A World of Financial Engineering

By: Henry To | Mon, Sep 12, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of Friday at the close, the Dow Industrials stood at 10,678.56 - putting us at a slight loss of 62.56 points. We continue to maintain that the current rally is not sustainable - with two to three weeks to go at the most. This position is consistent with the loss of rallying power within the major brand names (as well as in the homebuilding and financial stocks), the underperformance of the Dow Jones Transportation Average, the drain of global liquidity as well as the fact that this cyclical bull market is now in its late maturity phase. We will continue to remain 25% short in our DJIA Timing System until further notice - but don't be surprised if we move to a 50% short position (which is our maximum allowable short position) in our DJIA Timing System within the next two to three weeks.

An update of our latest Market Poll on the U.S. Housing Bubble: So far, we have had a pretty good turnout in this poll - 224 votes in all. A whopping 69% thinks that the U.S. housing bubble is in the midst of topping out, while 15% does not think this is the case. The rest is neutral. Again, please vote if you haven't already done so and please also let us know what your thoughts are on the U.S. Housing Bubble (or lack thereof if you don't agree) by replying to our post in our discussion forum.

Here at MarketThoughts, one of our primary concerns is our readers' sense of well-being (financial as well as a sense of security) as we move forward into the 21st century. Ever since we seriously started writing our commentaries about 15 months ago, we have written a lot on issues we are concerned about going forward - such as aging demographics in the developed world, our aging energy infrastructure, as well as other trends that will continue to be relevant in the 21st century - such as globalization, offshoring and outsourcing, and the continuing rise of the information/knowledge worker age. We will continue to ask questions and as new concerns creep up on our radar screen, we will inform our readers about them and seek potential solutions. Questions such as: How do we protect ourselves from being laid off from our current jobs, and if we do get laid off, how do we find new ones? Also, how do we protect ourselves from the housing bubble? If you are a full-time or serious investor, a spin off of that question could be: How do we protect ourselves from our emotions? And what are the necessary traits for long-term success in the markets? Readers who are interested in the latter should read our "On Jesse Livermore And His Legacy" article if you haven't already done so.

Today, the United States has the largest capital and the transparent market in the world, and yet with the exception of corporations, we as individuals have relatively few ways of hedging our risk - such as losing one's job, being hit by a life-changing disability, or being unsuccessful in one's chosen career. If Robert Shiller (author of the famous book "Irrational Exuberance") has his way, however, most of these risks that we suffer as individuals will be hedgeable in the not-too-distant future. In his latest book "The New Financial Order," Shiller envisions a somewhat utopian world where finance (the age-old issue of risk management) is "democratized," i.e. a world where everyday individuals will gain access to a futures market that will allow them to diversify away every risk imaginable. Shiller presents the following six incredible ideas:

  1. The concept of livelihood insurance, where contracts will protect individuals from long-term economic risks such as the loss of a paycheck or the depreciation of one's home value.

  2. The concept of what he terms "macro markets" - where individuals, corporations, and governments alike can trade or hedge risks associated with the fluctuations in GDP or national incomes.

  3. The concept of income-linked loans - where lenders will make loans to governments, corporations or individuals whose repayment terms are tied to the incomes of these entities. Such repayment terms could be a certain percentage of one's income, which would cause the outstanding balance to decline if income levels decline. This would reduce the change of bankruptcies but will also alleviate our fears of taking more risks (such as changing careers). Shiller also addresses the potential "moral hazard" problem of this approach in his book.

  4. The idea of inequality insurance - which is designed to address the income inequality problem within a particular nation.

  5. Intergenerational Social Security - which will allow "genuine and complete intergenerational risk sharing" - as opposed to today's Social Security program (which is basically a pyramid scheme) in the United States today.

  6. International Agreements - which will allow sovereign governments to manage the risks of their own national economies - by sharing their risks with other sovereign governments.

Any one of the above ideas is controversial in itself, but as Shiller points out, many such insurance or futures contracts were controversial before their widespread adoption. The most controversial of all proposals could very well be the massive database that Shiller suggests will be capable of handling all this (public as well as private) information - a database which is necessary if we were to implement any one of the above ideas. As of this writing, Robert Shiller is working with the Chicago Mercantile Exchange to implement a derivative market for housing prices, which would "provide homeowners with tools to help them protect the value of their largest asset." The message is clear: Financial engineering in the single-family home market (a $22.3 trillion market) relative to the NYSE and the NASDAQ which consists of domestic securities worth $13.3 trillion, and $3.6 trillion, respectively) is inevitable.

One has to wonder: If we were all just beginning college again, which career should we choose, assuming we have no personal preferences? Since the Renaissance and the subsequent development of probability theory and risk management, a career in finance has been relatively rewarding - as long as one grew with the industry. With the exception of the Great Depression, a career in finance has always been relatively insulated, through wars and other calamities alike. GaveKal has shown that the "inflection point" for the acceleration of the financial services industry is an average individual income of US$15,000 - which means that (and as one can see) only the U.S., Western European, and Japanese financial markets are relatively developed (and still the demand for financial services continues to grow). As the wealth of the average Chinese and Indian citizen grows, however, the need for a much larger global financial service profession will literally explode (see our link to the article "Financial Engineering Grows in India" on Financial Engineering News). In such a world, getting a CFA Charter, a FRM designation, or a MBA wouldn't hurt either.

Some of our subscribers will lament this development, and they have every right to be. After all, didn't portfolio insurance nearly cause the meltdown of the financial system in October 1987? What about LTCM in late 1998? Not to mention Enron - which tried to create a futures market for everything under the sun, including bandwidth, wine, and weather. At the same time, financial engineering has allowed sovereign governments to borrow from individual investors like you and us, which has allowed lenders to diversify their risks. No longer will a single event like the "Tequila Crisis" threaten the stability of major financial institutions. Moreover, securitization in the housing markets is a reason why I do not think a housing slowdown in the U.S. will alone cause a nasty recession. 20 years ago, I would have felt differently, as banks could not have diversified away their risks in the mortgage markets. At this point, the jury is still out - but being a relatively optimistic person, I am open to new ideas, especially when it comes to finance.

Okay, now let's get on with your commentary. Many commentators are now asking the question: Will the Federal Reserve hike the Fed Funds rate in their next meeting on September 20th? Both in our commentaries and in our discussion forum, I have stated my position: "Yes." I discussed the upside surprise in the ISM index, as well as the fact that many governors are still very hawkish in their speeches. Moreover, a hike on September 20th will work to further restore the integrity of the U.S. Dollar, which we desperately need given increased imports of oil & gasoline, decreased exports of soft commodities such as wheat and corn, and a significant increase of the Federal budget deficit this year given the Federal aid to victims of Hurricane Katrina. A further reinforcement of this hawkish position is the fact that inflationary pressures in the U.S. are now increasing - as evident by the five-year high in the ECRI Future Inflation Gauge for the month of August. Such inflationary pressures are further confirmed when one takes a look at the following chart - which shows year-over-year increases in productivity vs. year-over-year increases in unit labor costs for the American economy from 1982 to the 2nd quarter of 2005:

Y-O-Y Change in Output Per Hour (Productivity) vs. Y-O-Y Change in Unit Labor Costs (1982 to 2Q 2005*) - 1) * Note: The 1Q & 2Q 2005 percentages are obtained from comparing the productivity and unit labor costs to the 1Q & 2Q productivity and unit labor costs in 2004. 2) Productivity for the 2nd quarter of 2005 came in at a five-year low, while unit labor costs haven't been this high since the year 2000!  My guess is that the Fed will hike its Fed Funds rate in the September 20th meeting.

As shown on the above chart, the increase in productivity for the second quarter of 2005 most recently came in at a five-year low. At the same time, unit labor costs jumped to a high not seen since the year 2000. Prior to 2000, one would have to go back to 1990 to see a similar reading, and to 1982 for a higher reading. Given the lack of increase in productivity and corresponding inflationary pressures on unit labor costs, one would have to assume that the Federal Reserve will hike on September 20th. Finally, while Hurricane Katrina is expected to cost over $200 billion in damages (significantly more than initially estimated), the cleanup is expected to be much quicker than initially thought. The fact that the stock market rallied over the last two weeks may also give the Federal Reserve more comfort in hiking the Fed Funds rate on September 20th.

So much for what we think the U.S. Federal Reserve will do and how it will impact the U.S. markets. Let's now discuss the global economy in the context of our MarketThoughts Global Diffusion Index (the MGDI) and the implications of the performance of this index going forward, especially with regards to energy prices. The latest OECD leading indicators has just been released, and with it, we have updated our MGDI to reflect the latest data as of the end of July 2005 (for a revision of how the MGDI is constructed, please see our May 30th commentary). The following chart shows the historical correlation of the performance of the MGDI vs. the CRB Energy Index, whose components include WTI crude oil, natural gas, and heating oil (please note that our MGDI is updated to July while everything else is updated to August 2005):

Global Diffusion Index (GDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to July 2005) - Historically, the rate of change in the GDI has also led or tracked the YoY% change in the CRB Energy Index very closely.  Again, note the recent divergence - they should converge in due time - which will mean much lower energy prices ahead.

A peak in the world supply of oil notwithstanding, both crude oil and natural prices should continue to decline in the coming months - given the continuing weak performance in the MGDI. This author is calling for crude oil to at least decline below the $55 level while natural gas should also see much lower prices. That being said, please note that the above data only goes back to March 1990. That is, the growth in economic activity around the world has also meant higher demand in energy, which prompted more exploration and drilling when prices are high - but which will subsequently depress prices once more production came online. Given only its 15-year history, the above chart does not account for two things:

  1. An extended period of time where supply is constrained - such as an extended shut-in of natural gas production in the Gulf of Mexico, or a peak in Saudi Arabian oil supply.

  2. The recent explosion of demand in mainland China, and the expectation that the same demand situation will occur in India in the next three to five years. There is just no record of anything like the increase in Chinese energy demand in recent history.

As of right now, this author isn't doing anything in the energy arena, especially in natural gas (where we have seen no relief in natural gas supply and where there is still a reasonable change for a colder-than-expected winter). Keep in mind, however, that a falling oil price isn't necessarily bullish for the stock markets. In fact, a falling oil price (similar to a halt in the Fed Funds rate increases) is a leading indicator of falling global economic activity, which really isn't bullish for the stock markets at all. As I have mentioned before, when the Federal Reserve decided to start cutting the Fed Funds rate in January 2001, the market did not bottom until 22 months later.

Moreover, at this point, the chance of a further global economic slowdown is still very real - and global liquidity is nothing to write home about either. The recent surge in both Japanese and German equity prices on the anticipation of "radical" economic reforms is overdone, in this author's opinion, as reforms are virtually always painful in the short to intermediate term. That is, the reforms that are going to be carried out should actually impede economic growth for the foreseeable future. Will Japanese and German citizens revolt against further reforms if their economies continue to slow down in the near future? Will the equity prices of these two countries fall back to Earth (as I see it, the only thing that is supporting this rally in Japanese equity prices is their low valuations)? We should find out in the coming months.

Let's now turn to the U.S. stock market. The action over the last week definitely troubled us a little, but after reviewing all our indicators (most of which we have already discussed during the last couple of weeks), we have decided to stick to our 25% short position in our DJIA Timing System. Let's further explore why by first taking a look at the most recent market action with the following daily chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to September 9, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) For the week, the Dow Industrials rose 231 points while the Dow Transports declined 30 points - the second consecutive week where we experienced a negative divergence on the part of the Dow Transports from the Dow Industrials.  This author believes that this is a bearish development, as the Dow Transports has been the leading Dow index ever since March 2003.  I don't believe this time will be any different. We will stay with our 25% short position in our DJIA Timing System - with a possibility of going to a maximum allowable 50% short position within the next two to three weeks.

Prior to the action of last week, if you had told me that the Dow Industrials would rise by 231 points and that crude oil prices would decline five dollar a barrel at the same time, I would have definitely called for a corresponding percentage increase (if not more) in the Dow Transports, especially since the Dow Transports had been lagging the Dow Industrials since two weeks ago. As it turned out, however, the Dow Transports declined 30 points instead - suggesting that lower oil prices ahead are not necessarily bullish. As I have also discussed several times before, the Dow Transports has been the leading Dow Index ever since the March 2003 bottom - suggesting that the Dow Industrials should follow through on the downside in the weeks ahead. I am surprised that no other commentator has talked about this recent negative divergence on the part of the Dow Transports - which just makes it a more authoritative indicator (once an indicator becomes popular, it loses its usefulness). For now, we will stay with our 25% short position in our DJIA Timing System, but don't be surprised if we switch to our maximum allowable short position of 50% should the Dow Industrials continue to rise within the next two to three weeks.

The recent action of the NYSE McClellan Summation Index is also confirming the weakening action in the major indices, as shown by the following chart courtesy of http://www.decisionpoint.com/:

Weakening action in the McClellan Summation Index in early March preceded a significant top in the NYSE Composite.  Is history about to repeat itself?  We think so&

As readers can see from the above chart, the early March higher high in the NYSE Composite (and also the Dow Industrials) was not confirmed by the McClellan Summation Index - which acted as a precursor for a significant drop going into mid April and early May. Please also note that the recent higher high in the NYSE Composite is again not confirmed by a higher high in the McClellan Summation Index. Moreover, the late July/early August 2005 high in the McClellan Summation Index did not exceed the December 2004 high- suggesting that breadth is getting weaker and weaker going forward. My guess is that any upcoming decline in the major indices will be the most severe we have seen since the July to August 2004 decline.

Let's now take a look at our most popular sentiment charts - starting with the Bulls-Bears% Differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey rose from negative 6% to positive 9% in the latest week - still vacillating around the zero line.   Going forward, this author believes that this survey will need to get more overbought before the market will sell off again.  However, given that the Dow Industrials has been one of the weakest indices since October 2002, we will stay with our 25% short position in our DJIA Timing System for now.

During the latest week, the bulls-bears% differential in the AAII survey enjoyed a slight uptick - coming in at a reading of 9% from the negative 6% reading of last week. The four-week moving average is now at negative 0.8%, which is moderately oversold - suggesting that there is potential for further gains in the next two to three weeks. As a matter of fact, this is currently what this author is betting on. For now, we will remain 25% short in our DJIA Timing System, as two or three weeks more worth of gains is nothing to fret about - especially given the fact that the Dow Industrials has been the weaker index ever since the last cyclical bear market ended in October 2002.

The Bulls-Bears% Differential in the Investors Intelligence Survey, meanwhile, held steady in the latest week - as the bulls-bears% differential increased from 23.8% to 24.0%. Moreover, the four-week moving average reading (28.6%) is no longer overbought:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey remained fairly steady in the latest week - rising from 23.8% to 24.0%.  The four-week moving average of this reading is also no longer overbought at 28.6%.  At this point, however, this author does not suggest initiating any long positions until this reading reaches a more oversold level.  The message remains the same: We will remain 25% short in our DJIA Timing System.

The message remains the same from last week: The most recent readings in both the AAII survey and the Investors Intelligence Survey were not oversold enough to signal a sustainable market bottom and a sustainable market rally up ahead. In our humble opinions, the most recent rally signals only signals a pause in the most recent downtrend, and should have further room to go on the downside. The lack of an oversold condition is also evident when one looks at the most recent readings from the Market Vane's Bullish Consensus:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus inched down again increased from 62% to 65% in the latest week - while the ten-week moving average of this reading declined slightly from 66.3% to 66.1% - which is still in overbought territory.  This continues to be a red flag for the bulls, given that the Market Vane's Bullish Consensus is still in a downtrend and  had reversed from a highly overbought level.  The Market Vane's Bullish Consensus is still signaling more downside in the coming weeks.

During the latest week, the Market Vane's Bullish Consensus increased from a reading of 62% to 65% - the first increase in this reading in five weeks. As I outlined in the previous paragraph, however, the most recent reading of 62% is definitely nowhere near oversold enough to signal a sustainable bottom - thus paving the way for further downside within the next two to three weeks. The fact that the Market Vane's Bullish Consensus got so overbought during the month of July tells me that we are in for some rough action after this near-term rally runs out of steam.

Conclusion: As we move forward in the 21st century, one thing that we will definitely see is a continuing trend in financial innovation and the widespread adoption of those new financial products - not just in the United States but also in up-and-coming countries such as China and India. As the citizens of these latter countries acquire more wealth and obtain more education, the demand for financial services will literally explode. The bears who continue to caution against an explosion of hedge funds and the derivative markets will no doubt lament this development, but this author is relatively optimistic. Barring a worldwide economic recession or depression, the world for financial services professionals will be a very bright world going forward.

As I have outlined in the last few weeks and in this commentary, this author is still relatively bearish on the short-term to intermediate-term trend. This bearish view is further reinforced by my belief that the Fed will again hike the Fed Funds rate on September 20th - which is further compounded by the lack of breadth as evident from the NYSE McClellan Summation Index. For now, we will remain 25% short in our DJIA Timing System - and possibly looking to go 50% short in the coming weeks should the major market indices continue to rally during that time.

Signing off,


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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