Four-Year Cycle Low Now the Consensus
(September 10, 2006)
Dear Subscribers and Readers,
I am actually starting our commentary on Saturday this weekend, since I will be on a plane early in the morning to New York City. This commentary should be a little bit abbreviated – so I apologize in advance. The plan is for me to meet a few money managers and my coworkers (in my day job) in our New York office, and I will be there from Sunday to Wednesday afternoon. I will be back in Los Angeles on Wednesday evening and will be attending an American Funds conference on Thursday. I will keep our readers up-to-date on both the markets and with whatever I hear during that time. Since Bill is writing a guest commentary for us this Wednesday evening, my schedule is not going to be as hectic as I thought (thank God). With that said, let us now start with our commentary.
Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 – giving us a gain of 290 points. In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). As of the afternoon on Thursday, September 7th, this author entered a 50% long position in our DJIA Timing System at a print of 11,385 – now at 7 points in the black. A real-time “special alert” email was sent to our subscribers informing them of this change. As of Sunday afternoon on September 10th, this author is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which, as I have discussed over the last few months, will regain a significant chunk of microprocessor market share from AMD), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc. I am also getting very bullish on good-quality, growth stocks – as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). The market action in large caps has also been very favorable thus far.
The market action thus far has remained favorable, despite the correction of the major market indices last week. For now, the Dow Transports (now at 4,195.04) remains above its August 11th closing bottom of 4,141.62. And while both the popular mid and small cap indices such as the S&P 400 and Russell 2000 have severely underperformed the Dow Industrials and the S&P 500 – this is to be expected, given that leadership is now shifting away from U.S. small and mid caps to U.S. large caps. As for the number of new highs vs. the number of new lows on the NASDAQ Composite – this indicator dipped into slightly negative territory on both Thursday and Friday (32 new highs vs. 35 new lows), but subscribers should not be alarmed unless new lows outnumber new highs by 32 or more (said number which is equivalent to 1% of all issues trading on the NASDAQ Composite). As for the U.S. homebuilder ETF (XHB), this author continues to believe that they have collectively bottomed and is preparing itself for a sustainable bounce – as I will illustrate later in this commentary. And finally, the Dow Utilities – which, in a typical cycle, has historically been a leading market indicator of the broad market from 3 to 12 months – made a new record high as late as August 31st, thus officially extending the life of this cyclical bull market. Despite all this, however, we will continue to hold on to your 50% long position in our DJIA Timing System before there is more evidence of a sustainable rally going forward. I will provide more clarification on this in the introduction of this upcoming mid-week guest commentary.
If this weekend is just too hectic for you and you only have time for one article, I strongly urge you to read Ned Davis' interview on Smartmoney.com that was published late last week. In the article, Ned Davis discusses the history of election cycles and what those have historically meant for the stock market. While everyone and his neighbor should now be familiar with the so-called “four-year low” during the mid-term election cycle (such as 1990, 1994, 1998, and 2002), Mr. Davis suggests that the so-called “four-year low” has now reached a “comfy consensus,” and since the stock market does not cater to the view of the majority, there is a good chance that this may be the year where we won't see such an easy repeat of history. In other words, there is a strong likelihood that the market has already bottomed in mid-August and is poised to continue to rally from now to the end of this year (such as what occurred in 1986). Interestingly, I have also been pounding the table on such a scenario occurring for the last few weeks. Subscribers who want a refresh should check out our archives that are available on the MarketThoughts.com website.
Another must-read is the weekly commentaries published by Mr. John Mauldin of Frontlinethoughts.com. In this weekend's commentary, he discussed the Dallas Fed's measure of inflation (called “Trimmed Mean PCE Inflation Rate”) and why the underlying trend in this measure of inflation is bothering the Dallas Fed – perhaps leading to further rates hikes in the near future. The motivation for this mention was the August 30st speech made by Richard Fisher, the President and CEO of the Federal Reserve Bank of Dallas. Unfortunately, what Mr. Mauldin chose to not cover in his commentary is that Richard Fisher actually focused more on the “Taylor Rule” than the Trimmed Mean PCE Inflation Rate in deciding whether the Federal Reserve should raise the Fed Funds rate or not going forward (even though Richard Fisher does not have a vote on the FOMC Committee). Quoting from Mr. Fisher's speech:
In the simplest version of the Taylor rule, current inflation is the primary determinant of a central bank's policy actions. In the real world, policymakers look at many other indicators to gauge inflationary pressures before they show up in actual inflation rates. This makes sense, given the lags between policy actions and their ultimate effects on the economy—lags that economist Milton Friedman famously described as “long and variable.”
Among the additional variables we look at are measures of capacity utilization of business operators and tightness in the labor market—for example, the unemployment rate. Strong job growth will lead to demands for higher pay. Many of you might wonder why that could ever be bad. Well, when it comes to workers' pay and benefits, it is not the increases themselves that cause concern. Problems occur when labor costs rise faster than gains in labor productivity. When that happens, firms often see shrinking profit margins, which add to pressure to raise product prices. What policymakers look at is unit labor costs, a measure of workers' pay adjusted for productivity.
Even if we cull out the misleading signals, the traditional data set may no longer be sufficient. At the Dallas Fed, we are exploring the notion that capacity measures must be extended beyond the domestic market. Today, we live in a world where goods, services, money, and the ideas and tasks performed by American businesses cross international borders with great ease. It stands to reason, then, that inflationary trends in any economy cannot be properly assessed without knowing how readily resources, inputs, finished products and capital from outside the country can be brought to bear. The Dallas Fed's globalization initiative is aimed at developing measures of these broader output gaps, which we hope will let us determine how the dramatic rise of China and India, for example, or the processing of tasks in cyberspace will impact inflation in the U.S.
In other words – in Richard Fisher's views – the Federal Reserve should also take into account whether China or India continues to have excess capacity and to thus export deflation, along with other countries like Japan, South Korea, Taiwan, and even Western Europe. As I have mentioned in my previous commentaries, China is still busy exporting deflation, and it has done so since over 12 months ago (China temporarily raised prices during 2004 and early 2005). Moreover, Japan has also continued to ramp up its capital spending (more than 15% year-over-year increases) and combined with a declining yen, you can bet that Japan is competing with China on a neck-to-neck basis in exporting consumer deflation all across the world. As for India, no doubt everyone and his neighbor already knows that the country is a deflationary force in terms of software and other “virtual services” such as technical support, etc., but what folks may not know is that places like India and Thailand are now becoming popular places for the outsourcing of medical services as well, such as surgeries and cosmetic services. Moreover, there is now a huge push by Wal-Mart, Walgreen, and CVS to open clinics across the U.S. to treat everyday ailments and write common prescriptions. These clinics will be run by nurse practitioners and physician assistants, and will also be a huge deflationary force on healthcare costs in the U.S. going forward. Given that healthcare costs have been one of the components with the highest inflation over the last five to six years, this (along with the outsourcing of medical services) will be welcome news for the Federal Reserve for most probably the rest of this decade.
The only worry for this author right now is the continuing high prices of commodities But with the price of crude oil experiencing a year-over-year decrease for the first time in many years, and with gasoline refining margins plunging from $20 a barrel to only $1 to $2 a barrel over the last four weeks – there is also not much to worry about on the energy front either. As of today, the only worry right now is the price of certain metals, as many of these base metals such as zinc, tin, copper, and lead, etc. have made serious attempts to challenge their all-time highs made earlier in May of this year – as illustrated by the below chart showing the daily price of the CRB Metals Index vs. its annual rate of change (ten-day smoothed) from January 1, 2002 to September 8, 2006:
Such a challenge, however, is not being confirmed by either the price of gold or silver. Moreover, as I have mentioned before, the year-over-year of copper imports into China for the first seven months of this year is down 23%, while copper demand from the U.S. should decline going forward given the huge glut of housing inventories on the market right now. Moreover, while automobile production has been the pillar of support for other base metals prices (such as tin and zinc), it is not obvious that global automobile demand will continue to hold up, especially given the current economic slowdown in the U.S. and the fact that the Japanese economy is still relatively weak. In fact, according to the OECD, the leading indicators for Japan has recently plunged to a level not seen since late 2001, as shown in the following chart:
Meanwhile, the China economy is not doing so great either, as shown by the following chart:
Slowing automobile demand in the U.S., Japan, and China – coupled with slowing demand from Europe (which is virtually close to inevitable given the huge consumption tax increase that will be levied on German consumers starting January 1, 2007) will put significant pressure on base metals prices over the next few months. Combined with the fact that both Japan and China are continuing to export consumer good deflation, and combined with the new disinflationary trend in healthcare costs going forward, there is a good chance that the Fed will not raise rates for the rest of 2006 – contrary to Mr. Mauldin's views. Given the current yield of the 3-month Treasury bill (at 4.91%), I would not be surprised if the Fed starts its first rate cut later this year at its December 12th meeting. This will also be in line with historical experience, in that the Fed has usually started cutting rates six months after the end of its hiking cycle over the last 10 to 12 years (the last rate hike occurred in late June).
Going back to the homebuilder ETF (XHB), I continue to contend that the homebuilders collectively made a bottom in late June. Technically, the XHB is holding very well – declining only 74 cents last week and sitting right near its resistance level (its 50-day moving average of $31.32) – despite estimates coming down at Lennar, KB Homes and Beazer Homes at the end of last week. Following is the most recent daily chart of the XHB courtesy of stockcharts.com:
As the above chart implies, it is imperative that the XHB continues to hold above $28.78 (on an intraday basis) for it to have a chance of recovering going forward. The action of last week went very far in proving that the XHB should continue to hold above support. The next step would be for the XHB to pierce its 50-day moving average of $31.32 on a closing basis, and from there, pierce its previous high of $32.37.
The most recent technical action in the homebuilders is encouraging especially given the prevalent bearish sentiment among retail investors and the public's attitude toward the homebuilders. This was evident in this author's most recent gathering with other CFAs in the Los Angeles area. One of the members of the CFA Society openly predicted a “nuclear winter” for the homebuilders later this year and for the S&P 500 to end the year at 1,025. The question again is: Where was this guy when you needed him when the XHB topped out at early April of this year (see our April 13th commentary on homebuilders – when I had remarked that shorting the homebuilders was a no-lose proposition)? From top to bottom, the XHB has already declined 40%. Of course, while anything can happen and the XHB can certainly decline another 40% from current levels, it is certainly not a high probability event and definitely not one which I want to bet on with my own money. The prevailing bearish sentiment among retail investors is also evident in the following survey conducted by Yahoo! Finance (the snapshot is as of Saturday afternoon):
As mentioned on the above survey, over 80% of all Yahoo! Finance readers still expect homebuilders to have further room to fall. In terms of contrarian indicators go, the prevailing bearish sentiment among homebuilders is certainly the most pessimistic since the sentiment on global equities in early March 2003. Given that the Fed should cut rates as early as the December 12th meeting, there is now a good case in arguing for going long homebuilder stocks, as they have historically outperformed whenever the Fed starts cutting the Fed Funds rate.
Let us now discuss the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:
For the week ending September 8th, the Dow Industrials and the Dow Transports both declined – the former by 72 points while the latter 115 points. While the continuing decline of the Dow Transports is certainly not encouraging (especially in light of significantly lower gasoline prices), it is at least encouraging to see that the Dow Transports is still 53.42 points above its August 11th closing high of 4,141.62. In order for the stock market to embark on a sustainable rally going forward, it is imperative to see the Dow Transports to continue to close above its August 11th low. And in order for a healthier rally going forward, it is imperative for the Dow Transports to close above its August 16th closing high of 4,421.05. Should the Dow Transports close below its August 11th low, we will dump our 50% long position in our DJIA Timing System and turn completely neutral, yet again. However, should the Dow Transports continue to hold above its August 11th low for at least another week or so, then this author will either go 75% or 100% long in our DJIA Timing System (implying an additional 25% or 50% long position). Readers please stay tuned.
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 latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 15.1% in the latest week. 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 1997 to the present week:
As I mentioned in our last three weekend commentaries, there was a good chance that this survey has now bottomed and reversed – “suggesting higher prices over the near future.” Since that time, the market has indeed risen higher, and given the further rise in the four-week moving average in the latest week to 15.1%, there is a good chance that we should see even higher prices in the weeks ahead. However, since we had just entered into a 50% long position in our DJIA Timing System last Thursday, this author will stand pat for now and see what this upcoming week has to bring.
Last week, I had introduced a new sentiment indicator that has worked well in the past and which I believe will continue to perform relatively well at least for the foreseeable future. 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 for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
As one can see from the above chart, the 20-day moving average of the ISE Sentiment is now at a level not seen since late October 2002, and has in fact declined further from last week's levels (from 111.5 to 108.7). Meanwhile the 50-day moving average is at a level not seen since March 2003 (declining also from 121.1 to 116.0). This suggests that the market has already bottomed or is in the processing of bottoming out (most likely the former).
Conclusion: While folks all around us are predicting a further stock market correction over the next couple of months, it is important to remember the one big difference between this past hiking cycle and virtually all the cycles prior to the 1994 to 1995 hiking cycle. The big difference is: Similar to the 1994 to 1995 rate hike cycle, this current cycle had been preemptive in nature – in that the Federal Reserve had attempted to “take away the punchbowl” as early as it can (in fact, as early as June 2004), while many of the past hiking cycles didn't actually start until inflation really got out of hand (e.g. the 1970s). In those previous cycles, the Fed ultimately had to raise the Fed Funds rate to 8% to 15% - thus not only crushing inflation but the rest of the economy and stock prices as well. The fact that this one has also been preemptive is evident by the popping of the housing bubble and the peaking of both gold and crude oil prices with the Fed Funds rate only at 5.25% (for comparison purposes, the Fed Funds rate peaked at 6% on February 1, 1995) – suggesting that the Fed does not have to raise any further – which should be a boon for both the stock market and the economy going forward.
As for the one big difference between the current hiking cycle and the 1994 to 1995 hiking cycle, it is this: While both had been preemptive in nature, the current hiking cycle had also been well-communicated in advance and did not involve any big increases (as opposed to a huge 75 basis point hike on November 15, 1994). This has the additional effect of significantly decreasing volatility in the financial markets – as evident by the lack of high-profile hedge fund blowups and stock market volatility over the last two years compared to the 1994 to early 1995 period (when many hedge funds were forced to close). In other words, there probably does not have to be a 10% correction in the S&P 500 before we see a sustainable rally going forward. Again, readers please stay tuned.
Henry To, CFA