The Next Country to Tighten
(February 21, 2010)
The latest edition of Cisco's Top 25 Technology Predictions for the next few decades is a must-read. Many of the predictions are quite tame (e.g. the fact that home networking speeds will increase by 20 times over the next ten years or that Google will index as many as 775 billion pages by 2015), but nonetheless, some of the predictions are pretty daring. For example, Cisco predicts that by mid 2020, the first quantum computer will be commercially available, and that by 2030, artificial implants for the human brain will take place. Coincident with this press release, Sprint has just announced that its 4G WiMax technology will be commercially available for its cell phone subscribers by this summer. Other telcos will also have 4G technologies ready by the end of this year. With Google now poised to jump-start the next set of speed upgrades for the U.S. internet infrastructure, the vast majority of Cisco's predictions actually aren't so tame. No doubt, the inevitable (exponential) increase in computing power – combined with much greater connectivity speeds – will bring about the next set of Schumpeterian growth sometime over the next three to five years.
Dear Subscribers and Readers,
Let us begin our commentary with a review of 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 1,769.65 points as of yesterday at the close.
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 1,460.65 points as of yesterday 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.
In our Thursday night commentary, we had this to say regarding the Fed's latest discount rate hike and liquidity provisions: “So does the latest move mean that the next cycle of tightening is upon us? I recommend a wait-and-see approach. Sure, the Fed is not easing anymore. It has also hiked the discount rate by 25 basis points, but it is by no means tightening just yet. With banks still refusing to lend, with China still tightening, and with Western Europe and Japan still mired in a deflationary cycle, it is still difficult to see global inflation popping up anytime soon. Moreover, the fact that the Fed has kept open its credit easing program suggests that the Fed still has its eyes on the trigger, especially if risky assets such as global equities or corporate bonds start to dive again. In the meantime, I expect the U.S. stock market to be stuck in a consolidation phase for the foreseeable future, despite the strong rally we experienced over the last few trading days.”
Since then, the Bernanke Fed has officially indicated that the Fed is only “renormalizing” monetary policy with the 25 basis point discount rate hike – and that it is still very far away from tightening monetary policy. As mentioned in the above paragraph, it is very difficult to envision the Fed tightening anytime soon given the tightening in Chinese monetary policy (the Chinese government will most likely slow down capital spending growth over the next 12 months in order to cool inflation/economic growth), as well as the ongoing deflationary trends in Western Europe and Japan.
This view is further reinforced when one considers that banks in the U.S., Euro Zone, and the UK have continued to restrict lending (as shown in the following chart courtesy of the IMF, published January 26, 2010):
While corporate bond lending and cash flows have remained robust, this is still not sufficient to offset the drop in bank lending and securitization in order to ensure a strong rebound in economic growth. In addition, many banks (especially in the Euro Zone) have yet to take the full write-downs, despite the bounce in residential real estate prices and general securities prices over the last 6 to 12 months. More importantly – and this is especially important in the U.S. – commercial real estate prices have declined further, suggesting more write-downs to come over the next few months:
So Henry, aside from China, which country will most likely adopt a tighter monetary policy? Isn't Australia – which have benefited immensely from the bounce in commodity prices – even taking a wait-and-see approach?
As mentioned previously, many countries in the developed world simply cannot afford to tighten monetary policy anytime soon. A cursory look at the emerging markets countries, however, suggests a different story. As shown on the following chart, bank credit growth in China and Emerging Asia in general has continued to hold up, despite the slow credit growth in the rest of the world:
One country which hasn't been mentioned very much recently (both by MarketThoughts.com and the mainstream media) is India. Indeed, India is now the 12th largest economy in the world (right behind Canada, with a nominal GDP of around $1.2 trillion), and is now projected to grow in the 8% to 9% range over the next two years (after slowing down to “just” 6% in last year). Due to the recent obsession with tax cuts and fiscal stimulus spending, India's federal government budget deficit is projected to hit 6.3% of GDP in 2010, with an overall government budget deficit of approximately 10% of GDP. Moreover, inflationary pressures in India are now starting to build up, as shown in the following chart courtesy of Goldman Sachs:
With major countries around the world now reining in fiscal stimulus spending and budget deficits, I expect India to make some kind of cost-cutting effort in its annual budget announcement on February 26th as well. That said, given the ongoing global economic slowdown and the Indian government's ambitious plans to maintain 8% to 9% GDP growth over the next two years (to that end, the Indian government desperately needs to invest in infrastructure, education, and agriculture), I don't expect any significant cut-backs. Should there be significant cut-backs in its budget (or a hike in taxes), I expect this to again put pressure on global metals and energy prices (although its impact should be minimal given the small size of the Indian economy).
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 February 19, 2010, the Dow Industrials rose 303.21 points, while the Dow Transports rose 142.96 points. Both the Dow Industrials and the Dow Transports continued its short-term bounce after a four-week correction. Most likely, the positive momentum will carry through to at least the early part of this week. Whether that turns into something more sustainable is still a big question mark, although given the lack of a serious correction since early March of last year, I expect this current correction to be deeper and longer than all the corrections since that time (especially given the heightening policy risk and the ongoing concerns over the economies of Greece, Dubai, Portugal, Ireland, and Spain). At the least, I expect the market to consolidate further – possibly going into March or even April. However, given the strong momentum from the early March 2009 lows – and combined with decent valuations, strong liquidity, and strong upside breadth – there is no question that the cyclical bull market is intact. In the meantime, we 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 another 2.9% last week (after declining a whopping 5.4% the week prior) - from a reading of 8.2% to 5.3% for the week ending February 19, 2010. 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:
After hitting a 26-month high three weeks ago, the four-week MA of the combined Bulls-Bears% Differential ratio has literally dived – and is now at its most oversold level since August of last year. In particular, this reading has declined 12.8% over the last three weeks – representing its steepest three-week decline since July 2008. Whether the impending rally is sustainable is too soon to tell. My best guess is that the market has entered into a new consolidation phase (it takes time to work off the bullish sentiment) – one that could extend to March or even April. However, given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a decent rally starting in late spring and summer of 2010, and probability suggests that we will end 2010 with a new cyclical bull market high. For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March 2009 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 February 19, 2010, the 20 DMA declined from 107.2 to 105.9, and is now at its most oversold level since late November 2008! However, the 50 DMA still isn't in oversold territory. In addition, the macroeconomic backdrop - specifically the heightened policy risk, the ongoing troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market – all suggests that the market will probably need to consolidate further before the bull market can resume.
Conclusion: While much of the developed world still isn't in a tightening phase (which includes the Reserve Bank of Australia, despite rising commodity prices), there's no doubt that inflation (and the pressure to start tightening) is starting to develop in selected emerging market countries. The “poster boy” is of course China, but India will most likely be next, especially given its immense government budget deficits. For now, I don't expect any tightening in India to have a major impact on global asset prices – but should India start tightening, and should China continue to raise reserve requirements on interest rates, I expect global commodity prices to correct at some point.
As for the stock market, I believe that it is still consolidating, despite last week's relatively strong rally. While I don't believe a Greek default is probable, the market should remain jittery unless or until something concrete is done about the dismal fiscal situation in Greece. Given the rigidity of its financial system and the lack of its central bank to devalue and print money, it will be difficult for Greece to resolve its current situation without an EU or IMF-led bailout. Given the overbought conditions coming into the correction and the lack of a serious correction since early March of last year, probability suggests that the correction will be deeper and last longer than all prior corrections since March of last year. There is strong support for the Dow Industrials in the 9,500 to 9,800 range. However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market – and thus we remain 100% long in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA