The Global Financial Stability Report
(April 14, 2005)
Dear Subscribers and Readers,
First things first. Our Favorite Books section has finally been updated - there is now a new section on Warren Buffett and a new book review on one of his best biographies, "Buffett: The Making of an American Capitalist", written by Roger Lowenstein.
Before I begin this commentary, I would just like to say this: the market is oversold. Okay, so what? Well, the one-day NYSE ARMS Index hit 1.89 today (I am writing this as of Wednesday evening), while the 10-day moving average of the NY ARMS hit 1.22 today, the most oversold reading (per this indicator) since early February. As of Wednesday evening, the bulls-bears% differential in the Investors Intelligence Survey is 17.2%, a decline of 1.5% from last week and the most oversold reading since early September, 2004. Meanwhile, the bulls-bears% differential AAII Survey rose slightly, from negative 18% to negative 16% - still a very oversold reading any way you look at it. The four-week moving average of this reading sits at negative 19%, which is the most oversold reading since March 12, 2003 (and we all know what happened afterwards). The traditional NYSE McClellan Summation Index is sitting at a level of 58.03 - the most oversold reading since early June 2004.
Readers who have gotten used to the cyclical bull market over the last two-and-a-half years may now be very tempted to buy stocks here. To do this I say: Not so fast! We are very late in the cycle here, and it is not a given that the bulls will get away with it this time - even though the bulls did get away with it during March, May, July, and October of 2004. In fact, a great many institutional favorite stocks are now breaking or on the verge of breaking down - even such names like Starbucks, Harley-Davidson, Yahoo, Wal-Mart, Home Depot, Alcoa, FedEx, American Express (not to mention Freddie Mac, Fannie Mae, AIG, and GM) - and the great many speculative stocks of 2004 such as TASR, TZOO, and CME. Looking at these breakdown patterns, one is getting a sense that the breakdown is only just beginning. Moreover, from looking at our charts - the Dow Industrials is still slightly above its 200 DMA, while the NASDAQ Composite is only just slightly below. Is the market oversold in terms of prices? I don't believe so. Keep in mind that the most severe declines have happened while technical indicators such as the AAII Survey and the McClellan Summation Index are oversold. Conclusion: Keep your eyes focused on the stock market but don't do anything stupid and stay in cash for now. That is my message for the rest of this week. We will re-evaluate this weekend.
Okay, let's being this commentary. I normally don't keep track of what the IMF officially says (I do not have a high opinion of their economic forecasts if you really want to know) but one of their just-released publications entitled "Global Financial Stability Report: Market Developments and Issues" is definitely a must-read given the treasure-trove of information that the publication contains. According to the IMF, the report (GFSR) "assesses global financial market developments with the view to identifying potential systemic weaknesses. By calling attention to potential fault lines in the global financial system, the report seeks to play a role in preventing crises, thereby contributing to global financial stability and to sustained economic growth of the IMF's member countries."
Without going into forecasting, I believe the report does a very good job in communicating the possible risks to the world's various economies and asset classes - and especially letting the readers make up their own minds. For example, while the IMF's official line regarding the world's various economies is favorable, it also discusses that the various asset classes around the world are priced for near-perfection, and any combination of factors here (such as corporate earnings not meeting expectations or a rise in long-term Treasury rates) could shake the stock and bond markets in an adverse way. I will quote: "If history is any guide, the single most important risk factor for financial markets in good times is complacency. As discussed below and more extensively in Chapter II, current risk premiums for inflation and credit risks leave little or no margin for error in terms of financial asset valuations. The combination of low risk premiums, complacency, and untested elements of risk management systems dealing with complex financial instruments could ultimately become hazardous to financial markets."
As I stated in our March 17th commentary, the various markets (stocks, bonds, and real estate) domestically and around the world currently do not leave any room for disappointment or error. The following charts directly from the IMF report shows what we are talking about. The first two charts show corporate bond spreads of both investment-grade and high-yield bonds relative to U.S. Treasuries. Please note that both American and European corporate bond spreads are now at or near five-year lows:
In short, there is a general lack of risk aversion in the bond markets (including U.S. Treasuries which are overvalued themselves) - especially in the high-yield markets. The IMF report further states: "The narrowing of spreads has been helped by the improvement in the creditworthiness of borrowers and the shortage of high-grade corporate paper supply. With cash flows strong, debt-service ratios low, and companies paying down short-term debt, default rates have fallen to low levels (Figure 2.9). However, rating agencies have noted that default rates are low given the stage in the economic cycle and in absolute terms. Rating agencies have warned that easy money has allowed weaker, higher-yielding credits to obtain financing, and that this may contribute to a higher incidence of default and restructurings in the future." It is not often that I agree with IMF's findings or conclusions, but I am definitely agreeing here. For readers who are still optimistic and invested in corporate or junk bonds, I urge you to rethink your investments.
Like I mentioned before, the lack of risk aversion and overvaluation is not only evident in domestic or European bonds, but in emerging markets as well. Following are two more charts from the IMF report - the first showing EMBIG (Emerging Market Bond Index Global) sovereign spreads over the last five years and the second showing emerging market credit bucket spread difference (the spread between B and double-B and double-B and investment grade emerging market bonds) over the last two years:
In response to the record-low spreads, the IMF responds: "Emerging market debt valuations now appear stretched relative to their historical relationship with fundamentals and liquidity. Spreads are more than 100 basis points narrower than forecast on the basis of a staff model that incorporates ratings and a measure of liquidity as determinants of spreads (Figure 2.28). Nonetheless, these valuations reflect common trends across all credit markets. As a result, spreads against comparably rated U.S. corporate bonds remain attractive." On a relative basis, U.S. corporate bonds may appear attractive, but relative to bond prices, stock prices also appear attractive according to the Fed model. Does that prevent stock prices from going down?
While the various financial assets are priced near perfection, it is difficult to foresee any events that will trigger a reversal in the rise of asset prices over the last few years. This is the reason why economists have historically had a dismal record in predicting recessions; and why stock market analysts are always caught going long in a significant stock market decline. Past trends are usually extrapolated into the foreseeable future. It is better with the crowd and wrong than to be the lone voice and ultimately right. Worse yet - one may end up being the lone voice and wrong on all accounts as well! Virtually all economists would not have the courage.
The IMF is still forecasting reasonable economic growth for the rest of 2005, but because asset prices are now priced in the optimistic extreme and because we are so late in the cycle, the IMF is hedging its bets. The IMF basically concludes: "At present, it is not easy to see which single event, short of a "major devastating geopolitical incident or a terrorist attack" as highlighted in the September 2004 issue of the Global Financial Stability Report (GFSR), could possibly trigger a sharp and abrupt reversal of this positive assessment. However, because we are more advanced in the economic, profit, and credit cycles, disappointments or negative surprises are more likely to occur. Possibly, a combination or correlation of several less spectacular events might cause markets to reverse their course, and create a less hospitable environment for investors and borrowers who have become accustomed to low rates. Such risks include disappointing developments as to the narrowing of the U.S. current account deficit, continuing rises in commodity and oil prices feeding through to inflation, larger-than-expected rises in interest rates, as well as negative surprises for corporate earnings and credit quality."
Conclusion: Like I have mentioned in all my past commentaries, we are now late in the liquidity cycle and also the profit cycle. The Bank Index has broken down, and the central banks all around the world are now tightening their monetary policies. Corporate profits as a percentage of GDP were most recently at 9% - a historically high level. Ultimately, corporate profits cannot grow faster than the GDP, and it is difficult to imagine this percentage getting any higher, especially since earnings at financial companies have most likely peaked. Stock market analysts have always been historically overly optimistic in projecting earnings, and this time should be no different. In issuing this latest report, the IMF cannot be more clear/candid about the risks and the fact that they are now favoring the downside. Investors please beware.
Henry K. To, CFA