US GDP Growth Revision
(April 17, 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.
In our March 27, 2011 commentary (“Where is Crude Oil Going?”)—when the WTI oil price sat at $105 a barrel—we asserted that while a de-escalation of Middle Eastern conflicts will cause oil prices to decline in the short-run (Goldman estimates a $10 geopolitical premium given the record high speculative WTI futures positions), the structural bull market in oil remains intact. Indeed, the decline in OECD commercial inventories, the resurgence in global economic growth, the continuation of the Fed's QE2 policy, and negative real interest rates around the world all suggest the structural bull market in oil remains intact. We also argue that it will not end until either: 1) it collapses on itself—and likely WTI crude oil prices would peak at no lower than $160 a barrel; 2) cellulosic ethanol or 2nd-generation biofuels are commercialized—this will take at least a few more years.
In our January 9, 2011 commentary (“Our Dark Sides”), we argued that one of the largest downside risks to our 2011 benign economic scenario (we estimated 2011 real GDP growth of 3.0% to 4.0%) is another spike in commodity prices, with a focus on oil prices. At the time, the 12-month strip for light crude is about $92 a barrel—and we argued that supply constraints were reappearing. We also asserted that crude oil prices could easily spike to over $100 a barrel, and that should it touch $120 a barrel, this would adversely impact our US economic growth estimates. Since our January 9, 2011 commentary, crude oil prices have steadily increased—peaking at just over $105 a barrel during the first quarter, and touching nearly $113 a barrel just over a week ago. This would adversely impact 1Q 2011 real GDP growth, as well as our GDP growth estimates for the rest of the year. As shown in the following chart (courtesy of Goldman Sachs and the WSJ), US gasoline prices are now near its 2008 peak:
Note that total oil consumption accounts for about 5% of US GDP. About half of this oil is imported. Since early January, crude oil prices have increased by about 20%, suggesting a first-order drag of about 0.5% of GDP (5% x 20% x imported oil as a percentage of total oil consumption). Because of higher oil prices, we believe some substitution would emerge—including more public transportation commutes, hybrid car sales, or simply less driving. We estimate an overall “drag” on US GDP of about 0.2% to 0.3% for the entire year. That is, we are now revising our January 9th estimate of 3.0% to 4.0% real 200 GDP growth to a range of 2.8% to 3.8%. Slowly but surely, the labor market is recovering (see below chart courtesy of Goldman Sachs). Coupled with ongoing Fed easing (we don't expect the Fed to raise rates until at least the second half of next year) and record high cash levels/flows at US corporations (I believe Google has made a very sound strategic decision by hiring tons of workers coming out of a recession), I believe a range of 2.8% to 3.8% GDP growth for 2011 is a sound estimate.
Meanwhile, our technical indicators are unchanged last week but still deteriorating. The NYSE Common Stock Only Advance/Decline Line and the Advance/Decline Volume line remain weak. A similar story exists in the NYSE CSO McClellan Summation Index and new 52-week highs vs. 52-week lows. Finally, our liquidity indicators still indicate a tendency towards tightening—especially in light of the 25 basis point hike by the European Central Bank last week. Sure, the Federal Reserve's QE2 policy is still intact, but it is likely to “stand pat” once it expires at the end of June. It also remains to be seen whether Japan will flood its banking/financial system with more liquidity over the summer as it seeks to rebuild. Indeed, if the Dow Industrials and the S&P 500 make new highs in the face of deteriorating technicals, we will look for a higher-than-expected correction sometime this summer. We are going out on a limb: 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, we will go 50% 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 15, 2011, the Dow Industrials declined 38.22 points, while the Dow Transports rose 56.44 points. Note that the Dow indices haven't made concurrent highs since April 4th. However, the proximity to their bull market highs suggests that investors would at least try to further bid up prices through earnings season. While we believe both Dow indices could very well make new bull market highs, the ongoing deterioration in our technical and global liquidity indicators, we expect the market to stage a correction very soon. 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 from a reading of 18.1% to 21.1% for the week ending April 15, 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 declined by 9.7% to 21.1% last week. At the same time, the 10-week MA just made a four-year high eight weeks ago. Both readings remain overbought. Although there is likely more upside for this sentiment indicator, and for the market over the short-run, we still believe the market is highly vulnerable to a deeper-than-expected correction. 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 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 increased from 114.1 to 119.2 last week, and has stabilized and is now back at neutral levels. Similarly, the 50 DMA is also at neutral levels. There may be more upside in both sentiment and the market in the foreseeable future, especially since valuation levels remain decent. However, should the market rally further this week, we will likely go 50% short in our DJIA Timing System.
Conclusion: In light of the spike in energy and commodity prices in the first quarter, we are ratcheting down our real 2011 GDP growth estimates from a range of 3.0% to 4.0% to 2.8% to 3.8%. While labor growth is strengthening, there needs to be significantly more hiring to absorb the new college class that is graduating within the next couple of months. More important, there needs to be more breakthroughs in the technology and biotechnology sectors in order to drive Schumpeterian growth going forward. In the meanwhile, the market is likely to make a new cyclical bull market high over the next several weeks, but the deterioration in our technical indicators cannot be ignored, especially given the age of the bull market and declining global liquidity indicators. Moreover, the recent easing by the Bank of Japan may not be sufficient to sustain an increase in Japanese asset prices or the Japanese economy. We thus 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