The Need for Fiscal Restraint - Part II
(May 15, 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.
We first discussed the need to curb the US budget deficit in our April 3, 2011 commentary (“The Need for Fiscal Restraint”). As calculated by Goldman Sachs, the primary budget deficit is estimated to hit 7.7% of GDP in 2011. On a cyclically adjusted basis, the (structural) budget deficit should still hit 6% of GDP this year—about three times higher than that during the Reagan “Star Wars” defense spending years. With a US debt-to-GDP ratio of 96%--and with entitlement spending to rise by 2.2% of GDP over the next decade—the US would have no choice but to either cut spending or raise taxes soon. Moreover, a decline of US fiscal spending by 6% of GDP could be devastating, given the size of the US relative to the global economy. As we mentioned, there are 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 loose for years to come.
Unless there is a boost of Schumpeterian growth in the near future (e.g. the commercialization of 2nd generation biofuels, a workable quantum computer, or a cure for Alzheimer's), US GDP/productivity growth alone would not be sufficient to close the budget gap. Based on various academic studies and those done by the IMF, cuts in government spending have been more effective in terms of both closing the budget cap and allowing for future economic growth (following chart courtesy of Goldman Sachs):
One big caveat, however, is that historically spending-based consolidations have been significantly less successful without an accompanying monetary easing. In fact, spending-based consolidations have on average been only slightly more successful than raising taxes—although the results are likely not statistically significant.
With the Fed Funds rate already at zero-bound, and with the Fed unlikely to embark on another asset purchase program (a.k.a. “QE3”), there is really no room for further monetary easing. Of course, nothing is impossible—and should the CPI and the PPI remain relatively stable later this year, the Fed could very well embark on “QE3” should the President Obama and the Congress agree on a deficit reduction plan next year. One thing is for sure: US monetary policy will stay very loose for years to come!
Meanwhile, the primary uptrend in US equities remains intact. However, both our liquidity and breadth indicators have continued to deteriorate—suggesting that the bull market is maturing. Going forward, there would be more erratic movements and corrections in both the US stock market and individual securities. However, 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 13, 2011, the Dow Industrials declined 42.99 points, while the Dow Transports declined 87.87 points. Despite last week's decline, both Dow indices are still close to their three-year highs. The momentum behind this rally should propel the market further, especially since market valuations are still decent. However, given the weakness in our technical indicators, we expect a market correction sometime this summer. 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 declined from a reading of 21.7% to 20.8% for the week ending May 13, 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 declined to 20.8% last week. While there is likely more upside for 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 114.3 to 110.6 last week, and is now semi-oversold. Similarly, the 50 DMA is also at a semi-oversold level. There is likely more upside in both this sentiment indicator and the market in the foreseeable future, especially since momentum and valuation levels remain decent. However, should the market rally further, we will likely go 50% short in our DJIA Timing System.
Conclusion: The ongoing and out-of-control rise in US federal spending and budget deficit is a tremendous concern for the next five to ten years, especially given the recent sovereign debt concerns in various “developed” countries in the Euro Zone. Going forward, there needs to be a substantial cut in federal spending, accompanied by the maintenance of an extremely loose monetary policy for the next several years. Unless Schumpeterian growth picks up substantially, much of this cut will need to be picked up through consumption growth by countries such as China, India, Brazil, Indonesia, and South Korea. In the meantime, 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.
Henry To, CFA, CAIA