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Quick Market and Liquidity Comments

(October 2, 2009)

Dear Subscribers and Readers,

Morningstar.com just published its latest quarterly outlook for the stock market and various sub-sectors.  Based on its proprietary valuation model of the stock market, Morningstar believes that the market is now fairly valued.  Diving deeper into the various sub-sectors, Morningstar believes the most undervalued sector, by far, is the healthcare sector.  Quoting Morningstar's comments on the sector:

While reform and its implications have been the main determinant of the direction of health-care stocks in 2009, another broad industry trend is emerging quietly. Mergers and acquisitions in the health-care sector have picked up. On the valuation front, medical device firms continue to lag the overall recovery pace, but we think they represent compelling investment opportunities today.

As luck would have it, I am now taking a graduate level course on healthcare policy and finance at the UCLA School of Public Affairs as part of my joint MBA/MPP (Master of Public Policy) program.  One of the things that the course has done (I am now three classes into the course) is to help me cut through the half-truths and misleading information that is so prevalent in the media (not to mention blogs) – especially on why US healthcare is so much more expensive than those in other developed countries (both on a per capita basis and as proportion of the GDP), and why healthcare reform – done properly – is so sorely needed.  I will provide a more detailed commentary on healthcare reform and on the implications as soon as a healthcare reform bill is signed by President Obama.

Let us now discuss the stock market and the latest liquidity situation.  As implied by Morningstar's valuation indicator – and based on all the fundamental, technical, and liquidity evidence I have compiled – I continued to expect a “tough sledding” for the global equity markets for the next few weeks.  I am still bullish on the US Dollar Index.  Based on this bullishness, and based on the accumulating metals and energy inventories all around the world, I am still relatively bearish on metal and energy commodities going into Thanksgiving and Christmas.  As we move past October, I believe another significant rally in global equities (with a focus in technology and healthcare stocks) is very possible.  Should we experience another rip-roaring rally during the fourth quarter (note that the S&P 500 returned 15.6% during 3Q, including dividends) – that is, anything over 10% - 2010 would most likely be another tough year, given the lack of earnings/productivity growth visibility and a still-deleveraging US economy.

The reason why I believe a “rip-roaring” rally in US stocks is possible during the fourth quarter is because of the “momentum effect.”  As many investors are still under-invested in US equities, there will be a temptation to jump into equities should the current correction remain shallow.  Moreover, US leading indicators (as documented by the Conference Board, the ECRI, and the OECD) suggest that unemployment should peak sometime in the next three to six months.  As retail investors start to see signs of a recovery and stability in the job market (never mind that the unemployment rate is a lagging indicator), they will most probably increase risk-taking in their individual and retirement portfolios once again.  But while a retail investor-led rally is certainly possible later this year (or early next year), our liquidity indicators are starting to send out signals that the rally from early March is now getting maturing.

One sign that the market rally is now maturing is the latest equity mutual fund cash levels reading from ICI.  Specifically – and as shown in the following chart – mutual fund cash levels have declined to just 4.0% at the end of August, after hitting a eight-year high as recent as February:

Monthly Equity Mutual Fund Cash Levels (January 1996 to August 2009) - Aftering spiking to an 8-year high of 5.9% at the end of February, cash levels as a percentage of total assets at equity mutual funds has declined back to 4.0% - its lowest level since October 2007!

Note that the S&P 500 has risen another 2% since the end of August – suggesting that mutual fund cash levels may have declined even further over the last month.  While this still leaves the door open for a further market rally should retail investors decide to increase their equity allocation through the purchase of mutual funds (this will result in more equity mutual fund cash inflows), the lack of a cash cushion will make the stock market more vulnerable to a correction (and result in less room for another major rally) going forward.

In addition, while the amount of cash sitting on the sidelines (as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background on this measurement is still at a relatively high level, it has declined very quickly since its peak at the end of February this year, as shown in the following chart:

Total Money Market Fund & Checkable Deposits / S&P 500 Market Cap (January 1981 to September 2009) - At its peak at the end of February 2009, this ratio spiked to a 27-year high 65.95%. There is no doubt that the March 9th low represented a major bottom for the US stock market. Since then, it has declined to 43.21%, and is now at its lowest level since the end of September last year. This ratio has come down too far, too fast. This author is thus looking for a short-term correction in the stock market for the foreseeable future, although the longer-term uptrend remains intact.

As mentioned in the above chart, the ratio of “cash on the sidelines” to the S&P 500's market cap has declined relentlessly (to 43.21%) since peaking at a 27-year high of 65.05% at the end of February this year.  This ratio is also now at its lowest level since the end of September last year.  This ratio has definitely come down “too far, too fast” – suggesting relatively anemic returns in the S&P 500 going forward.

Finally – after buying a whopping $78 billion in Treasury and Agency securities under its “Credit Easing” policy for the two weeks ending September 23rd – the Federal Reserve slowed down its purchases last week.  For the week ending last Wednesday, the Federal Reserve only purchased $9.5 billion in securities, as shown in the following chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After purchasing a substantial $78 billion in Treasuries and Agency securities for the two weeks ending September 23rd, the Fed has dramatically slow down its *credit easing* program - consistent with the Fed's latest FOMC statement. For the week ending September 30th, the Fed only purchased $9.5 billion in Treasuries and Agency securities. Going forward, this should be less bullish for global liquidity and commodities, but bullish for the US Dollar Index.

True to its word in its FOMC statement last week, the Federal Reserve is now slowing down its asset purchases as part of its intention to wind down its credit easing policy by the end of the first quarter next year.  Going forward, I expect no more “positive” surprises (such as a further expansion of its balance sheet) from the Federal Reserve, unless another financial dislocation emerges or unless the Dow Industrials again declines below the 8,000 level.  Such a “clamp down” on debt monetization will also be bullish for the US Dollar Index.  We continue to expect the US Dollar to do well (especially against the Euro and commodity-related currencies) from now till the end of the year.

Signing off,

Henry To, CFA

 

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