Central Bank Tightening
(March 6, 2011)
Dear Subscribers and Readers,
Let us now 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.
China's annualized inflation rate in January was 4.9%--nearly 1% higher than the official target. February should be no different, as estimates currently put it at 4.8%. With housing, energy, and food prices rising rampantly, there will be substantial pressure for the People's Bank of China to raise interest rates and banks' required reserves. At the same time, fiscal policy would be on the easing side—as the government is working to ensure “social harmony” by raising minimum wages, increasing tax brackets, and other subsidies and incentives for low-income earners and rural citizens. Unless crude oil prices return to the $90 level, probability suggests that the People's Bank of China will raise rates by at least 75 basis points this year.
Meanwhile, the ECRI Future Inflation Gauge for the Euro Zone just hit a 28-month high. More worryingly—since many wage contracts are tied to inflation in the Euro Zone—the probability of an inflationary spiral in the Euro Zone is greater than that in the US, especially since the German economy is running with essentially no spare capacity. Make no mistake: The European Central Bank is now engaged in a huge balancing act as it struggles to make policy for Germany; while ensuring that Greece, Ireland, Portugal, and Spain do not go bust. I believe a 25 basis point hike by the ECB early next month is inevitable. Whether the ECB raises rates further will depend on the performance of both the Euro and whether Greece, Ireland, Portugal, and Spain can hang on to their current tightening fiscal policies.
Furthermore, with inflation in the UK topping 4%, the forwards market is now pricing in a cumulative 100 basis point rate hike by the Bank of England by the end of the year. In addition, tax revenues on income and wealth increased by 17.5% on a year-over-year basis in January as the UK government makes a concerted effort to cut its fiscal deficits. Estimates by Goldman Sachs suggest that the UK—given its current path—will close its fiscal deficit gap by the end of 2013 (as shown in the following chart):
Note that with the exception of the Federal Reserve, all the world's major central banks are in tightening modes. Even Japan—with its sustained deflationary pressures—is still not tilted towards reflating her economy. This is not too surprising when one realizes that the “tug of war” between the Bank of Japan and the government (in where the former has constantly accused the latter on spending on wasteful infrastructure) has resulted in a “non-activist” Japanese monetary policy. In fact, the year-over-year increase in the Japanese monetary base was relatively low at 5.6% at the end of February 2011, as shown in the following chart:
For the Bank of Japan to lift the Japanese economy out of deflation mode and to “contribute” to global liquidity, it must engage in a more aggressive easing strategy, similar to its quantitative easing strategy it adopted in late 2001. With year-over-year growth of just 5.6% (and with the size of the monetary base having declined by 2.9% since December 2010), the Japanese monetary base must rise before we could be bullish on global equities, especially given the still-challenging liquidity conditions and central bank tightening around the world. While we believe the Federal Reserve will keep its “QE2” policy of purchasing an additional net $600 billion of Treasuries as discussed in its November 3, 2010 press release, such a policy will not be sufficient to halt the decline in global liquidity or to prop up global equity prices.
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 March 4, 2011, the Dow Industrials rose 39.43 points, while the Dow Transports rose a miniscule 0.17 point. The miniscule “bounce” in the Dow Transports is disappointing—even more so given the whopping decline from the week prior. Since both the Dow Industrials and the Dow Transports made new cyclical bull market highs just a couple of weeks ago, we do not believe the cyclical bull market is over yet (our long-term technical, liquidity, and valuation indicators also support this thesis). However, the market remains highly overbought, and many of our short-term technical indicators are still signaling negative divergences and our sentiment indicators remain highly overbought. In light of all these developments, we expect the market correction to continue (our target range is 7% to 12% from its February 18th highs). We remain neutral in our DJIA Timing System, and will only shift to a long position once our technical and sentiment indicators become oversold.
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 26.6% to 24.5% for the week ending March 4, 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:
After peaking at 30.8% (its highest reading since late February 2007) six weeks ago, the four-week MA has vacillated in the 26.6% to 28.7% range. However, the four-week MA broke below its trading range last week. At the same time, the 10-week MA broke its 24-week uptrend that culminated in a four-year high a couple of weeks ago. This sentiment indicator remains highly overbought—and with the ten-week MA now in a downtrend (and combined with our bearish liquidity and technical indicators), I expect the market correction to continue. We will retain our neutral position in our DJIA Timing System, and will only shift to a long position when our technical and sentiment indicators become oversold.
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 128.8 to 126.8 last week, while the 50 DMA declined from 130.4 to 128.3. Despite the declines from their respective peaks during late December to mid-January, both the 20 and the 50 DMAs remain at overbought levels (relative to their readings over the last three years), and with the 20 DMA below the 50 DMA, bullish sentiment (and the stock market) is thus biased to the downside (this downward bias is confirmed by our other sentiment indicators). 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 correction will continue for the foreseeable future.
Conclusion: As inflationary pressures step up around the world, the vast majority of global central banks—with the glaring exception of the Federal Reserve—is now stepping up to tighten its monetary policies, or at the very least, pull back from their “emergency” liquidity measures that were initiated during the late 2007 to early 2009 global financial crisis. While most central banks should continue to tighten, I expect the Federal Reserve to keep its QE2 policy until it expires in June. As mentioned in last weekend's commentary, the Fed is not concerned with either a global output gap or any spike in commodity prices. Emerging market countries who complain of the Fed “dumping fuel onto the inflation fire” would have to tighten themselves and not rely on the Fed—by raising rates, encouraging currency appreciation, or increasing productivity. In the meantime, I expect the market to correct 7% to 12% from its highs. We would not be surprised if the Dow Industrials has already made its high for the first half of 2011. We remain neutral in our DJIA Timing System and will go long once our technical and sentiment indicators become oversold. Subscribers please stay tuned.
Henry To, CFA, CAIA