The Big Question of QE2
(October 24, 2010)
Note: The internal combustion engine is far from dead, as evident by Mazda's new Mazda 2 model.
Dear Subscribers and Readers,
I cannot emphasize enough the importance and power of intuition in both everyday life and in making life-changing decisions. Intuition—as applied in the financial markets—is the split-second ability of identifying whether a “head-and-shoulders” top in a chart pattern is legitimate, or whether your granduncle (who lost his savings in the Great Depression) getting into equities represents the final “blow-off” top, or just another investor going along for the ride. As chronicled by his biographers, for example, John Pierpont Morgan's genius lied not in his mastery of numbers, or in his relationships with the rest of Wall Street, but in his ability to synthesize every bit of important information and make a split-second decision, as exemplified in his genius in crafting the “Corsair Compact” and putting a stop to the “Panic of 1907.” The power of intuition is difficult to explain—and may involve something “higher” than the combination of the left and right brain working together.
Let us now begin our commentary with a review of the 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 917.78 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
With the Republicans control of the House nearly in the bag (Intrade.com is pricing in an 89.5% chance of Republican win), the impact of the mid-term elections on the stock market would be minimal. Again, there is little doubt that Federal Reserve policy—or the possibility of QE2—would dominate the market action from early November to at least the end of this year. In last weekend's commentary, we asserted that, “there's no doubt that the Federal Reserve will expand its quantitative easing policy (aka “QE2”) at the conclusion of its next Fed meeting on November 3rd.” We also stated that we “expect the Fed to expand its asset purchases by at least US$500 billion, with more purchases to be announced early next year.” We believe this is still the position of the market. Goldman Sachs, in particular, expects the Fed to expand its asset purchases by at least US$1 trillion, if not to US$2 trillion. However, Goldman also concedes that its assumptions are highly uncertain—but that based on the “Taylor Rule,” the Fed should actually expand its asset purchases up to US$4 trillion, assuming the “structural unemployment rates” is still at 5% to 5.25% (which we don't believe given the structural overcapacity in the retail, construction, and financial industries over the last five years).
Since then, however, many Fed presidents have openly questioned the wisdom of more asset purchases. In addition, Ron Paul—the most vocal critic of the Federal Reserve System—is poised to become chairman of the sub-committee responsible for overseeing the Federal Reserve. Furthermore, both the U.S. and the China conceded a little in the latest round of “currency wars,” at the weekend's G-20 meeting. China, in particular, announced its intention to lower its trade surplus over the next few years (as a percentage of GDP), and raised interest rates at the same time. Because of this latest concession, the U.S. may withdraw from its “threat” of flooding the world with U.S. Dollars—a strategy that Germany has openly criticized. With both internal and external political pressure to minimize the need for additional asset purchases, I would not be surprised if the Fed announces something that disappoints market participants. It is difficult to speculate what it may be—perhaps it could be a package less than $500 billion, or a temporary commitment of, say, $100 billion per month—a policy that could be eliminated or cut down at a subsequent FOMC meeting. The U.S. Dollar Index could also stage a significant rebound, especially against the Japanese Yen post the FOMC meeting. In fact, investors that want to hold on to their long positions could “hedge” them by going long the U.S. Dollar Index.
At some point, the Fed's strategy of focusing its purchases on Treasuries may come into question, as its impact on private lending (especially in credit availability) is little known. Nonetheless, there is no doubt that the Fed's Treasury purchases are “crowding out” other investors—thus leaving them to “search for yield” by purchasing riskier securities, which in turn lower yields across the board. At some point, the Fed, assuming it maintains its loose monetary policy, may be forced to purchase riskier securities, such as those of AAA-rated municipal bonds, corporate bonds, or asset-backed securities. This may be necessary, as the state of bank lending in the U.S. remains dysfunctional. Following is a monthly chart showing the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1949 to September 2010:
While bank lending has steadied in the last 12 months, subscribers should note that the plunge in banking lending in 2009 is unprecedented. To see similar stats, one would need to go back to the Great Depression – a period when more than one-third of all banks failed in the U.S. Note that the dramatic decline in bank lending came after the disintegration of the “shadow banking system” – if the Federal Reserve and the U.S. Treasury had not provided support under its various liquidity facilities and its quantitative easing policy, there is no doubt that the U.S. and much of the developed world would have been in a second Great Depression. If the “shadow banking system” were fully functioning, then the lack of back lending growth would not be a problem (although if the shadow banking system is functioning, then bank lending should be brisk as well). However, global asset-backed securities issuance remains below that of last year (as shown on the following chart, courtesy of ABS Alert)—suggesting that the Fed should remain accommodative, for now:
With both bank lending and asset-backed issuance still in disarray, the Federal Reserve should remain accommodative, including a plan to boost its asset purchases in the coming weeks. However, the Federal Reserve could be more reluctant than expected come November 3rd, given both external and internal political pressure to avoiding “flooding the world with U.S. Dollars.” Since the market has more or less expected an additional round of asset purchases (as much as US$500 billion, per Goldman) to be announced at the next FOMC meeting, there's a good chance the stock market could be disappointed. At the very least, we expect the U.S. Dollar Index to bounce into the end of the year.
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 October 22, 2010, the Dow Industrials rose 69.78 points, while the Dow Transports rose 60.19 points. Both the Dow Industrials and the Dow Transports have risen three weeks in a row and are now on the verge of breaking through their cyclical bull market highs. While the technical condition remains solid, the market is overbought on a short-term basis and still exhibiting negative divergences. Combined with the lack of bullish signals stemming from our global liquidity indicators (and the fact that the market has already discounted the Fed's QE2 policy), the market action could remain range-bound (or even correct) into Thanksgiving or even Christmas. For now, we will remain 50% long in our DJIA Timing System.
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 12.6% to 14.5% for the week ending October 15, 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 1998 to the present week:
The four-week MA increased from a reading of 14.5% to 16.1% last week, and is at its highest level since early May. This sentiment indicator is overbought—at least relative to its readings over the last few years. In addition, our liquidity indicators are no longer bullish, especially since the market has likely factored in the Fed's QE2 policy. We will thus retain our 50% long position in our DJIA Timing System. In the meantime, the action of the U.S. stock market will likely remain range-bound (or even correct) into Thanksgiving or even Christmas.
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 from 123.1 to 125.3 last week—reaching its highest level since the first week of May—while the 50 DMA increased from 113.5 to 114.1. The 20 DMA has been above its 50 DMA for six straight weeks, suggesting that ISE Sentiment remains in an uptrend. While this is normally a bullish signal, subscribers should keep in mind that the market has nonetheless remained range-bound for the last five months. Moreover, our liquidity indicators are no longer bullish—suggesting that the market will likely be mired in a consolidation period into Thanksgiving or even Christmas. We will remain 50% long in our DJIA Timing System.
Conclusion: As mentioned in last weekend's commentary, the market has no doubt already factored in a Republican victory in the House and the beginning of the Fed's QE2 policy on November 3rd—starting with a commitment to purchase an additional US$500 billion in Treasuries. With both external and internal political pressure to minimize the printing of more U.S. Dollars, the Fed could disappoint come the November 3rd FOMC meeting. Going forward, however, the Fed would likely expand its QE2 program, although it would take a more serious correction for the Fed to do so (especially from a political perspective). Since the “shadow banking system” remains dysfunctional, I would not be surprised if the Fed eventually adopt a more radical policy and purchase riskier assets, such as AAA-rated municipal bonds, corporate bonds, or asset-backed securities. Given that the market has been range-bound over the last five months, and combined with the challenging liquidity conditions, probability suggests that the market will likely correct or consolidate further in the short run. We are staying with our wait-and-see approach, and remain 50% long in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA