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Spain Not Out of the Woods

(December 5, 2010)

Dear Subscribers and Readers,

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 1,237.09 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

As discussed in our November 21, 2010 commentary (“Natural Gas Technically Bullish”), the technical conditions for the January 2011 NYMEX natural gas contract have turned bullish, with the 12-week moving average crossing above the 26-week moving average two weeks ago.  Over the last three years (and over a longer back-test that was done), natural gas prices have typically rallied whenever this occurred.  Sure, natural gas inventories are at historically high levels, while the number of natural gas drilling rigs has bounced over the last couple of weeks (and the number of horizontal drilling rigs now stands at an all-time high).  But with winter natural gas prices now at a multi-year low, and with technical conditions now bullish, I would not be surprised if natural gas prices continue its rally, especially if the 2010/2011 winter is colder than expected.  Following is the weekly chart of the January 2011 NYMEX contract showing the various times the 12-week moving average crossed above the 26-week moving average over the last three years:

As shown in the above chart (note the blue circles), natural gas prices have typically rallied whenever the faster MA (12-week) crossed above the slower MA (26-week)—as shown in the lower panel (which shows the Moving-Average-Convergence-Divergence technical indicator).  The 12-week crossed above the 26-week moving average for the January 2011 NYMEX contract just over two weeks ago.  Given the approaching winter, depressed natural gas prices, and the monthly $75 billion liquidity injections by the Fed's QE2 policy, I expect natural gas prices to rally over the next several months.  One thing is for sure: subscribers should stop shorting UNG (I know, this has been a rewarding trade).

Let's now discuss Spain in the context of the European sovereign debt crisis.  While Spain's public debt levels are not overly high by European standards (at just over 50% of GDP at the end of 2009), there are strong structural headwinds, such as a projected budget deficit of nearly 10% of GDP this year, and a projected 6% and 5.5% in 2011 and 2012, respectively.  In addition, domestic demand will remain a drag for the next couple of years; while its current account, although improving will remain negative in the next few years (especially with the strong Euro).  Finally, it is important to note that the Spanish central government has little control over regional government spending—meaning that further austerity measures would be difficult.  Goldman Sachs expects Spanish GDP growth to be 1.0% next year; and 1.8% in 2012.  However, a significant portion of this growth is expected to come from net exports growth, as shown in the following chart (courtesy of Goldman Sachs):

In fact, net exports growth is expected to add 2.7% in GDP growth next year—offsetting a significant decline in domestic consumption.  Domestic consumption is expected to increase slightly in 2012.  Note that this projection is precarious at best—with the strong Euro now a major danger to this scenario (Spanish exports are very sensitive to the level of the Euro as they don't have as much value-add as German exports, for example).  With public debt projected to increase by another 11.5% in 2011 to 2012, it is dangerous to assume that investors will continue to fund Spanish finances unless Spanish GDP growth accelerates quickly.  Given the amount of crushing debt, the precarious export situation, the strong Euro, and horrible demographics (pension benefit payments will increase as the baby boomers start retiring), I expect both Portugal and Spain to seek external assistance unless something is done immediately in the next few months (such as a commitment to “quantitative easing” by the European Central Bank or an EU-wide recapitalization of its banks).  In addition—given the overbought condition in the U.S. stock market—I also expect U.S. stocks to start correcting soon.  We maintain our 50% long position in the DJIA Timing System, but will not hesitate shifting to a completely neutral position should the stock market continue its rally over the next couple of weeks.

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 December 3, 2010, the Dow Industrials rose 290.09 points, while the Dow Transports rose 189.56 points.  Last week's resurgence in US stocks is no doubt a sign of long-term strength, but with the non-confirmation in the NYSE Common Stock Only A/D line, and with the global liquidity environment still challenged (how it transpires will depend on what unfolds in Europe), I expect the market to start correcting sometime in the next couple of weeks.  For now, we will remain 50% long in our DJIA Timing System, but will likely shift to a neutral position should the market rally further and accompanied by narrow upside breadth/volume.

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 four-week moving average of these sentiment indicators increased from a reading of 19.5% to 20.3% for the week ending December 3, 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 slightly from a reading of 19.5% to 20.3% last week—close to its most overbought level since early November 2007 (just a few weeks after the peak of the last bull market).  In addition, the ten-week MA now stands at 18.4%, a level now seen since late November 2007.  With our liquidity indicators remaining slightly bearish—and with the potential for a “black swan” event in Europe—I expect the U.S. stock market to correct starting sometime in the next couple of weeks.  We will retain our 50% long position in our DJIA Timing System but may shift to a neutral position should the market rally further on narrow upside breadth/volume.

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 slightly from 125.6 to 125.3 last week, while the 50 DMA increased from 121.4 to 123.7.  The 20 DMA has vacillated near the 50 DMA over the last several weeks.  While the 20 DMA is now above the 50 DMA again, it is difficult to discern a trend, given the lack of one over the last several weeks.  More importantly, both the 20 DMA and 50 DMA are at overbought levels—at least relative to their readings over the last three years.  Combined with the bullishness in our other sentiment indicators as well as the challenging global liquidity conditions, probability suggests the market will likely start correcting sometime in the next couple of weeks.  We will remain 50% long in our DJIA Timing System and will likely shift to a neutral position should the market continue to rally on narrow upside breadth/volume.

Conclusion: I expect US and global stocks to correct sometime in the next several weeks given their overbought conditions and as the European sovereign debt crisis continues to play out.  I do not expect the crisis to be over unless the ECB monetizes (i.e. print money) a significant amount of PIIGS debt over the next few months, and/or if the EU-wide banking system is recapitalized (similar to how the TARP situation eventually played out). It is difficult to see how the PIIGS countries could “grow out of their problems” given their statuses of being developed countries and given their horrible demographic situations (and generous pension systems).  In the meantime, I believe the only major bullish “play” for the next several weeks is U.S. natural gas.  I also believe that both the Euro and the Yen are still in confirmed downtrends.  We remain 50% long in our DJIA Timing System but will likely shift to a neutral position should the market keep rallying on narrow upside breadth/volume.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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