2009 4Q Flow of Funds Update
(March 14, 2010)
Dear Subscribers and Readers,
During the Civil War, the United States Congress attempted to suppress the speculation in the gold market by prohibiting gold trading. As soon as the Act passed, the premium of gold to the “Greenback” surged 100%. To paraphrase Winston Churchill, Americans always do the right thing – but only after they have exhausted all other possibilities. Being not as dumb as they look, the Congress, realizing its mistake, quickly repealed the Act. To quote Henry Clews (author of “Fifty Years in Wall Street”), “The law of supply and demand is the best regulator.”
By threatening hedge funds that have shorted the Euro – and by making a concerted effort to prevent hedge funds from purchasing Greek government bonds – the European governments are literally shooting themselves in the foot. At this point, the Greeks need as many buyers as they could find, despite the 25 billion Euro bailout that are rumored to be in the works. In addition – given the lack of domestic spending growth, a slow export market (and more competition from China), as well as general deflationary pressures – the Euro Zone desperately need a lower currency to remain competitive in the global exports market. Furthermore, the fiscal/financial problems in countries such as Greece, Portugal and Spain are structural in nature. Make no mistake, the 25 billion Euro bailout is merely a band-aid. Going forward, many of these countries will need to continue to cut fiscal spending and adopt a lower standard of living.
Let us now 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 1,547.31 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 1,238.31 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.
Last Friday, we sent a “Special Alert” email informing you of our decision to close our long position in the U.S. Dollar Index (basis March 2010 contract) at a level of 79.85, for a 4.3% gain (in a little over 4 ½ months). We will again update the performance of our MarketThoughts Opportunistic Investor Portfolio at the end of this month. As I mentioned, I expect to go long the USD again at a later point this year, given the promise of greater Schumpeterian growth in the U.S. and weaker fundamentals in the Euro Zone, the UK, and Japan going forward.
Let us now discuss the 4Q 2009 Flow of Funds update published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. Since the inception of MarketThoughts.com, one of the main themes that we have tracked through the Flow of Funds information has been the concept of overleveraged U.S. households, as well as their “new journey” as they actively deleverage and rebuild their balance sheets. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio (using the Fed's Flow of Funds data as of 1Q 2009) hit a new post WWII low, and that despite the rally in asset prices during the second quarter, it will take at least several years before U.S. households will finish rebuilding their balance sheets.
Since then, the state of U.S. households' balance sheets has continued to improve – with U.S. household net worth rising by $5.65 trillion over the last three quarters. As of the end of 4Q 2009, U.S. households net worth stood at $54.2 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.45 to 4.87 over the last three quarters. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth have a very long hill to climb before it can reach its prior peak levels, even assuming U.S. housing prices have already bottomed. Note this chart looks different compared to what we showed last quarter, as we have changed the absolute net worth scale on the right to a log scale:
Based on the above chart, US households are probably going to deleverage their balance sheets for another two to three years. Looking deeper into the data, however, it is interesting to see that US households' liabilities have only declined by $498 billion from its peak. This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as U.S. consumer credit has grown by a minimal amount over the last 12 months (note that banks have continued to par back their lending as well). So why did US households' liabilities only dip by $498 billion from its peak? The likely answer is that the many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). While this bodes well for the balance sheets of the US largest banks (whose portfolio are mostly in residential mortgage securities), it also means that the true deleveraging (and home foreclosures) is not yet over. That is, actual mortgage defaults will most likely stay elevated over the next 12 months. This is already occurring, as many lenders are now more eager to do deals that will make repossessing houses easier (for both the lender and the homeowner).
Indeed, as we have already mentioned, the sector that needs the most deleveraging over the next decade is U.S. housing. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 4Q 2009. While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
For every percentage growth in assets that U.S. households accumulated over the last 57 years, U.S. households incurred 3.54 times as much in mortgage debt, while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.) “just” 2.09 times as much. 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 need to occur in the U.S. 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 next decade and thus should provide a “cushion” to the U.S. housing market, U.S. 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 U.S. regional housing markets to underperform other asset classes for the next 10 to 15 years (although assisted living properties should outperform).
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 March 12, 2010, the Dow Industrials rose 58.49 points, while the Dow Transports rose 129.51 points. The most significant news this past week was the new bull market high in the Dow Transports, as well as the S&P 500. In the meantime, the Dow Industrials is only 86 points away from making a new bull market high. While the Greek fiscal crisis is now dying down, I still expect the global equity markets to consolidate further, given the overbought conditions in global equities. Any upcoming consolidation could last anywhere from two to six weeks. 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. We will 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 rose from a reading of 8.5% to 11.5% for the week ending March 12, 2010. Over the last three weeks, this reading has made a stunning advance – rising from just 4.9%. 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 rising from 4.9% to 11.5% over the last three weeks, this reading is no longer oversold. Because of this rise in bullish sentiment, I expect the market to consolidate further (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 March 12, 2010, the 20 DMA rose from 107.3 to 114.3. Despite the bounce over the last two weeks, the 20 DMA remains oversold relative to its readings over the last two years. In addition, the 50 DMA also remains in oversold territory. This is a longer-term bullish signal from a contrarian standpoint. However, I still expect the market to consolidate over the next few weeks, given the overbought nature of the U.S. stock market.
Conclusion: As U.S. households continue to deleverage, and as the effects of the U.S. fiscal stimulus plans wear off, I expect U.S. economic growth to remain below trend for the next few years (the U.S. housing market will remain very challenged0. 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. This next wave of technological growth will not only unleash the next great wave of global Schumpeterian growth, but will also drive the next secular bull market in U.S. stocks (and will once again put the U.S. at the top of the technological/business world).
As for the current state of the U.S. stock market, it is probably still in a consolidation phase given the overbought conditions in the global stock market. Even though the Greek fiscal crisis is over for now, the overbought conditions and the lack of a serious correction since early March 2009 suggests that the consolidation phase will probably last for a longer while. Should the market experience a deep correction, subscribers should note that 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