What’s Next for the US Economy?
(December 20, 2009)
Note: This will be our last formal commentary for the year and for the first week of January. Over the next two weeks, I will discuss more of my personal thoughts and our outlook for 2010. This will include our outlook for the US Dollar, commodities, and of course, the global stock market and the various economic sectors that we like or dislike in 2010. I promise this will be an interesting ride.
Dear Subscribers and Readers,
Before we review our most recent signals of our DJIA Timing System, I want to comment on the technical condition of the US stock market. After peaking at about 20% over its 200-day moving average (DMA) in mid November, the Dow Industrials entered into a five-week consolidation period (which we were looking for) – trading within the 10,230 to 10,500 range during that time. This has “cured” the Dow Industrials from its highly overbought condition – but as of last Friday, the Dow Industrials was still 14.29% above its 200 DMA.
As a comparison, the Dow Industrials peaked at 14% (in December 2003) above its 200 DMA coming out of its October 2002 bear market bottom, and 12% from its October 1990 bottom. At 14.29% above its 200 DMA – combined with weakening breadth and volume – the Dow Industrials is still overbought and in need of either a quick correction or a longer consolidation period extending into at least January. Carl Swenlin of Decisionpoint.com last week published a good technical picture of the US stock market on a short, medium, and long term basis that nearly concurs with mine. Should the US stock market correct in the short to medium term, I expect DJIA 9,750 to hold on a closing basis – but at this point, I am simply looking for an extension of the consolidation period into early January.
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 1,843.11 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 1,534.11 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.
As we discussed in our last weekend's commentary (“The Deleveraging of US Households (2009 3Q Flow of Funds Update)”), I am looking for US households' balance sheets to continue to deleverage for the foreseeable future (as consumers adept to a more frugal lifestyle, and as banks and credit card companies restrict lending). I personally do not buy PIMCO's “New Normal” view of a ten-year deleveraging process, although US economic growth should remain below trend for the next few years. Sometime in the 2012 to 2013 timeframe, I expect US economic growth to accelerate again – once US households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth. In addition, we commented that:
“Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen TVs (readers should not forget that some of these have also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging will occur in the US mortgage market. While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the long-term over the next decade and thus should provide a “cushion” to the US housing market, US housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or to relocate to smaller or cheaper living areas. I expect most US regional housing markets to underperform other asset classes for the next 15 to 20 years (although assisted living properties should outperform).”
The trend in US households' financial obligation ratios (ratios of debt payments to disposable incomes) over the last decade, as illustrated in the following chart, further reinforces our views:
As shown in the above chart, the debt obligation ratio of US homeowners has actually increased much faster than that of all US households (which includes renters) since the late 1990s. Specifically, the debt obligation ratio of the former rose more than 300 basis points from the late 1990s to its peak in 2007, while the debt obligation ratio for all US households rose less than 200 basis points in the same timeframe. This reinforces our assertion that much of the debt/leverage incurred in the US economy over the last ten years has been in the mortgage sector – and is the reason why US housing (with the exception of areas that are tied to international real estate prices such as Manhattan, west Los Angeles, Hawaii, San Francisco Bay, etc.) should underperform other major asset classes for the next one to two decades.
In addition, the above chart signals that the deleveraging in the broader US economy should continue for the next couple of years through a combination of a restriction in credit creation, a rise in disposable income, and an increase in loan defaults. As US households continue to pay down their debts and as they become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the US economy and society.
In the short-term, 4Q US GDP growth is likely to surprise on the upside as 1) the US economy continues to benefit from the numerous fiscal stimulus programs, 2) companies rebuild their depleted inventories in anticipation of strong Christmas sales, and 3) companies upgrade their IT infrastructure in light of the increased acceptance of Windows 7. While the $154 billion "Jobs for Main Street Act," (which would among other things, provide $75 billion in aid to states to boost infrastructure spending and to prevent public sector employees from being laid off) would prevent a bigger calamity in states' budgets finances, the overall US economy is expected to slow down as fiscal stimulus spending fades towards the second half of 2010. The following chart shows Goldman's GDP growth projects versus the effects of fiscal stimulus spending to 4Q 2011:
Unless another stimulus package is passed (which is possible), real GDP growth is expected to slow down to 1.5% during the third and fourth quarters of 2010 as US households continue to deleverage. Goldman then expects GDP growth to return to its 3% “normalized” rate in 3Q 2011 – which lines up well with our 2012 to 2013 timeframe (by that time, US household deleveraging should be nearly over and technological innovation will be sufficiently mature to drive the next wave of Schumpeterian/productivity growth).
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 18, 2009, the Dow Industrials declined 142.61 points, while the Dow Transports rose 34.71 points. While the Dow Industrials continues to consolidate in the 10,230 to 10,500 range, the Dow Transports actually made a new rally high last week. 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. However, given the still overbought condition of the US stock market, as well as the ongoing concerns about the economies of Spain, Greece, and Dubai, I expect the US stock market to consolidate further into the early part of January (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 15.2% to 15.7% for the week ending December 18, 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 another 25-month high and remains very overbought 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 (although the actual evidence – such as the lack of equity mutual fund inflows, says otherwise). Given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a further rally, but probability suggests that the stock market will consolidate further before the rally can continue. 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 18th, the 20 DMA decreased slightly from 132.2 to 131.4, after hitting a fresh 6-month high of 137.6 just three weeks ago. As mentioned on the above chart, the 20 DMA has now settled lower (and is in fact below its 50 DMA), although it remains overbought relative to its readings over the last two years. Combined with the 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 troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market - is also suggestive of a further consolidation period for the stock market into the early part of January.
Conclusion: With the US stock market still in an overbought condition – and with its weakening technical condition – I expect the Dow Industrials to consolidate in its current range of 10,230 to 10,500 into the early part of January. As discussed in last week's commentary, both the short and intermediate outlook of US real GDP growth remains tepid (although 4Q 2009 GDP growth should surprise on the upside), and should decelerate as the effects of the fiscal stimulus plans wear out in the latter part of 2010. Make no mistake: PIMCO's “New Normal” will not occur, but there is reasonable evidence suggesting that US economic growth will remain below trend for the next two to three years. Sometime in the 2012 to 2013 timeframe, I expect US economic growth to accelerate again – once US households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth.
As for the US stock market, our short-term belief is that the US stock market will be mired in a consolidation phase into the early part of January. Should the US stock market experience a correction, there will be significant support at the DJIA 9,750 level. However, we remain bearish on the retail industry (as discussed in our commentary a month ago), as well as the major US casino operators. Subscribers please stay tuned.
Henry To, CFA