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Summer Doldrums

(August 4, 2011)

Dear Subscribers and Readers,

As we discussed in last week's mid-week commentary, the squabbles over the U.S. debt ceiling are merely symptoms of a leadership void—not just at the highest levels in the U.S. (both our government and corporations), but in Europe and Japan as well.  Today, we live in a world of unprecedented wealth, yet “developed” countries such as Greece, Ireland, Portugal, and perhaps Italy are going broke—fueled by the lack of productivity investments (education, R&D, etc.) and the crushing weight of retirement and healthcare entitlements over the next 15 to 20 years.  The fact that many countries in the EU (including Japan) have low birthrates suggests these entitlements are unsustainable.  We are watching the European Sovereign Debt Crisis with interest, and will not be surprised if it gets much worse this summer.

In the meantime, the U.S. stock market is highly oversold in the short-run (with the Dow Industrials finally rising after an eight-day losing streak), and we thus expect a technical bounce over the next several days (S&P futures are up 5.5 points as I am typing this).  That said, neither our technical nor sentiment indicators are flashing readings consistent with a sustainable bottom.  For example, yesterday's equity put/call ratio only hit 0.79, while the ten-day equity put/call ratio is at a relatively neutral level of 0.68.  The VIX, meanwhile, sits at 23.38—a far cry from the >30 reading in mid-March, not to mention the close-to-50 reading that we got last summer.  The lack of an oversold condition is also evident in the percentage of NYSE stocks above their 20-, 50-, and 200-EMAs, as shown in the following chart (courtesy of

Note that while both the percentage of NYSE stocks above its 20-EMAs and 50-EMAs are at highly oversold levels, the percentage of NYSE stocks above their 200-EMAs is only at a mildly oversold level of 39.07%.  As such, we believe the market would experience a (violent?) technical bounce (especially given tonight's FOREX intervention by the Japanese)—but given the ongoing loss in confidence in our leaders and the festering European Sovereign Debt Crisis, we believe the market isn't yet close to a sustainable bottom.

This view is further reinforced by our liquidity indicators.  Looking at the other side of the Pacific, the Bank of Japan (tonight's intervention notwithstanding) is still in a tightening mode after opening the liquidity spigots in the wake of the March 11th earthquake.  This is disappointing given the much-needed rebuilding in Japan (not to mention the lack of leadership in the rebuilding efforts).  From month-end June to month-end July 2011, the year-over-year change in the Japanese monetary base decreased from 17.0% to 15.0%--down significantly from 23.9% at the end of April.  The pullback in liquidity creation is evident in the following chart:

When April numbers were published, we reminded our subscribers that while the increase was highly encouraging, the Bank of Japan has historically pulled back liquidity creation quickly after any exogenous shock.  This has again come true, given the declining growth in the Bank of Japan's monetary base.  Given all-around global tightening, subscribers should continue to be cautious.

Let's now shift to a discussion on U.S. stock market liquidity.  The weakness in our liquidity indicators is prevalent.  This weakness 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 June 2011 is equal to its all-time low of 3.4% set as of the end of July 2010; and has lingered at this level since March 2011, as shown in the following chart:

Note that mutual fund cash levels stayed 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 has since stayed at that level!  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 probably isn't over, we are looking for a deeper correction later this summer and possibly into Fall.

Signing off,

Henry To, CFA, CAIA

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