2009 2Q Flow of Funds Update
(September 20, 2009)
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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 2,351.80 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 2,042.80 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 August 23, 2009 commentary (“A Fear of Losing Money or a Fear of Losing Out?”), we discussed the dangers of buying an ETF or a closed-end fund with a substantial premium. We held up UNG, the natural gas ETF that attempts to mimic the price of natural gas by purchasing the prompt-month NYMEX contract, as an example. At the time, UNG closed the previous Friday at a 14% premium to NAV, and subsequently rose to a 19% premium to NAV the following week. We commented at the time:
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.
After the market close on September 11th, the manager of UNG announced that the fund would again create more investment “units” by September 28th through the use of OTC total return swaps benchmarked to the NYMEX prompt natural gas contract. At the same time, the contango in the natural gas futures curve suggests that on its next roll to the December contract (UNG is currently holding the November contracts) would only be able to purchase 87% of its current number of November contracts (since the December contract is trading at $5.27 vs. $4.61 on the November contract). This means that from a position limit standpoint, UNG should be able to offer more “units” through the purchase of the December NYMEX contracts on its next roll. Both of these developments suggest that the premium in UNG vs. its NAV should remain relatively tight going forward.
Indeed, as shown in the following table (courtesy of www.etfconnect.com), the premium in UNG has shrunk dramatically – to just 4.58% - since our August 23, 2009 commentary. More specifically, while the NAV of UNG has rallied by 12.0% since our August 23rd commentary, the price of UNG shares has only rallied by 2.6%:
More ominously, there is no telling how much fees UNG shareholders would need to pay to enter into the OTC natural gas total return swaps discussed in UNG's 8-K filing on September 11th. Quoting the 8-K filing:
The Authorized Purchaser [UNG's counterparty], its affiliate or a third party providing investments, including arranging a swap transaction with UNG in connection with the issuance of a Creation Basket, may receive fees or other compensation, trading gain or other benefits in connection with such investment, in addition to compensation, if any, it may receive as a result of purchasing and reselling units from a Creation Basket. In addition, UNG's payment of fees or other amounts in connection with these investments, including swaps, that exceed the amounts it currently pays in connection with its direct investments in natural gas futures contracts may have the effect of increasing transaction-related expenses and result in increased tracking error.
In other words, UNG's counterparty may be charging a significant fee (which would be debited against UNG's shareholders) in return for selling these total return swaps to UNG (which makes logical sense since UNG's counterparty would be providing a liquidity service). Since the goal of UNG's managers is to gather assets (and not to make a profit for its shareholders), there is no telling how much fees would accrue to UNG's shareholders once the fund enters into such a transaction. With US natural gas storage projected to fill to capacity by the end of October (and with the Producing Region now flooded with gas), there is no telling how much spot prices would decline over the next several weeks. With the November now converging very quickly to the prompt-month contract, the UNG ETF should be avoided like the plague.
Let us now discuss the 2Q 2009 Flow of Funds update that was published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. One of the main themes that we have been tracking through the Flow of Funds information has been the concept of overleveraged US households, as well as their “new journey” as they actively deleverage and rebuild their balance sheets. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we discussed the fact that US households' asset-to-liability ratio (using the Fed's Flow of Funds data as of 1Q 2009) hit a new post WWII low, and that despite the rally in asset prices during the second quarter, it will take at least several years before US households will finish rebuilding their balance sheets. As of 2Q 2009, US households' balance sheets have improved slightly, with household net worth rising $2.0 trillion to $53.1 trillion during the second quarter – its first quarterly improvement since the third quarter of 2007! This rise in US households' net worth corresponded to an improvement in households' asset-to-liability ratio from 4.63 to 4.78. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth have a very long hill to climb before it can reach its prior peak levels, even assuming US housing and stock prices have already bottomed:
Interestingly, US households' liabilities only declined $34.5 billion during the quarter (and $446.8 billion from its peak). This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as US consumer credit has grown by a minimal amount over the last 12 months. So why did US households' liabilities only dip by $446.8 billion from its peak? The likely answer is that the many US households who have seen their mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). While this bodes well for the balance sheets of the US largest banks (whose portfolio are mostly in residential mortgage securities), it also means that the true deleveraging (and home foreclosures) is not yet over.
Indeed, the sector that needs the most deleveraging over the next decade is, not surprisingly, US housing. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 2Q 2009 (source: the Federal Reserve's Flow of Funds data). While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
As mentioned on the above chart, for every percentage growth in assets that US households accumulated over the last 57 years, the growth of mortgage debt was 3.6 times as much, while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.). was “just” 2.1 times as much. Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen TVs (readers should not forget that some of these have also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging will occur in the US mortgage market. As I mentioned in a previous commentary, the “coming of age” of the Y-gens (the offsprings of the baby boomers) should generally add an extra 100,000 to 150,000 households over the long-term trend to the US economy over the next decade or so. This should provide a “cushion” to many housing markets in the US for the next 5 to 10 years. However, once the baby boomers start to retire en masse – and once they start to exhaust their savings – US housing could again underperform as baby boomers liquidate their residential properties to pay for living expenses or to relocate to smaller or cheaper living areas. I expect most US regional housing markets to underperform other asset classes (especially global equities and lower to middle market private equity) for the next 15 to 20 years (although assisted living properties would should outperform).
Another reason why US households will continue to deleverage is the lack of liquidity within households' balance sheets relative to the sheer amount of households' liabilities. As shown in the following chart, the ratio of cash savings (deposits + money market funds + checking deposits, etc.) of US households relative to their liabilities has declined from a “coverage ratio” of 1.56 in 1952 to 0.60 at the end of 1999, to a merely 0.56 today (it declined to as low as 0.50 at the end of the third quarter of 2006):
With cash savings as a percentage of liabilities still near an all-time low, US households can only deleverage through: 1) liquidating assets to pay for their liabilities, 2) rebuilding their savings through a structurally high savings rate over the next few years, and 3) through defaulting on their liabilities. I expect US households to do a combination of all three things over the next few years in order to rebuild their balance sheets. I also expect 2010 to be a “tough year” for US households given the ongoing rise in the unemployment rate and the relative lack of productivity growth opportunities from now until the end of 2010. However – once the next innovation and productivity cycle kicks in – I expect this “rebuilding” and “cleansing” of US households' balance sheets to be a relatively benign event (e.g. assuming cellulosic ethanol could be commercialized by the end of 2011, the US could conceivably cut its oil imports by half over the next five years through the use of cellulosic ethanol as an automobile fuel and through higher efficiencies gained through the adoption of hybrids and better battery technology).
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 January 2007 to the present:
For the week ending September 18, 2009, the Dow Industrials rose 214.79 points while the Dow Transports rose 5.10 points. Last week's action again took the two popular Dow indices to a new rally high. The latest concurrent highs in both the Dow Industrials and the Dow Transports suggest that the intermediate-term uptrend remains intact. Fortunately, we were sensible enough to keep our 100% position in our DJIA Timing System, despite our belief that the stock market would correct in the short-term! With the stock market now at an even more overbought level (the Dow Industrials is up 50% while the Dow Transports is up 85% since the early March lows), and with the ongoing shakiness of the European banking system (especially within Sweden and Austria), we continue to expect a brief stock market correction over the next several weeks. Should the rally continue on relatively weak breadth, we would 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 decreased from a reading of 5.4% to 6.4% for the week ending September 18, 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:
While the latest weekly rise in this reading does not yet result in an overbought level, its “spike” from early March to late August suggests that we should be mindful of a short-team peak in both bullish sentiment and the stock market. That is, while there is still enough “fuel” for a longer-term rally, there is a good chance the market will first correct. Moreover, while the “Bernanke Put” is still alive and well, I do not believe the Fed will expand its balance sheet in a meaningful way over the next several weeks given its record purchases during the last two weeks of August, as well as the broad weakness in the US Dollar over the last two weeks. For now, we will remain 100% long in our DJIA Timing System, although we will likely shift to a more defensive position should the stock market rally further on relatively weak breadth and volume.
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:
For the week ending September 18th, the 20 DMA increased slightly from 119.3 to 119.7, while the 50 DMA remained near a seven-month low at 122.0. While this sentiment indicator is somewhat oversold, subscribers should keep in mind that – with the 20 DMA below the 50 DMA – this sentiment indicator is now in a confirmed downtrend. Combined with the market's overbought conditions, the short-term liquidity headwinds and the troubles in the European banking system, we believe the stock market will likely correct over the next several weeks. For now, however, we will remain our 100% long position in our DJIA Timing System.
Conclusion: As the Fed's Flow of Funds for the second quarter shows, the deleveraging of US households' balance sheets is still an ongoing process. More specifically, we believe much of the deleveraging will focus on the housing and mortgage markets – and that 2010 will again be a difficult year, as US households will struggle to rebuild their balance sheets in the midst of a still-rising unemployment rate and the relative lack of productivity growth opportunities over the next 15 months. Once the next productivity and innovation cycle kicks in, however, the ride will be much smoother as “true wealth” can only be built through productivity growth – growth that can only be facilitated by the capitalistic process. As for the US stock market, we continue to believe the intermediate (6 to 9 months) uptrend remains intact, but there are many fundamental, technical, liquidity, and sentiment indicators suggesting that the US stock market will likely correct over the next several weeks. We believe this correction will be short and relatively shallow – presumably in the 4% to 10% range. However, should the market experience broad weakness on increasing downside volume, we would not be surprised if the correction runs further. Furthermore – and as we mentioned two weeks ago – we now believe that the correction in the stock market will be accompanied by a correction in commodity prices – as commodities face a stronger headwind in the form of a tighter Chinese monetary policy and the substantial increase in warehouse inventories over the last few months.
Despite our aversion to the stock market in the short-term, subscribers should keep in mind that short-term tops and corrections are notoriously difficult to time (and most importantly, are typically quick and shallow) during a cyclical bull market (this author believes that a new cyclical bull market began in early March of this year) – and thus we will continue to remain 100% long in our DJIA Timing System. By the time we come close to a major peak in this cyclical bull market, my sense is that retail investors will be much more bullish again and the liquidity headwinds will be much stronger. Subscribers please stay tuned.
Henry To, CFA