2011 1Q Flow of Funds Update - Housing Weakness No Surprise
(June 14, 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.
I apologize for the tardy commentary. This author graduated from the UCLA MBA/MPP (Master of Public Policy) joint-degree program last weekend, with a focus on investment management and international policy. Obviously, some celebration was in order—but other than that, the weekend was very hectic as I had to take care of a final on Saturday morning; and as a new chapter starts in my life. Aside from running MarketThoughts.com, I am also working for SageMill Capital Advisors—a start-up investment advisory firm focused on crafting structured notes for institutional investors. It's been fun so far, as I helped spear head the research process, along with helping out with fund-raising. Post-graduation, I expect to focus more time on the markets, and of course, on MarketThoughts.com. I look forward to this ongoing journey with all our subscribers!
Turning to the markets—while all the attention is on Greece—subscribers should note that Portugal has 7 billion Euros due this Wednesday, with 5 billion in redemptions, and 2 billion in coupon payments. Action needs to be taken immediately, as there is only a large chance that Portugal would not have the wherewithal to fund this amount this Wednesday. The problem is mostly political—while funding (78 billion Euros) is available from the IMF and EFSF, Portugal does not have a government in place to ratify such a plan following elections in the weekend before last. In fact, a prime minister may not be chosen until the middle of next week—meaning that Portugal may actually default on its bonds this Wednesday if no urgent action is taken. This is still why we are on a wait-and-see approach in our DJIA Timing System, despite the six-week decline and the highly oversold conditions in the short run.
Let us now discuss the 1Q 2011 Flow of Funds update published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. Since the inception of MarketThoughts.com, a main theme we have tracked through the Flow of Funds information has been the idea of overleveraged U.S. households, as well as the inevitable deleveraging resulting from the financial/housing crisis and the subsequent decline in household credit growth. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio hit a new post WWII low, and that despite the rally in asset prices during the 2Q 2009, it will take at least several years before U.S. households will finish rebuilding their balance sheets.
Since then, the state of U.S. households' balance sheets has improved – with U.S. household net worth rising by $8.66 trillion over the last eight quarters (despite a $1.27 trillion decline during 2Q 2010). As of the end of 1Q 2011, U.S. households net worth stood at $58.1 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.49 to 5.18 over the last eight quarters. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth still need to rise by $7.74 trillion before it hits its prior peak, even assuming U.S. housing prices have bottomed. Note that the absolute net worth scale on the right is a log scale:
Based on the above chart (and as reiterated in our title), U.S. households will likely continue to deleverage for the foreseeable future. As mentioned in a similar commentary three months ago, while I believe the Fed will end with its “QE2” easing policy (i.e. no “QE3”), the Bernanke-led Fed should not tighten until the asset-to-liability ratio of U.S. households rises back to 5.50 or higher. Interestingly, U.S. households' liabilities have “only” declined by $688 billion from its peak in 3Q 2008. This is interesting as global financial institutions have written off more than $1.5 trillion from their mortgage holdings and as U.S. commercial bank and consumer credit has grown by a minimal amount over the last eight quarters. So why did US households' liabilities only decrease by $688 billion from its peak? The likely answer is that many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). This likely means that true deleveraging (and home foreclosures) is not yet—as empirical evidence is proving. That is, actual mortgage defaults will most likely stay elevated for the rest of the year, despite a relatively low national housing-price-to-disposable-income ratio, a near all-time low in mortgage rates, and an improving employment picture.
Indeed, as we have mentioned, the sector that still need to deleverage over the next several years is U.S. housing. This is one reason why U.S. housing remains very weak. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 1Q 2011. While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
For every percentage growth in assets that U.S. households accumulated over the last 59 years, U.S. households incurred 3.27 times as much in mortgage debt (down from a peak of 3.89 times as of 1Q 2009), while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.) was “just” 2.05 times as much. Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen LCD TVs (readers should not forget that some also gone into “investments” such as education spending), but this does not change the fact that the vast majority of future deleveraging should occur in the U.S. mortgage market. While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the next decade and act as a “cushion” to the housing market, U.S. housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or relocate to smaller or cheaper living areas. In addition, a significant amount of residential housing demand in the major coastal cities (e.g. New York, Los Angeles, San Francisco, etc.) has come from international investors over the last several years. With much of the emerging market countries now tightening, and combined with ongoing deleveraging in the U.S. mortgage market, I expect most U.S. regional housing markets to underperform other asset classes for the next decade (although assisted living properties should outperform). The empirical evidence, as suggested by the continuing weakness in the U.S. housing market, confirms this view so far.
Of course, deleveraging isn't just limited to U.S. households. Over the next couple of decades, many countries in the “developed” world will have trouble fulfilling their pension and healthcare obligations as baby boomers retire, and as sovereign balance sheets become even more stretched. One example is the ongoing focus on the European sovereign debt crisis, as S&P's downgrade of Greece yesterday triggered a spike in Portuguese and Irish yield spreads to all-time highs. Three months ago, I assert “given the amount of crushing debt, the precarious export situation, the strong Euro, and horrible demographics (increasing pension benefit and healthcare), I expect Portugal to be in need of assistance very soon—especially with the European Central Bank likely hiking by 25 basis points at its April 7th meeting.” With 7 billion Euros in Portuguese debt or coupon payments this Wednesday, a reckoning is sure to come sooner than later. We maintain our neutral position in the DJIA Timing System, and we look for continued weakness in the stock market this summer.
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 six trading days end June 13, 2011, the Dow Industrials declined 198.29 points, while the Dow Transports declined 147.67 points. Over the last six weeks, the Dow Industrials has declined by 6.7%, while the Dow Transports by 8.0%. While the U.S. stock market is now very oversold in the short run, the combination of weak technical and liquidity conditions suggest the market will likely remain tough this summer. We remain neutral in our DJIA Timing System as we take a wait-and-see approach, for now.
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 11.8% to 6.7% for the week ending June 10, 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 1999 to the present:
After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 6.7% last week. Note that this sentiment indicator is now at its most oversold level since late September last year. Despite this oversold condition, however, it still isn't as oversold as it was during the correction last summer. We will retain our neutral position in our DJIA Timing System, as we don't believe the market has bottomed yet.
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 slightly from 101.9 to 102.1 last week—but remains at a very oversold level. Similarly, the 50 DMA is also at an oversold level. While the oversold conditions in this indicator suggests the market could rally in the short-run, the fact that our other sentiment indicators is not as oversold is a red flag—and suggests caution is warranted when purchasing stocks, especially given the weak technical and liquidity conditions. We will remain neutral in our DJIA Timing System, and will take a wait-and-see approach, for now.
Conclusion: As we asserted over the last two years, deleveraging within U.S. households, especially in U.S. housing, will be an ongoing theme for at least the next several years. The latest U.S. Flow of Funds data is indicative of this, and I expected the Bernanke-led Fed to remain accommodative until the asset-to-liability ratio of U.S. households rises to 5.50 or higher. In the meantime—given the short-term oversold conditions—the U.S. stock market could rally anytime, but I continue to expect a tough summer for U.S. stocks. We remain neutral in our DJIA Timing System, for now. Subscribers please stay tuned.
Henry To, CFA, CAIA