Global Leading Indicators Encouraging
(August 9, 2009)
Dear Subscribers and Readers,
Not only is Cray, Inc. (the supercomputing company known for its pioneering technologies in the field) back from the dead, but is surviving and thriving despite the tough economic times. Backed by its latest wins in the government sector and missteps from its competitors (SGI filing for bankruptcy in early April and acquired by Rackable Systems for a mere $42.5 million), Cray managed to grow its revenues from $46.7 million to $62.7 million (an increase of 34%) on a year-over-year basis during the second quarter of 2009. Gross profit margin also grew – to 45% from 33% in the second quarter of 2008. For the first time since 2003, Cray reported a profit – notching $3.4 million ($0.10 a share) in net income compared to a loss of $6.4 million in the second quarter of 2008. Cray also took advantage of the financial dislocation during the 2nd quarter by purchasing $27.6 million (in face value) in convertible notes at 98.5% of par. The firm has essentially wiped off all the debts from its balance sheet. As of June 30, 2009, it has $68.9 million in cash and cash equivalents outstanding. Note that this author currently has no position in CRAY.
The rising fortunes of CRAY has as much to do with the firm's management, the evolution of its business model, the competitive nature of the supercomputing market (many players have exited the supercomputing market in the 15 to 20 years), as the “comeback” in the popularity of supercomputing systems over the last five years. Commenting on the latter theme, it is interesting to note that the supercomputing market suffered a series of setbacks from the mid 1990s to the early 2000s. Coming off the end of the Cold War, the Clinton administration saw no need to spend millions on the latest supercomputing technologies. At the same time, the private sector had no need for supercomputers. Problems in the gene sequencing, climate modeling, and protein folding arenas simply did not exist – and even if they did, neither the hardware nor the software were capable of handling these tasks in a cost-effective manner. Today, this has been flipped on its head. With the rise of the Chinese economy and technology sector, and with the emergence (or re-emergence) of fields such as customized medicine, alternative energy, climate modeling, protein folding, human brain modeling, and nano-materials, both the US and other developed economies will have an ongoing need for supercomputing technologies for at least the next decade (see our July 5, 2009 commentary for our latest update of the global supercomputing statistics). As the bulk of the operating costs of a supercomputing is from energy usage (annual energy usage costs as much as the purchase price), the “tipping point” will come once renewable energy such as algae-based biofuels or solar power reach “grid parity.” This will ensure a nearly limitless source of cheap power – and in turn, will substantially lower the total costs of operating a supercomputer. Sometime in the next five to seven years, I expect the demand for supercomputing systems (and near-supercomputing systems) to explode substantially higher.
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 2,801.93 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 2,492.93 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 the first-time home mortgage credit and lower mortgage rates (both the 30-year fixed conforming and jumbo mortgage rates; see below chart courtesy of Bankrate.com) work their way through the US housing market, existing home sales have risen while housing inventory has declined. As of June 30, 2009, existing home inventory has declined to 3.82 million units (9.4 months of supply) from 3.85 million units in May (9.8 months of supply); and from 4.50 million units (11.0 months of supply) as of June 2008.
With the Federal Reserve committed to purchasing agency securities and thus putting a cap on mortgage rates, the US housing market should gradually work its way out of its current “inventory problem” over the next six months. But wait Henry, isn't there a so-called “shadow housing inventory” – i.e. inventory that will inevitably flood the market as US unemployment continues to rise?
That is a huge concern and that is why I don't believe we have reached a bottom in US housing prices. In fact, it is silly to think that prices in certain bubble parts of the country – especially in California and Florida – will bottom for the foreseeable future. From a “glass half full” standpoint, however, the latest uptick in the US leading indicators (such as the ECRI Weekly Leading Index) and the OECD leading indicators suggests an economic recovery that will last until at least Christmas, if not winter/spring 2010. This should put a temporary bottom in the vast majority of the regional housing markets, as potential homebuyers feel more secure in their jobs or have more money to afford a mortgage. Note that I continue to believe a four to five-year deleveraging period is ahead for the US economy, but this does not mean we can't take a “breather” from the two-year economic/housing downturn.
Let us now take a look at our global economic leading indicators – starting off with our MarketThoughts Global Diffusion Index (or “MGDI” for short). To recap, we first featured the MGDI in our May 30, 2005 commentary. For newer subscribers who may not be familiar, the MGDI is constructed using the "Leading Indicators" data for 25 countries in the Organization for Economic Co-operation and Development (OECD), as well as China, Brazil, and India. Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages. More importantly, the MGDI has never had a false signal in foretelling major turns in the global economy, and has also historically led or tracked the CRB Commodity Index and the Dow Jones Industrial Average ever since the fall of the Berlin Wall. We last discussed the MarketThoughts Global Diffusion Index (MGDI) in our August 10, 2008 (“An Upcoming Chinese Slowdown?”) and June 22, 2008 commentaries (“Oil and the Stock Market”) – arguing that the spike in energy prices was not sustainable due to the significant divergence of the action of the MGDI and the CRB Energy Index, the dearth of new production hedges (which take the other side of the long-only speculators and thus serve to dampen prices) due to liquidity and credit concerns, and the overly bullish sentiment in energy and commodities. Since those commentaries, both energy and general commodity prices have endured one of their largest plunges in history, further confirming the validity of the MGDI's signals.
Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the Dow Industrials and the YoY% change in the CRB Index from March 1990 to June 2009 (the July readings will be available on the OECD website in early September). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Note that while there was an immense divergence in the year-over-year change in the CRB index vs. that of the MGDI during the summer of last year, the former ultimately followed the MGDI to the downside as global commodity demand plunged due to the economic downturn (sooner or later, fundamentals will prevail). Over the last few months, the MGDI (both the first and second derivative) has troughed and has risen significantly. This strength in our MGDI confirms the recent strength in the commodity markets, stock prices, and of course, US and global economic growth. The strength in the MGDI is also confirmed by the ECRI Weekly Leading Index – and in an amazing turn of events, the 180-degree turnaround in Turkey's current account situation. As recent as two months ago, consensus has held that Turkey would eventually need an IMF loan. In June, Turkey's current account deficit declined for a ten consecutive month, to just $2 billion from $5.5 billion in the year-ago period. More recently, the demand for the auction of Turkish bonds has exceeded all expectations – strengthening the Lira in the process. This prompted the Turkey's central bank to resume purchasing foreign currency for its reserves last week – suggesting that its fiscal/monetary crisis is over, for now.
Of course, whether the current turn/growth in the US and global economy is sustainable into 2010 and beyond is another matter Personally, I still think there is a four to five-year deleveraging process ahead of us (especially in US consumers' balance sheets) – not to mention an ongoing decline in housing prices in certain parts of the country, such as major parts of California and Florida. A further correction in Californian housing prices will ultimately be healthy for the economy, as this will allow Y-gens to purchase their own homes in California at relatively affordable prices. Moreover, as US consumers continue to build their savings, this will “free up” resources for capital investments (including education, VC funding, science funding, etc.) – ultimately resulting in higher potential GDP and productivity growth for the US and global economy. That being said, I don't believe the US will enter a “20-year Japan-style recession” given: 1) cultural differences, and 2) the fact that US banks are much healthier (i.e. higher core earnings power) than those in Japan after the popping of its stock market and housing bubble in early 1990. The following chart, courtesy of Goldman Sachs, suggests that US banks in general have significant loss-absorbing power, relative to Japanese banks in the early 1990s:
Combined with the recapitalization of the 19 largest US banks in early April, and the potential for private equity capital to recapitalize the community and regional banks, the outlook for the US banking system is much brighter than that of the Japanese banking system in the early 1990s, despite the inevitable defaults in the commercial real estate market (which we are tracking very closely). Again, our current roadmap for the US economy is this: The US economy should experience a strong bounce for the next 6 to 9 months, but the four to five-year deleveraging process will reassert itself in summer 2010. This should lead to below-potential GDP growth on and off for the next four to five years as US consumers rebuild their savings. But the US economy will not experience any downturn similar to what the Japanese economy experienced in the 1990s.
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 August 7, 2009, the Dow Industrials rose 198.46 points while the Dow Transports rose 169.59 points. While the stock market is now very overbought on both a short and intermediate term basis, the strong upside breadth over the last four weeks suggests that the rally still has more upside. More importantly, both the Dow Industrials and the Dow Transports have broken out to new six-month highs two weeks ago and are still holding their ground. Even the absolute amount of upside volume (the one area of weakness that I have been worrying about) has increased. Of course, with the two Dow indices having risen 43% and 75%, 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 if the stock market correct later this year. Should the amount of systemic risk increase (unlikely at this point as even Turkey has enjoyed substantial inflows), 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 -4.8% to 0.6% for the week ending August 7, 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 4-week MA of the combined Bulls-Bears% Differential ratios rose for the third week in a row to a reading of 0.6%. That said, it is still marginally below its most recent peak of 1.0% made for the week ending June 18th. With the strong upside breadth in the rally over the last four weeks, this “semi-oversold” reading should provide further “fuel” for the stock market for the foreseeable future. Moreover, the latest rise in our MGDI suggests that investors are finally taking risks again (as exemplified by the inflows into Turkey – a country which was asking for an IMF handout just a couple of months ago). 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 uptick to 123.9 (after declining to as low as 113.1 on July 15th), the 20 DMA has no doubt turned up thus confirming the recent uptrend in the stock market. At the same time, the 20 DMA has risen above the 50 DMA, which further confirms the uptrend in the stock market. From a momentum standpoint, this is bullish for the stock market, especially given the strong upside breadth in the stock market over the last four weeks. While the one to two-month outlook is still positive, there are still significant obstacles that the financial markets on a longer-term basis. 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 global leading indicators now decisively turning up, the six to nine-month outlook for the US and global economy is also turning up. More importantly, the latest rebound in our MarketThoughts Global Diffusion Index (MGDI) suggests that investors are starting to take risks again. With substantial funds now inflowing into countries such as Turkey (two months ago, the country was still negotiating for an IMF loan), much of the systemic risk is off the table, for now. As we mentioned last week, 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 (this will also provide support for commodity prices). By the time this rally is exhausted, my sense is that retail investors will be much more bullish again (which will show up in our sentiment as well as our technical indicators such as the NYSE Common Stock Only McClellan Summation Index). Despite these tailwinds, there are still various obstacles to contend with later in 2010. 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. We will continue to track both of these going forward.
Should upside breadth deteriorate on any future rallies, 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). For now, we will remain 100% long in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA