What are Base Metals' Prices Saying?
(August 29, 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 5.65 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
Two weeks ago, the European central bank indicated that its emergency lending measures would remain in place at least until the end of the year. The original policy was to end emergency lending in the late September to mid-October timeframe. Rumors also suggested that Japan was considering a new fiscal stimulus plan. As I am penning this commentary, the Japanese government is designing a fiscal stimulus package that it claims could arrest the decline in consumer prices and spur economic growth. The Bank of Japan also just expanded the size of its bank-loan program by 10 trillion Yen (US$116 billion) to 30 trillion Yen—effectively easing monetary policy—to cap the rise in the Yen, the decline in consumer prices, and encourage economic growth. The Nikkei initially rallied by more than 200 points, but has since pared back its gains (the Yen has also risen back to Friday's levels) as traders expressed disappointment on the size of the bank-loan expansion.
I doubt Japanese policy makers are bold enough to do anything that would impact global liquidity or the global financial markets. We maintain that any major impact on global equity markets would have to come from the Federal Reserve's policies. 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 expand its 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, despite the latest easing by the Bank of Japan.
Last week, we discussed that our liquidity indicators are still indicating a tough environment for equities. Interestingly, the prices of base metals (copper, aluminum, lead, tin, zinc, etc.) have been a good coincident indicator for global liquidity, and more importantly, a leading indicator for equity prices over the last six months. This is exemplified by the chart below:
As mentioned in the above chart, the prices of base metals (with the exception of tin) have been a leading indicator of global equity prices over the last six months. Since their respective peaks during the January to April 2010 timeframe, base metal prices have struggled—suggesting that the environment for equity prices should remain tough for the foreseeable future, despite the latest monetary easing by the Bank of Japan. In addition, further easing by the Federal Reserve has already been baked in. Until the next FOMC meeting on September 21st, subscribers should remain cautious about taking on commodity or equity risk.
Perhaps just as important, LME inventory levels of copper, aluminum, and nickel are near one-year lows (see below charts, courtesy of Kitco.com). That is, inventory levels should be supportive for higher base metal prices. The fact that base metal prices are still weak in light of low inventory levels suggest that global liquidity levels remain very challenged:
Despite the latest easing by the Bank of Japan, the global liquidity situation remains precarious. Until we see some improvement in our liquidity indicators (more to come next week), 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 July 2007 to the present:
For the week ending August 27, 2010, the Dow Industrials declined 62.97 points, while the Dow Transports declined 24.38 points. While the DJIA was able to hold above 10,000 at Friday's close, the fact that both the Dow Industrials and the Dow Transports are still below their 200-day moving averages suggests that the price action is still not that bullish. Combined with the lack of bullish signals from our 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 results of the next FOMC meeting on September 21st. For now, we will remain 50% long in our DJIA Timing System, and should eventually shift to a 100% long position depending on the market action and fundamentals 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 decreased from a reading of 1.1% to -3.3% for the week ending August 27, 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 for four consecutive weeks, the four-week MA of this indicator declined from 1.1% to -3.3%. While sentiment has gotten more bearish again, this reading is still not that oversold compared to the readings of mid to late July. As such, we would wait for a more oversold reading before shifting to a 100% long position in our DJIA Timing System, and would 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 increased slight from 106.9 to 107.0 last week. From late May to early July, the 20 DMA vacillated in an oversold range of 90 to 98, but seven 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 since been on an uptrend. With our popular sentiment indicators having reversed from extremely oversold conditions, we should be more bullish on the stock market. However – since our other sentiment indicators and liquidity indicators are not confirming – we are thus 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 latest easing by the Bank of Japan, the global the global liquidity situation remains precarious and is still not conducive to a sustainable rally in the stock market. This is also confirmed by the weakness in base metals prices, despite relatively low LME inventory levels. The earliest time for the Fed to act 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, we are 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