Waiting for the European Union's Stress Tests
(July 4, 2010)
Dear Subscribers and Readers,
First, I want to wish all our American subscribers a happy Fourth of July! This is a day when Americans should reflect on what it means to be patriotic – not only in terms of being a responsible American citizen, but a global citizen as well. In the aftermath of World War II, Winston Churchill remarked “The United States stand at this moment at the summit of the world.” At the time, U.S. GDP made up 40% of the world's GDP, one-third of the world's exports, and possessed two-thirds of the world's gold reserves. While successive generations of Americans have enjoyed ever-higher living standards, there's no question that American standing around the world has deteriorated since the end of World War II – both in terms of prestige and relative wealth. Going forward, Americans can be patriotic by simply living within our means, as well as adopting a good work ethic.
Before we begin our first commentary for the second half of the year, I want to update our DJIA Timing System's performance to June 30, 2010. Note that subscribers who want to independently calculate our historical performance could tally up all our signals going back to the inception (August 18, 2004) of our system (we have sent our subscribers real-time emails whenever there is a new signal). Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to June 30, 2010:
Our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way. We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500 or the Russell 1000), since most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market. In addition, the Dow Industrials has a rich history going back to 1896, while the S&P 500 was created in 1957 (although it has been retroactively constructed back to 1926).
Looking at our performance since inception, it is clear that a significant portion of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and when we decided to shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we subsequently closed out on January 9, 2008). While we have stayed on the long side for the most part from mid-January 2008 to April 2010, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance during that timeframe. Looking at the last 18 months, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided about 4% in outperformance, although that resulted in slightly higher volatility (since we were 125% long). In the last few months, we also made a couple of timely tactical moves, when we shifted from a 100% long to a 50% long position on March 29, 2010 (at DJIA 10,888), and then to a completely neutral position on April 27, 2010 (at DJIA 11,045). We subsequently went 50% long again on May 27, 2010 at a DJIA print of 10,145. While we were early on this move, I have no doubt that this position would work out by the end of this year. In addition, we still have some “dry powder” available as we are only 50% long (and will likely go 100% long depending on how the European sovereign debt crisis evolve over the summer).
Subscribers should keep in mind that our goal is to beat the Dow Industrials by a significant margin over a market cycle with lower volatility. While we are not totally happy with our performance over the last two to three years, subscribers should note that we are still ahead of the Dow Industrials by nearly 10% on an annualized basis over the last three years, or since the beginning of the credit crisis. In addition, on a cumulative basis, we are ahead of the Dow Industrials by more than 26% since the inception of our DJIA Timing System on August 18, 2004, returning 23.54% vs. -3.07% for the Dow Industrials (on a price-only basis). Our goal is to beat the stock market with less risk over the long run, and so far, we have done that.
Subscribers should remember that:
It is the major movements that count. Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;
Capital preservation during times of excesses is the key to outperforming the stock market over the long run. That being said, selling all your equity holdings or shorting the stock market for a sustained period is not something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back in the next innovation cycle. I am not going to change my mind on this unless: 1) the Fed or the ECB makes a major policy mistake, 2) an inflationary spiral emerges, 3) the Obama administration makes a major policy mistake, such as protectionist policies or higher taxes (the inevitability of U.S. bank reforms is one factor we are tracking), 4) extreme overvaluations in the U.S. stock market, or 5) a major regional war becomes a possibility, especially in the Middle East. At this point, I do not see too much threat to the stock market on any of these five counts, with the exception of a potential policy mistake by the ECB (should they fail to backstop Greek or Spanish debt if push comes to shove) and reforms that could potentially crimp bank lending in the next couple of years (versus late 2007, when valuations were overly high and when the Fed was reluctant to cut rates).
Also note that our long-term volatility levels continue to be lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods. For now, we believe that the stock market made a solid bottom in early March 2009, and thus we will likely shift to a 100% long in our DJIA Timing System should the market correct further this summer. We will again update the performance of our DJIA Timing System at September 30, 2010.
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 458.52 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
Make no mistake: The market is now very oversold in the short-run. That said, the technical and liquidity conditions for the stock market look horrible. Combined with the “overhang” from the ongoing European sovereign debt crisis (the EU-wide bank “stress tests” would not be published until July 23rd at the earliest), there's no reason to initiate any long positions in the stock market. Moreover, while some of our sentiment indicators have reached very oversold levels (e.g. the ISEE Sentiment Index), this is not consistent across the board. For example, the daily equity put/call ratio closed at 0.76 and 0.60 over the last two days – hardly what one could call oversold readings. In addition, the 10-day moving average of the equity put/call ratio stands at just 0.68 – hardly an oversold level either – as shown in the following chart, courtesy of Decisionpoint.com:
Similarly, from a valuation standpoint (according to Goldman Sachs' calculation of the cyclically adjusted P/E ratio), the S&P 500 is not selling at a compelling level either. Per the following chart, the cyclically adjusted P/E ratio of the S&P 500 is near historical norms:
Note that the cyclically adjusted P/E of 16.0 is as of June 23rd. With the correction in the stock market over the last two weeks, the cyclically adjusted P/E has now declined to 15.0. Despite the lower P/E, the S&P 500 still isn't selling at too compelling a level, given the European sovereign debt crisis overhang, the horrible technical and liquidity conditions, and the lack of visibility on corporate earnings growth and the job market into the end of 2010.
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 July 2, 2010, the Dow Industrials declined 457.33 points, while the Dow Transports declined 308.80 points. The failure of the market to rally despite three Lowry's 90% downside days in the last two weeks suggests a technically weak market. This is compounded by the fact that the Dow Industrials has now pierced the February 8th low, and the general lack of liquidity in the global financial markets. In addition, I don't believe the European sovereign debt crisis is over unless the European Central Bank starts seriously hitting the printing presses. As a result, this summer will continue to be tough. 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 (the next thing to watch for would be the publication of the EU's bank stress tests scheduled for July 23rd).
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 from a reading of -0.2% to -2.1% for the week ending July 2, 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 last week's decline, this reading is again near its most oversold level since the week ending July 31, 2009. Unfortunately for the bulls, this sentiment reading isn't that oversold when compared to its readings over the last two years. Moreover, technical and fundamental indicators suggests that the market action will likely remain tough for the next several weeks, unless or until the European Central Bank starts the printing presses or the publication of the EU's bank stress tests is benign. Right now, we are in a wait-and-see approach, but would not hesitate shifting to a 100% long position should the market continue to correct going into the publication of the EU's bank stress tests on July 23rd.
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:
Since last Friday, the 20 DMA increased slightly from 97.3 to 97.5. Since late May, the 20 DMA has been vacillated in an oversold range of 90 to 98, and in fact declined to as low as 90.0 on June 16th – its most oversold reading since April 1, 2008. In addition, the 50 DMA has finally declined to near a historically oversold level. While the historically oversold condition in the ISE Sentiment indicator presents a good backdrop for a rally, our other sentiment indicators are not confirming this oversold condition in investor sentiment. In addition, the weak technical and fundamental conditions suggest otherwise. For now, we will take a wait-and-see approach, but will likely shift to a 100% long position should the market continue its correction going into the publication of the EU's bank stress tests on July 23rd, as I believe that the cyclical bull market that began in March 2009 remains intact.
Conclusion: Since the inception of MarketThoughts.com in August 2004, we have clearly communicated our thoughts on the U.S. stock market through the signals in our DJIA Timing System. While not all our moves were perfect (in fact, we made some costly decisions during the summer of 2008), I would like to think that we have made some brave and gutsy moves that were highly contrarian at the time but which in retrospect, turned out very well (such as our decision to remain 100% long during the October 2008 to March 2009 period, and our decision to shift to a 125% long position on February 24, 2009). Since the beginning of the cyclical bull market that began in early March 2009, we been 100% long until the end of March 2010, when we switched to a 50% long position (and then to a completely neutral position at the end of April). We have since gone 50% long again, and will likely at some point go 100% long as upside breadth, upside volume, momentum, and liquidity have still remain strong since the beginning of the cyclical bull market in early March 2009.
In the meantime, we are taking a wait-and-see approach and will await the results of the EU's banks “stress tests” that are to be published at or near July 23rd. Until that happens (or until the European Central Bank starts printing money in a meaningful way), we will remain cautious. However, should the market becomes more oversold going into July 23rd, we will likely shift to a 100% long position in our DJIA Timing System, from our current 50% long position. Subscribers please stay tuned.
Henry To, CFA