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Europe Stuck in a Quagmire

(July 19, 2009)

Dear Subscribers and Readers,

Let us begin 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 3,428.06 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 3,119.06 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.

As we covered in our July 10th commentary (“The Battle between the Bulls and the Bears”), the surprise announcement on July 9th by the Bank of England to bring its quantitative easing policy to a close means that – with the ECB, the Bank of Japan, and the People's Bank of China no longer flooding their markets with liquidity – it is now solely up to the Federal Reserve to “pick up the slack.”  As covered in our recent commentaries, the Bank of England has consistently purchased between 6 to 7 billion pounds (US$9.8 to US$11.5 billion) 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. With it latest decision to impose a restricted ceiling of just 125 billion pounds in its QE program, we had asserted that the Bank of England will either need to slow down or stop its purchases in as little as two weeks.  The Bank of England has chosen the former route.  For the week ending July 16th, as shown on the following chart, the Bank of England purchased 4.5 billion pounds of securities (mainly Gilts) – its lowest weekly level since its first week of purchases in early March:

Central Bank Reserves Supplied Via Asset Purchases by the Bank of England (in Sterling millions) - The amount of asset purchases by the Bank of England plunged to 4.5 billion pounds last week - its lowest level since its first week of purchases in early March!

The Federal Reserve is now the only major central bank that is still effectively on an easing bias.  With investors still reluctant to take on any additional risks, and with banks and credits still tightening credit, any policy mistake by the Federal Reserve or “shock” caused by geopolitical events (such as a spike in crude oil prices) could result in a rather painful correction for the financial markets (at the very least, the Bank of England should have allowed itself a further 25 billion pound of “cushion” to insulate the UK economy from any unexpected tightening in liquidity). 

Unfortunately, the “800 pound gorilla” in the room isn't the Bank of England or any systemic risks that could emanate from a dramatic slowdown in the UK economy.  As covered in the European Central Bank's latest Financial Stability Review and a recent NY Times article, and in our past commentaries, the real global systemic risks lie in the Western European banking system.  Despite flooding the Euro Zone's banking system with €442 billion of liquidity and purchasing €60 billion in covered bonds, the Euro Zone's banking system remains frozen.  The core of the problem lies in the fact that the Euro Zone's banking system is fundamentally a solvency problem; not a liquidity problem (similar to the plight of the US banks prior to the April “stress tests” and recapitalization of the 19 largest US banks).  The majority of banks in the Euro Zone thus prefer to deposit their funds with the ECB in overnight deposits or to purchase European government banks, as opposed to lend to the real economy.

According to the ECB's Financial Stability Review – based on today's environment of higher capital requirements and the recent recapitalizations by the largest US banks – European banks will need to target a Tier 1 ratio of 10% and a leverage ratio (equity divided by assets) of 4% to 5%.  As shown in the following charts (courtesy of the ECB), the 16 LCBGs (large and complex banking groups) in the Euro Zone will need to raise €47 billion (US$67 billion) in additional capital to meet a Tier 1 ratio of 10%, while a wider sample of 35 European banks (including those in the UK and Switzerland) would need to raise as much as €71 billion (US$101 billion) in additional capital to meet a Tier 1 ratio of 10%.  Alternatively, the 16 LCBGs and the wider sample of 35 European banks could also shrink their risk-weighted assets by €469 billion (US$666 billion) and €715 billion (US$1,015 billion), respectively, in order to meet a Tier 1 ratio of 10%.

European banks' Tier 1 capital ratios and capital shortfall. European banks' core Tier 1 leverage ratios and capital shortfall

While a US$101 billion recapitalization requirement for the Western European banking system is not a trivial matter, it is certainly very do-able from both a practical and a public policy standpoint.  Unfortunately, as the investor community and analysts in the US have indicated over the last six months, folks (including regulators) are now much more focused on higher-quality capital ratios such as the leverage ratio (equity divided by total assets) in terms of gauging banks' solvency.  Quoting the ECB's Financial Stability Review (and as shown in Chart B above):

Moreover, investors and regulators are increasingly focusing on high-quality capital such as core Tier 1 capital – which has the highest loss-absorbing characteristics – and on leverage ratios, instead of on the conventional Tier 1 capital ratios. Further simulations show that, on the basis of leverage ratios such as core Tier 1 to tangible assets (CT1), the capital shortfall is substantially higher (Chart B). The euro area banks would have to raise €240 billion in core Tier 1 capital to achieve a CT1 ratio of 4%, or would have to deleverage by €6 trillion, equivalent to a reduction of €1.3 trillion in risk-weighted assets. For the European banks, the capital shortfall would increase to €414 billion or require €10.3 trillion of (tangible) asset shedding, equivalent to a risk-weighted asset reduction of €2.3 trillion.

A €414 billion (US$580 billion) recapitalization for European banks – short of outright bank nationalization – is impossible in today's environment.  At the minimum, we estimate that €200 billion (US$284 billion) in additional capital will be needed to soothe investors' fears and to encourage European-based banks to start lending “normally” again.  More ominously, this study does not take into account a possible dislocation in Latvia or other vulnerable Eastern European countries such as Hungary and Bulgaria.  To top it all off – if it wasn't for the €442 billion flood of liquidity created by the ECB (which the banks have subsequently used to purchase European government bonds), government bond yields in countries such as Spain, Italy, and Greece would have been blown wide open.  All this suggests that the greatest systemic risks today are now centralized in the Euro Zone.

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 July 17, 2009) - For the week ending July 17th, the Dow Industrials rose 597.42 points, while the Dow Transports rose 202.79 points. From the March 9th bottom till now, the Dow Industrials and Dow Transports are up 34% and 54%, respectively. Last week's rally was especially *violent,* as the Dow Industrials rose 7.3% while the Dow Transports rose 6.5%. While last week's action suggests the rally still has potential, it remains vulnerable over the next few months, as the lack of central bank liquidity creation (the failure of the Bank of England to raise its asset purchase limit to 150 billion pounds is the latest disappointment), the vulnerability of the the European banking system, and the deterioration of the commercial real estate market hang over the horizon.  We will maintain our 100% long position in our DJIA Timing System, as we believe the current rally has more room to run, but will not hesitate to shift to a more defensive position should the market become overbought sometime in the next few weeks.

For the week ending July 17, 2009, the Dow Industrials rose a whooping 597.42 points while the Dow Transports rose 202.79 points.  The strong upside breadth (and descent although not impressive volume) last week negates the short-term downtrend that had been developing since early June.  Moreover, as I have covered previously, the “most bullish” scenario for the stock market would have been a quick and further correction as a reaction to 2Q earnings announcements. Such a correction would have washed out the short-term traders and the weaker hands, and pave the way for a more sustainable rally for the rest of this year.  As a result of last week's rally, this scenario is no longer in play.  More ominously, despite its strong upside breadth, last week's rally was actually weaker (in terms of upside breadth and upside volume) compared to the mid-May to early June rally.  While last week's action suggests that the current rally has at least a few more weeks of upside (especially with a successful rescue of CIT, which would help reliquify small businesses around the country), I am doubtful that this is sustainable until the end of the year.  With the two Dow indices having risen 34% and 54%, respectively, from their early March lows, and with the ongoing liquidity and systemic risks, there is a good chance we could shift to a more defensive position in our DJIA Timing System (such as a 50% long or even completely neutral position) should the stock market or bullish sentiment becomes more overbought (coincident with a lack of strong, upside breadth).  For now, we will maintain our 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 decreased from a reading of -6.1% to -8.0% for the week ending July 17, 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 July 17, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of -6.1% to -8.0% -its fourth consecutive down week since peaking at 1.0% three weeks ago. Coincident with the strong rally last week, this semi-oversold reading suggests that the current rally could continue for at least a few more weeks. As a result, we will maintain our 100% long position in our DJIA Timing System and may shift to a more defensive position should the market or this sentiment indicator get more overbought over the next few weeks.

After peaking at 1.0% three weeks ago, the 4-week MA has now declined four weeks in a row to -8.0%.  With the strong upside breadth in last week's rally, this “semi-oversold” reading should provide further “fuel” for the stock market over the next few weeks.  Over the longer-run, the global liquidity headwinds, the systemic risks emanating from Central & Eastern Europe, and US commercial real estate remain a giant concern, although this should not impede the market from a further rally in the short-run.  Again, the “Bernanke Put” – especially given last week's strong rally – has definitely disappeared for now.  For now, we will remain 100% long in our DJIA Timing System, and will not hesitate to shift to a more defensive position should the stock market become more overbought (on weak upside breadth) over the next few weeks.

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 latest reading of 117.7, the 20 DMA remains at near its most oversold level since early February 2009. From a contrarian standpoint, this is a positive for the stock market - especially given the strong rally in the stock market last week. However, there are still some significant obstacles that the market needs to deal with - including the systemic risks emanating from the European banking system, the US commercial RE market, and the recent lack of central bank liquidity creation. For now, we will remain our 100% long position in our DJIA Timing System, however.

With the latest reading of 117.7 (after declining to as low as 113.1 on Wednesday), the 20 DMA remains near its most oversold level since early February 2009.  From a contrarian standpoint, this is bullish for the stock market, especially given the strong upside breadth in the stock market last week (suggesting that investors are buying with both hands).  While the short-term outlook is positive, there are still significant obstacles that the financial markets need to deal with later this year.  Should this sentiment indicator or should the market becomes overbought; we would not hesitate to shift to a more defensive position.  For now, we will remain our 100% long position in our DJIA Timing System.

Conclusion: While the CIT recapitalization should provide a boost to the stock market for at least a few more weeks (note that last week's rally was also accompanied by strong upside breadth and a somewhat depressed investor sentiment), there are many headwinds that the global financial markets will need to contend with over the next six months.  Chief of all these headwinds is the liquidity headwind posed by the ailing European banking system.  With the German elections not until September 27th, the chances for a systematic recapitalization of bailout of European banks remain off the table for at least the next couple of months.  The fact that the Bank of England will be halting its QE policy in just two weeks is also an ominous development.  In addition, the Chinese government and the People's Bank of China are now pulling back from its loose monetary policy enacted over the last 8 months. 

Should the stock market continue its rally over the next few weeks, there is a good chance that we will turn defensive in our DJIA Timing System (i.e. we may reduce our current 100% long position to either a 50% long or completely neutral position).  Whether we do this will depend on the upside breadth/volume on the stock market (a good indication of whether this rally is sustainable), as well as investor sentiment and how public policy in Europe is shaped and implemented in the coming weeks.  For now, we will remain 100% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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