To Monetize or Not to Monetize?
(November 1, 2009)
Note: In light of our two “ad hoc” commentaries last week, we want to invite our subscribers to discuss the topic: “Is re-education the answer?” As the global workforce obtains more formal education, I believe that workers who have the ability should also obtain as much education as they can. But what about those who are simply not going to get a PhD or law degree? Poster nodoodahs suggests that learning a trade, such as welding or plumbing may be an answer. Subscribers please chip in!
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 2,459.27 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 2,150.27 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.
Despite our assertion that the center of global liquidity creation has now shifted to the Chinese government and the People's Bank of China (if only for this cycle), the Federal Reserve's monetary policies remain a very important contributor to global liquidity. With many speculators having effectively put on a US Dollar short position (i.e. using US Dollar-denominated loans to purchase risky assets, such as Chinese real estate or global equities), the decision by the Federal Reserve to whether to continue to monetize the national debt (through its credit easing policy) would help set the tone (aside from the People's Bank of China's policies) for both the US dollar and other risky assets going forward.
Over the last 12 months, the Federal Reserve purchased (or monetized) a whopping $1.2 trillion of Treasuries and Agency securities (the latter include agency debt and agency mortgage-backed securities), equating to a weekly purchase of $23 billion. Based on the FOMC statement released on September 23rd, the Federal Reserve will no longer be purchasing any Treasuries on a net basis after October, although it will continue to purchase both agency debt and agency MBS through the first quarter of 2010 until it has satisfied its ceiling of $200 billion of agency debt and $1.25 trillion of agency MBS. Assuming the Fed purchases the maximum announced under its current policy, it will purchase an additional $530 billion of securities until March 31, 2010, or approximately $26 billion on a weekly basis.
Following is a chart showing the weekly net purchases of Treasuries and Agency Securities by the Federal Reserve from January 2009 to the present:
For the two weeks ending October 28th, the Fed monetized a whopping $84 billion of Treasuries and Agency securities. The majority of that came during the week ending October 21st, when the Fed monetized nearly $70 billion, or about $55 billion more than its intended $26 billion weekly purchases. During that week, the US stock market hit a new high, while the US Dollar Index hit a new low. The question becomes: To monetize, or not to monetize? While the Fed can ramp up its purchases in the short-run, its current policy dictates a more benign set of purchases from now till March 31, 2010. At some point, the Fed's “ammunition” will run out, although a new round of credit easing is not out of the question. For now – given the precarious situation/sentiment in the US Dollar Index – I expect the Fed to take its asset purchases to a relatively benign level. This suggests at least an extended consolidation period for the US stock market into the end of the year, as well as a short-term bottom in the US Dollar Index a couple of weeks ago.
We thus remain long the US Dollar Index (via the March 2010 futures contract) in our MarketThoughts Opportunistic Investor Portfolio. We informed our subscribers our decision to go long the US Dollar Index in a Special Alert on Tuesday (specifically the March 2010 contract, which was trading at 76.58 at the time). As of Friday at the close, the March 2010 contract closed at 76.85, for a two-day gain of 0.4%. We do not have a price target of the U.S. Dollar Index contract, but will most likely hold it until the end of the year. Following is a performance update of the MarketThoughts Opportunistic Investor Portfolio as of last Friday at the close:
|The Opportunistic Portfolio
(As of October 30, 2009)
||Best Buy Common Stock
||Carnival Common Stock
||US Dollar Index March 2010 Futures
Another reason for why we're expecting the US stock market to (at least) extend its consolidation period until the end of the year is the relatively low amount of cash levels at equity mutual funds, as shown in the following chart (courtesy of ICI.org):
As shown in the above chart, cash levels as a percentage of total assets at equity mutual funds has declined to just 3.8%, its lowest level since September 2007 (just as the global equity market was making a bull market high)! While US investors are still underweight equities relative to fixed income and cash in their personal portfolios, this indicator has come down too far, too fast. While I don't believe the stock market has reached a major peak (since the A/D lines, liquidity, etc, are still bullish from a longer-term standpoint), this “hand over fist” buying from equity mutual funds suggests more consolidation for equities is needed before the market can rally further.
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 October 30, 2009, the Dow Industrials declined 259.45 points, while the Dow Transports declined 191.61 points. Since making a concurrent high two weeks ago, the Dow Industrials declined 2.8% while the Dow Transports declined a whopping 10.2%. The weakness in the Dow Transports suggests some more downside for the Dow Industrials, especially given the vulnerability of the European banking system and US commercial real estate market (at the very least, these two sectors still need to raise a substantial portion of capital from the equity markets). With CIT filing for bankruptcy protection this weekend, I also expect small business lending to remain challenged for the foreseeable future. I continue to expect the US stock market to be mired in a consolidation phase for the rest of this year. For now, probability suggests that the cyclical bull that began in early March remains intact. We will thus 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 11.2% to 9.6% for the week ending October 30, 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:
Note that the four-week moving average hit a 17-month high when it recorded a reading of 11.2% the Friday before last. While this reading is still far from a historic overbought level, its relentless rise from early March to the present suggests that individual investors have gotten too bullish, too quickly. While there is still enough “fuel” for a longer-term rally (the “cash on the sidelines” indicator, while not shown in this commentary, also confirms this), probability suggests that the stock market will need to consolidate before we can embark on a further rally. 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, as we believe the cyclical bull trend that began in early March remains intact.
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 October 30th, the 20 DMA increased from 128.2 to 131.0, while the 50 DMA decreased from 125.4 to 124.3. Note that the 20 DMA is now hovering near its highest level since June, suggesting that retail investors are again leaning towards the bullish side (and confirming our other sentiment indicators). With the 20 DMA above the 50 DMA, probability suggests that sentiment will get more bullish– suggesting that the stock market rally has further to go. That said, given the slowing liquidity creation by the Fed, and the ongoing vulnerability of the European banking system and the US commercial real estate market, the most likely scenario would be for the market to enter into a long period of consolidation till the end of the year.
Conclusion: With the Federal Reserve having monetized a whopping $84 billion of Treasuries and Agency securities over the last two weeks, probability suggests that the Fed's credit easing policies will slow down dramatically into the end of the year, unless the stock market takes another significant dive. Combined with the oversold condition in the US Dollar Index (including the fact that everyone and his neighbor is short the US Dollar Index), our sense is that the US Dollar Index made an intermediate-term low about 10 days ago. With many speculators having funded their risky investments (and sometimes illiquid) in US Dollar-denominated loans, we believe a good way to hedge one's position would be to either go long the US Dollar Index contract (which we have done through the MarketThoughts Opportunistic Investor Portfolio) or US Dollar Index call options.
As for the stock market – while many indicators suggest a long consolidation period into the end of the year (or a further correction) – probability suggests that the cyclical bull market that began in early March is still intact. One indicator that may act as an indicator of an impending peak is the NYSE Common Stock Only A/D line – however, at this point, this indicator is still giving us the “all clear.” For us to turn very bearish on the market again (i.e. for us to enter into a short position in our DJIA Timing System just like we did in October 2007), many other things would need to line up, including a potential fiscal policy mistake (i.e. higher taxes), economic policy mistake (i.e. major protectionist threats), or a monetary policy mistake (such as the failure of the ECB to assist the Euro Zone's banking system in raising capital). Moreover, while we no longer believe European banks pose a global systemic risk, there is no denying that European banks still need to raise $200 to $300 billion of capital in order to resume its “normal state” of lending going forward. This would be very dilutive for current equity holders – and thus I look for both European and US bank shares to underperform over the next 12 months. In addition, the ongoing decline in US commercial real estate prices continues to pose a global systemic risk, and is something that we will continue to track for the foreseeable future. For now, our short-term belief is that the US stock market will be mired in a consolidation phase and for the US Dollar Index to gain more traction for the rest of this year. Subscribers please stay tuned.
Henry To, CFA