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A New Liquidity Indicator

(July 26, 2009)

Dear Subscribers and Readers,

As California goes, so goes the nation?  As subscribers know, I am currently living in California doing my joint MBA/MPP (Master of Public Policy) degree at UCLA.  As a Californian (I moved here in June 2006 from Houston, Texas), I have witnessed the deterioration of the state budget and competitiveness of our industries first-hand over the last few years – and at this stage, it is difficult to be optimistic about the social fabric and the dynamism of the Californian economy going forward.  Two of the “crown jewels” of the state – Silicon Valley and the ten-campus University of California higher educational system higher – are losing their edge as both public policy and society at large are not doing much to safeguard these two institutions (on a side note, one could argue that VCs don't add too much incremental value for what they are being paid but this argument is a non-starter if VC funds/talent start relocating to other states or countries).  Post-graduation, many of my classmates (and other graduate students in other programs) will find it difficult to justifying staying in California – not only because of the lack of opportunities (the dynamism is gone) but because of entitlement spending that has squeezed the middle class (in both a psychological and monetary sense) – in particular, the Y-Gens with no houses or inherited wealth who will have a very difficult time trying to accumulate a decent nest egg given high taxes, high cost-of-living, high real estate prices, and the burden of student loans.  For the international students from Asia or Latin America, it is a no-brainer. Try to get three to five years of work experience here - learn the "best practices" - and then relocate back to their home countries where the dynamism is greater and where fortunes could still be made in relatively mature industries.

For the vast majority of the 19th century, the US economy ran a current account deficit as it sucked up most of the world's capital to build out its economy and infrastructure in a highly productive manner. But as the world's most advanced economy (and one of the most mature economies) in the late 1990s and early 2000s, one could argue that the US could fund all its R&D and infrastructure spending organically (at least on a net-net basis) - especially since much of this capital could obtain much better returns overseas. As Asia liberalizes more of its economies in the next decade or two (such as developing local bond markets and PE/VC industries), my sense is that Asia - just like the US in the 19th century - will suck up the excess capital (and talent!) because of the need for growth and better ROICs. Capital – in a transparent and financially-mobile world – will seek out the best returns.  While the US biotechnology, medical device, and technology industries should experience growth for years to come, you can bet that much of the mobile capital will not go towards funding a “nanny state.”  While Western Europe is in a worse situation, the US will not be out of the woods unless we could come up with cost-efficient solutions to solve the crisis that will arise from the aging of the baby boomers.  But one thing's for sure: Once Asia and Latin America develop a more sophisticated financial market and legal infrastructure, the region will “suck up” a disproportional amount of capital (and talent) as investors look for better returns.  The major implications are many, including: 1) Rising developing Asian and Latin American currencies, 2) A secular rise in interest rates in the US, Canada, and Western Europe as capital gets scarcer, 3) A lower US and Western European tax base to support welfare payments and the military as a significant amount of talent migrates to Asia and Latin America, and 4) Rising technological innovation, economic, and military power in Asia and Latin America.  For those who have been tracking developing Asia and Latin America over the last few years: You ain't seen nothing yet.

Let us now 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 3,078.76 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 2,769.76 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 discussed in our commentaries over the last couple of months, one of the main determinants of the sustainability of the rally is the amount of liquidity creation by the central banks of the world.  We asserted that – with the Chinese restraining credit growth and with the Bank of England hitting its debt monetization limit – it was up to the Federal Reserve to pump more liquidity into the financial markets to keep this rally going. From late May to early July, the Federal Reserve slowed down its debt monetization program, putting a damper on the financial markets.  At the time, we commented that the “Bernanke Put” had disappeared, at least in the short-run.  That said, we also mentioned that there was no doubt that it will come back if oil declined below $60 a barrel or if the Dow Industrials Average declines below 8,000.  Two weeks ago, the price of crude oil settled below $60 a barrel while the Dow Industrials was on the verge of declining below the 8,000 level.  The Federal Reserve responded by ramping up its debt monetization purchases – purchasing US$36.9 billion in Treasuries and agency securities during the week ending July 15th, and an additional US$60.4 billion for the week ending July 22nd, as illustrated in the following chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After slowing down its purchase of Treasuries and agency securities during late June and early July, the Fed's purchases for the last couple of weeks have been relatively robust - clocking in at US$36.9 billion and $60.4 billion, respectively. The amount of the latest weekly purchases is especially impressive, as it represented the greatest amount since mid to late April! Make no mistake: The Fed is now again getting more accommodative, despite the stock market rally over the last couple of weeks...

As mentioned in the above chart, the Federal Reserve monetized (printed) nearly $100 billion over the last two weeks.  More importantly, the Federal Reserve ramped up its purchases to $60.4 billion (its highest level since mid to late April) last week – even as the financial markets were rallying!  This is a powerful signal – suggesting that the Federal Reserve is firmly backstopping both financial assets and encouraging more lending by the banks.

Another liquidity indicator that we have developed and tracked over the last few years is a “cash on the sidelines” indicator.  This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge of how oversold the US stock market really is – as well as how sustainable a current rally may be.  I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006.  The last time we featured this indicator was way back in our February 15, 2009 commentary (“Is the Cult of Equities Dead?”).  A subscriber recently asked me to provide an update.  Alas, there is a reason why I haven't featured this indicator in recent months.  While this indicator was still useful in gauging the amount of readily investable cash on the sidelines, it had not been particularly useful as an overbought/oversold indicator – as evident by its incredible, unprecedented spike in late 2008 to early 2009.  I have since thought about potential modifications to this indicator – and have come up with a more intellectually robust measurement of “cash on the sidelines” (although not perfect) by adding in the amount of checkable deposits to total (both retail and institutional) money market assets.  There are two important reasons for this: 1) For many people, especially high net worth individuals and retail investors, checkable deposits could be considered as readily investable cash (myself included); 2) The money market vehicle did not become a very popular alternative to the checking/savings account until the late 1990s.  As a result, adding checkable deposits to the “cash on the sidelines” indicator is essential to obtaining a valid comparison across a long timeframe.  The “replacement” of checkable deposit accounts by money market funds is evident in the following chart.  The amount of checkable deposits peaked in late 1994 and went on a six-year decline, while the amount of money market funds (not shown) rose nearly 180% from the end of 1994 ($782 billion) to the end of 2001 ($2.2 trillion):

Total Checkable Deposits (TCD)

Following is a monthly chart showing our revised indicator, i.e. the ratio between U.S. money market assets plus checkable deposits and the market capitalization of the S&P 500 from January 1981 to July 2009:

Total Money Market Fund & Checkable Deposits / S&P 500 Market Cap (January 1981 to July 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 a three-year high in October 1990 - preceding a great rally in the stock market which would not end until Summer 1998. 3) The unprecedented inflows into the stock market during 1995 to 2000 was unprecedented - signaling that a mania was in full swing. This ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a bear market. 4) Ratio touched 8-year highs! 5) At its peak at the end of February 2009, this ratio spiked to a 27-year high 65.95%. There is no doubt that the March 9th low represented a major bottom for the US stock market. Since then, it has declined to 49.51% - but is still at a similar level as the highs set in the bottom of the previous bear markets in the late 1980s and late 1990. This ratio is definitely supportive for stocks for the rest of 2009.

Compared to our previous chart showing only money market fund assets, this chart shows that the spike in the “Cash/S&P 500 Market Cap” ratio during late 2008 to early 2009 is not unprecedented.  Specifically, this ratio had touched a similar high in the beginning of the great July 1982 to early 2000 bull market.  While this ratio has since come down to 49.51% (from 65.95% at the end of February), it is still close to the highs set in the bottom of the previous bear markets in October 1987 and October 1990 – suggesting that the rally is still intact.

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 24, 2009) - For the week ending July 24th, the Dow Industrials rose 349.30 points, while the Dow Transports rose 222.53 points. From the March 9th bottom till now, the Dow Industrials and Dow Transports are up 39% and 65%, respectively. The rally in the last two weeks was especially *violent,* as the Dow Industrials rose 11.6% while the Dow Transports rose 13.7%. This gave the Dow Industrials its biggest two-week gain since 2000. Despite the bullish implications of the reaction action, the stock market remains vulnerable over the next few months, as 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 (on weak breadth) later this year.

For the week ending July 24, 2009, the Dow Industrials rose 349.30 points while the Dow Transports rose 222.53 points.  The strong upside breadth (and decent although not impressive volume) over the last weeks negated the short-term downtrend between early June and mid July.  More importantly, both the Dow Industrials and the Dow Transports have broken out to new six-month highs.  While the relatively low volume is not an ideal setting for a continuation of the rally, subscribers should keep in mind that summer is traditionally a slow time for trading.  Of course, with the two Dow indices having risen 39% and 65%, respectively, from their early March lows, and with the ongoing systemic risks (originating from the European banking system and the US commercial real estate sector), I still would not be surprised to see a correction later this year.  Should the amount of systemic risk increase, and should the market continue its rally on relatively weak breadth, 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).  For now, we will maintain our 100% 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 -8.0% to -7.3% for the week ending July 24, 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 24, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -8.0% to -7.3% -its first up week in four weeks. Coincident with the strong rally last week, this semi-oversold reading suggests that the current rally should continue at least for the next few weeks. As a result, we will maintain our 100% long position in our DJIA Timing System and would only shift to a more defensive position should the market or this sentiment indicator get much more overbought over the next few weeks.

The latest increase in the 4-week MA was its first uptick in four weeks.  With the strong upside breadth in last week's rally, this “semi-oversold” reading should provide further “fuel” for the stock market for the foreseeable future.  Moreover, the latest round of asset purchases by the Federal Reserve suggests that the “Bernanke Put” is still alive and well.  Over the longer-run, 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.  For now, we will remain 100% long in our DJIA Timing System, although we will not hesitate to shift to a more defensive position should systemic risks increase again or should the stock market become much more overbought later this year.

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 117.9, the 20 DMA remains at near its most oversold level since early February 2009. In addition, the 50 DMA has also just declined to 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 in the last two weeks. However, there are still some significant obstacles that the market needs to deal with - including the systemic risks emanating from the European banking system and the US commercial RE market. For now, we will remain our 100% long position in our DJIA Timing System, however.

With the latest reading of 117.9 (after declining to as low as 113.1 the Wednesday before last), the 20 DMA remains near its most oversold level since early February 2009.  At the same time, the 50 DMA of the ISE Sentiment Index has also declined to 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 over the last two weeks.  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 become 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: With the Federal Reserve still pumping in massive amounts of liquidity into the financial markets, and with the amount of cash sitting on the sidelines still at an elevated level, the probability calls for a continuation of the rally for the foreseeable future, especially given the expansion of new 52-week highs on both the NYSE and the NASDAQ Composite.  In addition, the CIT recapitalization should provide a boost to small businesses around the country.  Despite these tailwinds, however, there are still various obstacles that the global financial markets will need to contend with over the next 6 to 12 months.  Chief of all these obstacles is the liquidity headwind posed by the ailing European banking system and by the Bank of England halting its QE policy as soon as late this week.  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.

Should the market rally further on declining breadth, 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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