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The Divergence between ECB and the Fed Policies

(May 8, 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 light of its 25 bps hike in March, the ECB expectedly left its policy rate unchanged at 1.25% last Thursday.  While its statement does not imply a June hike (and the recent plunge in commodity prices would add to the no-hike scenario in June), a July hike still seems likely.  Firstly, despite the latest plunge in commodity prices, pricing pressures in the Euro Zone remain elevated.  Early estimates suggest that April inflation for the Euro Zone will come in at 2.8% on a year-over-year basis.  Furthermore, year-over-year growth in M-3 rose from 2.1% in February to 2.3% in March.  With the ECRI Future Inflation Gauge for the Euro Zone also at a 30-month high, the ECB is unlikely to step back from its hawkish bias.  While Euro inflation is mostly being driven by pricing pressures in Germany, Spain, and to a lesser extent France, the ongoing bull market in commodity prices should also add slightly to Euro Zone inflation in the second half of the year (I believe that the recent plunge in commodity prices is just a breather).  We expect the ECB to raise rates by at least 50 basis points in the second half of the year—taking the ECB's policy rate to 1.75% by the end of 2011.

As for the US, note that the ECRI Future Inflation Gauge for the US just fell to a four-month low—while credit growth remains weak.  Moreover, the Fed has a “dual mandate” of targeting inflation and supporting job growth at the same time.  With US fiscal policy projected to tighten in the coming quarters (see following chart, courtesy of Goldman Sachs), the Federal Reserve will need to “fill in the gap” by maintaining a loose monetary policy for the foreseeable future to maintain job growth.

In addition, the Taylor Rule suggests that US monetary policy may actually not be loose enough, despite the Fed's unconventional “quantitative easing” policy (see following chart, again courtesy of Goldman Sachs).  Many pundits have argued that the Fed could raise rates before reining its balance sheet—but at this point, there's no indication that the Fed will do so.  With many central banks of emerging market countries now reining in their monetary policies to dampen the rise in commodity prices, the Fed will likely not raise rates anytime in the next 12 months (although I'm not sure if I'll agree with Goldman that there will be no rate hikes until early 2013).

As for the US stock market—while our liquidity and valuation indicators improved last week (given the correction in commodity prices; and the slight decline in equity prices)—our technical indicators are still deteriorating.  One lingering question about global liquidity though has been answered: Japan has responded to the March 11 earthquake by flooding its banking/financial system with liquidity, as exemplified by its April statistics of the Japanese monetary base (year-over-year growth hit 23.9%--more detail to come in our mid-week commentary).  Given the momentum behind global equity prices, the rally in the Dow Industrials and the S&P 500 should continue for the foreseeable future, although we are still looking for a larger-than-expected correction sometime this summer.  Again, should the Dow Industrials continue to rally (preferably to over 13,250) on dismal upside breadth and/or volume, we will likely 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 May 6, 2011, the Dow Industrials declined 171.80 points, while the Dow Transports declined 43.09 points.  Despite last week's decline, both Dow indices are still close to their three-year highs.  The momentum behind this rally—as well as the psychological implications surrounding the death of Osama Bin Laden—should propel the market further.  However, given the weakness in our technical indicators, we still expect the market to experience a correction 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 decreased from a reading of 22.5% to 21.7% for the week ending May 6, 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 to 21.7% last week.  While there is likely more upside for both this indicator and the market in the short-run, the lack of a recent correction suggests the market is highly vulnerable to a larger-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 over 13,250.

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 from 117.7 to 114.3 last week, and is now slightly oversold.  Similarly, the 50 DMA is also at a slightly oversold level.  There is likely more upside in both this sentiment indicator and the market in the foreseeable future, especially since valuation levels remain decent.  However, should the market rally further, we will likely go 50% short in our DJIA Timing System.

Conclusion: The divergence in the ECB's and the Fed's monetary policies may be a cause for concern, as neither central bank (the Bundesbank, prior to the formation of the Euro) has really strayed from the other since the beginning of the disinflation era in the early 1980s.  At a minimum, it could mean unforeseen volatility or movements in various asset or commodity prices—meaning substantial macroeconomic risks to global money managers.  However, while the longer-term implications are uncertain, the short-term momentum of the stock market remains to the upside.  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.

Signing off,

Henry To, CFA, CAIA

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