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What's Ailing Japan?

(November 8, 2009)

Note: Taking a break recently from my MBA and MPP (Master of Public Policy) studies - and having not seen any action movies lately - I decided to pick up "GI Joe" at the local Red Box.  While the film had decent action, it was unfortunate (and utterly disappointing) that the script writers had again decided to demonize scientists by portraying the major antagonist (the future leader of "Cobra") as a mad scientist - hell bent on sacrificing the world and those that are precious to him to achieve his ends.  The demonization and the childish portrayal of the scientific community (especially the demonization of nanotechnology) by Hollywood scriptwriters and producers have to end if we as a society is to progress to the next stage of scientific enlightenment - an enlightening that will help lift living standards and provide adequate care to the aging baby boomers across the world.  I give the film a big "thumbs down."

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 2,148.58 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 1,839.58 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.

Early last week, the cost of insuring five-year Japanese government bonds - as indicated by the prices of credit default swaps - spiked to its highest level since early August.  At a level of 63 basis points, CDS on five-year Japanese government bonds rose a whopping 28 basis points since early September - and most importantly, have decoupled from those of Germany (21), France (22), the US (22), and Great Britain (47).  By the end of last week, it rose further to a whopping 67 basis points, equating to its highest level since April!

Clearly, something important is going on within the Japanese economy or the Japanese bond market - and yet, nobody appears to know what that is.  Some traders have attributed to this phenomenon as the "Einhorn Effect" - a reference to David Einhorn's recent speech on rising fiscal deficits across the world, with a specific reference to shorting 10-year Japanese government bonds as a global macro trade.  Others equate it to the newly-elected government's reluctance for financial reforms, especially its backing down of a pledge to cut the fiscal deficit.  And with the Japanese government debt-to-GDP ratio now close to 200% - the bears argue that something has to give at some point, especially given the Japanese "demographic time bomb" and the ongoing weakness in the Japanese economy.

The jitters surrounding the Japanese government's indebtedness is also being reflected in the rise in the yields of Japanese government bonds.  In fact, the 10-year JGBs recently hit a 3-month high, and is now about 25 basis points higher than its level a month ago, as shown in the following chart:

Japanese Government Bond Yield Curve

But as every global macro researcher and trader would know, many analysts (and traders) have been calling for an imminent rise in JGB yields for the last ten years, and yet JGB yields have failed to budge.  With the exception of Peter Thiel's Clarium Capital (who shorted JGBs at the nadir of yields during Spring and the Summer of 2003), the vast majority of global macro traders have lost a lot of money shorting JGBs over the last decade.  Indeed, there are many reasons why JGB yields have failed to budge.  First of all, the drivers of JGB yields are somewhat different to those of US Treasuries, as 94% of all outstanding JGBs are held by Japanese citizens (versus just 50% for US Treasuries).  With a chronically weak economy that is subject to constant bouts of deflation, Japanese households have historically held a substantial portion of their savings in Japanese government debt.  In addition, the Japanese government still possesses a tremendous amount of assets that it could privatize in order to fund its public debt.  With the relatively amount of domestic savings, the Japanese government could also expropriate the savings of its citizens through higher taxes in order to repay its debts.  In other words, the "inevitable default" by the Japanese government is not so inevitable, after all.

Indeed - even with the Fed continuing its credit easing policy (although it did halt its Treasury purchases at the end of last month) - the 10-year Treasury yield isn't that much lower than its level a year ago (as seen in the following chart).  This suggests that the recent rise in the 10-year JGB isn't so disconcerting after all, as the 10-year JGB yield is also still lower than its level a year ago.

United States Government Bond Yield Curve

At some point, shorting 10-year JGBs would be a no-brainer (i.e. limited downside but significant upside), but not until the current rhetoric over the impending doom of the Japanese government bond market has died down.  We will continue to track the action of the 10-year JGB - but at this point, we would not anticipate shorting the 10-year JGB unless its yield declines to at least 1.25%, or below.

Focusing back on the US stock market, I am still expecting the major US stock market indices to be mired in a consolidation period at least into Thanksgiving (late November).  Given the monetary and other liquidity indicators I track (including insider sell/buys, mutual fund cash levels, the amount of money market funds outstanding, etc.), I would rate stock market liquidity to be neutral at this point.  While insider selling remains high and while mutual fund cash levels are near an all-time low, the reluctance by both institutional and retail investors to sell their equity holdings are providing a cushion to stock market prices.  It is difficult to see a wholesale change in psychology anytime soon - with the exception of a possible uptick in the technology sector as the proliferation of Windows 7 may be the catalyst for the next upgrade cycle.  One thing's for sure: Based on the strength in breadth and volume since the early March lows - and based on investors' sentiment and the ongoing fiscal and monetary easings around the world - the bull rally since the early March lows is nowhere close to its peak just yet.

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 2007 to November 6, 2009) - For the week ending November 6, 2009, the Dow Industrials rose 310.69 points, while the Dow Transports rose 239.14 points . Last week's bounce was most probably just a *relief rally* from its oversold condition a week ago - given the drop-off in volume last week and the fact that the Dow Transports is still 5% from its rally high. Going into Thanksgiving, IIstill expect the market to be mired in at least a trading range into the end of the year, as investors continue to be jittery over the US commercial real estate market and the US Dollar carry trade. For now, we will maintain our 100% long position in our DJIA Timing System, as we don't believe the cyclical bull trend that began in early March this year has ended just yet.

For the week ending November 6, 2009, the Dow Industrials climbed 310.69 points, while the Dow Transports rose 239.14 points.  Both of the popular Dow indices staged an impressive bounce from its oversold levels over a week ago.  Unfortunately for the bulls, the relative weakness in the Dow Transports (it is still 5% away from its rally high), along with the drop-off in volume over the last week, suggests that the latest rally is just a short-term bounce.  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), I continue to expect the US stock market to be mired in a consolidation phase going into Thanksgiving.  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 9.6% to 7.1% for the week ending November 6, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending November 6, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 9.6% to 7.1%. This reading has now declined two weeks in a row, as is in fact at its lowest level since late September. That said, it is still overbought relative to its readings over the last two years. While the strong upside breadth in the stock market since early March suggests the intermediate uptrend remains intact, many signs are pointing towards at least a consolidation period in the stock market, including the relentless rise in this sentiment indicator since March. For now, however, we will maintain our 100% long position in our DJIA Timing System.

While this reading has declined somewhat from its 17-month high two weeks ago, it is still a little overbought in the short-run.  In addition, 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 the rally can continue.  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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - The 20 DMA decreased slightly from 131.0 to 130.8 last week, although it's still hovering at its highest level since June. With the 20 DMA in an uptrend and still far from an overbought level, probablity suggests that stock market rally still has further to go. However, subscribers should keep in mind that given the significant obstacles that the market needs to deal with - including the systemic risks emanating from the European banking system and the downside risks in commodity prices - we believe the stock market will be mired in a consolidation phase until Thanksgiving. For now, however, we will remain 100% long in our DJIA Timing System.

For the week ending November 6th,  the 20 DMA decreased slightly from 131.0 to 130.8, while the 50 DMA increased from 124.3 to 126.2.  Note that the 20 DMA is still hovering at 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 at least Thanksgiving. 

Conclusion: While the Japanese government bond market remains very vulnerable to some kind of dislocation over the long-run, the dynamics of the JGB market and history suggest that the fears of an impending spike in JGB yields (and collapse of the JGB bond market) are somewhat overblown.  With 10-year JGB yields now at a fresh three-month high, I would not advocate a short position in 10-year JGBs right now.  We will continue to track the JGB market for our subscribers going forward.

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 three weeks 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.  We continue to believe that the US Dollar Index will gain strength as we head towards Thanksgiving, although any sustainable rally in the US Dollar Index is probably still further out.

As for the stock market – while many indicators suggest a long consolidation period into at least Thanksgiving  – probability suggests that the cyclical bull market that began in early March is still intact.  Our intermediate to long-term indicators, such as the NYSE Common Stock Only A/D line, are 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 into Thanksgiving.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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