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Italy Still a Concern

(November 13, 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.

Last week's action in Italian sovereign debt was a classic case of Soros' Theory of Reflexivity at work, as technical conditions in Italian sovereign debt (higher yields) caused a further deterioration in the fundamentals, given the country's high dependence on external funding and low interest rates.  This was further illustrated when LCH raised the margin requirements for Italian sovereign debt, generating more technical selling, which eventually toppled the Berlusconi government.  After over a decade of stagnation, the market is finally imposing “discipline” on Italy's balance sheet.  As I am penning this, former EU Commission Mario Monti has been asked by the Italian president to form an emergency technocratic government to impose quick austerity measures and resolve the crisis (all the more urgent given the €200 billion in refunding needs over the next six months).  It bothers me that Italy no longer has a democratically elected government; it also bothers me that there remains longer-term issues that have not and will not be resolved anytime soon.  For example, most “peripheral” countries (except for Ireland) have a significant productivity gap with Germany (see below chart courtesy of Goldman Sachs), which is especially alarming in the long-run given the stubbornly high Euro:

One major reason for the gap is the relatively inflexible labor markets of countries such as Portugal, Greece, Italy, and Spain, which hampers long-term productivity growth.  More important, this has not been accompanied by lower private or public consumption.  For example, Italy is still projected to have a current account deficit equal to 3.8% of GDP in 2011, and 3.6% in 2012 (vs. Germany's projected current account surplus of 4.6% and 4.3%, respectively).  As of today, Italy is also expected to have a budget deficit of 3.8% this year and 2.4% in 2012.  In other words, despite the recent austerity measures and funding crisis, Italy is still living beyond its means for the foreseeable future.  The new austerity measures will need to cover these gaps—whether through selling state assets, raising the retirement age, or cutting public expenditures. I also expect the European Central Bank to step in and cut interest rates again (by 25 bps) at its December 8th meeting. The Euro needs to weaken substantially against the US$ in order for Italy to become competitive again in the global markets.

There is no way to tell how the markets will act this week.  The last 18 months of “stop-gap” measures have failed, and the chances of getting this crisis resolved in the next couple of weeks are honestly rather dismal.  There has also not been enough “fear” in the market to indicate a sustainable bottom in global equities (although I continue to believe the market bottomed on October 3rd).  One example is the relatively low market volatility over the last several weeks (as illustrated in the below chart showing the running 10-day and 21-day annualized volatility of the Dow Industrials).  For example, the current 10-day volatility is “only” 29.5%; and the 21-day 27.5%.  During the volatility spike in mid-August, the former hit 53.8% and the latter 42.5%.  Should a major G-20 country experience (or come close to) a financial collapse, I anticipate a much higher spike in volatility.  The recent lack of volatility suggests that market participants are still not that fearful.

Last week, we mentioned:

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.

We stand by the above statement and continue to anticipate a further correction to global equities.  We also believe any correction (at least in the Dow Industrials) will be rather limited, given the decent valuations of U.S. large cap stocks.  As such, we are looking to initiate a 50% long position in our DJIA Timing System should the Dow Industrials decline below the 11,250 level.  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 11, 2011, the Dow Industrials rose 170.44 points, while the Dow Transports rose 65.81 points.  Despite stronger-than-expected earnings and the prior oversold conditions seven weeks ago, the rally has come too far, too fast, with the Dow Industrials rising 1,382.20 points over the last seven weeks.  Given the ongoing troubles in the Euro Zone and the weakness in our liquidity indicators, we anticipate a further correction over the next several weeks.  While we no longer think the Dow Industrials will revisit the sub-11,000 level (unless Italy exits the Euro Zone), 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 11, 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 rose a whopping 15.7% from a severely oversold level of -11.3% over the last five weeks. Combined with the ferocious rally over the last seven weeks, we believe the market has come too far, too fast, and is susceptible to a 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 decline of the 20 DMA below the 50 DMA is a somewhat bearish development, although given the severely oversold conditions, I do not expect much downside from here.  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: The lack of fear in the market (as indicated by the relatively low recent volatility and the VIX) is worrying from a bullish standpoint, given the worsening conditions in the Italian sovereign debt market, which could lead to an eventual break-up of the Euro Zone and severe asset mark-downs in the region.  That said, while the market remains vulnerable in the short-run due to the ongoing European Sovereign Debt Crisis and the short-term overbought conditions, valuations suggest that 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.

Signing off,

Henry To, CFA, CAIA

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