Negative Divergences in the Health Care Sector
(April 11, 2010)
Dear Subscribers and Readers,
Let us begin our commentary with a review of our 10 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;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 865.65 points as of yesterday at the close (note that this is our only active position right now);
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;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
Amgen, the $60 billion biotechnology company, is one of the many companies I have been tracking since the cyclical bull market began in March 2009. While Amgen has seen the popularity of its core anemia drugs (Aranesp and Epogen) decline in recent years, the breadth and depth of its long-term drug pipeline remains intact. Sure, there has been uncertainty surrounding the introduction of Denosumab, its revolutionary drug used to treat osteoporosis and other bone loss issues, but conservative estimates suggest this drug alone will bring in annual revenues of $5 billion by 2015. In addition, the aging demographics in the developed world – as well as the adoption of “Western lifestyles” by developing countries – will bring about a rising incidence of cancer and chronic diseases. From 2010 to 2020, global cancer rates should double from 10 million to 20 million cases a year. Coupled with the relatively friendly policies in the Obama's administration healthcare reform package (such as keeping the 12-year exclusivity period for biotech drugs, increased healthcare insurance coverage, etc.), we should now be entering the new “Golden Age of Biotech” – and Amgen should be one of the primary benefactors.
Another tailwind for Amgen is its relative undervaluation. At a forward P/E of just 11, Amgen is trading at a substantial discount to many of the largest biotech companies, as well as relative to its historical valuations. That said, the technicals for Amgen and the healthcare sector have acted horribly over the last few months. According to Decisionpoint.com, the Rydex equal-weighted healthcare ETF –despite just making new highs recently – has been losing upside momentum and is now looking “toppy.” The underlying weakness of healthcare stocks is also confirmed by the weakness in the healthcare ETF (XLV) Advance/Decline line as well as its Advance/Decline Volume line, as shown in the following chart courtesy of Decisionpoint.com:
As shown in the above chart, the XLV A/D line peaked in late March, while the XLV A/D Volume line (along with the actual price of the XLV) actually peaked as far back as mid-January! This technical weakness – coming in the face of a friendly healthcare reform policy and decent valuations – suggests that there may be more than meets the eye. In fact, the weak technical condition of U.S. healthcare stocks may simply be reflecting the weakening nature of the general U.S. stock market, as the latter is also heavily overbought and seems to be about to roll over (although the NYSE Common Stock Only A/D line did make another new high last week).
I would now like to spend some time on the liquidity environment. As we covered in our March 25, 2010, April 1, 2010 and April 4, 2010 commentaries, liquidity in the financial markets – as measured by the ratio of total checkable deposits and money market funds outstanding relative to the S&P 500's market cap, equity mutual fund cash levels, and the year-over-year change in loans and leases held under bank credit – has continued to decline even as the U.S. stock market got more overbought. Sure, this weekend's €45 billion (US$61 billion) bailout package offered to Greece (at a below-market rate of 5%) offered by the European Union and the IMF will no doubt give a boost to the markets on Sunday evening, but subscribers should note that this is only a temporary band aid for Greece. Unlike many Central and Eastern European nations where IMF loans were recently provided, Greece's structural growth rate is many times lower due to its deteriorating demographics, generous retirement packages, and a general lack of capital and education investments in recent years. While the short-term “Armageddon” scenario has been averted, the Greek economy will probably “muddle on” (to borrow a term from John Mauldin) for years to come, similar to Japan's “lost decade” immediately after the popping of its stock market and real estate bubble in 1989.
Moreover, while the decline in liquidity and velocity in the “traditional” banking system has been well covered, many folks have neglected to point out that the “shadow banking system” is still far from having fully recovered. For example, the first multiple-loan CMBS deal in two years was just priced last Friday, while the recovery in the asset-backed security market remains tepid. In fact, worldwide ABS issuance – after starting off well earlier this year – is now running below that of last year (just as folks were scared of a widespread bank nationalization) on a year-to-date basis, as shown in the following chart courtesy of Asset-Backed Alert:
Note that if the Federal Reserve hadn't stepped in with its US$1.75 trillion “credit easing” policy to increase liquidity in the U.S. mortgage and Treasury markets, both the financial and the stock market will likely not have recovered so quickly. With the Fed's credit easing policy now expired, chances are that U.S. liquidity will be much impaired for the foreseeable future. The combination of an extremely overbought stock market, emerging negative divergences, declining liquidity, and rising investor bullishness all point to a significant correction in the U.S. stock market sooner rather than later. While we simply cannot know when and where any upcoming correction will halt – I believe for the most part that any correction should last from 3 to 6 weeks, or until our intermediate term technical/sentiment indicators become oversold. As for the price target, I also do not have a solid one (and anyone who tells you otherwise is lying through their teeth) – although subscribers should note that there is strong support in the DJIA 10,000 to 10,300 range.
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 April 9, 2010, the Dow Industrials rose 70.28 points, while the Dow Transports rose 115.17 points. Note that the Dow Industrials has now risen 11.0% while the Dow Transports has risen 18.8% since the February 8th bottom. In addition, both Dow indices managed to make new cyclical bull market highs last week, suggesting that the bull market is nowhere close to a major top. While the Greek fiscal crisis has now died down, I still expect global equity markets to correct soon, given the highly overbought conditions, emerging negative divergences, as well as lingering concerns about Greece's (and other peripheral countries in the Euro Zone) austerity plans, the troubles in the European Banking System, and the ongoing troubles in the U.S. commercial real estate market. My guess is that any upcoming consolidation will last from 3 to 6 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 remain 50% long in our DJIA Timing System for now.
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 15.5% to 16.5% for the week ending April 9, 2010. Over the last six weeks, this reading has made a stunning advance of 12.1%. 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 by 12.1% over the last six weeks, this reading is now again at an overbought level. Because of this rise in bullish sentiment, I expect the market to stage an imminent correction, given the flagrant negative divergences and declining liquidity in the financial markets. However, given the decent valuations in the stock market and strong momentum from the March 2009 bottom, 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 50% long in our DJIA Timing System, although we will likely shift to a 100% long position again should the market reach oversold levels again.
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 April 9, 2010, the 20 DMA rose from 129.4 to 130.5. Over the last six weeks, the 20 DMA has literally skyrocketed – rising from just 107.4 (its most oversold level since November 2008) to 130.5. With the bounce over the last six weeks, the 20 DMA is now actually at an overbought level, at least relative to its readings over the last two years. While the latest reversals in both the 20 DMA and the 50 DMA are a bullish sign in the longer-run, I still expect the market to correct over the next 3 to 6 weeks, given the overbought nature of the U.S. stock market and the negative divergences that have now emerged. Again, we will remain 50% long in our DJIA Timing System, for now.
Conclusion: Since the beginning of the cyclical bull market that began in early March 2009, we have remained stayed at least 100% long (with a shift to a 125% long position during the early parts of the bull market). We have continued to stay long despite signs showing that the market were overbought as early as September, but we decided to remain 100% long as upside breadth, upside volume, momentum, and liquidity remained strong at the time (not to mention that investors were also still bearish). However, this has recently changed, as the technical condition of the market has deteriorated despite the superficial strength in the major indices. Moreover, these negative divergences have also now appeared in U.S. healthcare stocks – this is an additional “black mark” against the bull market given the decent valuations in the healthcare sector, the global demographic/lifestyle tailwinds, as well as very decent valuations in the sector. The negative divergences have only gotten more blatant in the last week, as such, we will remain 50% long in our DJIA Timing System in order to control for risk.
I continue to expect a short-term correction – a correct that should last 3 to 6 weeks. Assuming the correction come, subscribers should note that there is strong support for the Dow Industrials in the 10,000 to 10,300 range. However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market. We remain 50% long in our DJIA Timing System, but will likely shift back to a 100% long position to should the market becomes oversold again. Subscribers please stay tuned.
Henry To, CFA