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Watching Portugal

(May 30, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 12 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;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; giving us a loss of 8.37 points as of Friday at the close; the DJIA Timing system is now in a 50% long position.

While everyone and his neighbor knows that Italy's government debt position ranks as one of the worst among OECD countries (see table below, courtesy of Goldman Sachs), what they do not know is the relative financial strength of Italian households.  At 180% of GDP, Italian households have the strongest net financial position among the PIGS countries, with Portugal coming in second.

Unfortunately, the strong financial position held by Portuguese households is offset by the significant leverage in the country's non-financial corporations, and to a lesser extent, its government sector.  If we sum up the net financial positions of households, the government sector, the nonfinancial, and the financial sectors, the total net indebtedness of Portugal actually outstrips that of Greece!  Of course, this does not mean Portugal will turn into a failed state tomorrow (note that Portuguese companies have the assets to match their liabilities the above statistic is simply showing the leverage within the nonfinancial sectors).  What the above table shows is the dangerous leverage within the Portuguese economy, taking into account all four of its economic sectors.

More importantly (as shown in the following chart, courtesy of Goldman Sachs), private sector savings have increased in Greece, Spain, and Italy, while those of Portugal have stayed highly negative:

Going forward, Portugal will need to deleverage yet further, especially as its economic growth rate will likely remain stagnant over the next couple of years.  Goldman (who has been very optimistic on the PIGS countries in the last few months) believes that Portugal will need to de-lever by approximately 10% of its GDP.  With lenders starting to lose patience, chances are that Portugal may need to impose more austerity measures in the coming days.  Should it fail to do so, its borrowing costs may spike again.  Going forward, Portugal is a key country to watch.  Since the country's nonfinancial corporate sector is among the most leveraged in the world, subscribers should focus on Portuguese corporate bond yields.  I still believe a fundamental restructuring of Greek, Portuguese and Spanish debt would be needed at some point.

In the meantime, I expect the market to stage some kind of rebound in the coming week.  Whether this develops into a sustainable rally will depend on the fundamental backdrop and the technical action of the market.  With the People's Bank of China no longer engaged in an active tightening policy, and with the Bank of Japan making another effort to spur domestic bank lending, the liquidity backdrop is looking more promising.  That being said, I expect this rebound to be short-lived.  For now, we will stay 50% long in our DJIA Timing System, although we may shift back to a neutral position or even a 100% long position in the days ahead depending on the future action of the market.

Let us now discuss the most recent action in the U.S. stock market using 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 28, 2010, the Dow Industrials declined 56.76 points, while the Dow Transports rose 94.47 points.  The decline during the week before last had sunk the market to its most oversold condition since the March 2009 bottom.  Last week's bounce in the market did little to change that, although the internal condition has improved somewhat. In light of this severely oversold condition, probability suggests that the market will rebound this week.  That is why we went 50% long in our DJIA Timing System on May 21st.  Whether this rebound becomes more sustainable will depend on the subsequent fundamental backdrop and technical action.  However, at this point, I don't believe the European sovereign debt crisis is over unless the European Central Bank starts seriously hitting the printing presses.  That is, I still expect a tough summer.  For now, we will remain 50% long in our DJIA Timing System, and will shift either to a neutral or 100% long position depending on how the market action pans out.

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 declined by a whopping 7.1%, from a reading of 12.5% to 5.4% for the week ending May 28, 2010.  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 for 9 weeks in a row, this reading has now declined four weeks in a row to 5.4%, and is now at its most oversold level since the week ending February 26, 2010.   In light of this oversold reading, I expect the market to stage a rebound this week.  However, we will let the future action of the market dictate our position.  In addition, given the lack of resolution in the European sovereign debt crisis and the decline in liquidity over the last six months, I am no longer confident that we will end 2010 with a new cyclical bull market high.  For now, we will remain 50% 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 28, 2010, the 20 DMA declined from 98.7 to 92.5.  The 20 DMA has plunged over 40 points over the last four weeks and is now at a historically oversold level.  However, the 50 DMA is still at a neutral level, at least relative to its readings over the last two years.  With our other sentiment indicators now approaching oversold levels, I thus expect the market to stage a rebound this week.  Whether it turns into a sustainable rally will depend on the future fundamental and technical backdrop.  For now, I still believe that any bounce that emerges this week will be short-lived.  For now, we will remain 50% long in our DJIA Timing System.

Conclusion: Unless the European Union or the IMF releases a more comprehensive package that could take care of the fundamental solvency problems of the PIIGS countries, chances are that the financial markets will next focus on Portugal, given its highly negative financial asset position (with a primary focus on its nonfinancial corporate sector).  Subscribers should watch Portuguese corporate bond yields as an initial proxy.  However, while the Euro Zone's sovereign debt crisis remains unresolved, both the market action and the developing fundamental backdrop is definitely conducive for a rebound rally this week.

At this point, I still believe the challenging liquidity environment and the inevitable debt restructuring in Europe will pose a problem for the stock market during this summer.  This should not be a surprise, as the €750 billion bailout bill it 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, the long-term solvency problems remain in place, especially as it pertains to the PIIGS countries.  For now, we will stay 50% long in our DJIA Timing System, although we may shift back to a neutral or even a 100% long position should our technical and sentiment indicators tell us to.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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