Correction in Play
(January 30, 2011)
Dear Subscribers and Readers,
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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.
A recent study of two centuries of financial crises by Goldman Sachs suggests: 1) the probability of a sovereign debt crisis is especially elevated after a banking crisis; and 2) the probability of a sovereign debt crisis actually lingers on and peak six years after the end of the banking crisis. Goldman asserts that one explanation for this is that investors simply have a lower appetite to finance the debt of a country after it has undergone a banking crisis. Not surprisingly (as shown in the following chart), the probability of a sovereign debt crisis is elevated for a country with a high debt-to-GDP ratio:
As shown in the above chart, “small economies” understandably have a substantially higher chance of a debt crisis after a banking crisis. There are several reasons, including that smaller economies tend to be poorer, and many of them tend to issue debt denominated in foreign currencies, such as the U.S. Dollar. While the probability of a sovereign debt crisis for a country like the U.S. is non-trivial, it is still very low, given the size of the U.S. economy, its status as the world's reserve currency, and the fact that U.S. economic growth remains robust (complete with decent demographics, relative to Western Europe, Japan, or even China).
Speaking of the U.S. banking system, U.S. bank lending has stabilized somewhat but still remains dysfunctional. This is one reason why the Fed is continuing with its QE2 policy of purchasing $600 billion in U.S. Treasuries (mainly in the 7- to 10-year maturity window). Following is a monthly chart showing the state of U.S. bank lending—i.e. the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1949 to January 2011 (updated to January 19, 2011):
While bank lending has steadied in the last 12 months, subscribers should note that the plunge in banking lending in 2009 is unprecedented. One would need to go back to the Great Depression to see similar stats (when one-third of all U.S. banks failed). 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 policies, the U.S. and much of the developed world would have plunged into a second Great Depression. Note that while bank lending growth has risen back to the zero line, we are not out of the woods. In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) has actually declined by $78 billion (to $6.72 trillion) from the end of September 2010 to January 19, 2011. The lack of liquidity creation within the U.S. banking system does not bode well for the short-term outlook for the stock market. In fact, we believe that a correction has begun and that it should last for at least several more 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 in the following chart from January 2008 to the present:
For the week ending January 28, 2011, the Dow Industrials declined 48.14 points, while the Dow Transports declined 50.75 points. In retrospect, last week's correction was foretold by the non-confirmation of the Dow Industrials by the Dow Transports the week prior (which is one of the most flagrant divergences in the Dow indices, per the Dow Theory, since the beginning of this cyclical bull market). Combined with the overbought market, challenging global liquidity environment, the ongoing troubles in the European Monetary Union and the disturbances in various emerging markets, I expect the stock market correction to continue. 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 (finally) decreased from a reading of 30.8% to 28.7% for the week ending January 28, 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:
Note that last week's decline in the four-week MA was the first decline in nine weeks! More important, the four-week MA remains very overbought, while the ten-week MA (not shown) rose for the 21st consecutive week to 26.6%, and is at its highest level since early March 2007. By any measure, both the stock market and investors' sentiment is remains highly overbought. Combined with our bearish liquidity indicators, I expect the U.S. stock market to continue for the next several weeks. 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 from 132.9 to 130.1 last week, while the 50 DMA decreased from 135.2 to 133.3. Note that the 20 DMA declined below the 50 DMA two weeks ago—and both are in a downtrend. All else equal, this suggests that the market is also in a downtrend. Meanwhile, the ISE Sentiment Index remains at a heavily overbought level—in fact, at the peak in late December, the 20 DMA rose to its highest level since mid-July 2007. 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, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe the current market correction will last at least several weeks.
Conclusion: With REITs (and commercial real estate) having rallied nearly 130% since their lows in March 2009, it is time for this asset class to take a breather. More important, commercial mortgage origination remains low—and probability suggests that more deleveraging is to come over the course of 2011. I expect 2011 to be a “transition year” for REITs and commercial real estate, despite the fact that we're looking for 3% to 4% real GDP growth this year. In addition, the U.S. stock market remains highly overbought. Combined with extremely bullish sentiment, challenging liquidity, and a slightly overvalued market, we are short-term bearish on the U.S. stock market. We remain neutral in our DJIA Timing System and will remain so until the market becomes oversold. Subscribers please stay tuned.
Henry To, CFA, CAIA