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A Less Liquid Market

(November 13, 2009)

Dear Subscribers and Readers,

While consumer leverage in the vast majority of emerging market countries (see following chart, courtesy of Goldman Sachs) is relatively benign, this is not the case in most developed countries.  As shown on the following chart, American consumers are not the only ones that have gone on a credit binge in the last 25 or odd years:

Consumer Leverage Low in Most Emerging Markets (especially in China)

There are essentially six countries with higher consumer leverage than that in the US, with Australia, France, Spain, Norway, and Canada not far behind.  Should commodity prices suffer a big correction going forward, countries such as New Zealand, Australia, Norway (who is already suffering from depleting North Sea reserves) and Canada will have a very difficult time, and will most likely experience a significant deleveraging in their consumers' balance sheets.  The UK, France, and Spain in particular not only suffer from high consumer leverage, but also significant competitive pressures stemming from a low US Dollar, as well as horrible demographics given their aging populations and generally early retirement ages.  The deleveraging process in these countries will be as painful as that in the United States, if not more painful.

In yesterday's "ad hoc" commentary, I reiterated my stance that the US and global equity markets will most likely endure a consolidation phase going into Thanksgiving and probably into the end of the year.  While valuations are less attractive than they were a few weeks ago, and while the quality of the rally has declined, the vast majority of my technical, sentiment, and valuation indicators are still point to a continuation of the rally over the longer-term.  However - given the relative overbought conditions in the medium term - as well as declining liquidity conditions - the market will most likely take a breather into the rest of this year.  This view is supported by the following chart showing the amount of "investable cash on the sidelines" versus the S&P 500 market cap:

Total Money Market Fund & Checkable Deposits / S&P 500 Market Cap (January 1981 to November 2009) - At its peak at the end of February 2009, this ratio spiked to a 27-year high 65.89%. There is no doubt that the March 9th low represented a major bottom for the US stock market. Since then, it has declined to 41.58%, 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 the market to at least consolidate for the rest of the year, although the longer-term uptrend remains intact.

As can be seen in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has continued to make rally lows.  In fact, this ratio - currently at 41.58% - is now at its lowest since the end of September of last year.  While this ratio is still high from an absolute standpoint (especially compared to its historical record from January 1995 to December 2007), it has definitely come down too far, too fast.  Should the market continue to rally to Thanksgiving, there's a good chance we may scale back our 100% long position in our DJIA Timing System, especially if the DJIA rallies to the 10,750 to 11,250 range over the next couple of weeks.

In the meantime, the Fed has not really been helping in terms of the liquidity situation.  In fact, the Fed has been at its most timid since late February and early March (right before it started purchasing Treasuries) - purchasing a rather insignificant amount of $7.3 billion under its credit easing program over the last two weeks:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After purchasing a whopping $84 billion in Treasuries and Agency securities under its *credit easing* program over the two weeks ending October 28th, the Fed dramatically slowed down its purchases for the two weeks ending November 11th - purchasing only $7.3 billion in Treasuries and Agency securities. Going forward into Thanksgiving, I expect the Fed 's purchases to be relatively low, and thus should be less bullish for global liquidity and commodities, but bullish for the US Dollar Index.

As we head towards Thanksgiving and into Christmas, it doesn't seem like the liquidity situation will improve anytime soon (unless the stock market takes a dive).  In addition, investors may start getting more jittery as the Fed's credit easing program will be coming to a close at the end of the first quarter of 2010.  The wildcard is the Bank of Japan - which may come to the assistance (by monetizing its debt or by buying US Dollars by printing money) should the Yen continues to strengthen or should the Japanese government bond market gets any weaker.  At this point, the Bank of Japan is the only other central bank that is capable of influencing global liquidity, along with the European Central Bank and the People's Bank of China (which incidentally has tightened liquidity over the last couple of months).  Subscribers please stay tuned.

Signing off,

Henry To, CFA


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