By Jeffrey Saut | 26 November 2007
... A precept of Dow Theory is that neither the duration nor the extent of a bull or a bear market can be predicted in advance. It is far easier to IDENTIFY the end of a bull or bear market than it is to predict their end. Bull markets tend to build extended and often deceptive tops while bear markets tend to build more definite and identifiable and faster bottoms. Therefore, it's usually easier to identify the bottom of a bear market than it is to identify a bull market top. ... I expect a lot of wild and confusing movements from the stock market in the days ahead. But I remind subscribers that a rally here, even a powerful rally, will not mean that the bull market has suddenly been reborn. This bear market will not end in four months. But any rally here will allow subscribers to ‘trim their sails’." ... Richard Russell, Dow Theory Letters |
So wrote Richard Russell on Friday (11/23/07) opining on last Wednesday’s Dow Theory "Sell Signal" when the DJIA finally confirmed the D-J Transportation Average (DJTA) by closing below its August reaction low of 12845.78. We have read Richard’s missives since the early 1970s. We remember his bull market "call" of December 1974. Likewise, we remember his bear market "call" in the fourth quarter of 1999. As one of the few remaining interpreters of Dow Theory, when Richard makes such a "call," we pay attention; especially if it "foots" with our sense of the markets.
Recall that we have been cautious on the equity markets since mid-September, often remarking, "The time to be aggressively bullish was in mid-August (we were), not following a 1,500-point Dow Wow!" We further noted that bottoms tend to be a function of time and price; and, that while we had hopefully satisfied the "price" requirement, the "time" factor was still lacking. Subsequently, we suggested a downside retest of the August lows was in order. Unfortunately last week’s downside retest, while looking successful (read: bullish), rendered a classic Dow Theory "Sell Signal."
However, we have seen many decent rallies develop following a Dow Theory "Sell Signal" since such signals tend to come after a fairly significant decline. In this case, according to Dow Theory, the bull market ended on July 19, 2007, which was the last time the DJIA and the DJTA both recorded higher closing prices. Therefore, the bear market is already four months old. While only time will tell how events play out, we are cautious and would remind participants that since 1935 the average P/E ratio for the S&P 500 is 16x; and, that the current P/E ratio is 18.3x, making stocks somewhat of a neutral value in the aggregate [[actually, rather negative; the average P/E of 16x goes with average trailing earnings; the 'cuurrent' 18.3x P/E is for one to two deviations above future (2008) earnings: normxxx]]. Also of note is that on a trailing 12-month basis, earnings momentum has turned negative, implying forward P/E ratio estimates are questionable. That said, we still own a lot of stocks, but will continue to rebalance those positions like we have been doing with our beloved "stuff stocks" over the past number of weeks.
Clearly, the various markets are currently grappling with how events play out in the coming year. As the always insightful GaveKal organization recently noted, there are four possible outcomes:
Scenario 2: The Fed sticks to its guns, does not cut rates, and the U.S. economy really tanks under the weight of the credit crunch. In essence, the U.S. would move into a Japanese-style "deflationary bust." In this scenario, equities around the world, commodities, and the U.S.$ would collapse, while government bonds would go through the roof. Scenario 3: The Fed ultimately cut rates, but this fails to rejuvenate the system and get growth going again. This would likely mean stagflation. As such, gold and other commodities would do well, while stocks and the U.S.$ would struggle. Excluding bonds, this is increasingly what the market is pricing in today. Scenario 4: The Fed ultimately cuts rates, and succeeds in reigniting the economy. This would be good news for equity markets, commodity markets, and the U.S.$ (as world trade and foreign buying of U.S. assets would again expand, increasing the need for U.S.$s). Of course, this scenario would be terrible news for bonds.” |
GaveKal concludes by opining that the market is betting on Scenario 3 and thus one has to be concerned that the Fed’s hand could be forced by the market to cut rates. Cut rates indeed, yet history shows while the first rate cut is impactful, the second and third tend to be less so. This is demonstrated once again by the fact that the S&P 500 is already below where it was when the Fed cut interest rates for the third time on October 31st. Meanwhile, Treasuries have been rallying sharply and junk-bond spreads over Treasuries have expanded materially. This is not an unimportant point for the stock market’s outsized "winners" (energy, materials, commodities, industrials, anti-U.S. dollar bets, emerging markets, etc.) bottomed in 2001 concurrent with the narrowing of such credit spreads. Now that these spreads are widening, it could spell trouble for the overcrowded "long stuff stock, short U.S. dollar" trade that has made us so much money over the last six years (see the attendant chart from the invaluable service "thechartstore.com"). This is one of the reasons why we have been rebalancing our stuff-stock positions (read: selling partial positions and holding the balance in cash) and reducing our anti-dollar "bets."
Another reason we have tilted our strategy is a growing sense that what we may be dealing with is more of a solvency rather than a liquidity issue. Recently, many articles have dealt with certain financial institutions’ "Equity Base" being smaller than their exposure to "Level 3 Assets". Plainly, all these folks’ Level 3 Assets are not going to go bad, but the new FASB #157 accounting rule forces financial institutions to divide assets into three categories called Level 1, Level 2, and Level 3. Under FASB’s terminology, Level 1 assets can be marked-to-market (valued on real prices). Level 2 assets are marked-to-model (an estimate based on observable inputs). Level 3 assets, however, have been marked-to-myth until now. With FASB 157’s implementation it appears these assets will be much more stringently valued on the balance sheet, potentially raising "solvency" questions. Because the central banks are much less effective at dealing with "solvency issues" than they are with "liquidity issues" this too makes us cautious.
The call for this week: Due to the aforementioned observations, we find ourselves asking the question, "Has the leadership baton been passed to the 4Q07 leaders of utilities, techs, consumer staples, and healthcare?" If so, the daily list of "new lows" might be a fertile universe for ideas now that we are entering the "teeth" of tax selling season. While only time will tell, the recent decline "feels" different than the one we anticipated, and bought at the lows, of last summer. Moreover, when interest rates cuts are met by sinking stocks, and a Dow Theory "Sell Signal," it always makes us nervous! Nevertheless, "they" are going to try and talk-up last week’s action as a successful "retest" of the August lows and may just be able to get things going on the upside, which is why we are trading some "long" indexes like the S&P 500 Geared Fund (GRE/17.04) with a close trading stop-loss point in keeping with the George Soros quote, "Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."
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“I’m flat and I’m nervous."
November 19, 2007
. . . A European portfolio manager
"I’m flat and I’m nervous," is what one portfolio manager (PM) said to us as we wound our way through 11 European cities over the past 19 days. The reference was clearly to illustrate that while he was "delta neutral" on stocks, he was still nervous. And that, ladies and gentlemen, was our observation of the investment position du jour of roughly 300 PMs we interfaced with over nearly three weeks. Other observations included: why are there NO American cars in Europe?; why don’t Europeans wear sunglasses?; where are the joggers?; why are the airport bathrooms so clean in Europe?; and the list goes on. The other near ubiquitous observations were that every taxi driver was listening to American/British music, a unanimous opinion that the U.S. dollar is going lower, a reluctance to invest in U.S. stocks, and despisement of the Bush Administration and the situation in Iraq. Even the British are disgusted with Iraq, but it is not America and Americans that are despised. Indeed, a party was given for us in Paris with roughly 30 Parisians that we knew when they were living in America. To a one, they would move back to the U.S. tomorrow!
While I should probably not comment on the Iraq situation, I would suggest that thanks to the internet, and TV, the under 30 crowd has become extremely savvy as to what’s going on in the world. Manifestly, the younger generation is quite aware of the "popular culture" and they want to be part of it. The only thing standing in their way (in certain countries) is their governments. Consequently, anything that stifles their radical leaders, and allows the young people to gain political traction, should (over time) permit the "Iraqs of the world" to modernize and subsequently join the world’s society. We can already see hints of this dynamic in the underreported riots of Iranian twenty year olds against President Ahmadinejad.
Speaking to the U.S. dollar, we have been bearish on the dollar versus most of the world’s currencies since 2001. That was the view we carried to Europe six years ago along with the recognition that China was joining the World Trade Organization (WTO), which was likely to "kick off" a secular bull market in "stuff" (energy, timber, cement, agriculture, water, electricity, infrastructure, base/precious metals, etc.). We had remained steadfastly bearish on the dollar, and bullish on "stuff," until a few weeks ago. Indeed, 'short the dollar, long "stuff,"' has gained such popularity that it has become an "overcrowded trade." And, that’s why we told accounts we were reducing our anti-U.S. dollar "bets" and rebalancing most of our stuff-stock positions (read: selling partial positions and holding those funds in cash for the moment). Most of the European accounts were shocked about this reversal of opinion, just as shocked as they were when we first voiced the aforementioned anti-dollar strategy six years ago.
Nevertheless, we stood our ground when asked for a fundamental reason for turning bullish on the dollar, and while we don’t really have a fundamental reason, save the improvement in the trade balance, our mantra was, "It’s just too crowded a trade to be short the dollar right here. I don’t know if I will be bullish on the greenback for three months, or three years, but I do know I no longer want to be short." Concurrently, we have been bullish on the Japanese Yen since the low 80s (FXY/90.11), and while I didn’t make any money on this trade, many of our accounts did. Interestingly, year-to-date there is an amazing 93% correlation between the ups and downs in the world’s stock markets and the spread between yen and the euro. To wit, when the euro rallies against the yen, the world’s stock markets rally. The quid pro quo is that when the yen rallies versus the euro, stocks decline. In past missives we have written extensively about this tendency driven by the famed yen "carry trade," but that is a discussion for another time.
Other talking points from our European presentation included the U.S. consumer, the housing debacle, the subprime contagion, and the political situation; all of which should become much clearer over the next few months. Regarding the consumer, for decades our mantra has been, "never underestimate the American consumer’s ability to spend money even if they don’t have it." Said mantra has served us well. However, recently there have been some "tells" that the under-saved, overspent American consumer may finally be sated with debt. If the U.S. consumer has become unwilling to take on any more debt, it spells trouble for the Federal Reserve and suggests the Fed may be "pushing on a string."
As for housing, our real estate research team made a great "call" a few years ago by stating that the housing cycle was peaking and that before the downturn was over the homebuilding stocks would be trading at 80% of their book value. Before I left for Europe I had a discussion with that team’s leader (Paul Puryear), who told me with the homebuilders now trading at 80% of book value he would like to become more constructive on the group, but the numbers keep getting worse. Hereto, we think the next few months will provide more clarity as we enter the spring selling season and the mortgage resets expand at higher interest rates.
"The subprime situation is contained," is what we heard earlier this year when the word "subprime" crept into America’s lexicon. At the time we were skeptical and suggested the fallout from the subprime contagion was unknowable and it would likely take more time than most believed to sort things out. We still feel this way and would note that even the prowess of Citigroup (C/$34.00) can’t seem to ascertain the extent of the contagion, or value the opaque assets (CDOs, RMBS, etc.) in its own portfolio. What we find ironic is that all of this is occurring as the new FASB #157 accounting rules are being implemented (more stringent marking to the market of assets), while it looks to us as if the Structure Investment Vehicles (SIVs and SPIVs) are going to be moved from "off" balance sheet items to "on" the balance sheet items for many financial institutions. Even more ironic is that the more stringent Basel II banking standards are slated to "kick in" this January as things continue to get curiouser and curiouser.
On politics, Mark Twain remarked, "The political and commercial morals of the United States are not merely food for laughter, they are an entire banquet," . . . except in this case we are not laughing. To be sure, one of the things that continues to bother us is the movement by politicians toward protectionism, intervention, and regulation. This political rhetoric is going to torque-up as we enter the New Year. What you are going to hear regards increasing taxes on the rich. History suggests that when you hear this the middle class had best grab their wallets. Further, there is going to be more talk about raising the capital gains tax and eliminating the favorable tax treatment on dividends. How this plays out longer term is anyone’s guess, but we think it is a headwind.
As stated, we think there will be more clarity on the aforementioned points over the next few months, which is why we have been opining since mid/late-September, "the time to be aggressively bullish was in mid-August (we were), not following a 1500-point Dow Wow!" As written in our strategy report dated 9/17/07 ("Heads I win, tails you lose!"):
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The call for this week: Well we’re back. And we find it interesting that despite three interest rate reductions, the major averages are below where they were on the last rate cut of 10/31/07 (this is almost unheard of). Also of interest is the fact that crude oil has declined, yet the D-J Transportation Average has also declined and actually broken below its August 16, 2007 closing low, rendering either one-half of a potential Dow Theory "sell signal," or a huge downside non-confirmation. Plainly, since the October "peak" things have gotten pretty confusing, leaving the four strongest sectors since that point: utilities, consumer staples, energy, and healthcare. Meanwhile, the over-crowded negative dollar "bet" has changed the export-import equation, making America just plain "cheap!" The effects can be seen along the Canadian border, in New City retail stores (read: foreigners), cruise lines, Disneyworld, etc., and the result has made us reduce our anti-dollar "bets" of the past six years.
Normxxx
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