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Breakout! But Overbought...

(February 5, 2012)

Dear Subscribers and Readers,

Make no mistake—despite the benefits of unseasonably warm weather (which contributed to less workers missing work due to bad weather), last Friday's jobs report signals genuine employment growth—meaning that the drop in the employment rate to 8.3% was no statistical fluke or due to a drop in the labor participation rate. This jibes with our relatively optimistic real GDP growth estimate of over 3% for 2012. Combined with the Fed's ongoing dovish policy, a relatively stable Euro Zone, low inflation in the developed world, decent equity valuations, and record high corporate cash levels, it is no surprise that the Dow Industrials made a fresh four-year high; while the NASDAQ made an 11-year high. Last week's rally was a genuine breakout, confirmed by a resilient US economy and labor market. Note that this jobs growth number was recorded in the midst of a decline in government employment (which is nearly always good).

Going forward, however, the Euro Zone, especially Greece and Portugal remains a concern. With short-term Spanish and Italian yields having declined to tolerable levels, all eyes are now on the Greek debt talks and the stubbornly high Portuguese yields. It is our assertion that given Portuguese debt levels (<120% GDP), its projected primary surplus as soon as this year, and the relatively low levels of debt maturing this and next year (about 35 billion Euros, see below chart courtesy of Goldman Sachs), there is no dire need for private investors of Portuguese debt to take the drastic haircuts which have befallen private Greek debt investors.

That is, while the market is definitely overbought and is vulnerable to a correction (potentially triggered by fears of a Portuguese default/haircut), we believe that any correction should be bought, given the huge breakout of major indices and the fact that Portuguese debt levels are sustainable, for now. In addition, China has expressed interest in contributing to the IMF in support of the Euro Zone—which makes sense, as a relatively small “investment” of China's sizable foreign reserves (>$3 trillion) would prevent the Euro Zone from breaking up, and ensuring the security of a major export market. Just as important, given Portugal's quick implementation of its austerity measures, a relatively low debt-to-GDP ratio, and a primary budget surplus, both China and European policymakers have no incentive to “grandstand” on moral hazard issues—which is very different to their attitude towards Greece. Again, I believe the market will decisively pierce the 13,000 level over the next several months. Of course, the European Sovereign Debt Crisis hasn't been resolved, but we may not experience any further adverse effects until later this year.

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 February 3, 2012, the Dow Industrials rose 201.77 points, while the Dow Transports rose 24.15 points.  Over the last five weeks, the Dow Industrials has railed 644.67 points, and closed at a four-year high. Meanwhile, the Dow Transports is just 4.4% from an all-time high. As long as the Greek debt talks make progress, and with the Fed committed to a more dovish policy (near-zero Fed Funds until 2014; and potential QE3 later this year), it is likely that the Dow Industrials will surpass the 13,000 level decisively over the next several months. We remain bullish on US and US financial stocks (although we could experience a short-term correction over the next several weeks), but since we are dissolving the end of February, we will not make any more 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 decreased slightly from 22.7% to 22.6% for the week ending February 3, 2012.  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 surged by a whopping 33.9%. The four-week MA is hovering at its most overbought level since March 2011, after hitting 34.0% the week prior. As such, we would not be surprised if the market beings a correction sometime over the next several weeks. That said, it is still at a neutral level in the long-run  With the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines, a dovish Fed, and the resilience of the US economy—we continue to look for a rally in US stocks and US financial stocks over the next 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 in mid-December, the 20 DMA had been on a tear until a couple of weeks ago, spiking to as high as 123.9. The 20 DMA finally corrected over the last couple of weeks, however, declining from 123.9 to 112.9. This pullback was much-needed as this indicator was getting very overbought in the short-run. That said, our other sentiment indicators remain overbought on a short-term basis—hence, the market will likely correct over the next several weeks. Over the next several months, we remain bullish on US stocks and US financial stocks.

Conclusion: With US jobs growth now recovering, it is likely that both corporate credit demand and bank lending will reinforce this positive trend. Consequently, this further reinforces our belief that US GDP growth this year would surpass 3%. Our base line scenario suggests a market correction soon—probably triggered by fears over a Portuguese default. However, as we have outlined, any risk of a systemic crisis triggered by Portugal is overstated, given the country's relatively low debt-to-GDP ratio, its primary budget surplus, and a benign debt maturity schedule. That said, whether the European Sovereign Debt Crisis comes back to haunt us later this year will depend on policy makers' actions over the next several months.

Signing off,

Henry To, CFA, CAIA


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