The ECB Needs to Ease
(August 7, 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.
Last Friday, the Dow Industrials closed at a level below where we exited our 50% long position in our DJIA Timing System on December 15, 2010, when the Dow traded at 11,487 on an intraday basis. We have remained neutral, citing declining global liquidity, the festering European sovereign debt crisis, weakening technicals, and overly bullish sentiment levels. Since then—despite the market rally in the first half of the year—several developments have wounded investors' confidence, such as the lack of Japanese leadership as a response to the March 11th earthquakes, the inaction of European leaders to its festering sovereign debt crisis, and finally the squabbles over the U.S. debt ceiling, which indirectly led to the S&P downgrade of U.S. sovereign debt last Friday. As I am penning this commentary, S&P futures are down nearly 30 points, despite the ECB's initial promise to purchase Italian and Spanish sovereign bonds (which we mentioned was a necessary step to abating this crisis in our July 17, 2011 commentary). Note that the markets are now very oversold in the short-run. As a result, we believe the market will stage a technical bounce over the next week or two, but the intermediate trend remains down.
We believe the European Central Bank will need to slash rates further; and buy at least 250 billion Euros worth of Spanish and Italian sovereign debt (10% of outstanding stock) in order to “buy time” for the two countries to get their economic houses in other (which simply means more immediate austerity measures—especially cutting entitlements). An ECB rate cut, combined with quantitative easing through the purchase of Spanish and Italian sovereign debt would also weaken the Euro—allowing both Spain and Italy to benefit in the intermediate and long-term through increasing exports. As we mentioned in our July 17, 2011 commentary (“Evaluating Italy”), an Italian 10-year yield in the low 6% resembles more of a liquidity crisis. Once Italian 10-year yields surpass 6.75% it starts becoming a solvency problem, as Italy cannot fund its long-term deficits with a 10-year yield of 7% or over. Now is the time for the ECB to ease—by slashing interest rates and implementing a quantitative easing package through a 250 billion Euro purchase of Spanish and Italian sovereign debt.
Given the ECB's single mandate of inflation targeting (it hiked rates as recently as early July), and its grandstanding over moral hazard issues, I don't believe any Spanish or Italian sovereign debt purchases would be substantial at this point—until/unless global equity markets decline by 10% to 20% from current levels. Indeed, it's imprudent for the ECB to make substantial purchases until it is able to obtain budget concessions from the Spanish and Italian governments, especially their entitlement spending over the next five to ten years. That said, the time is getting closer for more easing in the Euro Zone, especially given the decline in oil prices (September WTI below $84 a barrel as I am writing this). Once the prices of base metals (e.g. copper, aluminum, tin, nickel, lead, etc.) start to decline (see below chart), then the ECB will have no inflation argument to fall back on:
Note that nickel prices topped out in summer 2007, lead in Fall 2007, and aluminum in summer 2008. In fact, none of these three metals is currently anywhere close to their all-time highs—and all have declined over the last three to six months. While copper and tin prices have made new highs in 2011, they have also declined significantly since those all-time highs. The recent weakness in oil prices (an input to base metals production), combined with a Chinese slowdown and general declining global liquidity, suggest that global inflationary pressures will ease—paving the way for an ECB rate cut and quantitative easing.
Speaking of liquidity, U.S. stock market liquidity better has improved over the last couple of weeks, due to the decline in U.S. equity prices. One measure of this is the amount of cash sitting on the sidelines, as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background. Since its February 2009 peak, it has declined very quickly, but has bounced in the last several months. As of the close last Friday, it is just over four percentage points above its cyclical bull market low (set at the end of April 2011), as shown in the following chart:
As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been consistently declining since February 2009. The ratio made its recent bottom at 28.06% at the end of April 2011, and has bounced to 32.11%. This liquidity reading remains low, and along with the leadership void in the EU and the U.S., this suggests market conditions should remain tough for the rest of this summer.
Finally, while our valuation indicators are now getting oversold, they still don't suggest the market has reached a sustainable bottom. This is exemplified by Morningstar's aggregate valuation, a valuation factor that I regularly track. Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is now at an oversold level of 0.87 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”)—its most oversold level since July 2009. Note, however, that this ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid-2001). This means that in a liquidity or confidence crisis (such as what we are now experiencing), valuations may not matter as much:
While Morningstar's proprietary valuation indicator suggests the stock market is below its fair value, subscribers should note that – given the trend of corporate earnings over the last two years – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom. In addition, the weighted cost of capital has declined dramatically – suggesting that valuations may be more stretched than meets the eye, especially given the overhang from the European sovereign debt crisis and last Friday's downgrade of U.S. sovereign debt. In other words, Morningstar's proprietary valuation indicator suggests that the market may not be so undervalued after all—and more important, that in a liquidity/confident crisis, valuations do not matter too much.
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 August 5, 2011, the Dow Industrials declined 698.63 points, while the Dow Transports declined 490.46 points. Over the last couple of weeks, the Dow Industrials and the Dow Transports have declined by 9.8% and 13.5%, respectively. Since hitting an all-time high in early July, the Dow Transports has declined a whopping 16.5%. While both Dow indices are now immensely oversold in the short-run (suggesting a technical bounce over the next week or two), our longer-term technical indicators are still not that oversold. Combined with our weak liquidity and technical indicators, the festering European sovereign debt crisis, and the stubbornly optimistic investors sentiment, 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 decreased from a reading of 17.3% to 12.2% for the week ending August 5, 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 2001 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% five weeks ago—near its most oversold level since mid-September last year. The four-week moving average has since bounced to 12.2%--which is overly optimistic given the market action over the last several weeks. Given this overly bullish sentiment, 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:
Since declining to a historically oversold level of 97.6 three weeks ago (its most oversold level since late July 2010), the 20 DMA has bounced to 106.5. Meanwhile, the 50 DMA also declined to a new low three weeks ago, has bounced slightly, and is still near its most oversold level since early August 2010. Both the 20 DMA and 50 DMA remain very oversold. While this indicator's oversold conditions suggest the market should rally (we are in fact looking for a technical bounce over the next week or two), the fact that our other sentiment indicators is not as oversold is troubling—and suggests caution is warranted, especially given the weak liquidity and technical conditions. We will remain neutral in our DJIA Timing System for now.
Conclusion: The festering European sovereign debt crisis—as well as the squabbles over the U.S. debt ceiling—has turned into a full-blown liquidity and investor's confidence crisis. The S&P downgrade of U.S. sovereign debt last Friday is simply an offshoot of this confidence crisis in our leadership and the long-term entitlement schemes of social security and Medicare. It is also about time for the ECB to ease aggressively, as long as it can wrestle further budgetary concessions from Spain and Italy. The last thing on the ECB's mind should be inflation, given the latest decline in crude oil prices and the stubbornly high euro. In the meantime, investor's sentiment is still overly bullish—while our longer-term technical indicators are only mildly oversold—suggesting the U.S. stock market hasn't yet made a sustainable bottom, and will likely remain in a consolidation period this summer. We remain neutral in our DJIA Timing System, for now. Subscribers please stay tuned.
Henry To, CFA, CAIA