Our Reasons for Turning Neutral on the U.S. Stock Market

By: Henry To | Thu, Jun 5, 2008
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Dear Subscribers,

I want to begin our commentary by reiterating the purpose of the MarketThoughts.com DJIA Timing System as well as our most recent signal to shift from a 100% long position to a completely neutral position on May 22nd at a DJIA print of 12,640. We covered most of our reasons in a broad manner in our "special alert" to subscribers on May 21st, but we will get into more details in this commentary. Suffice it to say, our stance remains the same as it was on May 21st.

Let us begin our commentary with a review of our 8 most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630;

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively.

We will update the performance of our DJIA Timing System after the end of this quarter. As of today, the performance of our DJIA Timing System is still beating the Dow Jones Industrial Average on both an absolute and a risk-adjusted basis over the last one, two, and three years and since inception.

The disease of the "two-armed economist" inherent in all financial market newsletter writers is unavoidable. Trying to forecast movements in the stock market or other financial instruments in general is a tricky and virtually impossible business over the long run. That is why - at least in my train of thought - I always engage in scenario analysis, and is constantly revising my "most likely" forecast on a day-to-day basis or as new information comes in. As has been quoted many times before, John Maynard Keynes, in responding to a criticism of his changed stance on monetary policy during the Great Depression is supposed to have said: "When the facts change, I change my mind. What do you do, sir?" That is why so many writers incorporate qualifiers into their commentaries when writing of a particular event that the writers believe may occur. The cynic in us would say that this allows newsletter writers to claim that they were right no matter what the stock market does.

It is difficult for me to avoid this type of "writing style" in our newsletter, since I am constantly reviewing my scenarios and adding new ones, as well as revising the probabilities attached to each scenario. It is especially difficult given the current market environment - as the probability of the "worst case scenario" has dramatically increased over the last 9 months, despite the Fed's intervention which eliminated a significant chunk of the tail risk in the U.S. banking system when it made its balance sheet available to the 23 primary dealers, including Bear Stearns. This is the major reason why we instituted on DJIA Timing System in the first place. That is, we wanted to find a way to communicate to our readers our position on the stock market in a concise and effective manner, with no ambiguities. While one of our aims is to educate our readers on the U.S. and global financial markets, much of these efforts would be futile if our subscribers could not make profitable investments or avoid a significant amount of the "tail risks." Having the DJIA Timing System would tie us down to a clear position in the U.S. stock market - and would also force us to be more disciplined and responsible for our words and actions.

As we have mentioned before, there were many reasons for our latest shift in our DJIA Timing System from a 100% long position to a completely neutral position on May 22nd. For those who did not get a chance to read our "special alert" sent to subscribers on May 21st, I urge you to do so now. For those who would like more details, I am now going to give you a point-by-point view of the indicators that we are currently tracking.


As we mentioned in our May 21st special alert, liquidity in the stock market is now waning. For example, primary liquidity - as evident in the growth of the St. Louis Adjusted Monetary Base (the only monetary measurement that the Fed directly controls) - has been growing at a negligible pace and is now down again after rising by a minuscule rate during late March to early April. The 52-week change in the ten-week moving average of the St. Louis Adjusted Monetary Base is now at 1.04%, the lowest reading since the 1.02% reading on February 27, 2008, and prior to that, the 0.24% reading on February 21, 2001. While the banking system should benefit from the steeper yield curve, all the recent cuts in the Fed Funds rate won't do much for the American consumer if the banks are not lending - and are instead, tightening terms in consumer and home equity lending. However, as I have reiterated in the past, the Fed is not impotent. Surely, the U.S. stock market and the U.S. economy would've suffered a great deal more if it hasn't been for the Fed's easing campaign and other liquidity easing policies since the beginning of this year. The Fed definitely "cushioned the blow" from the unwinding of the subprime/housing bubble, but given the recent trend in the St. Louis Adjusted Monetary Base (and other indicators which I will talk about), the stock market is definitely not out of the woods yet.

Stepping away from primary liquidity, we know that lending in the commercial banking system has remained, for the most part, robust ever since the credit crisis began. Part of this has to do with the immense recapitalization of commercial banks such as Citigroup, Wachovia, and Washington Mutual - an act that allowed these banks to continue lending despite their subprime losses. Another part of this has to do with the many lending commitments that these banks had made with U.S. corporations during the previous boom - many banks are now "on the hook" to lend to cash or liquidity-strained corporations even though they do not want to. On the consumer side, commercial bank lending is no doubt being reined in as we speak. Following is a monthly chart showing the year-over-year change in loans and leases held under bank credit of the U.S. commercial banks from January 1948 to May 2008:

Year-Over-Year Change in Loans and Leases Held Under Bank Credit (January 1948 to May 2008) - Four of the last six recessions over the last 60 years were preceded by a significant plunge and a subsequent dive to the zero line in the growth of loans and leases held under commercial bank credit. So far, we have not see much evidence that commercial banks are shrinking their balance sheets and curtailing lending - but from the spike in credit spreads and continuing write-downs, it is obvious that the *shadow banking system* has been actively shrinking its collective balance sheet.

As mentioned in the above chart, U.S. commercial bank lending is still relatively high - with a year-over-year growth of around 9.6%. However, it is to be noted that this reading is now at its lowest level since September 2004. More importantly, the global asset-backed market - the major liquidity creator over the last few years - is still effectively shut. Until the issuance of asset-backed securities and commercial mortgage-backed securities start to grow again (unlike the MBS market, there are no GSEs such as Freddie and Fannie that can provide liquidity in these markets by buying these instruments), liquidity will continue to be tight for both consumers and corporations alike.

From a stock market specific standpoint, many stock market liquidity issues that I track, such as the amount of insider buying, secondary offerings and company buybacks, and the amount of investable capital sitting on the sidelines have also been deteriorating. For example, after being very active in the second half of last year, many sovereign wealth funds have now refused to participate in any significant recapitalizations in the Western financial system over the last few months, forcing many of these entities (such as AIG and RBS) to seek funds by selling debt and equity in the secondary markets, sometime at great discounts. Not only has this significantly diluted existing investors, but it has also taken liquidity away from many institutional balance sheets. At the same time, many of these financial institutions are still in "balance sheet building mode," and are not utilizing this newfound capital to do any new lending. In the meantime, many of these sovereign wealth funds are instead choosing to invest in their own domestic economies, thus putting further pressure on commodity prices, which are consequently straining the balance sheets of consumers all around the world.

Moreover, from an institutional standpoint, many U.S. defined benefits pension funds, endowments, and foundations are still overweight U.S. equities - and are continually seeking to not only "diversify" away from U.S. equities, but also equities in general into bonds (mainly asset-liability matching strategies), real estate, commodities, hedge funds, infrastructure funds, and so forth. This is what I am currently seeing - and is also a point that Mohamed El-Erian (co-CEO and co-CIO of PIMCO and former President of Harvard Endowment) mentioned in his most recent Barron's interview and in his new book "When Markets Collide." Following is (courtesy of Barron's and "When Markets Collide") a typical portfolio allocation that El-Erian recommends for institutional investors:

Portfolio for a New Era

Given that the typical institutional portfolio has around 35% to 50% allocated to U.S. equities, any short-term buying power coming from institutions - short of a significant pension contribution from GM, IBM, or GE - should be minimal at best. More importantly, investors such as Mohamed El-Erian are regarded as leaders and shrewd investors by the investment management industry and by institutional investors. Given that CalPERS is essentially holding the same view (they are still actively "diversifying away" from U.S. equities into international equities and other asset classes such as infrastructure investments, hedge funds, etc.) and given that CalPERS is also regarded as a leader by other pension funds, my sense is that this trend will hold for the foreseeable future. Bottom line: Institutional investors are no longer a source of liquidity for the U.S. stock market - and may actually be actively taking liquidity away from U.S. stocks as we speak.

Technical Indicators

In our May 18, 2008 commentary ("The Message of the NYSE A/D Line"), we asserted that the weak breadth in the stock market coming off of the mid March lows (as evident by the dismal action of the NYSE Common Stock Only Advance/Decline Line) should be expected, given the continuing deleveraging in the U.S. economy. We also stated that this was not without precedent, as the NYSE A/D line was also very weak coming off of the October 1990 lows, as the smaller and weaker firms of the U.S. economy go out of business due to a weaker economic environment and lack of financing options. However, the much larger companies, such as those within the Dow Jones Industrial Average or the S&P 500 should not only be relatively immune (especially since nearly 50% of their net income now come from foreign economies) but should also benefit from this deleveraging, as a significant amount of competition from the much smaller firms should go away.

Unfortunately, the NYSE CSO A/D line has continued to weaken since our May 18th commentary. More ominously, even the A/D line for the components within the Dow Jones Industrial Average has gotten progressively weaker (note the lower high in the DJIA A/D line despite the higher high made since late February), as evident in the following chart courtesy of Decisionpoint.com:

DJIA Net Advances and Declines

Given this ominous divergence in the DJIA A/D line vs. the Dow Industrials, we are simply not comfortable in staying invested in our DJIA Timing System for now.

More follows for subscribers...



Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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