How Potent is the €720 billion Bailout Package?
(May 9, 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.
Last Sunday (May 2, 2010), Greece agreed to a €110 billion bailout package to be provided by the EU and IMF in return for implementation of government spending austerity measures totaling €30 billion. At the time, we commented:
While this will prevent Greece from default during the next refunding date, 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.
On the surface, the latest €720 billion package scraped together by the EU and the IMF seems to be sufficient to deal with the dislocations in the Greek sovereign market (after all, many economists believe that an outright bailout of Portugal and Spain would require “only” €500 billion). In addition, this “show of force” suggests that there is enough political will to implement a bailout for Portugal and Spain should they need them (although this plan still needs to go through the respective legislatures in the Euro Zone). But while this package (details as discussed in this Financial Times article) may provide a backstop to other sovereign countries in the Euro Zone should funding become too expensive, this does not change the overall situation: that the financial markets are increasingly viewing the PIIGS countries as broke and that there needs to be a restructuring at some point, especially given the low structural economic growth in the area given horrible demographics and the lack of a capitalist spirit. In other words – given the seniority of EU/IMF loans over current sovereign government bonds, and given the significant debt burden – probability suggests that European banks and insurance companies alike will continue to avoid Greek, Portuguese, and Spanish sovereign debt. Moreover, should any of these countries choose to tap into this €720 billion package, they will be forced to implement severe austerity measures – thus creating a negative feedback loop – plunging said countries into a slow, deflationary death.
While an immediate crisis has been averted (S&P futures are up 28 points as I am writing this), the combination of a default and deflationary scenario for the PIIGS countries is still there. Unless the European Central Bank implements the “nuclear option” of printing money, these pressures will continue to be a “dark cloud” for the market for most of this summer (IMHO, the long-term trend for the Euro is still down). Moreover, as I have mentioned before, the most bearish development going into the recent correction 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. As mentioned, the summer of 2010 will be a tough time for equities and risky assets.
Moreover, despite the correction last week, our liquidity indicators remain relatively bearish. 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) is still deteriorating, despite the correction last week (which should lead to a lower denominator and thus a higher ratio) – suggesting that the correction likely isn't over yet. As shown in the following chart, “cash on the sidelines” relative to the S&P 500's market cap (as of May 7, 2010) has declined by 48% since its peak at month-end February 2009 (after declining as much as 51% at the end of April 2010):
As mentioned 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). For the months of February to April 2010, this ratio declined by a whopping 7.1% (due to a combination of a rising stock market and a decline in money market funds outstanding), although it did bounce slightly by 2.2% last week due to a plunge in the U.S. equity market. 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 continue its correction, unless a major central bank announces a new liquidity facility (e.g. the Federal Reserve announces an extension of its “credit easing” program or the European Central Bank a plan to monetize a significant portion of the Euro Zone's sovereign debt).
Similarly (but not surprisingly), the Bank of Japan has been rather timid in pumping up its monetary base. Although the latest monthly numbers (April 2010) showed an uptick in the year-over-year growth in the monetary base to 2.9% (from 2.1% last month), it is still down from a peak of 8.2% at the end of April 2009:
As shown in the above chart, the year-over-year growth in the Japanese monetary base reached a five-year high of 8.2% in April of last year. Since then, the year-over-year growth in the Japanese monetary base has consistently shrank, and is standing at 2.9% as of the end of April 2010 – just slightly higher than the 15-month low of 2.1% set last month. Moreover, subscribers should note that the divergence between the growth in the monetary base and the change in the Nikki Index is still wide – suggesting that the Nikkei rally has likely run out of steam as well. Combined with the tightening policies by China and India – as well as the lack of a quantitative easing policy from the European Central Bank, the global liquidity situation thus remains depressed. I thus expect the global equity correction to continue over the summer.
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 May 7, 2010, the Dow Industrials declined a whopping 628.18 points, while the Dow Transports declined 372.80 points. The market is now extremely oversold in the short-run – suggesting that the market should at least experience some kind of relief rally, given the €720 billion EU/IMF bailout package. Despite this correction, however, the Dow Industrials is still up 4.8% while the Dow Transports is up 13.3% since the February 8th bottom. Subscribers should note that the technical, sentiment, and liquidity indicators are still flashing bearish signals. I also don't believe the European sovereign debt crisis is over unless the European Central Bank starts hitting the printing presses. Once any upcoming relief rally runs its course, I expect the market correction to quickly reassert itself and to last throughout the summer if not into early Fall. However, given the strong momentum from the early March 2009 lows – and combined with decent valuations and strong upside breadth – probability suggests 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 decreased slightly from a reading of 20.0% to 19.5% for the week ending May 7, 2010 – breaking its 9-week up streak. 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 after matching its January 22, 2010 peak (which represented the most overbought level since November 2007), this reading declined slightly to 19.5% last week. Given this overbought condition, I expect the correction to reassert itself sometime over the next few weeks, especially given the flagrant negative divergences and the challenging liquidity situation 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. 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 May 7, 2010, the 20 DMA plunged from 133.2 to 120.4. After rising nearly 30 points in the prior nine weeks, the 20 DMA has nearly retraced half of its ascent in just a week, and is thus very oversold in the short-run. I thus expect some kind of relief rally this week. However, given the still overbought condition in our other sentiment indicators (including the equity put/call ratio) and given the still-challenging liquidity environment, I expect the market correction to reassert itself sometime over the next few weeks. 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: In last weekend's commentary, I stated: 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.
From our perspective, last week's sell-off was certainly not a surprise, and while the EU/IMF did announce a wider plan to tackle the sovereign debt problems of Portugal and Spain this weekend, this does not change the fundamental problem of over indebtedness of the Euro Zone in general. In particular, while the short-term refunding risk is off the table, there is no doubt that long-term solvency problems remain in place, especially as it pertains to the PIIGS countries. In the meantime, U.S. liquidity conditions also remain challenging. With our electronic trading systems now in question (after Thursday's plunge), I also expect investors to get more panicky should another correction materialize further down the road. 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