Liquidity and Sentiment Indicators Still not Cooperating
(August 22, 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 68.62 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
Last week, European Central Bank's Axel Weber (the most hawkish member on the council) indicated that the ECB's emergency lending measures would remain in place at least until the end of the year, with a review to be conducted in the first quarter of next year. The original policy was to end emergency lending in the late September to mid-October timeframe. At the same time, Japanese political leaders indicated that they were considering a new fiscal stimulus plan, although details are still unavailable. The market hardly reacted to these two news stories, as the former was no surprise, while the details of the latter are still sketchy (and to be fair, the vast majority of Japanese fiscal stimulus plans have not been very effective). We maintain that any further easing that would have an impact on global equity markets would have to be from the Federal Reserve. Should global equities remain downbeat (i.e. below DJIA 10,000) going into the next FOMC meeting on September 21st, we believe the Fed would announce another quantitative easing package (U.S. Treasuries only). This package should start small – possibly in the $250 billion to $500 billion range. For now, we are taking a wait-and-see approach with respect to signals in our DJIA Timing System.
In last weekend's commentary, we introduced a new sentiment indicator – the NAAIM (National Association of Active Investment Managers) Sentiment poll, which tracks the percentage of overall equity exposure for 40 NAAIM member firms who are active money managers. As discussed last week, the U.S. stock market has either corrected or consolidated whenever NAAIM net equity exposure pierced the 80% level over the last three years. Conversely, the best time to buy U.S. equities is when NAAIM net equity exposure declined to 20% or below. Last week, the NAAIM equity exposure was 54.68% - a level signaling that the U.S. stock market was stuck in “no-man's land.” This week, NAAIM equity exposure actually increased to 56.08% - suggesting that the market may need to consolidate further before it could embark on another sustainable uptrend, especially in the context of our not-so-bullish global liquidity and technical indicators. That is why we are still taking a wait-and-see approach with respect to our DJIA Timing System.
Given the correction in the last two weeks, I feel it is appropriate to update one of our major liquidity indicators. This liquidity indicator – the “investable cash on the sidelines” versus the S&P 500's market cap – has come down dramatically since the February 2009 peak, as shown in the following chart:
As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has consistently hit new lows since February 2009. This somewhat changed since the end of April – with the ratio rising by 3.36% during that time (from 32.29% to 35.65%). However, this ratio has come down too far, too fast, and remains low relative to its readings over the last two years despite the recent uptick. From a pure liquidity standpoint, probability suggests that the market will undergo more consolidation going into the next FOMC meeting (whether the market will subsequently rally will depend on the Fed's actions on September 21st).
Another domestic liquidity indicator is the size of the Fed's balance sheet. Securities outstanding on the Fed's balance sheet total $2.05 trillion, up $603 billion from a year ago. Since the Fed ended its “credit easing” policies on March 31, 2010, securities outstanding increased another $54 billion up to late June, but have since declined $19 billion as of last Wednesday (see following chart). Over the past 18 months, the mix of the Fed's balance sheet has shifted substantially as the Fed shifted 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. For now, the Fed will keep its balance sheet steady by purchasing Treasuries as its agency debt and MBS instruments mature.
With the Chinese still in a semi-tightening mode, and with Western Europe and Japan still in a deflationary cycle, the global liquidity situation remains precarious. Until we see some kind of improvement in our liquidity indicators, we will remain 50% long in our DJIA Timing System; as opposed to going 100% long (although there's a good chance we will eventually go 100% long sometime in September or October, depending on the liquidity situation or the level of the stock 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 August 20, 2010, the Dow Industrials declined 89.53 points, while the Dow Transports rose 7.47 points. The non-confirmation of the Dow Industrials by the Dow Transports on the downside suggests that technical conditions may be improving (per the Dow Theory), even though both the Dow Industrials and the Dow Transports are still below their 200-day moving averages. Nonetheless, given the still-tough global liquidity indicators, the lingering default risks for Greek sovereign debt, and a further slowdown in the U.S. economy (although we do not believe there will be a double-dip recession), probability suggests that the market action will remain tough for the rest of the summer, if not into October. Of course, the latter will depend on the Fed's actions in the next FOMC meeting. For now, we will remain 50% long in our DJIA Timing System, and should eventually shift to a 100% long position depending on how the market action and fundamentals pan out in the coming weeks.
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 0.3% to 1.1% for the week ending August 20, 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 four weeks ago, this reading has bounced back significantly – rising from -9.9% to 1.1% over the last four weeks. Typically, the most bullish time is when sentiment levels reverse from a very oversold level (which this sentiment indicator has done in the last four weeks) – but in this case, the action of this sentiment indicator may be misleading given the relatively high readings of the National Association of Active Investment Managers (NAAIM) sentiment indicator, as well as our deteriorating global liquidity and technical indicators. Make no mistake, we are still looking to shift to a 100% long position in our DJIA Timing System, but would likely do so only once our liquidity indicators improve. In the meantime, the U.S. stock market will likely remain tough over the summer, if not into October.
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 decreased from 112.9 to 106.9 last week. From late May to early July, the 20 DMA 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. Six weeks ago, the 20 DMA finally pierced through the 98 level. 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 our popular sentiment indicators having reversed from extremely oversold conditions, we should be more bullish on the stock market. However, we are still looking for a further consolidation period for the rest of the summer (possibly into October), and will only shift to a 100% long position should the liquidity conditions improve or should the stock market declines further.
Conclusion: Despite the stock market decline in the last two weeks, the global liquidity situation remains precarious and is still not conducive to a sustainable rally in the stock market. The soonest time for the Fed to act decisively is the next FOMC meeting on September 21st – this is the time when we expect the Fed to announce a decisive resumption of its quantitative easing policy – starting with a $250 to $500 billion commitment to purchase more U.S. Treasuries. However, 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 (although we are not looking for the Fed to exercise this option). Finally, given the deteriorating liquidity and mediocre technical conditions, as well as the relatively neutral reading of the NAAIM equity exposure poll, we are still taking a wait-and-see approach in terms of our DJIA Timing System. Until our global liquidity indicators improve or until the U.S. stock market corrects further, we will refrain from shifting to a 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA