The Entitlement Culture
(September 27, 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 2,506.81 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 2,197.81 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 commentary last week, we discussed – based on the Fed's 2Q Flow of Funds data – why US households are still deleveraging and why they will continue to do so for the next several years. Specifically, we asserted that the majority of the deleveraging would occur within the US mortgage sector, given the tremendous percentage increase in mortgage debt relative to all other consumer debts since 1952. Quoting last weekend's commentary:
“… 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).”
The trend in US households' financial obligation ratios (ratios of debt payments to disposable incomes) over the last decade, as illustrated in the following chart, further reinforces our views:
As shown in the above chart, the debt obligation ratio of US homeowners has actually increased much faster than that of all US households (which includes renters) since the late 1990s. Specifically, the debt obligation ratio of the former rose more than 300 basis points from the late 1990s to its peak in 2007, while the debt obligation ratio for all US households rose less than 200 basis points in the same timeframe. This reinforces our assertion that much of the debt/leverage incurred in the US economy over the last ten years has been in the mortgage sector – and is the reason why US housing (with the exception of areas that are tied to international real estate prices such as Manhattan, west Los Angeles, Hawaii, San Francisco Bay, etc.) should underperform other major asset classes for the next one to two decades.
In addition, the above chart signals that the deleveraging in the broader US economy should continue for the next several years through a combination of a restriction in credit creation, a rise in disposable income, and an increase in loan defaults. As US households continue to pay down their debts and as they become more productive through “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the US economy and society.
As US households continue to deleverage and become more productive, we also expect this to be bullish for the US Dollar index. This view is reinforced by our comments in our latest mid-week commentary – or more specifically, the Federal Reserve's intent to slow down its asset purchases and to officially end its “credit easing” policy” by the end of the 1Q 2010. Quoting our mid-week commentary:
With the US and global economic leading indicators rallying to new highs, there is virtually no doubt that the Federal Reserve will end its credit easing policy once they have finished purchasing their current commitment ($300 billion in Treasury purchases, $1.25 trillion in agency MBS, and $200 billion in agency debt, for a total of $1.75 trillion high-quality securities). Since this has been one of the most worrying Fed policies among inflation-wary investors, an ending of this “credit easing” policy should provide some support to the US Dollar, especially since the European Central Bank has made no commitment to ending its de-facto easing policy anytime soon (its latest policy has just effectively guaranteed the entire Irish government debt by allowing Irish banks to post Irish government bonds as collateral at the ECB). I now expect a sustained rally in the US Dollar Index for the rest of this year, with a corresponding weakness in commodities, commodity-related currencies, and of course, the Euro.
With the European Central Bank's open-ended commitment to support and to “quasi-monetize” the debts of the Spanish, Greece, and Irish governments, it is only a matter of time before the Euro starts a sustained decline against the US Dollar. For subscribers who hold significant long positions in US or global equities, we recommend a hedge through a short position in the Euro and/or a long position in puts on the Euro currency. A sustained rise in the US Dollar Index at this point also won't be surprising given the oversold conditions in the US Dollar Index, as exemplified by the following chart:
As mentioned in the above chart, the percentage deviation of the US Dollar Index from its 200-day moving average hit a -7.52% reading on September 22nd – representing its most oversold level since late March 2008 (when the Fed was forced to “back stop” the entire broker-dealer community after the Bear Stearns crisis). With US households still paying down their debts (thus indirectly reducing “short position” on the US Dollar), and with the Federal Reserve monetizing less of the country's debts and a relatively dovish ECB, we expect the US Dollar Index to rally through to the end of the year.
Over the longer-run, the path of the US Dollar Index (note that the US Dollar Index does not capture the value of emerging market currencies against the US Dollar) will depend very much on the “entitlement culture” in US society. Even though the ascension of the G-20 (especially China, India, and Brazil) will lessen the role of the US Dollar as the world's reserve currency, we do not believe this will have much impact on the US Dollar Index. Sure, the Chinese Renminbi should continue to rise against the US Dollar in the long-run, but subscribers should note that the US Dollar Index (as defined by the futures contract traded on the New York Board of Trade) is a measure against the value of only six other currencies, namely the Euro, the Yen, the Pound Sterling, the Canadian Dollar, the Swedish Krona, and the Swiss Franc. In other words, the rise of the Chinese Renminbi and the Indian Rupee would have no effects of the US Dollar Index going forward.
The “entitlement culture” that I am talking about is one that has characterized the rise of the “consumer culture” and the short-term fickleness and “instant gratification” of both professionals and individuals since the end of World War II. For example, as a society, we tried to implement “quick fixes” to social problems that would make John Maynard “in the long-run, we are all dead” Keynes blush. The minimum wage policy – a policy that all first-year public policy students know to be ineffective – is one such “quick fix.” Both state and local governments chronically underfunded their pension plans (and borrowed money) to fund entitlement programs – and partially depended on the stock market to bail them out. Hedge fund managers, bankers, and selected Fortune 500 CEOs were all incentivized to maximize short-term profits (which they did) at the expense of long-term performance and productivity growth. US consumers chronically underfunded their 401(k) and 403(b) plans – and at the same time, bought ever-bigger houses and splurged on imported cars, plasma TVs, and long vacations using their enlarged credit lines. Make no mistake: Politicians, the GSEs, and credit card companies were simply dishing out what US consumers had wanted all along. This entitlement culture was directly responsible for the explosion in the US budget and current account deficits – and indirectly, in the decline in the US Dollar Index. Every one of us living in the US is at least partially responsible for this.
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 25, 2009, the Dow Industrials declined 155.01 points while the Dow Transports declined a whopping 170.93 points. In retrospect, the weakness in the Dow Transports the week prior to last week was a precursor of last week's weakness in the stock market, as the Dow Transports has typically led both the Dow Industrials and the broader stock market since the beginning of the last bull market in October 2002. With the extreme weakness in the Dow Transports last week – and given that the overall stock market is still overbought – my sense is that the stock market will continue to correct over the next several weeks, or at the very least, enter into a long consolidation period that will last until the end of 2009. With the stock market still at an overbought level (the Dow Industrials is up 48% while the Dow Transports is up 77% since the early March lows), and with the ongoing shakiness of the European banking system (especially within Sweden and Austria), we do not recommend any new stock purchases right now. Should the market rally on relatively weak breadth next week, 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 increased from a reading of 6.4% to 6.7% for the week ending September 25, 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 four-week moving average is still far from a historic 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, the Federal Reserve has already indicated it will end its “credit easing” policy at the end of 1Q 2010 – thus constraining liquidity creation and support for the financial markets. For now, we will remain 100% long in our DJIA Timing System, but will likely shift to a more defensive position should the stock market rally this week 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 25th, the 20 DMA increased from 119.7 to 123.7, while the 50 DMA remained near a seven-month low at 124.0. 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 still 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, and if not, at least be mired in an extended consolidation period for the rest of the year. For now, however, we will remain our 100% long position in our DJIA Timing System.
Conclusion: The deleveraging of US households' balance sheets is still an ongoing process, as shown by the latest trend in households' debt obligation ratios. This trend also confirms that 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. As US households pay down their debts – and given the Fed's termination of its “credit easing” policy and the oversold conditions of the US Dollar Index – we expect the US Dollar to do relatively well against the Euro and commodity-related currencies for the rest of this year. As for the US stock market, we continue to believe that it will at least be mired in a consolidation period for the rest of this year. While 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) –it is likely that we will shift to a more defensive position (50% long) in our DJIA Timing System should the stock market rally early this week on relatively weak breadth and/or weak volume. Subscribers please stay tuned.
Henry To, CFA