Hope: The Four-Letter Word
(September 6, 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.
We still want to initiate a 50% long position in our DJIA Timing System, but over the last couple of weeks, other “Black Swan” risks have emerged aside from the one we have been tracking—i.e. the European Sovereign Debt Crisis. In a way, the emergence of new Black Swan risks—such as the $30 billion bank lawsuit by the Federal Housing Agency and the worsening joblessness situation—is not surprising given the pro-cyclicality of the U.S. political institutions, as well as the fact that the bubble preceding the financial crisis was built on non-productive assets (at least when the technology bubble burst, the unused “dark fiber” was eventually lit). As I am finishing this commentary, the S&P futures are down about 30 points, implying a 280-point down open in the Dow Industrials. Valuations on U.S. large cap equities are decent; but with the 10-day MA of the equity put/call ratio declining to just 0.70 (from 0.79 the week before!), and with the Ticker Sense Blogger Sentiment Poll only 29% bearish (as of August 29, 2011), investors' sentiment is still overly bullish. As such, we do not anticipate initiating a 50% long position anytime soon, unless the Dow Industrials decline to the 10,000 to 10,500 range this week. The combination of the FHA lawsuit, the ongoing European Sovereign Debt Crisis, the U.S. economic slowdown, and the implementation of the Basel III capital standards may even push the U.S. economy back into recessionary territory. Such an outcome is avoidable, insofar as these are all political problems with real political solutions. For now, the bulls will need to rely on “hope”—which as veterans know, is the “four-letter word” in the investment language.
Let us now quickly review our various liquidity and valuation indicators. Firstly, U.S. stock market liquidity has improved over the last several 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 four months. As of the close last Friday, it is just over five 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 consistently declined since February 2009. The ratio bottomed at 28.06% at the end of April 2011, and has bounced to 33.19%. This liquidity reading remains low, however, and along with the possibility of more “Black Swan” risks, this suggests market conditions should remain tough going into early Fall.
Looking at the other side of the Pacific, the Bank of Japan's monetary policy is still relatively tight 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) and the appreciation in the Japanese Yen. From month-end July to month-end August 2011, the year-over-year change in the Japanese monetary base increased from 15.0% to 15.9%--but 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 easing was 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, Japanese investors should continue to be cautious. That said, Japanese shares are now severely oversold and undervalued. As crazy as it sounds, buying overweighting Japanese equities (and U.S. large cap equities) once the market finds a sustainable bottom may be a good way to go!
Finally, while our valuation indicators are 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 0.85 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”)—near its most oversold level since July 2009. Note, however, that this ratio declined to as low as 0.81 in mid-August; and 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 the ongoing decline in global banking shares. 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/confidence crisis, valuations do not matter too much. While we may initiate a 50% long position in our DJIA Timing System should the Dow Industrials decline to the 10,000 to 10,500 level, we still nonetheless expect market conditions to remain tough going into early Fall.
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 September 2, 2011, the Dow Industrials declined 44.28 points, while the Dow Transports declined 14.87 points. While last week's decline was mild, the daily volatility remains high as investors remain skittish about the U.S. economic slowdown, the European Sovereign Debt Crisis, and other political risks. However, the combination of our weak liquidity indicators, weak technical indicators, the ongoing European sovereign debt crisis, and the stubbornly optimistic investors' sentiment suggests the market action is likely to remain tough going into early Fall. We remain neutral in our DJIA Timing System; although we may initiate a 50% long position should the Dow Industrials decline to the 10,000 to 10,500 range.
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 rose from a reading of -0.2% to 0.8% for the week ending September 2, 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:
This sentiment indicator pierced below its July 1st low in the week before last, but despite the challenging market conditions, this sentiment indicator actually rose last week from a reading of -0.2% to 0.8%. As we mentioned, the four-week MA is still relatively optimistic given the global economic slowdown, the market action, and the emereging political risks over the last six weeks. We would like to see this reading decline to at least its July 2010 lows (when it bottomed at -9.9%). 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 Dow Industrials decline to the 10,000 to 10,500 range.
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 from 92.1 to 90.8 last week—making another new low—and is at its most oversold level since mid-June 2010. Meanwhile, the 50 DMA also declined to a new low, and is at its most oversold level since late July 2010. Both the 20 DMA and 50 DMA remain highly oversold. While this indicator's oversold condition suggests the market may be bottoming, 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 Dow Industrials decline to the 10,000 to 10,500 range, we may initiate a 50% long position in our DJIA Timing System.
Conclusion: The “Black Swan” surprises are still piling up. This is not surprising given the pro-cyclicality of U.S. political institutions, as well as the immense level of debt and misallocation of capital going into the recent financial crisis. More important, the U.S. has failed to sufficiently invest in our infrastructure, institutions, and human capital for at least the last decade, if not more. Again, we don't believe the U.S. stock market has made a sustainable bottom. We will thus remain neutral in our DJIA Timing System; although we may initiate a 50% long position should the Dow Industrials decline to the 10,000 to 10,500 range. Subscribers please stay tuned.
Henry To, CFA, CAIA