Japan – An Enigma
(February 13, 2011)
Dear Subscribers and Readers,
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.
Since we shifted from a 50% long position to a completely neutral position in our DJIA Timing System on December 15, 2010, the market has kept powering higher, despite the overbought conditions, the negative divergences, and overly investors' bullish sentiment (equity mutual fund inflows just turned positive in January and early February, after being in negative territory for the vast majority of this bull market). Most of our indicators (including Lowry's proprietary Buying Power and Selling Pressure indices) are still signaling a 5% to 10% market correction sooner rather than later. Should the Dow Industrials rise further to the 12,500 to 13,000 level, we will likely shift to a 50% short position in our DJIA Timing System (if that occurs, we will look for a 7% to 12% correction). Subscribers please get ready for the ride.
Let us get to the gist of our commentary. There's no place like Japan. Whether it is Japanese equities, shorting the Japanese government bond, shorting the Euro-Yen cross rate, or the Japanese Yen carry trade, investors/speculators all around the world have been burned too many times to count. For example, shorting the 10-year JGB at a yield of 1.6% (thinking David Einhorn) sounds like a good move, until the 10-year JGB yield subsequently declined to just 0.9% late last year. We last discussed the vulnerability of the JGB to a spike in yields in our January 2, 2011 commentary (“Identifying Short and Long Term Trends for 2011 – Part II”). Quoting our January 2, 2011 commentary:
The latter [Japan and its indebtedness] is an interesting case—as it is also on a precarious path similar to that of most Western European countries (high debt load, negligible economic growth, and horrible demographics). Based on current exchange rates, Japanese GDP is around 400 trillion Yen. Its sovereign debt load is about 200% GDP, or 800 trillion Yen. In 2011, Japan is expected to borrow a net 44 trillion Yen, or 11% of GDP! Already 15.4 trillion Yen (or 16.7% of the budget) goes towards interest payments—and interest rates in Japan are already as low as they can be! In addition, Japanese banks hold a substantial amount of JGBs. Should an ongoing crisis in Europe cause a renewed loss of confidence in sovereign debt, than Japanese yields could also spike. No matter what happens in 2011, the Japanese debt situation is untenable; even though Japanese savers have 1,200 trillion Yen stashed away (the Japanese will start consuming their savings as baby boomers retire).
Since our January 2, 2011 commentary, the 10-year JGB yield has spiked to a nine-month high. That said, it is still at a relatively low yield of 1.32%. As we've mentioned, the timing on shorting the JGB is very important, given the fact that 95% of JGBs are held by domestic investors (who have a very high savings rate). This has compressed the 10-year JGB yield to a relatively low level, despite the fact that the Japanese sovereign debt load is set to surpass 220% of GDP at the end of fiscal 2010 (which ends on March 31, 2011; note following exhibit is courtesy of Goldman Sachs):
Note that Greece has a debt load of less than 150% GDP. Again, the key is that 95% of JGBs are held by domestic investors. At the same time, both Japanese institutions and retail investors have had no incentive to invest in other instruments, given the strength of the Yen and the mediocre returns of Japanese equities over the last 20 years (while ROEs of corporations and Japanese real estate returns remain dismal). With corporate ROEs at depressed levels (not surprising given Japan's dismal economic performance over the last 20 years), corporations have not had much incentive to borrow to invest. With the lack of a “crowding out” effect (i.e. the lack of Japanese corporate bond offerings), the JGBs have found much more willing investors. As shown in the following exhibit (again, courtesy of Goldman Sachs), there has been no net corporate borrowing in Japan since the mid-1990s:
Finally, ongoing deflationary expectations in Japan (aside from indirectly leading to low nominal GDP growth, equity returns, etc.) have kept nominal yields depressed. Indeed, the major underlying basis for low nominal Japanese yields is the significant savings and the current account surplus enjoyed by Japan. We maintain that this situation is untenable in the long run, as the Japanese population declines and as baby boomers start retiring en masse. At some point, the Japanese current account surplus will turn into a deficit—thus crippling Japan's ability to fund its fiscal deficits. As Japanese yields start rising, interest payments will become debilitating—thus causing a ripple effect in the solvency of the Japanese government/economy. Of course, we are not close to this scenario yet—but this will be an ongoing theme as this decade progresses, especially in the next financial crisis.
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 February 11, 2011, the Dow Industrials rose 181.11 points, while the Dow Transports rose a whopping 179.84 points. Both the Dow Industrials and the Dow Transports made new cyclical bull market high—thus extending the life of the bull market, per the Dow Theory. However, the Dow Transports only made a marginal new high (just 0.1% higher than its January 13th peak). With our technical indicators weakening and given highly bullish sentiment, I expect the stock market to experience a 5% to 10% correction soon. We remain neutral in our DJIA Timing System, but will not hesitate shifting to a 50% short position should the Dow Industrials rally to the 12,500 to 13,000 range.
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 decreased from a reading of 27.3% to 26.7% for the week ending February 11, 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:
While this sentiment indicator has declined three weeks in a row, subscribers should note that prior to this, it has risen for a consecutive eight weeks! More important, the four-week MA remains very overbought, while the ten-week MA (not shown) rose for the 23rd consecutive week to 28.0%, and is at its highest level since early March 2007. By any measure, both the stock market and investors' sentiment remains severely overbought. Combined with our bearish liquidity and technical indicators, I expect the U.S. stock market to correct soon. We will retain our neutral position in our DJIA Timing System, although we will not hesitate shifting to a 50% short position should the Dow Industrials rally to the 12,500 to 13,000 range.
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 128.2 to 126.3 last week, while the 50 DMA increased from 135.1 to 137.0. Note that the 20 DMA declined below the 50 DMA three weeks ago—suggesting that sentiment (and the stock market) is in a downward bias. 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 overbought conditions in our other sentiment indicators, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe the market will experience a correction soon.
Conclusion: For those who want to dabble in anything Japanese-related, we should note that those have done so over the last 20 years have generally regretted the experience. That said, the JGB situation remains on our watch list—if only it is an important piece to the global economic puzzle. We believe the Japanese debt situation is untenable, although our timing of the “reckoning” is extremely uncertain. For those who want to short the 10-year JGBs, I suggest holding off until the yield gets closer to the 1.0% level again. As for the U.S. stock market, we believe that the rally since last December has been built on “shaky ground” given our weakening technical, liquidity, and sentiment indicators. We remain neutral in our DJIA Timing System and will likely shift to a 50% short position should the Dow Industrials rally to the 12,500 to 13,000 area. Subscribers please stay tuned.
Henry To, CFA, CAIA