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2010 4Q Flow of Funds Update – More Deleveraging Needed

(March 13, 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.

At this time of uncertainty just after the earthquake off the coast of northern Japan, we should all remember and understand that—when it comes down to it—we (the human race) all live under one roof, and quite literally, are all brothers and sisters.  Ultimately, investing/speculation is just a game—a diversion, so to speak, of what is truly important.  Family, friends, relationships, and happiness; not material wealth.  That said, we all need material wealth to survive on a daily basis.  As Jesse Livermore would say, the “financial market paymaster” is always on the job.  The adversarial nature of the financial markets means that we need to be vigilant when it comes to protecting and allocating our material wealth.  This is why I still follow the markets, geopolitics, and other structural trends on a daily basis.

Let us now discuss the 4Q 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, 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 2Q 2009, 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 $8.07 trillion over the last seven quarters (despite a $1.63 trillion decline during 2Q 2010).  As of the end of 4Q 2010, U.S. households net worth stood at $56.8 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.45 to 5.08 over the last seven quarters.  As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth still need to rise by $8.84 trillion before it hits 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 (and as reiterated in our title), U.S. households will likely continue to deleverage for the foreseeable future.  While I believe the Fed will end with its “QE2” easing policy (i.e. no “QE3”), the Bernanke-led Fed should not tighten 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 $615 billion from its peak (and has in fact risen by $27 billion during 4Q 2010).  This is interesting as global financial institutions have 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 seven quarters.  So why did US households' liabilities only decrease by $615 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 for the rest of the year, 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 several 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 4Q 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 3.35 times as much in mortgage debt (down from a peak of 3.93 times as of 1Q 2009), while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.)  was “just” 2.07 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 in the future should 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.  In addition, a significant amount of residential housing demand in the major coastal cities (e.g. New York, Los Angeles, San Francisco, etc.) has come from international investors over the last several years.  With much of the emerging market countries now tightening, and combined with ongoing deleveraging in the U.S. mortgage market, I expect most U.S. regional housing markets to underperform other asset classes for the next decade (although assisted living properties should outperform).

Of course, deleveraging isn't just limited to U.S. households.  Over the next couple of decades, many countries in the “developed” world will have trouble fulfilling their pension and healthcare obligations as baby boomers retire, and as sovereign balance sheets become even more stretched.  Over the last six weeks, investors have more or less taken their focus off of the European sovereign debt crisis—but with Euro Zone talks again in the focus, and with the recent Moody's downgrades on Greece and Spain, spreads in the PIGS countries are blowing out again.  Given the amount of crushing debt, the precarious export situation, the strong Euro, and horrible demographics (increasing pension benefit and healthcare), I expect Portugal to be in need of assistance very soon—especially with the European Central Bank likely hiking by 25 basis points at its April 7th meeting.  Given the still-overbought condition in the U.S. stock market and deteriorating technical indicators, I expect the European sovereign debt crisis to deepen the current correction in the global equity markets.  We maintain our neutral position in the DJIA Timing System, and will likely shift to either a 50% or 100% long position only when both our technical and sentiment indicators become oversold again.

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 11, 2011, the Dow Industrials declined 125.48 points, while the Dow Transports rose 66.44 points.  While the strength in the Dow Transports is an official non-confirmation in the market's weakness, it really doesn't do much for the bulls—as the Dow Transports had been exceptionally week over the last few weeks.  While the cyclical bull market that began in March 2009 isn't over yet, there is also no evidence that the correction that began on February 18th is over—given the lack of an oversold condition in all our technical and sentiment indicators.  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 24.5% to 22.3% for the week ending March 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:

After peaking at 30.8% (its highest reading since late February 2007) seven weeks ago, the four-week MA has declined by 8.5% to 22.3% last week.  At the same time, the 10-week MA broke its 24-week uptrend that culminated in a four-year high three weeks ago.  More important, 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 by a whopping 8 points from 126.8 to 118.8 last week, while the 50 DMA declined from 128.3 to 125.6.  While the 20 DMA is no longer at an overbought level, the 50 DMA remains at an overbought level (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: The latest U.S. Flow of Funds picture suggests that there is more deleveraging needed in U.S. households, especially in the residential mortgage sector.  With emerging market countries now tightening, I also expect money flows into coastal real estate to slow down in the next 12 to 18 months—meaning housing prices will stay soft for the foreseeable future.  Again, I expect the Bernanke-led 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 continue its correction, especially as the European sovereign debt crisis remains a danger.  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 expect the market to correct 7% to 12% from its February 18th 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.

Signing off,

Henry To, CFA, CAIA

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