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Merkel Dragging Her Feet: Trading Range into Next Year?

(December 4, 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.

As we mentioned in last week's mid-week commentary, the establishment of the US$ bilateral swap lines by the world's six largest banks last week was necessary.  While not sufficient to “solve” European's sovereign debt contagion, it was necessary because: 1) the coordinated central bank action gave investors hope that there could be coordinated moves by the governments of Germany, France, the US, China, etc. as well—indirectly telling investors that there exists global financial leadership, after all, and 2) Injecting US$ liquidity has given European policymakers time to find a solution—as this gave European banks (and emerging market countries like India) much-needed US$ funding. Indeed, 10-year yield spreads (relative to German Bunds) of Italy, Spain, and France were already steadily declining by the time the US$ swap lines were announced on Wednesday (US time), as shown in the following chart courtesy of Goldman Sachs:

In addition, traders at are now pricing in a 43.5% chance that at least one Euro Zone country will drop the Euro as its currency by the end of 2012, down from 46% when we last discussed it on Wednesday night.

Make no mistake: The establishment of the US$ bilateral swap lines has bought Merkel and Germany much more time to decide next steps—and given what has been witnessed so far, Merkel is definitely using this opportunity to try to impose some kind of uniform fiscal behavior/discipline in the Euro Zone region.  The steps are slow and methodical, but it is clear nonetheless (Merkel spending an entire swimming lesson perched on a diving board as a schoolgirl is a case in point—or it may simply be a symptom of a genuine lack of leadership).  By doing so, Merkel risks the chance that events may ultimately overwhelm her and sweep control (or at least the illusion of control) from her and the grasp of other European policymakers.  But to some extent, this is necessary—as Merkel is a politician first, and there simply cannot be fiscal union (and a mass transfer of wealth from Germany to the PIIGS countries) unless Italy and Greece impose some sort of tax collection and spending reforms.  The fact that Italy is actually a wealthy country—with a primary surplus and significant household net worth (they're just not paying their bills)—is frustrating from a policymaker standpoint.  This also precludes them from getting IMF aid, as the latter is intended for genuinely bankrupt/poor countries.  Besides, any long-term solution that involves IMF will need to include more IMF funding—particularly from China and Brazil—and these countries cannot justify spending money on the Euro Zone when their own populace remains stuck in poverty. 

Turning back to the US, one of our stock market leverage/liquidity indicators, the percentage of cash in equity mutual funds, experienced a noticeable decline in October, after spiking to a two-year high in September.  In particular, cash as a percentage of equity mutual funds' assets decreased from 3.8% as of the end of September 2011 to 3.5% at the end of October 2011, as shown in the following chart:

Given the down tick in equity mutual fund cash levels in October, and given the potential “Black Swan” events as a result of the European Sovereign Debt Crisis, the market remains very susceptible to a correction.  The fact that Merkel is willing to turn the European Sovereign Debt crisis into a marathon struggle means that events could potentially wrestle control from her and other policymakers—as such, we are no longer looking to purchase stocks even if the Dow Industrials decline to below the 11,250 level.  We remain neutral in our DJIA Timing System and will take a wait-and-see approach. 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 December 2, 2011, the Dow Industrials rose a staggering 787.64 points, while the Dow Transports rose 413.23 points.  Last week's market action represented its greatest weekly rise since over two years ago.  The market is now overbought in the short-run, and given the ongoing problems in the Euro Zone and the weakness in our liquidity indicators, we believe the market could undergo another correction as soon as this week.  As such, we will remain neutral in our DJIA Timing System, for now.

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 decreased from 6.3% to 5.9% for the week ending December 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:

Since hitting a multi-year low of -11.3% two months ago, the four-week MA has risen 17.2%--and is thus slightly overbought in the short-run. Given our weakening technical indicators and the ongoing European Sovereign Debt Crisis, we will remain cautious until the four-week MA hits oversold territory again.  Again, we are anticipating a correction into the end of this year.

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 has been stuck in a range of 91 to 99 over the last four weeks, and remains below its 50 DMA.  Both the 20 DMA and the 50 DMA remain oversold, but given the potential “Black Swan” events as a result of the European Sovereign Debt Crisis (our overall liquidity indicators have improved given the bilateral US$ swap lines established by the world's six largest central banks last week), we will remain neutral in our DJIA Timing System, for now.

Conclusion: While the establishment of the US$ bilateral swap lines has bought Merkel and other policymakers time to craft a workable “solution” to the European Sovereign Debt Crisis—it seems like what Merkel is looking for is a marathon struggle—a struggle which would involve hardline measures to impose more fiscal discipline upon the PIIGS countries.  This runs the risk of events sweeping her away and creating a systemic event, as more austerity measures at this point could result in a further loss of confidence among investors should the Euro Zone experience a severe recession.  Moreover, the lack of fear in the market (as indicated by the relatively low VIX) is worrying from a bullish standpoint.  We remain neutral in our DJIA Timing System; and will take a wait-and-see approach.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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