The Cyclical Bull Trend is Not Over
(December 6, 2009)
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 1,783.10 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 1,474.10 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.
According to ICI.org, cash levels as a proportion of total assets at equity mutual funds were 3.9% at the end of October – an improvement over the 3.8% level at the end of September. As shown in the following chart, cash levels at equity mutual funds have declined consistently since hitting an 8-year high of 5.9% at the end of February:
Since the Fed's last ultra-low interest rate policy under Alan Greenspan, cash levels at equity mutual funds have been a horrible timing indicator. In addition, the mutual fund community in general – with the exceptions of funds such as PIMCO and FPA – no longer tries to time the market and thus does not maintain a significant cash allocation (the asset allocation decision is usually left for pension fund plan sponsors or managers within endowments and foundations). As a result, while the 3.9% cash level is indeed a concern, it does not indicate a top per se. In fact, there is no evidence suggesting that investors have become too bullish – investors actually withdrew $10.4 billion and $7.1 billion from equity mutual funds during September and October, respectively! On a year-to-date basis, investors withdrew a net $1.9 billion from equity mutual funds. On the other hand, bond funds received net inflows of $253.4 billion on a year-to-date basis!
No matter what we indicators we study – breadth, volume, momentum, liquidity, sentiment, valuation, monetary, and fiscal – there is no indication of a stock market peak in the foreseeable future. Even the potential collapse of Dubai's economy could not derail the cyclical bull market that began in early March. In fact, the big news last week was not the potential collapse of Dubai, but that the U.S. stock market simply waived it off after a one-day correction (the correction also took the market down to a semi-oversold level, with the 10-day NYSE ARMs Index hitting 1.54 – which could be regarded as a very oversold level in a bull market). While the Dubai debt load is definitely big (over $60 billion with potentially another $80 to $100 billion in off-balance sheet liabilities), it pales in comparison to the subprime losses taken by investors over the last three years (it even pales in comparison to the $300 billion “ring fence” that the U.S. Treasury provided for Citigroup alone). In the long-run, the fall of Dubai's economy would not only mean better asset allocation decisions (instead of building useless man-made islands, empty condos, or buying eight-gallon-a-mile hummers, funds would again be diverted to more worthwhile projects), but also that investment funds could come back to the US and other developed countries in lieu of emerging or “frontier” regions such as the Middle East or Africa. This is bullish for both US stocks (and less so for commodities) and for Schumpeterian innovation over the long-run.
Aside from the Dubai crisis, there have been three other developments that were of consequence over the last five days. They are (in no particular order):
- After languishing the Dow Industrials and the broad market since mid-October, the Dow Transports has finally confirmed the Dow Industrials on the upside, as it made a new cyclical bull market high of 4,101.76 last Friday. Per the Dow Theory, the latest confirmation of the Dow Industrials by the Dow Transports suggests that the cyclical bull market in U.S. stocks remains intact.
- The decision by the Bank of Japan to provide an additional US$115 billion in short-term low-cost funds to the Japanese banking system has sparked speculation that the Bank will announce more measures to reflate the economy and combat deflation in the coming days. Following this announcement, Reuters just reported that the Japanese government will provide cheap long-term mortgage loans to prop up its housing market. Assuming both the Japanese government and the Bank of Japan follow through with more stimulus and liquidity measures, global liquidity will improve substantially (yet again) by early next year.
- The Obama administration is poised to announce more stimulus programs this Tuesday. In particular, there is speculation that part of the funding will go towards improving state and municipal finances. This potential provision is important because of two reasons: 1) State and municipal finances are in dismal shape – and in fact could be the next source of a financial dislocation. While the “Build America” program has succeeded in helping states obtain funding through the debt markets, their balance sheets will need to improve, and hopefully this does the job, and 2) In a “normalized economy,” creating jobs through more government spending is not that effective (and the data shows it), due to the “crowding out” effect (i.e. taxing or borrowing more money from the private sector to create government jobs is very inefficient and could actually result in the private sector losing jobs). In addition, there are simply not that many “shovel ready” projects that could hire at such short notice. However, in a recession – especially in a recession where folks are hoarding money or where even government agencies are laying off people due to insufficient funding – government spending can be very effective in creating jobs, and my actually even result in a multiplier effect. Hiring teachers, professors, and other essential service workers that have been laid off due to insufficient municipal funding is the best way to go, as this also provides a long-term benefit to our kids and society overall.
All of the three above developments over the last five days are positive for US stocks and economic growth in the longer-run, assuming that Japan follows through with its stimulus plans and Obama with his plans to improve state and municipal finances.
In the meantime – the cash levels at equity mutual funds notwithstanding – the amount of liquidity (investable cash) sitting on the sidelines also suggests that the cyclical bull market that began in early March is still alive and healthy. This view is supported by the following chart showing the amount of "investable cash on the sidelines" versus the S&P 500 market cap:
While 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 decline (this ratio currently stands at 40.02%), it is still high from an absolute standpoint (especially compared to its historical record from January 1995 to December 2007). In other words, there is still a significant amount of “fuel” that could be used to propel the market higher in the coming weeks. Sure, the ratio of investable cash to the S&P 500 market capitalization has come down very quickly, but while this may result in a consolidation period (or even a correction), I doubt the stock market is anywhere close to a major top.
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 December 4, 2009, the Dow Industrials rose 78.98 points, while the Dow Transports rose 178.92 points. With the Dow Transports having made a rally high and thus confirming the Dow Industrials on the upside – combined with decent valuations, strong liquidity, and strong upside breadth/momentum – there is no question that the cyclical bull market that began in early March is intact. In addition, new plans by the Obama administration to inject funds into struggling states and municipalities should eliminate a potential source of dislocation – that of a debt crisis in one of the major states or municipalities (which in turn would have a detrimental “multiplier” on other states). However, given the ongoing concerns about the European banking system and the US commercial real estate market, I expect the US stock market to continue to consolidate going into the end of this year (such a consolidation period would also be healthy for the market in the longer-run). We 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 increased from a reading of 8.2% to 13.2% for the week ending December 4, 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:
The four-week MA of the combined Bulls-Bears% Differential ratios just hit a 19-month high and is now overbought, at least relative to its readings over the last two years. In addition, its relentless rise from early March suggests that individual investors have gotten too bullish, too quickly. Given the amount of cash on the sidelines and decent valuation, there is enough "pent-up demand" for a further rally, but probability suggests that the stock market will need to consolidate further before the rally can continue. In addition, both the Federal Reserve and the European Central Bank are indicating that monetary policy may be tightened by early next year (the second quarter for the Fed, and the first quarter for the ECB) - meaning that liquidity creation will be constrained in the short-run (in the longer-run, however, I would not rule out the Fed extending its credit easing program to purchase more Treasuries or to include other securities, such as municipal bonds). 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 December 4th, the 20 DMA decreased from 134.4 to 132.4, after hitting a fresh 6-month high of 137.6 last Tuesday. As mentioned on the above chart, the 20 DMA has now settled lower, although it still remains overbought relative to its readings over the last two years. Combined with the relatively overbought readings in our other sentiment indicators, probability suggests that the market will consolidate further before it can embark on a sustainable uptrend. In addition, the macroeconomic backdrop - specifically the ongoing vulnerability of the European banking system, and the US commercial real estate market - is also suggestive of a further consolidation period for the stock market into the end of the year.
Conclusion: With the announcement of Japan's latest monetary and fiscal liquidity measures, the short-term liquidity picture no longer remains as challenged, despite the increasing hawkishness of the European Central Bank and the imminent ending of the Fed's “credit easing” policy by the end of 1Q 2010. Assuming the Obama administration decides to support state and municipal finances through a federal injection, the liquidity situation (and the willingness to take risk) should improve further by January next year – as supporting state and municipal finances most probably provides the “best bang for the buck” for US economic growth in the short-run (aside from directly purchasing houses and renting them out to distressed homeowners, which would directly reduce housing inventories and support home prices nationwide, if it's well implemented). Should the housing and employment picture remain challenged next year, I would not be surprised if the Fed extends its credit easing program to purchase more Treasuries or agency securities, or to include the purchase of other securities, such as higher-rated municipal bonds or even AAA-rated corporate bonds. While many indicators suggest a consolidation period for the stock market into the end of the year – probability suggests that the cyclical bull market that began in early March is still intact. 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 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). For now, our short-term belief is that the US stock market will be mired in a consolidation phase into the end of the year.
We also remain bearish on the retail industry (as discussed in our commentary three weeks ago), as well as the major US casino operators. All gaming/casino operator analysts are now focused on the opening of MGM's CityCenter and whether that will revive the gaming industry in Las Vegas. Subscribers please stay tuned.
Henry To, CFA