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All Quiet - For Now

(December 29, 2011)

Dear Subscribers and Readers,

There would be no weekend commentary this week (New Year's) so I want to wish all our subscribers a great New Year's and an even better 2012! All is quiet on the battlefield right today, but I expect 2012 to be a year filled with immense reforms—coming after a year of significant geopolitical shifts (North Korea may start to open up), financial calamity (which will at least lead to pension reforms in Western Europe), and natural calamity in Japan (exposing a wide range of institutional incompetency in Japan and banishing the acceptance of nuclear energy as a “bridge fuel” for next-gen fuels around the world). I will discuss our 2012 outlook in more detail next week; in the meantime, I expect the financial markets to sustain its latest uptrend. The bottomless pit of the ECB three-year lending facility (with the ECB balance sheet swelling to a record US$3.55 trillion)—combined with the possibility of a direct QE policy next year—should keep Euro Zone's short-term yields in check for the foreseeable future.

One reason for our benign view (at least in the US stock market) is the recent decline in leverage within the US stock market, as exemplified by the amount of margin debt outstanding (which we last addressed in our November 6, 2011 commentary “U.S. Stock Market Deleveraging Likely Done”).  Since the February 2009 bottom, total margin debt outstanding has risen by 52%, and has retraced about 48% of its peak-to-trough decline from July 2007 to February 2009. However, subscribers should note that margin debt outstanding has declined by 16% since its May 2011 peak.  Over the last six months (till month-end November), margin debt outstanding declined by an astounding $51.8 billion to $303.9 billion:

Margin debt outstanding likely remained stagnant this month as risk-taking remains generally challenged and as the stock market remained stagnant. As we mentioned in our November 6, 2011 commentary, the US stock market likely bottomed in late September/early October, especially given the hugely oversold conditions in our sentiment indicators at that time. Bottom line: The recent decline in margin debt outstanding is a reflection of a general aversion to risk-taking and deleveraging; and is thus indicative of a more benign financial environment at least during 1Q 2012.

Similarly, the oversold conditions of our sentiment indicators suggest more upside to come (as discussed in last weekend's commentary).  The oversold condition in our sentiment indicators is reaffirmed by another sentiment indicator (which we first covered in August 2010)—the percentage of overall equity exposure for 40 NAAIM (National Association of Active Investment Managers) member firms who are active money managers.  Since this survey contains leveraged and long-short strategies, responses can vary widely.  The results are averaged to come up with the results (inception of the poll is 2006).  The NAAIM readings over the last several weeks have remained in the 30 to 40 range, which puts the survey in somewhat oversold territory, as shown in the following chart (courtesy of

As shown on the above chart, the U.S. stock market has either corrected significantly or endured a tough time whenever NAAIM net equity exposure pierced the 80% level over the last three years.  Conversely, the best time to buy U.S. equities is when NAAIM net equity exposure declined to 20% or below.  Since declining to below 0% in early October, this indicator has not pierced above the 60% level, let alone the 80% level. As such, we are cautiously bullish on the U.S. stock market. More to come next week!

Signing off,

Henry To, CFA, CAIA

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