Our Base Scenario: No QE3 and Revising U.S. GDP Growth
(August 14, 2011)
Video of the Week: Watch how modern science (theoretical physics) interprets Plato's Cave metaphor of our 3-D reality in this video describing “The Holographic Principle.” Presented by famed physicists/string theorists Peter Galison, Brian Greene, and Cumrun Vafa.
Dear Subscribers and Readers,
Hope everyone is doing well in light of the volatile market action! In times like this, it is better to turn off the PC, go out and enjoy the weather/movies/skydiving if you are a long-term holder of equities. That said, there are legitimate questions that everyone should be asking—dormant questions that the recent market volatility (and the Italian debt crisis) is serving to remind us. One subscriber recently asked:
If the Federal Reserve continues to keep interest rates at record lows, where is the money going to go? And what do recent mutual fund redemption levels and mutual fund cash levels indicate about the intermediate and the long-term outlook of the stock market?
These are great questions. As we discussed in last week's mid-week commentary (note that we still haven't taken a 50% long position in our DJIA Timing System; and we will notify you in real-time once/if we do), we like the long-term outlook of U.S. equities given the S&P 500's relatively high dividend yield, as well the high cash levels and cash inflows of the underlying companies. In addition to the high dividend yield (approximately 2.2%), companies are also buying back their stock. Coupled with decent earnings growth, this is a great time to buy U.S. equities—especially since our base case scenario isn't a U.S. or even a Euro Zone recession.
That said, we also note that the greatest threat to U.S. equity prices isn't high interest rates, valuations, or even financial dislocations, but indifference. For most investors (retail and institutional), it is about being able to sleep at night; and not lose their jobs. A defined benefits pension fund that still has over 50% of its assets in global equities must now be seriously thinking about further “diversification” and adopting a lower risk budget—whether it is through Asian (ex. Japan) sovereign debt, private equity, hedge funds, hedge fund replication strategies, infrastructure investments, or other esoteric asset classes such as investments in law suits, life settlements, or frontier markets. Moreover, the mass retirement of the baby boomers suggest that mutual fund redemptions (at least by domestic investors) may become the norm sometime in the next several years—and some may not have the stomach to experience daily portfolio swings of 2% to 3%. In such a scenario, getting a minimal yield on their investments may be more important than chasing stocks. This has happened before; and I have no doubt it will again—although probably not in the foreseeable future. In other words, the money doesn't have to flow into U.S. or global equities despite record low interest rates.
In the short-term, equity mutual fund redemptions could be viewed as a contrarian indicator, although as I mentioned, they may be the norm in the longer-term. As for mutual fund cash levels, its low levels (3.4% to 5.0%) over the last several years has mainly been a reflection of a “fully-invested” policy demanded by its investors—namely, pension funds and consultants (since they want to control their own asset allocations). That said, the little fluctuations still count a lot—both in terms of liquidity and sentiment levels. The recent record low levels of 3.4% (although this likely rose in July) still signal a tough market for the rest of the summer, if not into the fall.
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.
Talk about having egg on our faces! Since our January 9, 2011 commentary (“Our Dark Sides”) outlining our 2011 real U.S. GDP forecast, we have already revised it twice—from 3.0%-4.0%, to 2.8%-3.8%, and finally to 2.6%-3.6% in our May 29, 2011 commentary (“Revising 2011 US GDP Growth Yet Again”). At the time, we cited the extent of the U.S. consumer deleveraging (debt repayments as a percentage of income had fallen to a low not witnessed since the mid-90s), high corporate cash levels, and strong global economic growth for the relatively optimistic forecasts (not to mention the strong leading U.S. economic indicators). Since then, global equities have done horribly (at least we weren't caught off guard in our DJIA Timing System!), while global economic growth has disappointed, despite the relatively muted increase in crude oil prices (which, along with commodity prices, we cited as a major threat to global economic growth). More worryingly, it seemed like we have hit a major tipping point in terms of our post WWII (and LBJ's Great Society) socioeconomic model as exemplified by the festering European Sovereign Debt Crisis—prompting entitlement cuts all over the world, including the threat of Social Security and Medicare payment cuts in the U.S. Going forward, we will likely see increased taxes, especially at the higher income levels, along with the closing of tax loopholes.
While the implementation of the Fed's QE1 policy, along with TARP, was a necessary step to prevent a major financial dislocation, the failure of QE2 to spur a quicker economic recovery suggests there are deeper and more structural obstacles. As we have already covered, the general misallocation of capital, as exemplified by the U.S. housing bubble, was unprecedented. Such a bubble, along with the resultant consumer spending and general borrowing, resulted in significant overcapacity in many industries, including construction, retail, financial, and the restaurant industries. The strength of the U.S. Dollar during this time also accelerated the outsourcing trend—resulting in a major relocation of U.S. industry and corporate support stuff. With the weakness of the U.S. Dollar this year (and high unemployment, resulting in more competitive salaries), both these trends have significantly decelerated—and some would say, are reversing as U.S. companies shift their manufacturing and support stuff back to domestic shores. Despite this, the U.S. economy is still struggling to grow—which is not a surprise given the general overcapacity and leverage coming into the late 2007 to early 2009 financial crisis.
Going forward, Asia, excluding Japan, will need to “pick up the slack” by encouraging higher currency appreciation, and domestic consumption. To some extent, China has already allowed its currency to appreciate more than expected in the last year—with the Renminbi rising nearly 7% since the government removed the U.S. dollar peg last year; and nearly 3% since the beginning of this year. Chinese wages have also picked up—with many foreign multinationals now shifting their manufacturing to the Chinese interior or relocating to other cheaper Asian countries. Domestically, the U.S. simply needs to be more creative—either to create organic, Schumpeterian growth in existing industries (e.g. technology, biotechnology, and clean energy) or develop new industries altogether. There needs to be more innovation, or the commercialization of a set of technologies that could usher in the next era of extraordinary growth—much like railroads the mid-19th century, the automobile in the early 20th century, and the internet in the late 20th century.
Because of the failure of QE2—and perhaps with the realization that the Fed cannot effect structural shifts in the U.S. economy (e.g. it cannot speed up technological growth)—I do not believe the Fed will implement a QE3 policy. I would argue that QE2 actually hurt the U.S. economy, insofar as it resulted in higher oil/commodity prices, which disproportionately hurt lower-income U.S. consumers. At the most, I expect the next FOMC statement to be revised to indicate that the Fed will keep its current balance sheet holdings for an “extended period”—thus ensuring that no Treasuries or Agency securities on its balance sheet will be sold anytime soon. With the Fed's hands tied, and with the festering European Sovereign Debt Crisis, I expect real U.S. GDP growth to be mediocre this year. We are thus revising our 2011 U.S. real GDP growth from a range of 2.6%-3.6% to 2.0%-3.0%. This new forecast is being backed up by the weakening ECRI's Weekly Leading Index, as well as the Ceridian-UCLA Pulse of Commerce Index, which dropped 0.2% in July, after rising 1.0% in June. I first discussed this index in our March 28, 2010 commentary (“Building a Better Mousetrap”). To recap, predicting U.S. economic growth (not to mention economic growth of other countries) has is a tricky endeavor, as timely and accurate leading indicator is usually difficult to obtain, and are typically subject to significant revisions. As a response to the lack of real-time and accurate data, the UCLA Anderson Forecast, in a partnership with Ceridian, has created an alternative index that has been more accurate as a leading indicator of the U.S. economy. Among other services, Ceridian provides credit and debit cards, including fuel cards and employer pay cards, and processes card transactions for various industries in the U.S., including the transportation industry (see the following link for the company's background). The underlying data of the Ceridian-UCLA Pulse of Commerce Index is derived from credit card swipes for the purchase of diesel fuel at over 7,000 truck stops all over the country. Per the Forecast, “The interstates that crisscross America are the arteries along which flow the products that are the lifeblood of the economy. If the goods do not move, the economy turns comatose. Rather than measuring the pulse at a couple of locations, like the wrist and the neck, Ceridian has, in effect, installed sensors at truck stops all over the United States that measure the flow through this arterial system…
“The Pulse of Commerce Index is based on real transactions, observed instantaneously, with rich geographic detail. By tracking the volume and location of fuel being purchased, the Pulse of Commerce Index closely monitors the over-the-road movement of produce, raw materials, goods-in-process and finished goods to U.S. factories, retailers and consumers. Working with economists at the UCLA Anderson School of Management and Charles River Associates, Ceridian releases the index monthly for the national overall and for the nine Census regions, but the geographic detail of the data offer vast opportunities for studying details of local economies.”
The PCI has its limitations. For example, if some retailers shift their transportation contracts from trucks to railways due to increased freeway congestion, then diesel purchases will decline, and will have an unjustified negative impact on the PCI. Similarly, an increase in the fuel efficiency of the general vehicle fleet will also have a detrimental impact on the accuracy of the PCI. That said, the PCI has three major attractive features: 1) the data collected is in real-time – in theory, the PCI can be updated on a daily basis, 2) the data is accurate in that it measures actual transactions, as opposed to survey data as collected by the BLS or other government organizations, and 3) the data is very granular. For example, the Federal Reserve's Census region data is quite spotty and thus, the PCI can add significant value in terms of being a leading indicator of economic growth in the nine individual Census regions. In fact, the various regional Federal Reserve banks have engaged in discussions with Professor Ed Leamer in utilizing the PCI as part of their Beige Book reports (which are published 8 times a year).
As shown in the following graph, the PCI would have been instrumental in calling the last recession, as the index started turning down in late 2007. The launch of the Ceridian-UCLA Pulse of Commerce Index is one of the most exciting launches (in the world of U.S. leading economic indicators) since the launch of the ECRI Weekly Leading Index. We will continue to track this index going forward. The following chart contains the most updated reading. As suggested by the new PCI data, Ceridian and the UCLA Anderson Forecast asserts “The PCI has started the second half of 2011 on a slightly down note, and wobbly, slow growth is expected to continue for the rest of this year as the economy struggles to find a catalyst… However, another dip appears unlikely, as the traditional sources of recessions—homes and automobiles—are not currently positioned to produce a downturn.” This is consistent with the action of the following graph—note while the Ceridian-UCLA PCI has consistently risen since late 2009, it has pretty much stalled over the last 12 months.
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 12, 2011, the Dow Industrials declined 175.79 points, while the Dow Transports declined 71.01 points. Over the last few weeks, the Dow Industrials and the Dow Transports have declined by 11.1% and 14.8%, respectively. Since hitting an all-time high in early July, the Dow Transports has declined a whopping 17.7%. 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 very oversold. Although the market's valuation is very attractive, the combination of our weak liquidity, the festering European sovereign debt crisis, and the stubbornly optimistic investors' sentiment suggests the market action is likely to remain tough this summer. We remain neutral in our DJIA Timing System, although we will likely initiate a 50% long position should the market decline again this week.
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 12.2% to 8.4% for the week ending August 12, 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% six weeks ago—near its most oversold level since mid-September last year. Since then, it has bounced to as high as 17.3%, and is now at 8.4%. Despite this dip, the four-week MA is still 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, although we may initiate a 50% long position in our DJIA Timing System should the market decline again this week.
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 four weeks ago (its most oversold level since late July 2010), the 20 DMA has bounced to 109.3. Meanwhile, the 50 DMA also declined to a new low four 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. However, if the market declines again this week, we will likely initiate a 50% long position in our DJIA Timing System.
Conclusion: With the recent weakening U.S. leading economic indicators—and combined with the diminishing effectiveness of Fed easing to effect higher economic growth—we are revising our 2011 U.S. real GDP forecast from a range of 2.6%-3.6% to just 2.0%-3.0%. As the developed world adjusts to a period of less government spending and entitlements, real GDP growth in these countries will likely continue to disappoint into 2012. However, sometime in 2013 to 2015, I expect a “new era” of economic growth as the next Schumpeterian wave of technologies is unleashed. As long as the capitalistic process is allowed to work, and as long as creativity can be harnessed into commercial products/services, such a wave will occur sooner than later. 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. However, should the market take another dip this week, we will likely initiate a 50% long position. Subscribers please stay tuned.
Henry To, CFA, CAIA