2010 3Q Flow of Funds Update - Deleveraging Process Ongoing
(December 12, 2010)
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 1,265.32 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
Let us now discuss the 3Q 2010 Flow of Funds update published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. Since the inception of MarketThoughts.com, a main theme we have tracked through the Flow of Funds information has been the idea of overleveraged U.S. households, as well as the inevitable deleveraging as a result of the financial/housing crisis and the subsequent decline in household credit growth.. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio hit a new post WWII low, and that despite the rally in asset prices during the second quarter, it will take at least several years before U.S. households will finish rebuilding their balance sheets.
Since then, the state of U.S. households' balance sheets has improved – with U.S. household net worth rising by $5.99 trillion over the last six quarters (despite a $1.42 trillion decline during 2Q 2010). As of the end of 2Q 2010, U.S. households net worth stood at $54.9 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.46 to 4.94 over the last six quarters. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth have a long hill to climb ($10.85 trillion) before it reaches its prior peak levels, even assuming U.S. housing prices have bottomed. Note that the absolute net worth scale on the right is a log scale:
Based on the above chart, U.S. households will likely deleverage their balance sheets for the foreseeable future. In fact, I don't believe Bernanke will “let up the gas” in any way until the asset-to-liability ratio of U.S. households rises back to 5.50 or higher. Interestingly, U.S. households' liabilities have only declined by $623 billion from its peak. This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as U.S. commercial bank and consumer credit has grown by a minimal amount over the last six quarters. So why did US households' liabilities only decrease by $623 billion from its peak? The likely answer is that many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). This likely means that true deleveraging (and home foreclosures) is not yet over. That is, actual mortgage defaults will most likely stay elevated over the next 6 to 12 months, despite a relatively low national housing-price-to-disposable-income ratio, a near all-time low in mortgage rates, and an improving employment picture.
Indeed, as we have mentioned, the sector that still need to deleverage over the next 5 to 10 years is U.S. housing. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 3Q 2010. While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
For every percentage growth in assets that U.S. households accumulated over the last 58 years, U.S. households incurred 3.46 times as much in mortgage debt, while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.) was “just” 2.11 times as much. Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen LCD TVs (readers should not forget that some also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging would occur in the U.S. mortgage market. While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the next decade and act as a “cushion” to the housing market, U.S. housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or relocate to smaller or cheaper living areas. I expect most U.S. regional housing markets to underperform other asset classes for the next 10 years (although assisted living properties should outperform).
Household deleveraging isn't just limited to the U.S. As we discussed in last weekend's commentary, the European sovereign debt crisis is still playing out. Given the amount of crushing debt, the precarious export situation, the strong Euro, and horrible demographics (pension benefit payments will increase as more baby boomers retire), I expect 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). Given the overbought condition in the U.S. stock market, I expect the crisis in Europe to trigger a correction in U.S. and global stocks starting in the next couple of weeks. We maintain our 50% long position in the DJIA Timing System, but will likely hesitate shift to a 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 10, 2010, the Dow Industrials rose 28.23 points, while the Dow Transports rose 30.57 points. As we mentioned last week, the NYSE Common Stock Only A/D line remains weak, 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 on 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 20.3% to 21.1% for the week ending December 10, 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 again from a reading of 20.3% to 21.1% last week—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 (not shown) rose to 20.0%, a level now seen since mid-November 2007. With our liquidity indicators remaining bearish—and with the potential for a “black swan” event in Europe—I expect the U.S. stock market to correct starting 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 spiked higher from 125.3 to 134.0 last week, as the ISE Sentiment Index registered two highly overbought readings of 208 and 230 on Thursday and Friday, respectively. Meanwhile the 50 DMA increased from 123.7 to 127.8. With both the 20 DMA and 50 DMA at overbought levels (relative to their readings over the last three years), and combined with the bullishness in our other sentiment indicators as well as the challenging global liquidity conditions, the chance of a market correction sometime in the next couple of weeks is now very high. 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: The U.S. Flow of Funds picture shows that U.S. households are still in the midst of a deleveraging process, especially given the still-elevated mortgage debt levels. I expect the Bernanke Fed to remain accommodative until the asset-to-liability ratio of U.S. households rises to 5.50 or higher. In the meantime, I expect US and global stocks to correct sometime in the next couple of weeks given their overbought conditions and as the European sovereign debt crisis remains a danger I do not expect the crisis to end 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 low structural growth 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.
Henry To, CFA