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The Ongoing European Sovereign Debt Crisis

(September 18, 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.

Despite the latest US$ liquidity injections into the global financial system, the European Sovereign Debt Crisis runs unabated.  To the extent that the Euro Zone's countries have misallocated their resources or failed to tackle their debt load, the market has been “forward-looking” and forced them (Greece, Portugal, Ireland, Spain, and Italy) to cut back spending and to tap the resources of Germany, France, and other better capitalized Euro Zone countries.  It has become a cliché, but the European Sovereign Debt Crisis remains at a crossroad.  True, the problem of a crushing debt burden and overspending may miraculously disappear tomorrow, but the “policy” of “kicking the can down the road”—a policy that has worked tremendously worked since the “LDC crisis” of the early 1980s—no longer works, given the horrible demographics, crushing entitlement spending, and lack of human capital and infrastructure investments in the Euro Zone countries over the last 20 to 30 years.  The lack of a resolution so far is demonstrated by the stubbornly high yields of Portugal, Greece, Ireland, and Spain, as well as the 5-year CDS spreads of the top 5 Euro Zone banks by market, courtesy of the following Goldman Sachs' chart:

 

With the recent spike in European banks' CDS spreads, the decline in European stock prices, and the stubbornly high sovereign debt yields, it is obvious that what was once an illiquidity crisis (e.g. that of Italy) is turning into a full-blown insolvency crisis, despite the latest round of austerity measures from Italy.  The probability of a self-reinforcing debt spiral is further increased by the recent U.S. economic slowdown, as well as the ongoing weakness in the Euro Zone's leading economic indicator (below chart again courtesy of Goldman Sachs):

An exit of the Euro by one of the peripheral countries or Germany remains extreme; so for now, we expect ongoing monetization of peripheral debt (and Italian debt) by the European Central Bank, and ultimately for Germany to bear the burden of actual monetary transfers to the periphery countries (whether direct or indirect—the latter through a recapitalization of the ECB to cover the latter's credit losses and/or bearing higher inflation due to debt monetization).  As it currently stands, the European Sovereign Debt Crisis will continue to be a systemic burden; but at the same time, there's not sufficient political will to resolve the problem unless the “Black Swan risks” becomes clearer to the German electorate.  We believe the confidence/liquidity crisis as a result of the Euro Zone's debt burdens will have a negative impact on the markets for the foreseeable future.  While we may initiate a 50% long position in our DJIA Timing System should the Dow Industrials fall below its recent lows, we 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 16, 2011, the Dow Industrials rose a staggering 516.96 points, while the Dow Transports rose 295.61 points.  Last week's rally was definitely impressive—but at the same time, this signals the high-volatility environment remains in place, as investors remain skittish about the U.S. economic slowdown, the European Sovereign Debt Crisis, and other political risks.  The combination of our weak liquidity indicators, weak technical indicators, and the ongoing European sovereign debt crisis (investors' sentiment has gotten more bearish over the last couple of weeks) suggests the market action is likely to remain tough into early Fall.  We remain neutral in our DJIA Timing System; although we may initiate a 50% long position should the Dow Industrials fall below its recent lows.

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 declined from a reading of -1.0% to -4.6% for the week ending September 16, 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:

The four-week MA declined made a new recent low last week—its most oversold level since September 2010.  However, the four-week MA is still relatively optimistic given the global economic slowdown, the market action, and the emereging political risks over the last couple of months  We would like to see this reading decline to at least its July 2010 lows (when it bottomed at -9.9%) before going long.  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 fall below its recent lows.

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 90.5 to 90.1 last week—making another new low—and is at its most oversold level since mid-June 2010.  Meanwhile, the 50 DMA is hovering near 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, the fact that our other sentiment indicators are not as oversold is troubling—and suggests caution is warranted, especially given the weak liquidity and technical conditions.  However, if the Dow Industrials fall its recent lows, we may initiate a 50% long position in our DJIA Timing System.

Conclusion: The potential for more “Black Swan” surprises will remain as long as the European Sovereign Debt Crisis is allowed to run unabated.  For now, there's no sufficient political will to resolve the crisis (i.e. ultimate transferal of resources from Germany to the peripheral countries)—and this won't change until the German electorate recognizes the severity of the situation.  As the global economy continues to slow this year, Germany and France will be forced to deal with this issue.  As a result, we don't believe either the U.S. or the global stock market has made a sustainable bottom.  We remain neutral in our DJIA Timing System; although we may initiate a 50% long position should the Dow Industrials fall below its recent lows.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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