Looking for a Further Fed Easing
(August 10, 2010)
Dear Subscribers and Readers,
I am still tackling my recent move of apartments so this will again be a relatively quick update. I apologize for any inconvenience caused. I promise that I will write a more substantive commentary in next weekend's regular commentary. Until then, all our eyes are on the Fed's upcoming FOMC meeting later today.
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 508.56 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
With one of the best U.S. leading indicators still showing substantial negative year-over-year change, and with the lack of fiscal stimuli coming down the pipeline over the next 18 months, there is no doubt that U.S. GDP growth will likely slow substantially in the near future. According to Goldman Sachs (see the chart below), the overall impact/drag on GDP growth from the lack of fiscal stimuli and inventory adjustments would turn negative as soon as this quarter, and would peak at nearly 2% by the second quarter of next year.
More importantly, the resistance of the general population to further fiscal stimuli – along with the political pressure to reduce the U.S. fiscal deficit – suggests that there is likely no further fiscal stimuli down the road. That means any further easing will have to come from the Federal Reserve. With Federal Reserve President hinting that the Fed may consider more asset purchases should GDP growth continue to slow down, there is a good chance that the Fed may resume its “quantitative easing” policy as early as during today's FOMC meeting. In fact, the stock market may have already “priced in” a minor step where the Fed would reinvest its matured agency MBS holdings in U.S. Treasuries. We also expect the Fed to announce another quantitative easing (most probably in U.S. Treasuries only) package later this year – an amount that is likely to range between $750 billion to $1.25 trillion. Should the Fed fail to announce any measures today, the U.S. stock market will likely react very harshly. We are still taking a wait-and-see approach with respect to our DJIA Timing System.
Since the stock market moved minimally on Monday, we have chosen not to update our charts with Monday's numbers. Keeping that in mind, 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 August 6, 2010, the Dow Industrials rose 187.62 points, while the Dow Transports rose 34.32 points. Both the popular Dow indices are now above their 200-day moving averages. In addition, the technical action of the Dow Transports has particularly improved as the recent uptick in the index means that the index is now close to negating the bearish “heads and shoulders” pattern that has developed since early May. Moreover, the ability of the Dow indices to make new seven-week highs in the face of a short-term overbought condition is very impressive. Despite the ongoing threat of a Greek default and a further slowdown in the U.S. economy (we do not believe we will suffer a so-called double-dip recession), both the price and technical action suggests the future looks bright, even with our weakening liquidity indicators (which we will update next week). For now, we will remain 50% long in our DJIA Timing System, and may shift to a 100% long position depending on how the market action and fundamentals pan out in the coming days. In the meantime, I believe that there's a good chance the U.S. stock market will suffer a short-term set back after the publication of the FOMC statement later today.
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 increased from a reading of -6.6% to -2.5% for the week ending August 6, 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 declining to its most oversold level since the week ending April 10, 2009 just two weeks ago, this reading has bounced back with a vengeance – rising from -9.9% to -2.5% over the last couple of weeks. Fortunately for the bulls, this reading is still oversold, even relative to its readings over the last two years. While our liquidity indicators do not suggest much upside in the market, our fundamental and technical indicators are improving. We are thus looking to shift to a 100% long position in our DJIA Timing System, and would likely do so once our liquidity indicators improve. In the meantime, the U.S. stock market will likely face a headwind post the FOMC meeting today given its short-term overbought conditions.
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:
The 20 DMA increased yet again from 103.0 to 107.5 last week. From late May to early July, the 20 DMA had 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. Four weeks ago, the 20 DMA finally pierced through the 98 level convincingly. At the same time, the 50 DMA declined to a historically oversold level of 94.1 on July 14th, and has been on an uptrend since then. With all our sentiment indicators now at an oversold level, and with the improving technical conditions, there's no doubt that the cyclical bull trend remains intact. However, we are still looking for a further consolidation period over the next 6 to 12 weeks, and will only shift to a 100% long position should the liquidity conditions improve.
Conclusion: As the ECRI Weekly Index remains in negative territory, and given the inevitable drag on the U.S. economy due to the lack of further fiscal stimuli, probability suggests that the Fed could announce a first step towards more quantitative easing policies with the reinvestment of agency MBS proceeds later today. Combined with the recent results of the EU stress tests, this should have a positive impact on global liquidity, although the immediate impact is definitely up for debate. I would argue that in order for the Fed to make a substantial difference, it would have to initiate another program consisting of BOTH Treasuries and agency MBS – a program in the range of $750 billion to $1.25 trillion. With bank lending still subdued, the biggest “bang for the buck” would be for the Fed to purchase private sector assets, such as AAA-rated asset-backed securities (which would allow the “shadow banking system” to supply more credit to the private sector) or even AAA-rated corporate bonds. Thus, while the technical conditions of the market are still improving, the tough liquidity backdrop means that we will refrain from shifting to a 100% long position in the DJIA Timing System for now, although we would definitely watch our liquidity indicators like a hawk (sorry, no pun intended). Subscribers please stay tuned.
Henry To, CFA