Credit Conditions Easing?
(June 20, 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 gain of 305.64 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
Even though global funding conditions only eased marginally (and remain elevated) last Friday, investors all breathed a sigh of relief, as Spain was able to easily push through a €3.5 billion sale of 10-year and 30-year government bonds. More important, Spain indicated that it has sufficient funds to meet an upcoming €24 billion in debt payments over the next six weeks. For now, any Greek-type squeeze in financing for Portugal and Spain is off the table. Finally, the Bank of Spain announced that it would provide “stress test” results on a bank-by-bank basis in order to “provide the markets with a perfectly clear idea of the situation of the Spanish banking system.” Subscribers should recall that the publication of the U.S. banks' stress tests in early 2009 did wonders for the financial markets at that time. As long as the Bank of Spain does not publish dire results (which is actually questionable), and as long as any dire results are followed up with capital raises or Euro government backstops, then the publication of Spanish banks' stress test results could be a catalyst for the next global equity rally.
On a Euro Zone-wide basis, credit conditions have also been easing, as shown by the following chart (courtesy of Goldman Sachs):
The above chart attempts to quantify the Euro Zone's financial conditions through an aggregation of the region's liquidity/financial indicators such as short-term rates, the level of the Euro against other currencies that the region trades with, corporate bond prices, and equity prices. Goldman's financial conditions index peaked (that is, financial conditions were tight) in the immediate aftermath of the financial crisis, and has since eased significantly, and is now at its lowest (easiest) level since inception in 1999. According to Goldman, about half of this easing could be explained by the decline in corporate bond yields, with the remaining by the decline in short-term rates and the recent dramatic decline in the Euro. That is, as long as the Euro declines on an orderly basis going forward, the Euro Zone's financial conditions should continue to ease, and the probability of any potential financial dislocations (at least on the short-term) should thus remain low.
Closer to home (for most of our subscribers), let us take a close look at the status of the Fed's balance sheet. Total Reserve Bank credit now sits at $2.32 trillion, up $266.7 billion from a year ago. Since the Fed ended its “credit easing” policies on March 31, 2010, the size of the Fed's balance sheet increased by only $32 billion. Over the past 18 months, the mix of the Fed's balance sheet has shifted substantially as the Fed has shifted its focus from providing direct liquidity to the banking system and other central banks (such as the Bank of Korea) to providing direct liquidity to the broader system/economy through the purchase of U.S. Treasuries, agency debt and agency MBS under its credit easing program. In total, the Fed has made a commitment of purchasing $1.25 trillion in agency MBS and $175 billion of agency debt by the end of March 31, 2010. As of Wednesday afternoon, the Fed still has $129 billion left under this commitment, although it is not obligated to purchase the full amount. Obviously, since the end of March, the Fed has dramatically slow down its purchases, but it nonetheless purchased $50 billion in agency MBS since then (with $7.2 billion of those purchases made last week), as shown in the following chart:
Despite constant rhetoric from analysts on the ever-increasing risk on inflation, I still do not believe the Fed will tighten anytime soon. With the U.S. Dollar strengthening in recent months, and with the Chinese still in a semi-tightening mode, and with Western Europe and Japan still mired in a deflationary cycle, it is difficult to see global inflation popping up anytime soon (this is also confirmed by the recent weak readings in the ECRI Future Inflation Gauge). Until commercial banks start lending again, the Fed will stay with its loose monetary policy. More importantly, given the ongoing troubles in the developed world, I expect the Fed to stand ready to purchase more assets under its credit easing program, as needed. The Fed's liquidity support would no doubt be supportive for a resumption of the cyclical bull market in U.S. equities once the European debt crisis resolves itself.
I now want to digress a little bit and discuss the trend of deleveraging U.S. household that we last discussed in our June 13, 2010 commentary (“2010 1Q Flow of Funds Update”). As mentioned, I am still looking for US households' balance sheets to continue its deleveraging process (as consumers adept to a more frugal lifestyle, and as banks and credit card companies restrict lending). I personally do not buy PIMCO's “New Normal” view of a ten-year deleveraging process, although US economic growth should remain below trend for the next few years. As mentioned previously, I believe that sometime in the late 2012 to 2013 timeframe, US economic growth will accelerate again – once US households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth. While we did see some deleveraging in the 1Q 2010 Flow of Funds data, the more obvious evidence showing that U.S. households are indeed saving and paying down their debts is the most recent trend in US households' financial obligation ratios (ratios of debt payments to disposable incomes), as illustrated in the following chart:
While the above chart signals that the deleveraging in the broader US economy should continue for at least the next 12 months, it also suggests that we have probably finished the most painful adjustments. Going forward, I expect U.S. households to deleverage through a combination of higher disposable incomes (the unemployment rate has most probably peaked), higher savings, and as lenders work through its backlogs of foreclosures and loan defaults. Furthermore, as U.S. households continue to pay down their debts and as they become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the U.S. economy and society.
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 18, 2010, the Dow Industrials rose 239.57 points, while the Dow Transports rose 113.72 points. Both of the Dow indices continued to bounce nicely, and more importantly, surpassed their 200-day moving averages. Combined with the fact our sentiment indicators are still oversold and that the Spanish debt situation looks manageable (in the short-term), the market should logically continue its rally over the next couple of weeks. However, 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 -2.7% to -3.0% for the week ending June 18, 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:
This reading has now declined 7 weeks in a row to -3.0%, and is now at its most oversold level since the week ending July 31, 2009. In light of this oversold reading – as well as the successful Spanish debt refunding last Friday – I expect the market to continue its rebound over the coming days. For now, we will remain 50% in our DJIA Timing System, although we may shift to a neutral or 100% long position depending on the future market action.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. 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 18, 2010, the 20 DMA increased from 92.9 to 93.1. Since late May, the 20 DMA has been vacillated in an oversold range of 90 to 97, and in fact declined to just 90.0 last Wednesday – its most oversold reading since April 1, 200. In addition, the 50 DMA has finally declined to an oversold level. The oversold condition in the ISE Sentiment indicator, as well as our other popular sentiment indicators, presents a good backdrop for a further rally in the stock market over the next couple of weeks. Whether it turns into a sustainable rally will depend on the future fundamental and technical backdrop. We will remain 50% long in our DJIA Timing System, and will shift to a neutral or 100% long position depending on the future fundamental and technical backdrop.
Conclusion: With the “contagion” effects of the Greek debt crisis off the table for now (since Spain has indicated it has sufficient funds to meet its debt repayment schedule over the next six weeks), there is room for a further stock market rally over the next few weeks, especially given the relatively bullish technical and sentiment backdrop. Whether this turns into something more sustainable will depend on the results of the Spanish “stress tests,” as well as whether the European Central Bank will monetize more of the region's sovereign debt.
The latest U.S. debt obligation ratios published by the Federal Reserve confirm that U.S. households are still in a deleveraging process. Sometime in the next 12 to 24 months, I expect this deleveraging process to pause, although the U.S. mortgage sector will remain challenging for years to come. 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. 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 otherwise. Subscribers please stay tuned.
Henry To, CFA