A Fear of Losing Money or a Fear of Losing Out?
(August 23, 2009)
Dear Subscribers and Readers,
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 2,666.04 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 2,357.04 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.
In our most recent mid-week commentary, we discussed our short-term and intermediate-term outlook for natural gas – including a discussion of the historical natural gas/crude oil price relationship (which has completely broken down this year – mostly due to fundamental factors), the record high storage levels, and the recent decline in drilling activity. We concluded by stating our increasing bullishness on natural gas but with the following caveat:
While the short-term outlook for natural gas prices is still blurry, this author is getting more bullish on the longer-term (over 12 months) outlook. Given the premium in the UNG ETF and the significant seasonal spread on natural gas future prices, I do not recommend a long position just yet (and probably won't for the foreseeable future unless the natural gas price curve drops another 10% across the board). In the meantime, I will continue to keep track of natural gas and alert you should I decide to go long on the commodity.
On Wednesday evening, UNG (the natural ETF) closed at $12.01, at a 13% premium to its NAV. By Friday at the close, UNG had declined 5.5%. Most amazingly, the premium had increased to over 14%, as evident from the following table:
From the inception of UNG on April 18, 2007 to the end of last month, the price of UNG has never traded outside a 2% band around its NAV. Since the CFTC started making waves about limiting position sizes of funds or “speculators” in the commodity market, the managers of UNG have stopped issuing new shares – thus driving up its premium to NAV as most retail investors do not have access to purchasing natural gas contracts via the futures market. More ominously for UNG bulls, the managers of the fund have started to shift some of their long exposure via total return swaps within the OTC market – suggesting that sooner or later, the premium to NAV will close (i.e. UNG can easily decline by 14% even if the price of its front-month contract remains stagnant). For subscribers who want to gain long exposure to natural gas (note that MarketThoughts isn't going long just yet), there's only one way to do it: Buy the NYMEX futures contracts.
In the meantime, it is interesting to see natural gas production holding steady even though drilling activity has declined dramatically (as we illustrated in our mid-week commentary). As far as I can tell, there are two reasons for this: 1) Many well completions have been deferred this year – suggesting that supply can easily be brought online (and probably have been) without a corresponding increase in drilling activity (as these wells have already been drilled; just not completed); 2) Many natural gas producers have vowed to continue production until storage is filled, as most producers have hedged most if not all their production for the rest of 2009. Should actual 2009-2010 winter weather be milder than expected (Accuweather.com's early forecast predicts that the US will experience its coldest winter since the 2002-2003 winter) – and should natural gas storage levels be filled to the brim going into the winter – then the delivery price for the January 2010 natural gas contact could easily fall to $4.50, or below.
In a perverse sort of way, it is interesting to see how the majority of investors' minds have worked throughout the unprecedented events in the financial markets over the last five to six years. During the 2003 to 2007 period, the “fear of losing out” dominated the thinking of both retail and institutional investors, as supposedly “cautious” investors (e.g. Harvard Endowment) loaded up on illiquid large buyout investments (at 7x to 8x peak EBITDA), while using leverage to fund some of these investments. We also witnessed an unprecedented institutional entry into the commodity markets beginning in 2006 – culminating in the spike in crude oil prices to $147 a barrel last summer as the commodity hedging market fell apart. When we decided to go 50% short in our DJIA Timing System on October 4, 2007 (at a DJIA print of 13,956), our signal was treated with skepticism or even contempt. By the time Lehman filed for bankruptcy in September last year, this sentiment has fully reversed itself, as the “fear of losing out” (i.e. greed), was overwhelmed by the “fear of losing money.” Unfortunately for those who panicked during the three major lows in early October (DJIA 7,900), mid November (DJIA 7,450), and early March of this year (DJIA 6,500), these investors are now severely underwater as the market recovered, and to a major extent, are still overwhelmed by the fear of losing money.
With respect to natural gas, it doesn't seem like retail investors have learned (but then, they never do). With natural gas mired in one of its worst bear markets since it began trading on the NYMEX, retail investors are still possessed by a “fear or losing out” – as evident by the surging volume of the UNG and the 14% premium it closed at last Friday. My sense is that natural gas prices will not rise in a sustainable way until retail investors capitulate. Again, we will continue to track natural gas and alert you should we decide to go long the commodity via either UNG or natural gas futures.
Perhaps the Fed's ongoing easing bias and the accompanying liquidity creation could “spill over” to the natural gas market at some point. But looking at the record since March, the Federal Reserve's debt monetization program has been the most effective in providing liquidity to the housing markets (through lower mortgage rates), and course, to the financial markets. In other words, the Fed's ongoing easing bias suggests that the intermediate upside trend of the US stock market remains intact, and that last Monday's 90% downside day was a “head fake.” Perhaps as a response to last Monday's extreme market weakness, the Federal Reserve responded by purchasing a whopping $76.1 billion of Treasuries and Agency securities (its most aggressive weekly purchase since the week ending April 22nd), as illustrated in the following chart:
In addition, immediately after the announcement of its new monetary framework (essentially expanding its debt monetization program from a limit of 125 billion to 175 billion pounds), the Bank of England has stepped up its asset purchases over the last two weeks (after stopping three weeks ago). As we had expected, the Bank of England is now committed to about 4 billion pounds of asset purchases on a weekly basis, or 60% of its asset purchase level from March to early July. Should the UK banking system remain lending constrained, and should UK inflation remain below its targeted rate of 2%, I expect the Bank of England to again expand its QE program later this year. In the meantime, this new limit (the size of its balance sheet is currently 133 billion pounds, and is thus 42 billion pounds below its limit) allows the Bank of England additional flexibility in combating a slowing economy and the risk of another liquidity shock:
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 21, 2009, the Dow Industrials rose 184.56 points while the Dow Transports rose 61.71 points. With the stock market at a very overbought on both a short and intermediate term basis, and with the continued shakiness of the European banking system and the deterioration of the US commercial real estate market, I would not be surprised if the stock market experiences a sizable correction sometime later this year. That being said, the strong upside recovery from the Lowry's 90% downside day over the last four trading days 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 just last week, with confirmation from most major global market indices, with the glaring exception of China. 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 then 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 6.6% to 8.8% for the week ending August 21, 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 5th week in a row to a reading of 8.8%, which represents its most overbought reading since late May 2008. Note that this overbought reading is starting to warn of an impending short-term or intermediate-term top, but with the strong upside in the rally over the last six weeks (especially the market's impressive recovery from its 90% downside day last Monday), there is still enough “fuel” for the stock market to extend its rally for the foreseeable future. Moreover, the Fed's whopping $76.1 billion purchase of Treasuries and Agency securities last week suggests that the “Bernanke Put” is still alive even with a Dow Industrials print of over 9,000. 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:
Even though the 20 DMA has now risen to 127.8 (from as low as 113.1 on July 15th), this reading does not suggest an overbought condition in investor's sentiment. In a way, this sentiment indicator isn't confirming the “recovery” in bullishness in the combined Bulls-Bears% differential readings. At the same time, the 50 DMA still remains near its most oversold level since early February 2009. Combined with the strong upside breadth and volume in the stock market over the last six weeks, the near-term outlook for the stock market thus remains positive. That said, there are still significant longer-term obstacles that the financial markets still have to face over the next 3 to 12 months. Therefore, 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: Despite the uptrend in the world's stock markets, the ongoing support by the Federal Reserve and the Bank of England, and the strong recovery by the global leading economic indicators, many investors are still possessed by “the fear of losing money” rather than “the fear of losing out.” This is confirmed by the fact that many foreign and domestic (both institutional and retail) investors are still lukewarm on US equities – suggesting that the intermediate-term trend of the stock market remains up, for now. 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. For now, we will remain 100% long in our DJIA Timing System.
Interestingly, the natural gas market is still ruled by “the fear of losing out” on a potential rally despite the fact that natural gas is still mired in one of its worst bear markets since it began trading on the NYMEX. This is exemplified by the huge surge in volume in the natural gas ETF, UNG, over the last year and the 14% premium it closed at relative to its NAV. While this author is now turning longer-term bullish on natural gas, we will not go long the commodity until there are some signs of retail investor capitulation. For now, we will continue to keep track of the commodity and inform you once we change our mind. Subscribers please stay tuned.
Henry To, CFA