The Risk of Contagion is Overblown
(April 25, 2010)
Quotes of the Week:
“Sell it short and invite me to your funeral!” – Jim Fisk
“He who sells what isn't his'n; must buy it back or go to prison.” – Daniel Drew
Appearing before the Pujo Committee investigating a “money trust” in 1913, this famous exchange occurred between John Pierpont Morgan and Samuel Untermyer, the counsel to the Committee:
Untermyer: Is not commercial credit based primarily upon money or property?
Morgan: No, sir. The first thing is character.
Untermyer: Before money or property?
Morgan: Before money or anything else. Money cannot buy it … a man I do not trust could not get money from me on all the bonds in Christendom.
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 658.72 points as of Friday 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.
As I mentioned in last weekend's commentary, the bulls are typically given the benefit of the doubt in a cyclical or secular bull market. Overbought indicators and bearish technical patterns should be ignored, unless these are patterns are confirmed by other indicators, such as a significant decline in liquidity, negative divergences in breadth and volume, and highly bullish sentiment, etc. While it has been nearly 14 months since this cyclical bull market began, momentum in upside volume, breadth – and most important of all, confidence (as implied by the Morgan quote) – is still clearly on the upside. As Jim Fisk would say, short this market at your own peril.
However, that is not to say that we should not be careful. After all, the market is extremely overbought – with the Dow Industrials now having risen 8 weeks in a row. Global liquidity is still declining, with the central banks in China, India, Canada, Australia, etc., now clearly tightening monetary policy, while the Federal Reserve is now seriously thinking of shrinking its agency MBS holdings. Investors are also more complacent – specifically, the lack of reaction to the still-lingering Greek fiscal crisis (which could be a source of systemic risk as many European banks hold a substantial amount of Greek government bonds) is simply astounding (to refresh our subscribers' memory, the global financial system got jitters over a potential Dubai default late last year – an economy with less than 30% of the total amount of Greek debt outstanding). As a result, we decided to shift our 100% long position in our DJIA Timing System to a 50% long position on March 29, 2010 purely for risk-control purposes. While we are still looking for a correction in global equities, we would not under any circumstances short the market for any sustained period given that the market is still in a cyclical bull. However – should the market continue to rally in the coming days – we would not hesitate shifting to a completely neutral position in our DJIA Timing System to further cut down our exposure. Subscribers please stay tuned.
In the meantime, the Greek fiscal crisis is spiraling out of control. “Real money” investors such as the world's biggest bond funds, pension funds, endowments, and even Western European banks have gone on a buyers' strike as the situation has turned into a political one (making money on Greek bonds is simply not considered a “prudent” thing to do anymore, and is now treated as a significant career risk for bond managers). Meanwhile, the funds that have the capacity to take on risk – i.e. relative value fixed income or global macro hedge funds – are being shut out by the Greek government. This disdain of hedge funds has caused significant harm to the Greek bond market. In addition, the three credit rating agencies, Moody's, S&P, and Fitch still have Greece on their “negative watch” lists. Should the rating agencies continue to cut Greek's bond ratings (which would not be a surprise as Greek yields are already higher than those of other countries' that are rated as “junk”), the European Central Bank would no longer allow Greek government bonds to serve as collateral for bank borrowing under its current rules. Such an occurrence would result in a general liquidity crisis in the region, and will be the “end game” for many Western European banks.
It is difficult to imagine that current investors of Greek bonds will be made whole under any circumstances. For example, the purported 10 to 15 billion Euro aid from the IMF will no doubt have seniority over exiting Greek sovereign debt. Sure, the Greek government is getting a low-cost IMF loan that will help it get through the next few months, but this will not resolve Greece's long-term problems. Greece is not experiencing just a liquidity crisis, but a longer-term, structural crisis plagued by low productivity, horrible demographics, and therefore low, structural economic growth for the foreseeable future. The status of the 30 billion Euro aid from the rest of the Euro Zone countries, meanwhile, may or may not have seniority over current Greek sovereign debt – but given the intense opposition in Germany (the biggest contributor) to the aid package, there's a chance that a compromise could be worked out where even loans from the EU would be senior over Greek sovereign debt. In this scenario, then I don't see how or why current holders would not take a “haircut” on their Greek debt holdings. Excuse the cliché, but this is like watching a slow-motion train wreck.
While public finances across the Euro Zone are a collective mass (see below table, courtesy of Goldman Sachs), the short-term risks of a “Greek contagion,” especially in Portugal, Ireland, and Spain, are overblown. As mentioned before, the long-term outlook is bleak. Even the bastion of economic strength/conservatism, Germany, is looking at a 5.6% budget deficit this year, and a projected public debt of 79.3% by the end of the year (actually higher than Ireland's). Laughably, Greece is looking for a three-year bailout package from its Euro Zone neighbors – do they seriously think they will get it without more dramatic austerity measures (such as raising the retirement age to 65 or over)?
However, the short-term (2010) outlook is less dire. For example, the projected 2010 Portuguese debt of 86.0% would still be below that of Italy, Belgium, and 24% below that of Greece. In fact, Portugal's public indebtedness is only a little bit higher than that of France. Meanwhile, projected 2010 Spanish public indebtedness of 66.6% is not even worth fretting about in the short-term, as this number is even more benign than that of the U.S. and UK public debt outstanding. Nevertheless, while I do not believe there is a risk of Greek contagion this year, the long-term outlook for government spending in the Euro Zone is very dire in the long run, especially given the region's bleak outlook for long-term productivity and economic growth.
In the meantime, I want to provide a quick liquidity update to our subscribers. In particular, the amount of cash sitting on the sidelines (as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background) has continued to deteriorate – suggesting that a correction will occur sooner rather than later. As shown in the following chart, “cash on the sidelines” relative to the S&P 500's market cap has declined by 52% since its peak at month-end February 2009:
As can be seen in the above chart, 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 been making new rally lows consistently since the beginning of this bull market (with only slight pauses in June 2009 and January 2010). In fact, this ratio plunged by 3.41% in March (due to a combination of a rising stock market and a decline in money market funds outstanding), and plunged by a further 2.14% so far in April. In addition, this ratio is no longer high from an absolute standpoint (especially when compared to its historical experience excluding the late 1990s and mid 2000s). While the long-term trend of the stock market is still up, probability suggests that the market will experience a correction right here, unless: 1) A major central bank announces a new liquidity facility (e.g. the Federal Reserve announces an extension of its “credit easing” program), or 2) a major technology (one that could speed up U.S. productivity growth) is commercialized over the next several months (which is not likely).
With the market now at a highly overbought level, and with global liquidity no longer conducive to a further rally, and with negative divergences now emerging in the global equity markets (as exemplified by the weakness in U.S. healthcare stocks and the declining momentum in former leaders such as AMZN and ISRG), the market is most likely setting itself up for a significant correction going into this summer (or at the very least weeks of consolidation). Should the market continue to rally on declining upside breadth or upside volume, we will most likely shift to a completely neutral position in our DJIA Timing System to cut our risk exposure further. Subscribers, please be careful out there.
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 23, 2010, the Dow Industrials rose 185.62 points, while the Dow Transports rose 105.58 points. Note that the stock market is now extremely overbought; with the Dow Industrials having risen 13.1% while the Dow Transports 25.3% since the February 8th bottom. While both Dow indices managed to make cyclical bull market highs last week, subscribers should note that the technical, sentiment, and liquidity indicators are now flashing bearish signals. In addition, the Greek fiscal crisis has flared up again, and will continue to present a fundamental problem for the Euro Zone over the next 2 to 3 years. I expect any correction from here to last throughout the summer, if not until Fall. However, given the strong momentum from the early March 2009 lows – and combined with decent valuations and strong upside breadth – there is no question that the cyclical bull market is intact. But should the market continue to rally on declining upside breadth/volume, we will not hesitate cutting our exposure to a completely neutral 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 again from a reading of 18.4% to 19.8% for the week ending April 23, 2010. This reading has now risen eight weeks in a row – over that period, this reading has made a stunning advance of 15.4%. 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 15.4% over the last eight weeks, there is no doubt that this reading is now at an overbought level. With 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. Should this reading get more overbought in the next couple of weeks, and should this be accompanied by a higher stock market and more negative divergences, we will likely go completely neutral in our DJIA Timing System. With so much complacency now in the market, I am no longer confident that we will end 2010 with a new cyclical bull market high, given declining liquidity and heightened policy risks. For now, we will remain 50% long in our DJIA Timing System.
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 23, 2010, the 20 DMA rose from 132.2 to 134.0. The 20 DMA has skyrocketed over the last 8 weeks – rising from just 107.4 (its most oversold level since November 2008) to 134.0, its most overbought level since January 15, 2010. With this bounce, the 20 DMA is now at an overbought level, at least relative to its readings over the last two years. Given the overbought condition in the ISE sentiment indicator (and as confirmed by our other sentiment indicators, including the equity put/call ratio) and the market highly overbought levels, I expect the market to correct soon. I also expect the correction to last at least until the end of the summer, if not into Fall. Again, we will remain 50% long in our DJIA Timing System, for now.
Conclusion: While the Greek fiscal crisis will continue to cast a shadow over the European banking system (and hence, global equity markets), we believe that the short-term threat of contagion in the region is very low, given the relatively low public indebtedness in countries such as Portugal, Spain, and Ireland. Over the next 2 to 3 years, however, it is likely that the Euro Zone as a whole would need to impose more austerity measures, given the region's high indebtedness and low structural economic growth. With fiscal policy no longer an effective tool, the European Central Bank will likely maintain its low interest rate policy for the next couple of years. As a result, the Euro remains a “sell.”
In the meantime, U.S. liquidity conditions are still deteriorating. Many leading stocks are also losing strength. I expect the stock market to correct soon, but should the U.S. stock market continue to rally in the next couple of weeks on declining upside breadth/volume, we will likely shift to a completely neutral position in our DJIA Timing System. For now, we will stay 50% long. Subscribers please stay tuned.
Henry To, CFA