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Japan Government Bonds Unattractive but no Imminent Decline

(October 16, 2011)

Dear Subscribers and Readers,

Let's 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 upsurge in global equity markets, we are still looking to initiate a 50% long position in our DJIA Timing System.  Given the market's high volatility, along with the short-term overbought condition, we will likely initiate a 50% long position only when the Dow Industrials declines to below the 11,000 level.

Let us now discuss Japan.  The Japanese government bond market, especially in light of recent fiscal crises in developed markets, is a topic that has been beaten to death.  So many speculators have lost money shorting Japanese Government Bonds that hardly anyone would touch it with a ten-foot pole (especially since over 95% of the Japanese sovereign market is owned by local investors).  At some point, however, fundamentals (or the lack thereof) will take over.  With the Japanese population aging and in a structural decline, and with a government debt level close to 230% GDP and a budget deficit close to 10% GDP (see below chart, courtesy of Goldman Sachs), it is fair to say that there is no value with 10-year JGBs yielding just 1.0%.

We believe that shorting 10-year JGBs in Yen will eventually pay off, especially at a current yield of 1.0%.  To support its sovereign market down the road, the Bank of Japan would need to resort to a quantitative easing policy.  Such a policy would ultimately cause a decline in the Yen.  A short position in 10-year JGBs for a foreign investor (in Yen) would thus pay off even if yields do not rise.

In trading and speculation, however, timing is everything.  We cannot put a precise timeframe around this trade any more than we could predict the lottery numbers for this week.  The math suggests a short trade in 10-year JGBs would pay off sometime over the next 5 to 10 years.  In the meantime, while JGBs remain unattractive, it is probably not a good time to short just yet.  One reason is because we do not see any imminent trigger for a decline in JGBs.  For example, the local appetite for JGBs is still sound, and there is still robust demand for Japanese Yen from local investors repatriating their foreign investments (especially Japanese baby boomers heading into retirement).  On a more immediate level, there is no pressure for the Japanese government to recapitalize any Japanese banks, given the latter's non-exposure to European peripheral debt (following chart again courtesy of Goldman Sachs).


Just as important, Japanese banks are in very good financial health; given their non-existent exposure to the U.S. mortgage crisis, as well as their conservative lending standards.  Of course, the “Black Swan” event is a global recession.  Such an event will have a proportionally larger impact on Japan, given the country's dependent on exports for economic growth.  In addition, any spike in JGB yields could cause depletion in bank capital, as Japanese banks' balance sheets contain a significant amount of JGBs.  At this point, I don't believe either event will transpire.  Bottom line: Japanese government bonds remain unattractive, but there is no imminent decline, and I certainly would not recommend a short position in JGBs today.

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 July 2008 to the present:

For the week ending October 14, 2011, the Dow Industrials rose a whopping 541.37 points, while the Dow Transports rose 331.91 points.  Even though we were anticipating continued high volatility, we did not foresee such a tremendous rally in the market, especially since no solid solutions have arisen from the European Sovereign Debt Crisis.  Since our liquidity indicators and technical indicators remain weak, we anticipate some kind of retest.  We believe the Dow Industrials will at least revisit the sub-11,000 level.  Given our severely oversold sentiment indicators, however, we may initiate a 50% long position should the Dow Industrials fall below 11,000.

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 -11.3% to -10.0% for the week ending October 14, 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 bounced from a severely oversold level in the week prior, but remains near its lows during last summer's correction.  Moreover, the ten-week MA (not shown) declined to a new low, hitting its most oversold level since early September last year.  As such, we may initiate a 50% long position in our DJIA Timing System should the Dow Industrials fall below the 11,000 level again.

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:

Both the 20 DMA and the 50 DMA increased last week—with the 20 DMA jumping from a historically oversold level of 90.9 to 97.7.  In general, a reversal from a historically oversold level has significantly bullish implications from a sentiment standpoint.  Coupled with bullish confirmations from our other sentiment indicators, there's a chance that the U.S. stock market has already hit its lows a couple of weeks ago.  However, given the significant volatility, we will refrain from initiating a 50% long position until the Dow Industrials decline to below the 11,000 level again.

Conclusion: With global investors focusing on the long-term health of developed economies, the topic of Japan, along with the country's high government debt level, will be a point of focus.  But while JGBs remain unattractive, there is no immediate trigger for a substantial decline.  However, should the European Sovereign Debt Crisis spiral out of control—and should it “spill over” and cause a global recession—then JGBs would be under a bigger threat.  At some point over the next 5 to 10 years, JGBs would be a very attractive short—but we are definitely not there yet.  As for the U.S. stock market, we remain neutral in our DJIA Timing System; but may initiate a 50% long position should the Dow Industrials fall below the 11,000 level.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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