The Need for Fiscal Restraint
(April 3, 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.
The big market news last week was the cyclical bull market highs in all the major market indices (the small cap index, the S&P 600, hit an all-time high). While stocks are now slightly overvalued, there's nothing to worry about. For example, one valuation factor that I regularly track – Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is slightly overvalued, as suggested by its current ratio of 1.04 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”). This ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid-2001), and as high as 1.14 on December 31, 2004. Moreover, as shown in the following chart, courtesy of Morningstar, this ratio is still about 6% below where it was right before the market had its last major correction starting late April 2010:
As mentioned, Morningstar's proprietary valuation indicator suggests that the stock market is slightly overvalued. More important, subscribers should note that – given the trend of corporate earnings over the last two years – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom. In addition, the weighted cost of capital has declined dramatically – suggesting that valuations may be a little bit stretched, especially given the recent rise in inflationary expectations and the still-unresolved European sovereign debt crisis. In other words, Morningstar's proprietary valuation indicator provides further evidence that the market is now highly vulnerable to a correction. However, there is still some upside to go in the short-run—I would not be surprised if the market rallies another 3% to 6% before experiencing a major correction. Should the Dow Industrials rally to the 12,750 to 13,250 level, we will likely go 50% short in our DJIA Timing System.
Let us now get to the gist of our commentary. As you all know, the structural fiscal deficit of the US is at around 6% of GDP. As shown in the following chart (courtesy of Goldman Sachs), a 6%-of-GDP fiscal deficit is about three times higher than that during the Reagan “Star Wars” defense spending years:
More important, the US debt-to-GDP ratio is currently at 96%. At its peak immediately in the aftermath of World War II, the US debt-to-GDP ratio spiked to 120% of GDP. Clearly, a structural fiscal deficit of 6% of GDP is not sustainable; at it will literally just take four years for the US debt-to-GDP ratio to run up to 120%. Although there's no set limit to how high this ratio can rise, numbers such as 100% and 120% do represent an important benchmark for investors around the world. In addition, as shown in the following chart (again, courtesy of Goldman Sachs), entitlement spending will rise by 2.2% of GDP over the next decade—thus putting further pressure on the US budget:
It is important to note that shrinkage of fiscal spending by 6% of GDP has rarely been achieved in OECD countries. Moreover, the vast majority of countries that was able to achieve this got substantial assistance from a lower currency and a boost in net exports. In particular, the US is such a big country that it is mathematically impossible to “export our way out” to maintain economic growth, especially since many countries in Western Europe are also cutting fiscal spending and economic growth at the same time. The unsustainable fiscal spending in the US and many Western European countries has two direct implications: 1) The aggregate spending that comprises global GDP will be very challenged going forward—and would need to be “made up” by consumption spending growth in countries such as China, India, Brazil, and Indonesia; and 2) Monetary policy in the US and Japan—and most likely the UK and the Euro Zone—will remain relatively loose for years to come. That means interest rates in most OECD countries will stay near the “zero-bound” in order to cushion tightening fiscal policies. There may also be more crises down the road that deal with sovereign debt issues.
In the meantime, the technicals of the US stock market are now at their weakest levels since the cyclical bull market began in early March 2009. Again, while the NYSE Common Stock Only (CSO) A/D line has made new highs, the NYSE CSO A/D Volume line has lagged tremendously. That means while the number of issues rising vs. declining still look bullish, the “intensity” of the buying vs. selling has not been as impressive. Also, the NYSE CSO Only McClellan Oscillator and Summation Index have also weakened considerably. While the Dow Industrials and the S&P 500 could continue to make new highs in the face of deteriorating technicals, what it does mean is that the market is getting increasingly vulnerable to a deeper-than-expected correction. We are going out on a limb here: Should the Dow Industrials and S&P 500 continue to rally (preferable to the 12,750 to 13,250 range) on dismal upside breadth and/or volume, there's a good chance we will go short in our DJIA Timing System.
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 April 1, 2011, the Dow Industrials rose 156.13 points, while the Dow Transports rose 162.90 points. While both Dow indices made new cyclical bull market highs last week (thus extending the life of the bull market, per the Dow Theory), our technical indicators are still deteriorating. In fact, our technical indicators are now at their weakest since the beginning of this cyclical bull market. Combined with weakening global liquidity conditions and geopolitical risks in the Middle East, we expect the market to correct sooner rather than later. We remain neutral in our DJIA Timing System, and may shift to a 50% short position should the Dow Industrials rally further on weak upside breadth/volume.
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 increased slightly from a reading of 16.1% to 16.3% for the week ending April 1, 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) in late January, the four-week MA has plunged by 14.5% to 16.3% last week. At the same time, the 10-week MA broke its 24-week uptrend that culminated in a four-year high just six weeks ago. Although the four-week MA is still overbought, there is likely more upside for this sentiment indicator, and for the market over the short-run. We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position if the Dow Industrials rally further to the 12,750 to 13,250 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. 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 slightly from 111.3 to 110.3 last week, and has stabilized in the last couple of weeks after declining by nearly 20 points since the end of February. Meanwhile, the 50 DMA is approaching neutral levels. Given the oversold condition in the 20 DMA, there is likely more upside in both sentiment and the market in the foreseeable future. Should the market rally further this week, we will likely go 50% short in our DJIA Timing System.
Conclusion: The cyclical bull markets in all major market indices last week, along with decent valuations and relatively neutral sentiment indicators, suggest more upside in the stock market for the foreseeable future. However, the deterioration in our technical indicators cannot be ignored, especially given the age of the bull market and declining global liquidity indicators. In addition—across the developed world—there needs to be substantial fiscal restraint over the next decade, especially with the aging of the baby boomers and the consequent increases in “entitlement” spending and its pressure on government budgets. Most likely, monetary policies across the OECD countries will stay loose over the next five to ten years. In the meantime, we remain neutral in our DJIA Timing System and will likely go 50% short if the market rally further on weak upside breadth/volume. Subscribers please stay tuned.
Henry To, CFA, CAIA