A Note on the ECB, U.S. Liquidity, and Sentiment
(November 5, 2010)
Note: As chronicled by Chart of the Day, the bull market that began on March 2009 is still relatively short in both duration and magnitude compared to bull markets over the last 110 years. Also, Rick Konrad, our guest commentator, will be penning a commentary for us this weekend! I understand it's a slight change in format, but this would give me a weekend worth of rest—for the first time in a long time! I appreciate all your patience!
In other news, I found out that I passed my CAIA Level II examination earlier this week. I am now a formal CAIA (Chartered Alternative Investment Analyst) charter holder, in addition to being a CFA charter holder. For those that want a better understand of the alternative investments industry (including the hedge fund, private equity, real estate, and structured finance industries), I highly recommend going through the CAIA study materials. The ones who would obtain the most value are those who control billions of institutional funds and who have an investment policy statement with a goal of investing in alternative assets. Studying the CAIA would make you much smarter in terms of understanding various hedge fund strategies, and how to more accurately measure investment performance (the separation between “alpha” and “beta”), for example. Whoever wants to invest in hedge funds should read this first.
Dear Subscribers and Readers,
One of the interesting developments over the last two years has been the near-unprecedented corporation between the world's major central banks in the midst of the financial crisis; and its subsequent divergence in policies as the global financial system came back from the edge of the abyss. Even as the Federal Reserve embarks on its unprecedented $75 billion-a-month QE2 policy (back in the early 1950s,, the Fed managed to effectively cap the 10-year Treasury rate at around 3% or so by pledging to purchase Treasuries soon rates rise), the European Central Bank has indicated that it will announce its details about its exit strategy as soon as next month (just in time for the holidays!). More specifically, ECB President Trichet reiterated that its “exceptional measures” of providing liquidity to the region's banks are temporary. Most likely, the ECB will announce a series of expiration dates of its allotment policy for maturities longer than a week. Not surprisingly, the German finance minister has publicly denounced the Fed's easing plan—labeling it as a form of currency manipulation and comparing it to the Chinese policy of purposely weakening its currency.
Meanwhile, the Bank of England is also set to expand its quantitative easing policy in January next year. In fact, the market expects the Bank of England to adopt a policy more aggressive to that of the Fed (as a proportion of GDP). This makes sense, as the UK has pledged to dramatically tighten its fiscal policy through a combination of public spending cuts and tax hikes. Right in the middle is the Bank of Japan, which has remained indecisive and uncommunicative regarding both its monetary policy and its policy of intervening in the FOREX market to weaken the Yen.
With the Euro now solidly above US$1.40, it is hard to be bullish on the Euro Zone's general economic activity, especially the “peripheral countries” such as Greece, Ireland, Portugal, and Spain. Interestingly, the Irish government pledged yesterday to consolidate its fiscal balance sheet further—cuts would be more front-loaded (€6 billion worth of cuts next year), and an additional €9 billion in cuts from 2012 to 2014. Most glaringly, the borrowing costs of Greece and Ireland have continued to make new post-Euro highs, as shown in the following chart (courtesy of Goldman Sachs):
With sovereign yields in the peripheral countries still at or making new highs, it is difficult to be bullish on these countries—especially given the ongoing cuts in fiscal spending and the rising Euro. The sovereign debt issue has still yet to “play out”—with Greece (obviously) being the most vulnerable as Greek yields continue to soar and as the Greek government refuses to implement a more efficient tax collection system (very understandable as it is hardly politically feasible to do so, especially since much of its debt is held by foreigners). I expect Greece to default on its debt sometime in the next several years.
I now want to provide an update on one of our main U.S. liquidity indicator for the stock market. This indicator, the amount of “investable cash on the sidelines” versus the S&P 500's market cap remains unsupportive for a year-end rally, as it continues to make new lows (as shown in the following chart):
Note that we have updated the numbers as of Thursday evening. 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. The ratio temporarily bottomed at the end of April, with the ratio rising by 4.47% from the end of April to the end of August (from 32.30% to 36.77%). However, with the best rally in a decade in September, and with the ongoing rally in October and the spike in stock prices yesterday, this ratio has declined to 31.27% as of Thursday evening. More important, this ratio has come down too far, too fast, and remains low compared to its readings over the last two years. As such, this liquidity indicator does not support a year-end rally.
We will now provide an update of some of our most 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. We will not provide an update of the ISEE Index as there is no significant development in that index. The latest four-week moving average of these sentiment indicators increased from a reading of 18.6% to 19.3% for the week ending October 29, 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 18.6% to 19.3% last week, and is now at its most overbought level since the first week of May. In addition, our liquidity indicators are no longer bullish. More important—with the exception of the Bank of England—the rest of the world isn't set on embarking on their own quantitative easing policies. The European Central Bank and the People's Bank of China in particular have pledged to tighten their policies for the foreseeable future. We will retain our 50% long position in our DJIA Timing System, for now, but should the U.S. stock market get more overbought, we will not hesitate shifting to a completely neutral position. In the meantime, the action of the U.S. stock market will likely remain range-bound (or even correct) into Thanksgiving or even Christmas.
Henry To, CFA, CAIA