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The Greek Euro Exit Spread and Breakout!

(December 27, 2011)

Dear Subscribers and Readers,

I hope y'all had a great Christmas weekend, and here's wishing you a great 2012! 2011 has been an eventful year—both for the financial markets, and my circle of friends and acquaintances. No doubt 2012 will again be a roller-coaster year. The death/rebirth cycle continues…

As I discussed in our mid-week commentary, it is with a sad and heavy heart that I am saying goodbye to the investment newsletter world starting the end of January next year. It has been an honor serving all of you over the last seven years. Prorated refunds would be provided to six- and 12-month subscribers over the next several days. I will focus my professional energy on life coaching instead (you can read more about my coaching services on my website). Please do keep in touch and I look forward to serving you—only in a different (and more meaningful) manner.

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 I discussed in our mid-week commentary, the ECB is now engaged in classic quantitative easing. The ECB has also made clear that it will engage in direct QE (i.e. unsterilized sovereign debt purchases) should inflation undershoot its target. While this does not solve the underlying competitive/fiscal problems of Greece, Portugal, Ireland, Spain, etc., it does buy more time for the Continent to muddle through (a la Japan over the last 22 years). At some point in 2012, I believe the ECB will engage in ACTUAL QE; as such, I believe the 17-country European monetary union would at least hold out for 2012 (accompanied by a gradual Euro devaluation, which helps the region's competitiveness). Also, while European banks have been reluctant to borrow at 1% from the ECB and buy longer-term peripheral debt, I expect the region's governments to “strong arm” the banks to purchase more government debt. Longer-term yields should thus decline for the foreseeable future. The European Sovereign Debt Crisis is on the backburner. As such, I expect global financial stocks to outperform.

Despite these extreme monetary (and short-term) measures, I still believe there's a good chance one country will exit the Euro in 2013. One way to take advantage of this is through a Greek Euro Exit Spread on intrade.com (note that there isn't much liquidity there). That is, sell the Euro.Dropped.2012 futures for a price of 33.3 per contract, and purchase the Euro.Dropped.2013 futures for a price of 51.0 (see below charts). The spread is 17.7—it should go to 100 if no Euro Zone country exit in 2012, but one or more countries exit in 2013. This is mostly a speculation on the declining optionality of the 2012 contract, with the 2013 contract as a partial hedge. I like the risk-reward ratio; although I believe the spread may narrow somewhat (to as low as 10.0) over the next several months.

https://www.intrade.com/graphing/temp/chart13246626310775005.png

https://www.intrade.com/graphing/temp/chart13246626310775008.png

In the short to intermediate term (several weeks to several months), I expect global financial stocks to outperform. In fact, US financial stocks now look very bullish on a technical basis. As evident in the following chart (courtesy of Decisionpoint.com), the 20 DMA of the XLF (US financials ETF) just broke above its 50 DMA, while the relative strength line of the XLF versus the S&P 500—after declining the entire 2011—has formed a base and is now breaking out of its 20 DMA.

Despite the significant refinancing risks of European peripheral countries and European banks in 1Q 2012 (approximately US$1 trillion), this is already a well-known fact and I expect policy makers and other investors to “fill this gap” when the time comes (I expect the Bank of England alone to expand its QE policy by another 100 to 125 billion pounds). Because of the ECB's latest policy—along with the collapse in short-term Spanish yields last week—I also do not expect France to lose its AAA-rated status anytime soon. Even Japan is now recognizing the severity of the liquidity situation—as exemplified by the establishment of a US$10 billion swap line by the Bank of Japan with India. Make no mistake: The potential for a “Black Swan” event in the financial market declined dramatically in the past week. Combined with historically low valuations, I believe US financial stocks are now a buy.

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 23, 2011, the Dow Industrials rose 427.61 points, while the Dow Transports rose 147.03 points.  Both the Dow Industrials and the Dow Transports broke out to a five-month high last week—which is technically bullish. More important, I believe the contagion risks from the European Sovereign Debt Crisis is now off the table, given the ECB's renewed commitment to reliquify the European banking system, as well as the resilience of the US economy. We are now bullish on US stocks in general, but given that we are dissolving MarketThoughts.com over the next several months, we will not make any future moves 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 increased from 4.5% to 6.3% for the week ending December 23, 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% in early October, the four-week MA has risen 17.6%. While it is slightly overbought in the short-run, it is not as overbought in the long-run  With the European Sovereign Debt Crisis now on the backburner—and combined with the resilience of the US economy—we are now looking for the market to rally over the next several weeks to several months.

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:

Ever since breaking 100 a couple of weeks ago, the 20 DMA has remained on its uptrend. Last week was a major breakout for the index, as it spiked up to 108.5 to end the week. It also remains above its 50 DMA. Such a breakout from a highly oversold condition is usually bullish—all the more so since the Euro break-up scenario is now off the table. We are now bullish on US stocks.

Conclusion: We are now witnessing breakouts of all kinds on a technical basis. We usually don't pay too much attention to breakouts on a standalone basis—but given the significant collapse in Spanish short-term yields last week, along with the ECB commitment on a QE policy should inflation surprise on the downside, I believe US financial stocks are now a buy. This is further affirmed by the historically low valuations in US financial stocks.

Signing off,

Henry To, CFA, CAIA

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