Market Liquidity and Leverage Updates
(June 3, 2011)
Dear Subscribers and Readers,
Important note! I'm preparing for my graduation from the UCLA joint MBA/MPP degree next week—and thus would not get a chance to pen our weekend commentary. I apologize in advance. I wish all of you a great weekend, and take it easy!
Aside from being the biggest down day of 2011, Wednesday's decline also resulted in a Lowry's 90% downside day. A Lowry's 90% downside day usually results in a quick two- to seven-day bounce—but given yesterday's feeble market reaction and the lack of an oversold condition, there is likely more market downside over the next week or so. That said, while the short-term trend is very uncertain, the cyclical bull market that began in early March 2009 remains intact. We are still looking for the Dow Industrials to pierce above the 13,000 level before a more serious market correction—possibly later this summer or even into the Fall. With Moody's threatening to downgrade US large banks, and with the European sovereign debt crisis still unresolved, it would be very tough for the market to rise significantly above 13,000.
Let's now shift to a discussion on market liquidity. Despite the recent market downdraft, our liquidity indicators are still exhibiting weakness. This lack of strength is exemplified by the percentage of cash in equity mutual funds. In particular, cash as a percentage of equity mutual funds' assets (at 3.4%) as of the end of April 2011 is equal to its all-time low of 3.4% set as of the end of July 2010, as shown in the following chart:
Note that mutual fund cash levels lingered at 3.5% from December 2010 to February 2011 (matching the low of 3.5% in July 2007—near the peak of the last bull market)—and declined to a record low of 3.4% in March and stayed there at the end of April! Cash levels likely remain low despite the recent downdraft. We will continue to take a wait-and-see approach to the markets—and while the cyclical bull market isn't over, we are looking for a deeper correction later this summer and possibly into Fall.
Interestingly, after showing a significant willingness in liquidity creation during April (in response to the March 11th earthquake), the Bank of Japan is now paring back. This is disappointing, as general global liquidity is still tight, while the Fed's QE2 will end on June 30. From the end of April to the end of May 2011, the year-over-year increase in the Japanese monetary base decreased significantly from 23.9% to 16.2%, as shown in the following chart:
Upon seeing the April numbers, we reminded our subscribers that while the increase was highly encouraging, subscribers should note that the Bank of Japan has historically tightened liquidity quickly post any exogenous shock. This is again coming true, given the latest decline in the Bank of Japan's monetary base. Given all-around global tightening, subscribers should continue to be cautious. Indeed, while the market is likely to make another high (possibly on weakening technicals) later this year, this means the market is increasingly vulnerable to a deeper-than-expected correction.
I now want to address the steady rise in leverage within the stock market, as exemplified by the amount of margin debt outstanding. Since the February 2009 bottom, total margin debt outstanding has increased by 81%, and has retraced about 75% of its peak-to-trough decline from July 2007 to February 2009. Total margin debt outstanding increased by $5.5 billion during April—standing at $360.9 billion, its highest level since month-end February 2008 (right before the Bear Stearns collapse):
No doubt margin debt outstanding is now extremely elevated—and given the decline in global liquidity and the negative technical divergences we've covered over the last several months, we advise our subscribers to be more cautious and selective. We are going out on a limb: Should the Dow Industrials and S&P 500 continue to rally (preferably to over 13,000) on dismal upside breadth and/or volume, there's a good chance we will go short in our DJIA Timing System.
Henry To, CFA, CAIA