2010 1Q Flow of Funds Update – Households Still Deleveraging
(June 13, 2010)
Dear Subscribers and Readers,
Question of the Week: The Meiji Restoration beginning in 1868 still stands as the greatest transformation of a traditional non-Western society to a modern one that allowed Japan to become a legitimate world power. The political scientist Michael Mandelbaum remarked, “Because it represented the first occasion on which a non-Western country mastered the techniques of modernity and so served as an example for many non-Western societies of the periphery, it is also arguably the most influential modern national accomplishment. Certainly it ranks with the emergence of the United States as the world's most powerful country, and behind only the French and industrial revolutions themselves, as the most important events in history.” With a generation of Commodore Perry's arrival, and partly because of the growing weakness of the Tokugawa regime, Japan restored the rule of the Emperor and thoroughly reformed its institutions to emulate that of the great powers, including reforms in its laws, banking systems, military organizations, scientific knowledge, etc. The $64 trillion question is: After being in relative decline since 1989, can Japan pull out of its current slump, especially given its declining population and the rise of so-called herbivore men? Just as the American Revolution shaped the ideals of the United States, the nature of modern Japan is heavily shaped by the Meiji Restoration. With the rise of China to the west, would Japan ultimately step up and restore itself to the pinnacle of global economic or even perhaps military influence? Scholars will be debating this for years to come.
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 gain of 66.07 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
Let us now discuss the 1Q 2010 Flow of Funds update published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. Since the inception of MarketThoughts.com, one of the main themes that we have tracked through the Flow of Funds information has been the concept of overleveraged U.S. households, as well as the inevitable deleveraging as a result of the financial/housing crisis and the subsequent decline in household credit growth. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio (using the Fed's Flow of Funds data as of 1Q 2009) hit a new post WWII low, and that despite the rally in asset prices during the second quarter, it will take at least several years before U.S. households will finish rebuilding their balance sheets.
Since then, the state of U.S. households' balance sheets has improved – with U.S. household net worth rising by $6.30 trillion over the last four quarters. As of the end of 1Q 2010, U.S. households net worth stood at $54.6 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.41 to 4.91 over the last four quarters. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth have a long hill to climb ($11.3 trillion) before it can reach its prior peak levels, even assuming U.S. housing prices have already bottomed. Note this chart looks different compared to what we showed six months ago, as we have changed the absolute net worth scale on the right to a log scale:
Based on the above chart, U.S. households are probably going to deleverage their balance sheets for at least a couple of more years. Looking deeper into the data, however, it is interesting to see that U.S. households' liabilities have only declined by $596 billion from its peak. This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as U.S. commercial bank and consumer credit has grown by a minimal amount over the last 12 months. So why did US households' liabilities only dip by $596 billion from its peak? The likely answer is that many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). While this bodes well for the balance sheets of the US largest banks (whose portfolio are mostly in residential mortgage securities), it also means that the true deleveraging (and home foreclosures) is not yet over. That is, actual mortgage defaults will most likely stay elevated over the next 12 months, despite a relatively low national housing-price-to-disposable-income ratio, a near all-time low in mortgage rates, and an improving employment picture.
Indeed, as we have already mentioned, the sector that still need to deleverage over the next decade is U.S. housing. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 1Q 2010. While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
For every percentage growth in assets that U.S. households accumulated over the last 57 years, U.S. households incurred 3.52 times as much in mortgage debt, while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.) was “just” 2.07 times as much. Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen TVs (readers should not forget that some of these have also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging would occur in the U.S. mortgage market. While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the next decade and thus should provide a “cushion” to the U.S. housing market, U.S. housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or to relocate to smaller or cheaper living areas. I expect most U.S. regional housing markets to underperform other asset classes for the next 10 to 15 years (although assisted living properties should outperform).
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 June 11, 2010, the Dow Industrials rose 279.10 points, while the Dow Transports rose 162.71 points. Both of the Dow indices bounced nicely towards the end of last week. In fact, Thursday was a Lowry's 90% upside day. Combined with the fact that the market and our sentiment indicators are still oversold, the market should logically continue its rally this week. Whether this rebound becomes more sustainable will depend on this week's technical action and the Spanish refunding due on June 18th. 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. 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 from a reading of 0.4% to -2.7% for the week ending June 11, 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 six weeks in a row to -2.7%, and is now at its most oversold level since the week ending July 31, 2009. In light of this oversold reading, I expect the market to continue its 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 June 11, 2010, the 20 DMA increased from 92.7 to 92.9. Over the last two weeks, the 20 DMA has been vacillating in an oversold range of 91 to 97. In addition, the 50 DMA has finally declined to a relatively oversold level – suggesting that the market may continue to rally this week, especially since our other sentiment indicators are also at oversold levels. Again, whether it turns into a sustainable rally will depend on the future fundamental and technical backdrop. I still believe that any bounce will be short-lived. We will remain 50% long in our DJIA Timing System.
Conclusion: With an ever-more assertive China on the horizon, will Japan again become more assertive and implement much-needed reforms to jump-start its technological prowess and economy? Will the current generation of Japanese men become more capitalistic, creative, or aggressive? As a reactive agent in a globalized world, Japan has responded to such challenges before, but it remains to be seen whether it can respond to the current challenge given a declining population and the lack of a serious catalyst (e.g. the arrival of Commodore Perry's gunboats in Tokyo in 1853).
As for the U.S. Flow of Funds picture, there's no question that U.S. households are still in the midst of a deleveraging process, especially given the still-significant mortgage debt levels. While the near-term picture for the stock market looks decent, 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. The 8 billion Euro Spanish refunding requirement this Friday is a must-watch. 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.
Henry To, CFA