U.S. Stock Market Deleveraging Likely Done
(November 6, 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.
While U.S. Dollar and global liquidity levels are still very challenged (forming the basis of our bullishness on the U.S. Dollar for at least the 1H 2012), we believe the recent “deleveraging” within the U.S. stock market is likely over. More specifically, both our sentiment and our leverage indicators (e.g. margin debt outstanding and mutual fund cash levels) sold off to highly oversold levels during late September to early October—suggesting that the Dow Industrials likely bottomed at 10,655.30 on a closing basis on October 3rd. As such, we are looking to initiate a 50% long position in our DJIA Timing System, but only if the Dow Industrials declines to 11,250 or below. In the short-run, there is no question that the European Sovereign Debt Crisis will get worse as we approach Thanksgiving and Christmas. The focus is now on Italy, as more than a decade of capital misallocation is now coming home to roost. The entire Euro Zone structure, the pension system, and geopolitical structures are shifting, and these changes (much like the break-up of the Soviet Union) cannot be “fixed” by throwing money at the “problem.” Besides, the availability of funds is limited—e.g. the ECB has even discussed halting Italian bond purchases if the Italian government does not press ahead for reforms. That said, while the short-term risks are high, I don't believe the Dow Industrials will correct very far, given the decent valuations of U.S. large cap stocks on both a book value and a cash flow basis.
Let us now address the recent decline in leverage within the stock market, as exemplified by the amount of margin debt outstanding. Since the February 2009 bottom, total margin debt outstanding has increased by 49%, and has retraced about 46% of its peak-to-trough decline from July 2007 to February 2009. However, subscribers should note that margin debt outstanding has declined by 17% since its May 2011 peak. During August to September, margin debt outstanding decreased by an astounding $46.3 billion to $298.3 billion:
Margin debt outstanding may have increased during October as the market rallied. However, with both our sentiment indicators and the leverage within the U.S. stock market declining to highly oversold levels in late September/early October, we believe the market bottomed at that time. As such, we will likely initiate a 50% long position in our DJIA Timing System should the market fall below the 11,250 level.
Moreover, another stock market leverage/liquidity indicator, the percentage of cash in equity mutual funds, exhibited significant uptick during September, despite ongoing mutual fund redemptions. In particular, cash as a percentage of equity mutual funds' assets increased from 3.5% as of the end of August 2011 (after hitting an all-time low of 3.3% at month-end July 2011) to 3.9% as of the end of September 2011, as shown in the following chart:
While cash levels have likely declined during September because of the appreciation in stocks, my sense is that the stock market likely bottomed in early October. In the short-run, the market is very susceptible to a correction, given the potential “Black Swan” events arising from the European Sovereign Debt Crisis, as well as short-term overbought conditions due to the 1,211.76-point rally in the Dow Industrials over the last six weeks.
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 November 4, 2011, the Dow Industrials declined 247.87 points, while the Dow Transports declined 99.81 points. Last week's decline (especially in light of the uncertainty in the Euro Zone) wasn't a surprise, given the whopping rally of 1,459.63 points in the Dow Industrials in the five weeks prior. Despite stronger-than-expected earnings and the prior oversold conditions six weeks ago, the rally has come too far, too fast. Given the ongoing troubles in the Euro Zone, and the weakness in our liquidity indicators, we continue to anticipate more of a correction over the next several weeks. While we no longer think the Dow Industrials will revisit the sub-11,000 level, we will only initiate a 50% long position should the Dow Industrials fall below 11,250.
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 increased from -4.0% to 0.4% for the week ending November 4, 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 by 11.7% from a severely oversold level of -11.3% over the last four weeks. Combined with the ferocious rally over the last six weeks, we believe the market has come too far, too fast, and is susceptible to a further correction. As such, we may initiate a 50% long position in our DJIA Timing System, but only should the Dow Industrials fall below the 11,250 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:
The recent action suggests both the 20 DMA and the 50 DMA have reversed from their historically oversold levels four weeks ago. In general, a reversal from a historically oversold level has bullish implications from a sentiment standpoint. Coupled with bullish confirmations from our other sentiment indicators, my sense is that the U.S. stock market has already hit its lows in early October. However, given the significant volatility and potential “Black Swan” events, we will refrain from initiating a 50% long position until the Dow Industrials decline to 11,250 or below.
Conclusion: Recent margin debt and mutual fund cash levels numbers suggest that the U.S. stock market likely bottomed in early October. While the market remains vulnerable in the short-run due to the ongoing European Sovereign Debt Crisis and the short-term overbought conditions, both valuations and sentiment suggest 2012 will be an up year. We remain neutral in our DJIA Timing System; but may initiate a 50% long position should the Dow Industrials fall below the 11,250 level. Subscribers please stay tuned.
Henry To, CFA, CAIA