercomputers in the top 500 list as of today (see above chart) once it comes online (or the equivalent of 20 of today's most powerful supercomputer).
In other words, simulations that would take 20 years of computing hours for the most powerful supercomputer today will only take just one year once Sequoia comes online. Tasks that take an immense amount of computing time today – such as weather forecasts, gene sequencing, airplane and automobile design, protein folding, etc. – will continue to be streamlined as newer and more efficient processors/software are designed. While my optimism is relatively guarded, futurist Ray Kurzweil asserted that a supercomputer with 10 petaflops of computing power would be capable of simulating the basic functions of a human brain (with a supercomputer 1000 times as power for full human brain neural simulation). Such a democratization of the supercomputing industry would also result in improvements in solar panel designs, better conductors, drugs that are more efficient, etc. As long as global technology innovation isn't stifled, the outlook for global productivity growth – and by extension, global economic growth and standard of living improvements – will remain bright for years to come.
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 3,891.26 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 3,582.26 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.
While we are definitely bullish on the innovative capacity of the US and global economy, we continue to express our doubts on the commitment of the world's central banks to reflate the economy in the short-run. As covered in our previous commentaries, both the Bank of England and the People's Bank of China have remained committed in further monetary policy easing and liquidity creation. The European Central Bank and the Bank of Japan, on the other hand, have remained reluctant. The ECB, in particular, has chosen to flood its banking system with US$1.5 trillion in loans in order to prop up both government and consumer borrowing in the region, but has so far been reluctant to shift to an outright quantitative easing program. As discussed in our latest mid-week commentary, the Bank of Japan had actually shrunk its monetary base over the last two months – signaling that it has all but stopped its monetary policy easing since early May (the Japanese government also canceled a plan to directly buy equities from various banks).
Even the Bank of England may not be able to commit to its easing policy over the longer run. As we covered in our June 18th commentary and our commentary last weekend, the Bank of England has been the one major central bank that has maintained its pace of asset purchases (known as “Quantitative Easing”). 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 July 2nd, the Bank of England purchased another 6.5 billion pounds (US$10.6 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:
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 105.6 billion pounds in debt. The Bank of England is expected to raise its QE program limit to 150 billion pounds this week. Even if the limit is raised to 150 billion pounds, however, the Bank of England's quantitative easing program will grind to a halt in as little as eight weeks if it does not ask and receive the authority from the UK Treasury to expand its QE program. With little political support for an expansion of the Bank of England's quantitative easing program, however, 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. While the Fed has signaled its commitment to its QE program, the pace of its asset purchases has slowed down over the last six weeks, as we covered in our last weekend's commentary. In fact, the Fed's asset purchases amounted to only $9.3 billion in the latest week – its lowest level in four weeks – as shown in the following weekly chart:
The reluctance of the Feds to further ease monetary policy is also exemplified by the scaling back of the PPIP program. When the PPIP was announced in March, the government had intended the program to be initially funded with $100 billion in public and private funds. Since then, it has been scaled back to a $20 billion program. In other words, the “Bernanke Put” has disappeared, at least in the short-run (I have no doubt it will come back if the stock market declines 5% to 10% from current levels or if the price of oil declines to below $60 a barrel). With the average 30-year fixed mortgage rate still at a relatively elevated 5.34%, 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. In addition – with California (if it were an independent country, it would rank as the tenth largest economy in the world) poised to raise taxes, and with systemic risks still present in Central and Eastern Europe, and US commercial real estate, it remains hard to be very bullish on US stocks until mortgage and credit rates fall by another 25 to 50 basis points, or until our short-term technical indicators (such as the 10-day MA of the NYSE ARMS Index, the VIX, or the equity put/call ratio) sell off to an oversold condition. 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 (earnings season kicks off this Wednesday evening with Alcoa; for folks interested in the casual dining sector, Ruby Tuesday is reporting Tuesday evening).
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 July 2, 2009, the Dow Industrials declined 157.65 points while the Dow Transports declined 104.33 points. With the two Dow indices having risen by 26% and 47%, respectively, from their early March lows, and with the ongoing liquidity and systemic risks, 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. For now, our short-term technical indicators are not close to oversold levels just yet – suggesting that the stock market still has some more downside over the next few weeks at the very least.
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 0.0% to -2.3% for the week ending July 2, 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:
After peaking at 1.0% two weeks ago, the 4-week MA has now declined two weeks in a row. 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, the “Bernanke Put” has disappeared for now. As a result, paring back our 125% long position in our DJIA Timing System on the morning of June 8th to control for risk was in retrospect 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 trades back down to the 7,000 to 7,400 level.
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:
After consolidating in the 127 to 137 range over the last three months, the 20 DMA declined to below the lower end of this range over a week ago. Since then, it has traded within the 119 to 122 range. 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 (along with the 50 DMA) declines to a more oversold level, probability suggests that the market should continue to correct in the short run.
Conclusion: While US and global productivity growth remains bright in the long run, there are still many short-term headwinds that the stock market needs to deal with. While the Bank of England should raise its 125 billion pound asset purchase limit to 150 billion pounds sometime this week, this is still a “drop in the bucket” relative to what the ECB and the Federal Reserve are capable are doing. Unfortunately, the ECB is content to simply flood the Euro Zone's banking system with loans and go on “cruise control” for now, while the Federal Reserve has actually been slowing down its asset purchases! With the California budget crisis now getting out of control (the best case scenario is for California to raise taxes, and even that is bearish from the market's perspective as California is the tenth largest economy in the world), and with a possible financial dislocation emanating from Central & Eastern Europe, 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.
Henry To, CFA