The Sentiment of the Masses
(August 2, 2009)
Dear Subscribers and David's Subscribers,
I want to welcome readers who are subscribers of Mr. David Korn's weekly e-newsletter. Mr. Korn pens a newsletter that includes his summary and interpretation of Bob Brinker's Moneytalk, as well as his own model newsletter portfolio and discussion of all things related to the financial markets and personal finances. Mr. Korn has graciously asked me to be a guest columnist on his newsletter this weekend (and which I am honored to be). David, I hope you're enjoying your trip to Bulgaria!
Fifteen years before the publication of Jesse Livermore's biography, “Reminiscences of a Stock Operator,” 27 years before Gerald Loeb's “The Battle for Investment Survival,” and 49 years before Bernard Baruch's “Baruch: My Own Story,” another long-time legendary Wall Street operator, Henry Clews, published his biography “Fifty Years in Wall Street” (this is a link to the original version, and not the Wiley's condensed version). Henry Clews' firm, Livermore, Clews & Co. (no relation to Jesse Livermore), along with Jay Cooke & Company, was instrumental in raising funds for the US Treasury during the Civil War. Clews was later offered the post of Secretary of the Treasury by Ulysses Grant, but refused. On the eve of the Civil War, Clews jumped at the chance of helping the US Treasury by offering – on behalf of his firm and his clients – to take the entire balance of the initial $50 million bond offering that were not taken up by other investors. Soon after arriving in Washington, Clews realized, contrary to popular beliefs at the time, that the impending war would be a long and bloody event. Clews immediately withdrew his initial offer; returned to New York City; and batten down the hatches (he would however later throw himself into raising funds for the Union at every opportunity). Quoting “Fifty Years in Wall Street”:
“About seven-eighths of the people of Washington, at that time, were Southerners. The office-holders were largely composed of the latter, and they were expecting to be suddenly turned out of office. This rendered the place a boiling caldron of conspiracy and treason.
“As I went around collecting information, the sight of those cannon that at first had made such an indescribable impression upon me, continued to haunt my vision wherever I went. The air was filled with rumors of war, and everybody was wound up to the highest pitch of hostile excitement.
“As I mingled among the people, the impress was forced upon me that war was inevitable, and that up to the very hilt of the sword. I felt that the contest would be long and bloody.
“I sent a dispatch to my firm in New York, conveying my impressions to that effect, and advised them to clear the decks in preparation therefor. I urged them to lose no time in selling off all the mercantile paper on hand, and requested them to communicate to the members of the syndicate, which I had formed for the purchase of bonds, recommending them to withdraw therefrom, as I was convinced that war to the knife was imminent, and that Government bonds must have a serious fall in price in consequence.
“I had no sooner accomplished this very desirable work of shifting my burden, and distributing it in a more equable manner on the shoulders of others, but at higher rates than I paid, than in less than a week after my return from Washington the exciting news arrived of the firing of the first hostile gun at Fort Sumter.
“The announcement of this overt act of war spread like wildfire, and the wildest scenes of excitement and consternation were witnessed in Wall Street and throughout the entire business community. The whole country was panic stricken in an instant.
“Stocks went down with a bound to panic prices. Fortunes were lost, and millionaires were reduced to indigence in a few hours. Money was unobtainable, and distrust everywhere was prevalent.”
This phenomenon (the decline in stocks) was mainly temporary. While the North instituted tariffs, income taxes, and borrowed money to finance the Civil War, it also printed “Greenbacks” to raise the necessary funds. From the beginning to the end of the Civil War, price inflation totaled 80% (this was far less than what the South endured as the latter had no effective tax collection system and did not have the backing of Wall Street to raise the necessary funds). The 80% inflation rate was comparable to that witnessed in the US during World War I and II. According to the Ibbotson SBBI Yearbook, large company stocks subsequently rose (including capital appreciation and dividends) 55.0% in 1862, 46.4% in 1863, 16.6% in 1864, and 4.8% in 1865. With the Federal Reserve monetizing the domestic debt load, and with more than $50 trillion of Social Security and Medicare liabilities due over the next 30 years, the US government and central bank may have no choice but to debase the US dollar unless we could control these costs through technological advances, more effective treatments, or healthcare rationing (my guess is that we could experience a combination of these sometime in the next decade). For those who are worried about domestic price inflation, it may actually make sense to purchase common stocks as an inflation hedge (similar to what Argentineans did in 2002) – especially US large cap stocks that derive the majority of their revenues from overseas markets – in particular Asia and Latin America (Europe is in a more dire situation than we are). At this time, however, inflation is still a non-issue.
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 3,000.39 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 2,691.39 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.
Based on my indicators, research, and general anecdotal evidence, the rally since March 9, 2009 was driven mainly by the withdrawal of selling, as 1) the hedge fund industry stopped experiencing redemptions and major closures, 2) pension funds and endowments finished raising the liquidity they needed – partly to meet cash outlays and capital commitments from private equity funds, 3) retail investors finally stopped panicking and liquidating their equity and mutual fund holdings. In other words, the mass deleveraging and liquidation was over. With the S&P 500 trading at a P/B ratio of 1.2, and with 2009 and 2010 earnings still projected to be in positive territory, US large caps stocks (especially consumer discretionary and financial stocks, with the exception of GM, CIT, etc.) were at their cheapest levels in 27 years. While an initial burst of “buying enthusiasm” did materialize, it only lasted until early May.
This means that the stock market has mostly been “floating up” over the last three months as sellers continued to shy away from the stock market. Institutional, foreign, and retail investors are simply not buying US equities in any meaningful volume. Over the last three weeks, this has definitely improved – especially given the high upside breadth and upside volume. Overall volume, however, is still relatively low, although that has probably more to do with seasonal patterns. The stock market is now overbought, but since both the short and intermediate-term trend still remains up, probability suggests that more buying will emerge in the coming days/weeks before the current rally exhausts itself. The odds are especially high given that the Federal Reserve are still actively purchasing Treasuries and agency securities, while there is also a small chance that the Bank of England will announce an expansion of its QE policy when it meets later this week on August 5th and 6th.
In terms of our sentiment indicators – while most of them are not in extremely oversold territory anymore – they also don't signal a strong intention to buy more equities. For example, the 52-week moving average (which we usually don't cover) of one of our most popular sentiment indicators, the American Association of Individual Investors indicator, touched a 19-year low just 2 ½ months ago. Similarly, the 52-week moving average of the Investors Intelligence Survey touched a 14-year low at the same time. While the weekly readings of these two sentiment indicators have gotten more bullish over the last five months, the longer-term moving averages suggest that retail investors are nowhere close to getting back into the market en masse. The latest readings from Ticker Sense's Blogger Index also confirms the lack of bullish sentiment, as its bullish reading made a 28-month low just three weeks ago.
The lack of widespread optimism over the upcoming economic recovery (over the last few weeks, the leading indicators have continued to make new highs) is also evident in the latest readings of the Conference Board's Consumer Confidence Index. Newer readers may not know this, but the Conference Board's Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint. While it has always been significantly better in calling bottoms during a bear market (although it was admittedly not that useful in last year's historical plunge), it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market – with one of its most successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90. During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points. More recently, the Consumer Confidence Index foretold the beginning of a bear market with its “rounding top” during the first half of 2007. Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to July 2009:
With the notable exception of its historical plunge from October of last year to April this year, the Consumer Confidence Index is still near its all-time low. More importantly, the Consumer Confidence Index has actually been declining since its May reading, from 54.8 to last month's reading of 46.6. With the exception of the readings from October to April this year, only the February 1992 reading is on a comparable basis. Consumers that are not confident about the economic or their job prospects usually don't buy much common stocks, and the empirical evidence supports this view.
On a more “tangible basis”, the lack of both institutional and retail purchases can also be shown by the liquidity indicator that we discussed last week, i.e. our “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 in our commentary last week and prior to that, in our February 15, 2009 commentary (“Is the Cult of Equities Dead?”). We modified this indicator last week as we believe our previous measurement of “cash on the sidelines” was not as intellectually robust. Although not perfect, we modified our definition of “cash on the sidelines” by adding 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.
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:
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 48.58% (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. Not only that, the vast majority of the decline in this ratio since the end of February is solely due to the appreciation in the S&P 500's market capitalization. Since the end of December (when total “cash” peaked), total “cash on the sidelines” has only declined by $45 billion (from $4.261 trillion to $4.216 trillion) – suggesting that both institutional and retail investors have remained on the sidelines.
All these suggest – especially given the ongoing support by the Federal Reserve's debt monetization program and the fiscal stimulus – that the five-month rally still has further to go, as rallies like this (even if it is a bear market rally) tend to only top out once retail investors get bullish again and buy back into the stock market. In addition, the systemic risks emanating from the European banking system is not unsalvageable. Should the German, Austrian, and Swedish governments unite and make a concerted effort to reliquify the region's banks – as well as start lending in Eastern Europe again – then this potential “Black Swan” event can disappear. We will continue to monitor this (as well as the potential systemic risk in the US commercial real estate market) for our subscribers over the next couple of months.
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 31, 2009, the Dow Industrials rose 78.37 points while the Dow Transports rose 43.51 points. While the stock market is now overbought on both a short and intermediate term basis, the strong upside breadth over the last three weeks suggests that the rally still has more upside. More importantly, both the Dow Industrials and the Dow Transports have broke out to new six-month highs last week and are still holding their ground. 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 40% and 67%, 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, we will most likely 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 -7.3% to -4.8% for the week ending July 31, 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:
The latest increase in the 4-week MA was its second consecutive up week. That said, it is still 5.8% below its most recent peak of 1.0% made for the week ending June 18th. Given the strong upside breadth in the rally over the last three weeks, 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 uptrend in the stock market in the short-run. For now, we will remain 100% long in our DJIA Timing System, although we will not hesitate shifting to a more defensive position should systemic risks increase again or should the stock market become 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:
With the latest bounce to 120.2 (after declining to as low as 113.1 on July 15th), the 20 DMA has most likely turned up after declining since early July (thus confirming the recent uptrend in the stock market). At the same time, the 50 DMA remains at near its most oversold level since early February 2009, although it is most likely turning up as well. From both a contrarian and a momentum standpoint, this is bullish for the stock market, especially given the strong upside breadth in the stock market over the last three 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 foreign, domestic institutional and domestic retail investors still largely out of the stock market – and with the deleveraging temporarily at an end – probability suggests that the 5-month rally will continue for the foreseeable future. By the time this rally is exhausted, my sense is that retail investors will be much more bullish again. This will not only show up in our sentiment indicators, but also in our technical indicators such as a significant expansion of new 52-week highs on both the NYSE and the NASDAQ Composite and in the percentage of NYSE and NASDAQ stocks trading above their 200-day exponential moving averages (a significant expansion at this stage is most likely an “exhaustion rally”). Despite these tailwinds, there are still various obstacles 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 the impending defaults in the US commercial real estate market. 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 eight weeks.
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 swill 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.
Henry To, CFA