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Evaluating Italy

(July 17, 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.

One of the greatest cultural periods in world history, the Renaissance (meaning “rebirth”), marked its birth in Tuscany, centering in the Italian cities of Florence and Siena.  The Italian Renaissance began in the late 1200s and lasted until 1600—when foreign invasions halted the movement in Italy.  From Italy, however, the Renaissance ideas and ideals spread into the rest of Europe, resulting in the Northern Renaissance and the English Renaissance.

Until the 16th century, Italy was the center of Western culture.  Despite its relative decline, Italian culture remained influential up to today—Italian artists drove the Modernism movement in the 1920s; and today, Italy remains a leader in global fashion and design.  Italy also has the greatest number of UNESCO World Heritage sites (46)—including the Historic Centre of Rome, the Historic Centre of Florence, the Historic Centre of Naples, the Piazza del Duomo, Pisa (housing the Leaning Tower of Pisa), and the Royal Palace of Caserta (used as a film location as Queen Amidala's Royal Palace in the film Star Wars Episode I: The Phantom Menance).  As of 2010, Italy's economy is the 8th largest in the world; and 4th largest in Europe (behind Germany, the UK, and France).  It is also a member of the G8, the OECD, and the European Union.  According to The Economist, Italy ranks 8th in terms of the quality of life; and has one of the lowest unemployment rates in the EU.  It also owns the fourth largest gold reserves in the world.  That said, Italy has been referred as the “sick man of Europe,” primarily because of its large budget deficits, relatively high levels of corruption, low economic growth, weak R&D spending (1.14% of GDP, relative to the EU average of 1.84%), and the prevalence of organized crime.

As evident last week, the European Sovereign Debt Crisis has now spread to Italy.  It is not clear why this is occurring now (other than the usual “buyer's strike” argument, as I don't know of any funds that are directly betting against Italy).  One contribution has been the inability of the EU to provide a comprehensive solution to the Greek debt crisis; and the refusal of the latter to impose more austerity measures or to collect taxes.  Another reason is the increasing likelihood of “private-sector involvement”—resulting in a haircut in Greek debt.  Finally, both Irish and Portuguese debt was downgraded to “junk” status by Moody's last week—triggering further sell-offs as institutional constraints prevent many firms from holding official junk-rated debt.

While Italy has attempted to halt the spike in Italian bond yields by imposing austerity measures (it passed a 70 billion Euro austerity measure last Friday), the markets have noted that it has no immediate impact, as most spending cuts are back-loaded in 2013 and 2014.  Moreover, Italy's composite PMI declined below 50 last week (signaling an economic contraction); while Italian industrial production declined by 0.6% on a month-over-month basis in May (compared to a 1.2% and 2.0% rise in Germany and France, respectively).  Note that Italian yield spreads over that of German bunds are now approaching those of Spain's, as shown by the following chart (courtesy of Goldman Sachs):

Italian debt-to-GDP ratio is expected to peak at 120% this year; and decline by about 8% over the next three years, assuming projected spending cuts and economic growth are met.  In its latest research, Goldman ran a simulation to determine a “sustainable” yield for Italy.  Last week, the 10-year yield for Italy soared by 80 basis points to 5.7%.  Assuming a 1.5% real economic growth (3.5% nominal), Goldman believes that Italy could sustain with an average yield of 6.7%; and that if the average yield tops 7%, funding Italy's deficits and debt levels would be highly problematic.  Given last week's jump in yields, the EU would need to do something dramatic over the next couple of weeks in order to halt this contagion into Italy.

Goldman asserts that it is not too late to halt the crisis.  For example—even at a 7.5% average cost of debt—Italy's debt-to-GDP ratio (as shown in the following chart) would only rise moderately over the next 30 years.  As long as yields are kept under 7% (and preferably below 6%), Italy's situation is still salvageable.  Since the sell-off in Italy resembles more of a liquidity crisis than a solvency crisis, Goldman asserts that a combination of secondary market purchases of Italian debt and a pullback for a private sector haircut in Greece would be sufficient to halt the rise in Italian bond yields.  We agree with this assessment, but given the recent track record of the EU, we would not be surprised if nothing is resolved this summer (especially given the lack of credibility in the most recent European bank stress tests).

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 July 15, 2011, the Dow Industrials declined 177.47 points, while the Dow Transports declined 206.12 points.  After hitting an all-time high the week prior, the Dow Transports suffered a significant correction last week.  As a result, both the Dow Industrials and the Dow Transports are no longer overbought.  However, given our weak liquidity indicators, the festering European sovereign debt crisis, and the lack of an oversold condition in the recent correction, the market action is likely to remain tough this summer. We remain neutral in our DJIA Timing System as we take a wait-and-see approach.

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 increased from a reading of 8.7% to 12.6% for the week ending July 15, 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 2000 to the present:

After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 3.5% two weeks ago—near its most oversold level since mid-September last year. Despite this oversold condition, and especially in light of the bounce over the last two weeks, this indicator is nowhere as oversold as it was during last summer's correction.  We will retain our neutral position in our DJIA Timing System, as we believe the market will remain tough this summer.

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 to a new recent low of 97.6 last week—to its most oversold level since late July 2010.  The 50 DMA also declined to a new low, and is now at its most oversold level since early August 2010.  While this indicator's oversold conditions suggest the market could rally further, the fact that our other sentiment indicators is not as oversold is troubling—and suggests caution is warranted when purchasing stocks, especially given the weak liquidity and technical conditions.  We will remain neutral in our DJIA Timing System and will take a wait-and-see approach.

Conclusion: As global liquidity conditions remain tight in the second half of the year, there's no hiding from the contagion effects of the European sovereign debt crisis.  Probability suggests that the next ECB move on rates would be a rate decrease of 25 basis points.  The lack of liquidity is now being manifested in the weakness of the world's third largest sovereign debt market (with 1.8 trillion Euros outstanding)—as 10-year Italian yields spiked 80 basis points in just two days last week.  Should Italian 10-year yields move close to 7% over the next several weeks, the current liquidity crisis could morph into a full-blown solvency crisis, especially if Spanish yields also suffer a corresponding spike.  Some form of resolution to the Greek debt crisis (preferably without a private-sector haircut) is needed to halt the contagion effects to Italy.  In the meantime, I believe the U.S. stock market remains in a consolidation period this summer.  I also believe that both the Euro and the Yen are unattractive relative to the U.S. Dollar.  We remain neutral in our DJIA Timing System, for now.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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