We Haven't Heard the Last of Greece
(May 2, 2010)
Dear Subscribers and Readers,
Let us begin our commentary with a review of our 11 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;
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.
11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points; the DJIA Timing system is now in a completely neutral position.
On Sunday, Greece agreed to a €110 billion (US$146 billion) “bailout” package to be provided by the EU and the IMF in order to avoid a Greek default. In return, Greece will push for a €30 billion (US$40 billion) cut in government spending (equivalent to 13% of Greek GDP), and would receive these loans at 5% over the next three years. While this will prevent Greece from default during the next refunding date (May 19th), this is obviously just a patch. Firstly, the EU/IMF loan package will likely have seniority over Greek sovereign debt – meaning that Greek debt will likely trade at junk levels for months (or even years) to come. Secondly, the forced austerity measures will mean that instead of a quick default, Greece will now experience a slow, deflationary death. Combined with the country's horrible demographics and the lack of a capitalist spirit, Greece will likely enter into a “Japan-like” period for the next decade, unless the EU/IMF forgive their loans or Greek sovereign debt investors take a “haircut” at some point. Thirdly, there is no similar plan to help Portugal or Spain with their funding issues should their bonds ever become “in play” – i.e. should their bonds be shunned by “real money” investors or should hedge funds start buying CDS contracts on Portuguese or Spanish sovereign debt. More importantly, both Portugal and Spain are simply too large for the EU/IMF to effectively bail out should either country ever need one (and after the latest Greek bailout, German voters will more than likely protest against a Portuguese or Spanish bailout), unless the European Central Bank triggers the “nuclear option” of directly purchasing/monetizing Portuguese and Spanish sovereign debt.
The fact that the EU/IMF did not outline a plan for Portugal or Spain means that investors will continue to treat these two countries as serious credit risks. With Greece now sure to plunge into a severe recession, European banks and insurance companies will likely pare down their risk exposures. In light of recent events, there is no doubt that Portuguese and Spanish sovereign debt will be downgraded further by the three major rating agencies – as a result, European banks and insurance companies will likely dump Portuguese and Spanish sovereign debt – thus triggering a negative feedback loop. Moreover, as I have mentioned before, the most bearish development going into last week's action wasn't the Greek deflationary measures or contagion risks, per se, but the fact that most investors were complacent despite the potential systemic risks or the negative feedback loops of any Greek plan focused on austerity measures. I continue to believe that the summer of 2010 will be a tough time for equities and risky assets.
Our “correction scenario” for this summer is further reinforced by the leverage within the stock market, as exemplified by the amount of margin debt outstanding. Since the February 2009 bottom, total margin debt outstanding has increased by 40%, and in fact has now retraced nearly 40% of its peak-to-trough decline from July 2007 to February 2009. As of March 2010, total margin debt outstanding stood at $278.7 billion – its highest level since month-end September 2009:
The dramatic rise/retracement of margin debt outstanding suggests that leverage has again built up in the stock market. With investors remaining complacent and the stock market overbought – combined with the deteriorating sovereign debt situation in the Euro Zone – there is no doubt in my mind that the summer of 2010 will be a tough time for equities.
Moreover, the amount of cash as a percentage of total assets at equity mutual funds has just hit a new record low(!) as of month-end March (as shown in the following chart) – which further suggests a corrective period for the stock market over the summer:
The last time that equity mutual fund cash levels was nearly this low was month-end July 2007 – just two months prior to ultimate peak of the October 2002 to October 2007 bull market and right at the peak of the NYSE Common Stock Only Advance/Decline line! At the time, equity mutual fund cash levels were at 3.5%. Today, this number, at 3.4%, is even lower. I thus expect the market to continue its correction for the weeks to come.
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 30, 2010, the Dow Industrials declined 195.67 points, while the Dow Transports declined 80.41 points. Despite last week's correction, the stock market remains extremely overbought, with the Dow Industrials having risen 11.1% and the Dow Transports 23.1% since the February 8th bottom. Subscribers should note that the technical, sentiment, and liquidity indicators are still flashing bearish signals. In addition, the European sovereign debt crisis isn't over yet, despite the Greek bailout (it 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. For now, we will remain neutral in our DJIA Timing System, and will likely shift to a 50% long position again once our technical and sentiment indicators decline to oversold levels.
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 19.8% to 20.0% for the week ending April 30, 2010. This reading has now risen 9 weeks in a row – over that period, this reading has made a stunning advance of 15.6%. 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 15.6% over the last 9 weeks, this reading has now matched its January 22, 2010 reading, and is now at its most overbought level since November 2007. With this rise in bullish sentiment, I expect the market to continue its correction, given the flagrant negative divergences and declining liquidity in the financial markets. With so much complacency still 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 neutral 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 30, 2010, the 20 DMA declined slightly from 134.0 to 133.2. The 20 DMA has risen dramatically over the last 9 weeks – rising from just 107.4 (its most oversold level since November 2008) to 136.8 last Monday its most overbought level since December 1, 2009), before settling at 133.2. 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 continue to correct. I also expect the correction to last at least until the end of the summer, if not into Fall. We will remain neutral in our DJIA Timing System, for now.
Conclusion: Despite the short-term solution to the Greek funding problem, the fact that the EU/IMF did not announce a wider plan to tackle the region's long-term deficit problems suggests that over the next 2 to 3 years, 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.” Should investors start selling their Portuguese or Spanish sovereign debt holdings, the decline in the Euro and the global equity markets may even accelerate.
In the meantime, U.S. liquidity conditions are still deteriorating. Many leading stocks are also losing strength. I expect the stock market to correct further, and for now, we will stay neutral in our DJIA Timing System, although we will likely shift back to a 50% long position once our technical and sentiment indicators become oversold again. Subscribers please stay tuned.
Henry To, CFA