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Greece and 2011 3Q Flow of Funds Update (Housing Still Needs Attention)

(December 11, 2011)

Dear Subscribers and David Korn's Subscribers,

Even as European banks continue to struggle (and to deleverage), and even as the Euro Zone enters a recession, German policymakers are still stuck on “normal policymaking” mode. As the last 18 months have beautifully demonstrated, “kicking the can down the road”—which has generally worked for the OECD's baby boomer leaders over the last 20 years—is no longer viable. Given the horrible demographics in the region, the bureaucratic red tape, and a general slowdown in the BRIC countries (not to mention India rattling its protectionist sabers in its retail sector), there needs to be a combination of severe pension/health reforms, austerity measures, as well as more quantitative easing from the ECB (the ECB is already engaging in stealth QE through its sterilized bond purchases and extension of loans to European banks) and a Euro devaluation. Failing such a move, it is likely that one or more Euro Zone peripheral country will default and/or exit the Euro. Note that is pricing in a 37% chance that one or more country will drop the Euro by the end of 2012:

While today's 20- and 30-something investors can't conceive of a Greek or any sovereign default, it is actually a quite common occurrence (Argentina was the last major country to default in January 2002). A partial default and devaluation becomes immensely attractive as the costs of default (e.g. domestic investor losses, a higher yield premium as the country borrows again, etc.) declines relative to the costs to sustain payments of a ballooning debt. Interestingly, a recent Richmond Fed paper (2007) suggests that the costs of default have actually declined over the last century, given the rising competition between international creditors. For example, in the 19th century, international lending was dominated by a few major lenders, such as Rothschild, Barings, Schroders, and Morgan. These banks can threaten to shut out borrowers in the future if the latter default. Today, international lenders can no longer do so, given the huge variety of potential lenders, such as hedge funds, private equity funds, sovereign wealth funds, fixed income mutual funds, and even high net worth individuals. In other words, there will come a point (likely next year) when it becomes highly attractive for Greece to default, assuming the ECB doesn't step in with a more aggressive QE package.

I now want to welcome readers who are subscribers of Mr. David Korn's weekly e-newsletter. David writes a weekly newsletter that includes his summary and interpretation of Bob Brinker's Moneytalk, as well as his own model newsletter portfolio and discussions related to personal finances. David has graciously asked me to be his guest columnist this weekend (which I am honored to be).  I have written for David's subscribers before – in fact, the first time I wrote for David was nearly six years ago.  One of my mottos has always been “Substance over form.”  Sure, presentation and communication skills are important – but what really matters in the long run is the soundness of our advice and the honesty behind the delivery.  We never try to generate readership by making outrageous “sky is falling on our heads” claims; nor do we pander to the public by claiming the ability to predict every little move in the market or engaging in revisionist history.  Rather, we let our results speak for themselves.

Let's begin our commentary on the Fed's latest Flow of Funds data 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.

Let us now discuss the 3Q 2011 Flow of Funds update published by the Federal Reserve last Thursday.  The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year.  Data is available for most statistics since 1952.  Since the inception of, a main theme we have tracked through the Flow of Funds information has been the idea of overleveraged U.S. households, as well as the inevitable deleveraging resulting from the financial/housing crisis and the subsequent decline in household credit growth.  In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio hit a new post WWII low, and that despite the rally in asset prices during the 2Q 2009, it will take at least several years before U.S. households will finish rebuilding their balance sheets.

Since then, the state of U.S. households' balance sheets has improved–with U.S. household net worth rising by $6.93 trillion over the last ten quarters (despite a $2.44 trillion decline during 3Q this year).  As of the end of 3Q 2011, U.S. households net worth stood at $57.4 trillion, resulting in an improvement in households' asset-to-liability ratio from 4.57 to 5.17 over the last ten quarters.  As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth is still $9.4 trillion below its prior peak, even assuming U.S. housing prices have bottomed.  Note that the absolute net worth scale on the right is a log scale:


Based on the above chart and as discussed in our previous commentaries on the Fed's Flow of Funds date, U.S. households should continue to deleverage for the foreseeable future.  As mentioned in similar commentaries over the last several quarters, while I believe the Fed will not adopt a “QE3” policy, the Bernanke-led Fed should not tighten until the asset-to-liability ratio of U.S. households rises back to 5.50 or higher (especially given contagion risks from the European Sovereign Debt Crisis).  Interestingly, U.S. households' liabilities have “only” declined by $752 billion from its peak in 3Q 2008.  This is interesting as global financial institutions have written off more than $2.0 trillion from their mortgage holdings and as U.S. commercial bank and consumer credit has grown by a minimal amount over the last ten quarters (although bank lending has recently picked up).  Why did US households' liabilities only decrease by $752 billion from its peak?  The likely answer is that many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices).  This likely means that true deleveraging (and home foreclosures) is not over—as empirical evidence is proving.  Actual mortgage defaults should remain elevated for the foreseeable future, despite a relatively low national housing-price-to-disposable-income ratio, a near all-time low in mortgage rates, and an improving employment picture.

Indeed, as we have mentioned, the U.S. housing sector still needs to deleverage over the next several years.  This is one reason why U.S. housing remains very weak.  The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 3Q 2011.  While Americans have indeed been “gorging” on credit, most of this gorging has occurred in the mortgage markets over the last 20 years:

For every percentage growth in assets that U.S. households accumulated over the last 59 years, U.S. households incurred 3.27 times as much in mortgage debt (although down from a peak of 3.83 times as of 1Q 2009), while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.)  was “just” 2.07 times as much.  Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen LCD TVs (or into “investments” such as education spending), but this does not change the fact that the vast majority of future deleveraging should occur in the U.S. mortgage market.  While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the next decade and act as a “cushion” to the housing market, U.S. housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or relocate to smaller living areas.  In addition, a significant amount of residential housing demand in the major coastal cities (e.g. New York, Los Angeles, San Francisco, etc.) has come from international investors over the last several years.  With Europe and emerging market countries now slowing down, and combined with ongoing deleveraging in the U.S. mortgage market, I expect most U.S. regional housing markets to underperform other asset classes for the next decade (although assisted living properties should outperform). The empirical evidence, as suggested by the continuing weakness in the U.S. housing market, confirms this view.

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 9, 2011, the Dow Industrials rose 164.84 points, while the Dow Transports rose 10.35 points.  Since the end of 3Q, the Dow Industrials has risen by 11.4%--putting the market in short-term overbought territory. Combined with 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.

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% just over two months ago, the four-week MA has risen 16.7%--and is 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 finally broke out of its four-week range of 91 to 99. Moreover, it broke above its 40 DMA. Such a breakout from a highly oversold condition is usually bullish, but given the potential “Black Swan” events as a result of the European Sovereign Debt Crisis (even though our overall liquidity indicators have improved given the creation of the bilateral US$ swap lines), we will remain neutral in our DJIA Timing System.

Conclusion: As we asserted over the last 3 years, deleveraging within U.S. households, especially in U.S. housing, will be an ongoing theme for the next several years.  The latest U.S. Flow of Funds data is indicative of this, and I expected the Bernanke-led Fed to remain accommodative until the asset-to-liability ratio of U.S. households rises to 5.50 or higher.  In the meantime, I expect the market to correct going into Christmas. 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 events will overtake them sooner rather than later.  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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