Where Does the Evidence Point To?

By: Henry To | Tue, Mar 7, 2006
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Dear Subscribers,

The latest issue of Newsweek features a cover story on India. And this author has to wonder: The Newsweek cover story on the "bear market" in the U.S. dollar in the beginning of last year called the bottom of the U.S. dollar almost to the day. Given its "very reliable" historical record as a contrarian indicator in the markets, one has to wonder: Is the Indian market about to suffer a huge correction here? Note that from its most recent bottom in May 2005, the BSE 30 has appreciated from 6,000 to 10,500 today. As recently as November 2005, this index was trading at slightly below 8,000. As I mentioned in our February 19th commentary, the India fund (a closed-end fund) is now trading at a huge premium (to its NAV) of approximately 30% - and was trading at a discount as recently as June 2005. Time will tell.

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,021.59), this position is 151.59 points in the red - but again, given that the market is now showing signs of a classic "blow off" top, this author is betting that this position will ultimately work out.

In last weekend's commentary, I stated that: "If we do see some more [strength in the Dow Industrials on relatively low volume and dismal breadth] on Monday or Tuesday, then this author will "break tradition" and go 75% short in our DJIA Timing System. Such a position is a very bold move on our part - but since both the financial markets and the stock markets of the world are showing signs of a classic top - this author is willing to stand both the criticisms and the volatility. Let me be clear: We are still in a secular bear market. The era of disinflation that supported a secular increase in P/E ratios during the 1980s and 1990s ended in 2000. It does pay to be a trend follower most of the time, but not when bullish sentiment is rampant and not when the market is hugely overbought and showing many signs of divergences. This author is now choosing to take such a stand." Keeping true to our word, we added a further 25% short position on Monday afternoon (February 27th) at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We sent a special alert to our readers on Monday afternoon and a further clarification email on Tuesday morning. As of Friday at the close, this latest short position is 102.41 points in the black. We anticipate covering this latest 25% short position once the market gets to a more oversold or neutral level in order to control for volatility. Clues to look out for: A daily NYSE ARMS Index of 2.0 or over, a daily jump in the VIX of 10% or over, and so forth. We will send our readers a "special alert" through email the moment we cover this latest 25% short position and (hopefully) take our profits.

The "gist" of this commentary does not change from last week's - divergences, huge leverage, and declining global liquidity all in the face of extremely bullish complacency are all pointing to a down market in 2006. I would like to repeat the following paragraph from last weekend's commentary: "In our many commentaries over the last few weeks, I discussed the many divergences in the current stock market - citing the recent "market top" study done by Lowry's Reports, as well as relative strength of the Bank Index, the retail HOLDR (RTH), the weakness of the McClellan Summation Index in the Dow Industrials during 2005, the further deterioration of our MarketThoughts "Excess M" (MEM indicator), the flattening/inverting yield curve, and the continuing weakness of the commodity currencies (AUD, NZD, South African Rand) with the exception of the Canadian dollar. At the same time, complacency is now at extremely high levels, as evident by record low emerging market spreads, record low option premiums (as exemplified by the historically low VIX and the record low Merrill Lynch MOVE Index), and extremely high bullish sentiment in our three popular sentiment indicators as well as the Conference Board's Consumer Confidence Index. And if that wasn't enough, the amount of leverage in the world financial system is now at unprecedentedly high levels - as evident by the exponential increase in derivative volumes on the CME, the CBOT, and the ICE. The growth in derivative trading in East Asia has been the most notable. Derivative contract trading on the Korean stock indices surpassed $12 trillion in the third quarter of 2005 - surpassing trading in U.S. domestic stock index derivatives for the first time in history. According to the BIS, total derivative trading on all international exchanges totaled $357 trillion during the third quarter of 2005, or approximately six times the world's annual GDP. This is further evident with the explosion of LBO and private equity deals - and more recently, with the resumption of the Yen carry trade. All of this - combined with global tightening liquidity conditions - make this a very dangerous market to be long of at this point. From a macro standpoint, all eyes should now be on the Bank of Japan (and the Yen, since most of the borrowing nowadays is done in Yen) as well as the Canadian dollar."

I just cannot emphasize the above paragraph enough. Make no mistake: Global liquidity has been and is still declining. The one currency which has continued to give "hope" and funding to the bulls and hedge funds has been the Japanese Yen - resulting in the all-too-familiar "Yen carry trade." Given that the Bank of Japan is about to end its "quantitative easing" policy (scheduled to come in April although some analysts have speculated as early as the coming week), there is a strong chance that global liquidity will take a further dive in the coming weeks.

In last weekend's commentary, I provided further evidence that the market is in the midst of topping - citing the record drop in NYSE short interest and the continuing decline in relative strength of the consumer discretionary sector. This was further confirmed by the release of NASDAQ short interest later on Monday. In our Tuesday morning's "Clarification" email, I stated: "Short interest for the NASDAQ for the month ending February 15, 2006 was just released, and it is not a pretty sight for the bulls - as short interest declined 84 million shares for the month, representing the highest monthly decline since July 2005 (when it declined 87 million shares). The three month rate of growth is now negative 1.9% - representing the greatest rate of decrease since December 2004 (and we all know what happened afterwards). Since February 15, 2006, the NASDAQ Composite has rallied approximately 30 points - suggesting that more shorts have been squeezed out of the markets since that time. Combined with the huge decrease in NYSE short interest for the month ending February 15, 2006, one can conclude that this rally is now on shaky grounds - especially given the low VIX, and the huge complacency (and extreme leverage) in the world's bond markets and emerging market securities."

I would like to take this chance to reiterate to our readers this: Continue to focus on the big picture as opposed to the day-to-day action in the stock and financial markets. Why? The day-to-day action of the markets is nearly purely random - and thus the day-to-day action is very deceptive and can "throw you off" your trading/investing discipline if you choose to focus on the day-to-day action as opposed to focusing on the big picture. Focus on weekly charts instead of daily ones. Read annual reports and evaluate companies on a longer-basis instead of focusing purely on the latest quarterly earnings statement. Markets do not turn on a dime, and neither does a well-run company. Signs of trouble are usually evident months ahead of the impending drop in stock prices. Case in point: S&P downgraded Russian debt as early as Christmas 1997. And yet by early August 1998, world bond volatility was still near an all-time low. A mere two months later, the Dow Industrials was more than 1,000 points lower.

As human beings, we tend to be overly optimistic and we also tend to extrapolate recent experience into the distant future. The events of 1998 (Russian, Brazilian, and LTCM crises) were one such example. Everything was pointing to a potentially huge financial crisis as early as the summer of 1998, and yet investors and traders alike did not start to focus on them until it was too late. Such over-optimism has been constantly witnessed in the history of human events - affecting even the most astute of leaders at times. Writing to the First Sea Lord on Christmas Day 1939, Winston Churchill reported: "... in France the lines run along the frontiers instead of six or seven of the French provinces and Belgium being in the enemy's hands. Thus I feel we may compare the position now very favourably with that of 1914. And also I have the feeling (which may be corrected at any moment) that the Kaiser's Germany was a much tougher customer than Nazi Germany." Within six weeks of a German invasion into France on May 9, 1940, the French government surrendered.

Of course, by the end of this year, this author may indeed be eating humble pie - but all the evidence is currently pointing to at least a slowdown in the economy and a significant correction in the stock market during 2006. Perhaps the chart that epitomizes the current situation (both in the financial markets and the "real" economy) the best is our weekly chart showing our MarketThoughts "Excess M" (MEM) indicator vs. the St. Louis Adjusted Monetary base vs. M-3. As readers may recall, our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.
  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.

Following is the weekly chart of our MEM Indicator vs. the Monetary Base vs. M3:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 (April 1985 to Present) - Speculators continues to be aggressive in the face of the Fed reining in the monetary base. Our MEM indicator perked up slightly from a bottom of negative 4.49% a few weeks ago to negative 4.05% in the latest week - but is still at its lowest since Jan 2002. This does not bode well for the markets going forward.

The green line above is telling us that the Fed is indeed tightening - but at the same time, the pink line is showing that both commercial banks and speculators alike are trying to "fight the Fed" and continuing to take on risks. This speculative nature of the general population in the midst of Fed tightening is being reflected in our declining MEM indicator (blue line). Today, this bullish complacency is also being reflected in record low implied volatility in the stock, bond, and currency markets - as well as record low emerging market spreads. Given this historically low implied volatility, the hedge funds have no choice but to continue to leverage up - said phenomenon being reflected in the continuing increase in exchange margin debt, exponential increases in exchanged traded derivatives (especially in Asia), as well as pension and mutual funds "diversifying" into more "exotic" investments such as commodities and timberland. As evident from the above chart, our MEM indicator touched a low of negative 4.49% a few weeks ago, representing the most negative reading since January 2002. The only source of funding (with the European Central Bank tightening and being hawkish as well) left in the world today and that is holding the financial market together is the Yen - and given that the Yen carry trade is now in danger of ending, there is a good chance that liquidity will literally "fall off the cliff" within the next couple of months.

I apologize - but I just got a call from my folks telling me that they were in a minor car accident so the rest of this commentary will be a little more abbreviated. Hope all of you don't mind!

In last weekend's commentary, I stated that "timing is of the essence" when it comes to calling tops in the stock market. I realize that this is a dangerous game, and many stock market operators over the decades have gotten burned with calling tops before. Anybody remember Jacob Little? Of course you don't - and even if you do, you may not have nice things to say about him. Of course, this author does not manipulate stocks, and nor does he spread rumors about certain companies, but nonetheless, bears are usually not welcomed on Wall Street. Besides, as JP Morgan likes to say, nobody has ever gotten rich by "selling America short."

This author would agree with that - but then many an investor and wealthy family have managed to keep their wealth by selling at the right time. Moreover, many investors and wealthy families also started acquiring their wealth by having cash on hand during a "panic" or recession and subsequently using that idle cash to buy securities, junk bonds, or real estate. If one can avoid "the big loss" and buy at the right time - just once in his/her life - then one will be ahead of 99% of all Americans when it comes to investing. This has always been and will continue to be our intentions: To keep our readers from taking the "big loss" and to help our readers deploy their capital at the most opportune time.

Going back to our previous paragraph, however, it is important to keep in mind that "timing is of the essence." Can this author be wrong about the stock market topping out in the next couple of months and subsequently experiencing a significant correction for the rest of 2006? Of course I can - after all, I am only human. However, I am a great believer of studying history and also of studying probabilities. Using this knowledge, I try to formulate "the most likely scenario" and other alternative scenarios going forward. This has served me well over the years, and hopefully this will continue to serve me well. Like I said before, all the evidence now points to a significant correction later this year - and even if I am wrong, I don't believe the bears will suffer a great deal either. Looking at the VIX, outstanding short interest on both the NYSE and NASDAQ, margin debt, and recent mutual fund inflows, probability does not suggest of a sustainable stock market rally going forward.

Let me try to illustrate further. Many analysts and "experts" have been comparing the most rate hike scenario with that of the 1994 and early 1995 rate hike scenario - claiming that once the Federal Reserve halts its rate hike campaign, the stock market will take off on the upside. In our February 23, 2006 commentary ("What the Investment Folks are Really Saying"), I dispelled this notion, stating: "... this author cannot disagree more - as the experience of most Fed hiking experience is for the market to decline AFTER the Fed is done with hiking rates. The market has already been rising during the rate hike process (because of the fact that the economy is still going strong) - can the market continue to go up once the Fed is done? Again, I agree with Trahan [Chief Investment Strategist of Bear Stearns] - that this current stock market is unlike that of the bull market in the 1980s and 1990s - when the secular trend of disinflation had caused a secular rise in the price-to-earnings multiple of the stock market. Going forward, the performance of the major market indices such as the S&P 500 will be more or less tied to economic cycles - therefore, the economic slowdown that I have been looking for (which Trahan is also looking for) should lead to an upcoming period of lackluster returns for the stock market. Essentially, the Fed is going to continue to hike rates until both the commodity markets and the stock market "cracks." If one compares the current stock market experience to that of the 1960s, one should witness a significant top about a month before the last Fed rate hike (i.e. either close to February 28th or April 10th), and a subsequent "relief rally" after the last rate hike (you can surely bet Wall Street will tell investors to get into the market en masse once the Fed is done) which should take us to a lower high. Unfortunately, for most investors, any relief rally after the last rate hike should be sold - and SOLD HARD." In other words, the 1994 to 1995 scenario should be treated as a unique scenario, not as the rule.

The erroneous comparison is also obvious if one takes a look at the bullish sentiment levels over the last couple of years vs. the sentiment levels experienced by investors during most of 1994. As our regular readers should know, we have always liked to use the various sentiment surveys from the American Association of Individual Investors (AAII), Investors Intelligence, as well as from Market Vane. In doing the following comparison, we have taken the average of the Bulls-Bears% differentials in these three popular sentiment indicators (and smoothed it on a rolling four-week basis) and plotted it from July 1987 to the present:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (July 1987 to Present) - many folks have compared the current rate hikes to those during 1994 - is this justified?

Please note that in July 2004, the Bulls-Bears% differential average in these three surveys was at negative 18.9%. Conversely, the lowest reading we have obtained so far in the last two years is POSITIVE 8.5% during early April 2005. As of the latest week, the current reading is still much closer to an all-time high than an all-time low - suggesting the comparison between the 1994 to the current time period is inherently flawed. More importantly, the record high readings over the last two years have for been more associated with significant tops in the stock market than significant bottoms - suggesting that we are most likely in the midst of forming a top here.

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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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