Japan and U.S. Household Debt Payments Update
(March 20, 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.
By taking the 1995 Hanshin earthquake in Japan as a proxy, Goldman Sachs estimates that the damage from the March 11 earthquake in eastern Japan would amount to about 16 trillion Yen (just under US$200 billion). This is very much a “ball park” number, as it simply takes the ratio of the production of the most affected areas of the March 11 earthquake, divided by the production of the affected areas of the 1995 earthquake, and multiplied by the total damages in the 1995 earthquake (approximately 10 trillion Yen). Through this calculation (which did not take into account any losses stemming from nuclear contamination or the loss in 23% of its nuclear power capacity, or 6% to 7% of its total power capacity), Goldman believes that the costs of this earthquake would be about 1.6 times that of the 1995 earthquake. For those interested, the following exhibit (courtesy of Goldman Sachs) summarizes the total direct costs of the 1995 Hanshin earthquake:
But what is more interesting is the rapid recovery of natural disasters and wars—as the Japanese so demonstrated after her utter destruction (physical and psychological) after the end of World War II. Sure, Japan got a little help from the Marshall Plan, required complete disarmament (a blessing in disguise), and a generous trading policy (free-flowing exports; while its domestic industries were allowed to develop through tariffs, etc.). The point is, however, as long as entrepreneurs and human capital are allowed to work to their potential, and as long as there is a good legal and financial system, many countries have been able to rebuild very rapidly. This phenomenon was observed by none other than John Stuart Mill. Quoting from its seminal work, Principles of Political Economy (1848):
“…what has so often excited wonder, the great rapidity with which countries recover from a state of devastation; the disappearance, in a short time, of all traces of the mischief done by the earthquakes, floods, hurricanes, and the ravages of war. An enemy lays waste a country by fire and sword, and destroys or carries away nearly all the moveable wealth existing in it: all the inhabitants are ruined, and yet in a few years after, everything is much as it was before.”
It is important to note, “this too, shall pass.” Going into the 1995 Hanshin earthquake, Japanese equities were still overvalued, while the Bank of Japan were still in tightening mode. Today, none of these two factors is in place. In fact, I will be looking for investment opportunities in Japanese equities over the next several months.
Let us know discuss one of our longer-term themes—that of deleveraging in U.S. households. We discussed this in our last weekend's commentary from a U.S. balance sheet standpoint (“2010 4Q Flow of Funds Update – More Deleveraging Needed”). We argued that more deleveraging was needed—preferably when U.S. households' asset-to-liability ratio reaches 5.50 or over—and that until that occurs, the Federal Reserve will not tighten (although it will likely end with its “QE2” policy). While we don't know whether it's voluntary or forced (likely a bit of both), the fact of the matter is that U.S. households are saving more, spending less, and paying out less interest payments as a percentage of their disposable income. One area where U.S. household borrowing is evidently slow is U.S. bank lending. 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 March 2011 (updated to March 2, 2011):
Note that while bank-lending growth has steadied over the last 12 to 15 months and has risen back to the zero line. However, we are not out of the woods yet, as the U.S. banking system remains a bit dysfunctional (smaller and mid-sized banks are still hoarding cash). In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) has actually declined by $96.7 billion (to $6.70 trillion) from the end of September 2010 to March 2, 2011. On a related note, 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 the current correction should last for several more weeks—paving the way for the Federal Reserve to continue with its QE2 policy.
On a disposable income basis, however, the picture looks brighter—although this has more to do with lower interest rates, etc. Again, the trend of deleveraging U.S. households could be seen in the declining proportion of U.S. disposable income dedicated to debt payments. As mentioned before, I expect US households' balance sheets to continue its deleveraging process (as consumers adopt a more frugal lifestyle; as banks and credit card companies restrict lending; and finally as GDP growth normalizes this year). I do not buy PIMCO's “New Normal” view of a ten-year deleveraging process, although U.S. economic growth could surprise on the low side as we seek to reduce the fiscal deficit. But the inevitability of Schumpeterian growth (as well as old-fashioned population growth) will no doubt allow U.S. economic growth to normalize again. The combination of this Schumpeterian growth and relatively clean U.S. household balance sheets will drive the next secular bull market in U.S. stocks. I expect the next secular bull market to begin sometime in the 2013 to 2015 timeframe. While the ongoing deleveraging wasn't clear in the 4Q 2010 Flow of Funds data, there is obvious evidence that U.S. households are saving and paying down their debts. This is clear in the most recent trends in US households' financial obligation ratios (ratios of debt payments to disposable incomes), as illustrated in the following chart:
The financial obligation ratio for all U.S. Households' declined again and is now at its lowest level since 1Q 1995! Note that one reason would be that many households simply stopped paying their debts. Despite these relatively benign numbers, the deleveraging in the broader US economy should continue—but at the same time, we have definitely finished the most painful adjustments. Going forward, I expect U.S. households to deleverage through a combination of higher disposable incomes (the unemployment rate has definitely peaked), higher savings, and as lenders work through its backlogs of foreclosures and loan defaults (although I expect U.S. housing prices to remain in the doldrums for years to come). Furthermore, as U.S. households pay down more of their debts and become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the U.S. economy and society.
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 18, 2011, the Dow Industrials declined 185.88 points, while the Dow Transports declined 71.03 points. In last week's commentary, we mentioned that the temporary strength in the Dow Transports doesn't do much for the bulls, as it had been exceptionally weak in the prior few weeks. This view was confirmed by last week's decline in both the Dow Industrials and the Dow Transports—with both Dow indices closing at their lowest level in 2011 last Wednesday. While the cyclical bull market that began in March 2009 isn't over, 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. We thus 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 22.3% to 17.5% for the week ending March 18, 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) eight weeks ago, the four-week MA has plunged by 13.3% to 17.5% last week. At the same time, the 10-week MA broke its 24-week uptrend that culminated in a four-year high just four weeks ago. More important, this sentiment indicator remains 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. 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 9.2 points from 118.8 to 109.6 last week, after declining by 8.0 points the week prior. Meanwhile, the 50 DMA declined from 125.6 to 122.6. While the 20 DMA is now at a semi-oversold level, the 50 DMA remains slightly overbought (relative to their readings over the last three years). 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 ongoing geopolitical risks, we believe the market correction will continue for the foreseeable future.
Conclusion: On an income (flow) level, U.S. households have likely bore the greatest pain of the deleveraging process, although there still needs to be more deleveraging on the balance sheet (stock) side. This will happen as the cyclical bull market in global equities is still in place (although it has likely peaked for the first half of this year); and as U.S. income levels rise and unemployment declines throughout 2011. Of course, the proportion of income that flows to debt payments will increase should the Federal Reserve raises rates—and because of this, I do not expect the Bernanke-led Fed to raise rates anytime soon (although it should end its easing policy once QE2 expires this June). In the meantime, I expect the correction in US and global stocks to continue, especially since 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 horrible demographics (and generous pension systems). I expect the market to correct 7% to 12% from its February 18th highs. 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