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Our Dark Sides

(January 9, 2011)

Note: More texts on China to recommend!  Stratfor's “China: Power and Perils”—essentially a compilation of Stratfor's articles on China—is a must-read for those interested in Chinese culture, geopolitics, and the Chinese economy.  As long-time Stratfor readers know, however, they tend to be too bearish on China (and almost everything else), so I recommend “balancing it out” by picking up a copy of Stephen Roach's “Stephen Roach on the Next Asia: Opportunities and Challenges for a New Globalization.

Dear Subscribers and Readers,

I hope everyone is off to a great start this year!  As subscribers could glean from Part I and Part II of our 2011 economic outlook, we are very optimistic on 2011, and immediately beyond.  Before we begin our commentary, though, I want to update our DJIA Timing System's performance to December 31, 2010.  Note that subscribers could independently calculate our historical performance by tallying up all our signals going back to the inception (August 18, 2004) of our system (we send our subscribers real-time emails whenever there is a new signal).  Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to December 31, 2010:

Our DJIA Timing System was created as a tool to communicate our position and thoughts on the stock market in a concise manner.  We chose the Dow Industrials as the benchmark (even though all institutional investors use the S&P 500 or the Russell 1000), since most of the investing public around the world have historically recognized the DJIA as “the benchmark” for the American stock market.  In addition, the Dow Industrials has a rich history going back to 1896, while the S&P 500 was created in 1957 (although it was reconstructed back to 1926).

Looking at our performance since inception, it is clear that a significant portion of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and when we decided to shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we subsequently closed out on January 9, 2008).  While we stayed on the long side for the most part from mid-January 2008 to April 2010, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance during that period.  Looking at the last two years, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided about 4% in absolute outperformance, although that resulted in slightly higher volatility (since we were 125% long).  In the last 12 months, we also made a couple of timely tactical moves, when we shifted from a 100% long to a 50% long position on March 29, 2010 (at DJIA 10,888), and then to a completely neutral position on April 27, 2010 (at DJIA 11,045).  We subsequently went 50% long again on May 27, 2010 at a DJIA print of 10,145; and exited that position on December 15, 2010 at a DJIA print of 11,487.  Note that despite the very low 12-month volatility in our DJIA Timing System (8.92% vs. 16.15% in the Dow Industrials), we still beat the market over the last 12 months.  Finally, our 3-year annualized performance of +2.49% is also ahead of that of the Dow Jones Credit Suisse Hedge Fund Index (+1.30%), and the Dow Jones Credit Suisse Long/Short Equity Index (+0.57%).  Since December 15th, we have been 100% in cash—and will look to go 50% or 100% long if the market corrects in the foreseeable future.

Subscribers should keep in mind that our goal is to beat the Dow Industrials by a significant margin over a market cycle with lower volatility.  Subscribers should note that we are ahead of the Dow Industrials by a good margin over all timeframes, and with lower volatility.  On a cumulative basis, we are ahead of the Dow Industrials by just under 20% since the inception of our DJIA Timing System on August 18, 2004, returning 34.16% vs. 14.82% for the Dow Industrials (on a price-only basis).  Our goal is to beat the stock market with less risk over the long run, and so far, we have done that. 

Subscribers should remember that:

  1. It is the major movements that count.  Active trading–for the most part–only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;

  2. Capital preservation during times of excesses is the key to outperforming the stock market over the long run.  That being said, selling all your equity holdings or shorting the stock market for a sustained period is not something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back in the next innovation cycle.  I am not going to change my mind on this unless: 1) the Fed or the ECB makes a major policy mistake, 2) an inflationary spiral emerges, 3) the Obama administration makes a major policy mistake, such as protectionist policies or higher taxes, 4) extreme overvaluations in the U.S. stock market, or 5) a major regional war becomes a possibility, such as in the Middle East or the Korean Peninsula.  At this point, I do not see too much threat to the stock market on any of these five counts, with the exception of a potential policy mistake by the ECB (should they fail to monetize Greek, Irish, and Portuguese debt should push comes to shove), a collapse in Japanese bond prices, or another spike in commodity prices.

Given our tendency to sit in cash during sustained times of market excesses; our Sharpe Ratio readings have been market beating across all periods.  For now, we believe that the stock market made a solid bottom in early March 2009, and thus we will likely shift to a 100% long in our DJIA Timing System should the market correct in the foreseeable future.  We will update the performance of our DJIA Timing System on March 31, 2011.

Let us begin our commentary with a review of our 13 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;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

Yoda in Star Wars once said to Anakin Skywalker “Fear is the path to the dark side.  Fear leads to anger.  Anger leads to hate.  Hate leads to suffering.”  Each of us has a dark side; it is our duty to recognize it, accept it, and ultimately rise above it.  People succumbing to their dark sides usually end up abusing drugs and alcohol, embracing violence and a “means to an end” or “succeed at all costs” mentality.  On a mass scale, the dark side of human beings (emotions including fear, anger, jealousy, hate, etc.) have led to mass slaughters, war and genocide, especially those in the 20th century.  It is ultimately destructive, and insane.

The advances in petroleum refining technology as led by Standard Oil in the 19th and early 20th centuries have allowed the further industrialization of the world, the proliferation of the automobile, and a build-up in the global transportation infrastructure.  At the same time, however, burning fossil fuels to satisfy our materialistic wants (large-screen TVs, luxury vehicles, cheap goods and meats, etc.) have resulted in mass pollution of our natural habitats and environment, especially those in developing countries such as China and India.  There are now talks of “cancer villages” in China, widespread destruction of natural habitats through the drilling of shale oil—not to mention the destructive effects of the BP oil spill last year.  The ever-growing desire for consumer goods is directly driven by our egoistic self—our “false worldly values” such as material wealth, status, etc.  At some point, the ingenuity of human beings would kick in—this would bring us new technologies (e.g. second-generation biofuels, solar panels that are more efficient, etc.) that would lessen our dependence on fossil fuels.   In the meantime, subscribers should be more conscious of the environment, especially each time we get the urge to buy that new TV, the big gas-guzzler, or the 6,000 square feet “McMansion.”

Of course, one detriment to rising fossil fuel consumption is another spike in crude oil or general energy prices.  As we discussed in last weekend's commentary, the final downside risk to our 2011 benign scenario is another spike in commodity prices.  I am mostly focused on oil prices.  The current 12-month strip for light crude is about $92 a barrel; but supply constraints are reappearing.  For example, the 90 million barrels in "floating inventory" have been largely eliminated.  Non-OPEC supply is expected to fall by 280,000 b/d in 2011--marking only the third time in the last 15 years that non-OPEC supply has fallen year-over-year.  Finally, assets indexed to crude oil prices are still below their peak in 2008 (please see below chart).  Combined with a resurging U.S. economy and a benign Chinese economy, crude oil prices could easily spike to over $100 a barrel.  Should crude oil prices touch $120 a barrel or over, this would adversely impact my U.S. economic growth estimates.

As for the European sovereign debt/EMU crisis, nothing has changed.  The PIGS countries need a significant increase in external demand to export their way to economic revival; but: 1) There is still a significant output cap in the United States; and the PIGS countries remain uncompetitive anyhow (vs. Germany, Korea, China, etc.) ; 2) To have a chance of being competitive, the Euro needs to fall at least 15%.  So to pay off its debt and to access the international bond market again, the PIGS would need to "rebalance' through a collapse in external demand alone--which no major country has been able to do.  The PIGS needs a combination of devaluation, export growth, and demand contraction.  Whatever the case, the economic problems have turned into a big political headache--which is a bigger problem since the Euro was really more of a political union than an economic union in the first place.  I believe there could be three outcomes in 2011: 1) Significant devaluation in the Euro to promote export growth, 2) Significant monetary easing (monetization of PIGS debt) by the ECB, or 3) A collapse of the Euro monetary union. Whatever's the case, all three outcomes point to a decline in the Euro.  I expect the Euro to decline to $1.20 (or below) sometime this 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 January 2008 to the present:

For the week ending January 7, 2011, the Dow Industrials rose 97.25 points, while the Dow Transports rose 71.70 points.  While both Dow indices made a cyclical bull market high (thus extending the life of the bull market), note that the Dow Industrials has risen six weeks in a row and is losing momentum.  Combined with the challenging global liquidity environment (and the ongoing troubles in the European Monetary Union) , I expect an imminent correction in the stock market. We remain completely neutral in our DJIA Timing System, although the cyclical bull market that began in early March 2009 remains intact.

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 27.4% to 28.8% for the week ending January 7, 2011.  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 for the sixth consecutive week from a reading of 27.4% to 28.8%—and is now at its most overbought level since late October 2007 (right at the peak of the last bull market).  In addition, the ten-week MA (not shown) rose for the 18th consecutive week to 24.1%, and is at its highest level since late July 2007.  Combined with our bearish liquidity indicators—and with the potential for a “black swan” event in Europe—I expect the U.S. stock market to correct starting soon.  We will retain our neutral position in our DJIA Timing System.

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 declined slightly from 140.6 to 140.4.  The ISE Sentiment Index remains at a heavily overbought level—in fact, at the peak in late December, 20 DMA rose to its highest level since mid-July 2007.  Meanwhile, the 50 DMA increased from 129.7 to 133.8.  With both the 20 DMA and 50 DMA at highly overbought levels (relative to their readings over the last three years), and combined with the bullishness in our other sentiment indicators as well as challenging global liquidity conditions, we believe a market correction is imminent.

Conclusion: Our DJIA Timing System has continued to outperform, with lower volatility than the Dow Jones Industrial Average.  In addition, our three-year performance has outperformed both the Dow Jones Credit Suisse Hedge Fund and the Long/Short Equity indices.  Finally, while we remain very optimistic on global economic growth in 2011, there is still cause for concern, namely, the European sovereign debt crisis, potential troubles in the Japanese bond market, and an unforeseen spike in commodity prices.  Again, 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).  We remain neutral in our DJIA Timing System and will remain so until the market becomes oversold again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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