U.S. Bank Credit and Household Debt Payments Update
(June 19, 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.
Since our March 25, 2011 commentary (“Update of the Shadow Banking System”), the amount of ABS originations has improved significantly, especially on a global basis. That is—despite more tightening by emerging market countries and the ongoing European sovereign debt crisis—access to liquidity remains decent, especially for consumers tapping into auto loans, credit card loans, and student loans. Following is a chart showing global issuance of asset-based securities for last year, and this year on a YTD basis (courtesy of Asset-Backed Alert):
That said, the amount of global issuance of asset-backed securities still trails that of global bank lending; and remains small relative to issuance earlier this decade. In addition, I have no doubt that the asset-backed market will “freeze up” again should the European sovereign debt crisis get out of hand (i.e. if Greece does not obtain more short-term funding). From a domestic standing, both the Fed and U.S. commercial banks would still need to play a big role to revive bank lending and economic growth. Over the intermediate to long run, bank lending needs to revive for a sustained uptrend in asset prices and economic growth. Following is a monthly chart showing the state of U.S. bank lending—i.e. the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1950 to June 2011 (updated to June 8, 2011):
While the decline in bank lending in 2009 was unprecedented (unless one cites data from the Great Depression—when one-third of all US banks failed), it has steadied in the last 12 months. However, bank-lending growth remains dismal. In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) actually declined by $66.0 billion (to $6.71 trillion) from the end of December 2010 to June 8, 2011. Again, the lack of liquidity creation within the U.S. commercial banking system does not bode well for the short-term outlook of the stock market or the U.S. economy. Because of this, the market action will likely remain tough this summer, despite its short-term oversold condition.
Let us know discuss one of our longer-term themes—that of deleveraging in U.S. households. We discussed this in our last weekend's commentary from a U.S. balance sheet standpoint (“2011 1Q Flow of Funds Update – Housing Weakness No Surprise”). We argued that more deleveraging was needed—preferably when U.S. households' asset-to-liability ratio reaches 5.50 or over—and that until that occurs, the Federal Reserve will not tighten. While we don't know whether it's voluntary or forced (likely a bit of both), the fact of the matter is that U.S. households are saving more, spending less, and paying out less interest payments as a percentage of their disposable income. On a disposable income basis, however, the deleveraging process is further into the game—although this has more to do with lower interest rates. From this perspective, the trend of deleveraging U.S. households is evident in the declining proportion of U.S. disposable income dedicated to debt payments. As I mentioned, US households' balance sheets will continue its deleveraging process (as consumers adopt a more frugal lifestyle; as banks and credit card companies restrict lending; and finally as GDP growth normalizes this year). I do not buy PIMCO's “New Normal” view of a ten-year deleveraging process, although U.S. economic growth could surprise on the low side as we seek to reduce the fiscal deficit. But the inevitability of Schumpeterian growth (as well as old-fashioned population growth) will allow U.S. economic growth to normalize again. The combination of this Schumpeterian growth and relatively clean U.S. household balance sheets will drive the next secular bull market in U.S. stocks. I expect the next secular bull market to begin sometime in the 2013 to 2015 timeframe. While the ongoing deleveraging isn't as clear in the 1Q 2011 Flow of Funds data, there is obvious evidence that U.S. households are saving and paying down their debts. This is clear in the most recent trends in US households' financial obligation ratios (ratios of debt payments to disposable incomes), as illustrated in the following chart:
The financial obligation ratio for all U.S. Households' declined again and is now at its lowest level since 3Q 1994! Note that one reason would be that many households simply stopped paying their debts. Despite these relatively benign numbers, the deleveraging in the broader US economy should continue, although we have definitely finished the most painful adjustments. Going forward, I expect U.S. households to deleverage through a combination of higher disposable incomes (the unemployment rate has peaked), higher savings, and as lenders work through its backlogs of foreclosures and loan defaults (although I expect U.S. housing prices to remain in the doldrums for years to come). Furthermore, as U.S. households pay down more of their debts and become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the U.S. economy and society. Because of this, I believe the Federal Reserve should start to normalize its interest rates as soon as feasible, the European sovereign debt crisis notwithstanding.
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 June 17, 2011, the Dow Industrials rose 52.45 points, while the Dow Transports rose 97.96 points. Last week's rise in the Dow Industrials was its first up week in six weeks. Despite last week's action, both the Dow Industrials and the Dow Transports remain highly oversold—suggesting that a further bounce is likely over the next several weeks. However, the combination of weak technical and liquidity conditions suggest the market action will 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 6.7% to 4.3% for the week ending June 17, 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 4.3% last week—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 (although a short-term bounce is very likely).
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 decreased from 102.1 to 100.3 last week—its most oversold level since late July 2010. 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: On an income (flow) level, U.S. households have likely bore the greatest pain of the deleveraging process, although there still needs to be more deleveraging on the balance sheet (stock) side. This will happen as the cyclical bull market in global equities is still in place (although the market action will likely be tough this summer); and as U.S. income levels rise and unemployment declines throughout 2011. Of course, the proportion of income that flows to debt payments will increase should the Federal Reserve raises rates—and because of this, I do not expect the Bernanke-led Fed to raise rates anytime soon. The peripheral countries in the Euro Zone, however, are a different story. In the meantime, the U.S. stock market should rally in the short-run, 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