Leverage and Divergences Getting Red Hot
(February 19, 2006)
Dear Subscribers and Readers,
I have just gone through Barton Biggs' new book “Hedge Hogging” and it is a book that I highly recommend for individual investors or just anyone who are interested in the financial markets (and history). Mr. Biggs was formerly the Chairman of Morgan Stanley Asset Management, and was ranked as number one global strategist by “Institutional Investor” from 1996 to 2003. He left MWD in June 2003 to form his own hedge fund (with two other partners), Traxis Partners. This book does jump from one topic to another (I realize that not many “mainstream folks” have kind words to say about this book), but the general financial insights and history that the book provides is definitely very valuable. For example, there is a good snippet about “Gibson's Paradox and the Gold Standard” for the gold bugs, and lest we ever need to concern ourselves with a societal breakdown, Biggs conjectures that it may be a much better option to be holding fine jewelry, instead of gold or silver coins. The fact that not many “mainstream investors” have kind words to say about this book makes me more confident in his insights. By the way, anyone that has access to the latest research by Sun Valley Gold LLC – please do somehow try to get me a copy!
For readers who are currently still long on individual stocks, I highly recommend reading the latest two-part interview of Paul Desmond on TheStreet.com – President of Lowry's Reports. In the latest interview, Desmond discusses the art of picking stock market tops – which as this author has mentioned before – is inherently much more difficult than picking bottoms. In the two-part interview, Desmond discusses that we may be on the verge of a major top, and that the next few weeks of stock market action will be crucial for the bulls. To get a copy of Lowry's original report (cost $10), one can do so by surfing over to the Lowry's research studies page. Note that this author does not have any personal or business relationships with Lowry's reports at this time. The conclusion of the latest Lowry's research confirms with the divergences that we have been seeing and that we have been discussing over the last few weeks.
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 (11,115.32), our position is 245.32 points in the red – but again, given all the weakening fundamental and technical indicators that this author is currently witnessing, I believe that this short position will ultimately work out well.
In our February 9th commentary (“The Bank of England Financial Stability Review”), this author discussed the extreme complacency as experienced currently by most financial players – and along with that extreme complacency – the use of leverage to heights we have never witnessed before. I discussed the LBO market, as well as the explosive use of derivatives and leveraged loans. I argued that this in fact can be regarded as a “new era” but just like with other “new eras,” what started out as a structural story may ultimately turn out be just another cyclical story:
In other words, the hedge funds and the pension funds have no choice. In a world of historically low actual and implied volatility, returns have significantly declined and one can only generate “excess alpha” by investing in more risky assets or buying more of the same assets by utilizing leverage. This is dictated by the Capital Asset Pricing Model (and especially by the models that the hedge funds utilize) as well as the modern concept of finance and investments.
Just as with other cycles, what started out as a structural story may ultimately turn out to be just another cyclical story. No doubt, the advent of the internet, globalization, and securitization may have resulted in more sophisticated deals being done – and given the latter two, one could also have found more willing participants than ever before. This has the fortunate result of spreading the systematic risks among a greater number of investors than ever before – creating a more liquid marketplace – which is a God-send in times of great financial distress. However, the effects of such structural changes in the financial system are not infinite. For example, total assets as held by hedge funds rose from $600 billion to over $1 trillion over the last two years. At the same time, American investors have grown more sophisticated, and globalization in recent years has brought in a number of new investors from both China and India. But can such structural changes “handle” the continuing exponential explosion in derivative products and leveraged loans, such as the 55% increase in options volume on the CBOE or the 71% increase in futures volume on the Intercontinental Exchange? The more sturdy the car, the faster I drive. At some point, the pool of new, willing participants will be exhausted – which brings us back to square one unless such volumes and transactions are curbed. And judging by the numbers and complacency that this author is witnessing (and given that hedge fund inflows actually turned negative for the first time in a decade in the fourth quarter of 2005), we may be coming to such a breaking point.
Further evidence of a highly leveraged, worldwide financial system is outlined in the latest quarterly review published by the Bank for International Settlements (“the BIS”). Chapter 4 discusses the widespread use and proliferation of derivatives, starting with the observation that total derivative trading volume on all international exchanges during 3Q 2005 experienced “year-on-year rate of growth… [of] 23%, after 21% in the preceding quarter.” As stated by the report, total trading volume in fixed income, currency, and equity contracts totaled $357 trillion during the third quarter of 2005, or approximately six times the world's annual GDP. Note that this trading does not take into account trading in the over-the-counter markets. Make no mistake: The financial industry is now by far the biggest industry in today's globalized world. Following is a chart from the BIS report showing the trading volumes of exchange-traded derivatives from 1Q 2002 to 3Q 2005. Please note that trading volume as late as the first quarter of 2002 only stood at $150 trillion – representing an increase of over 135% in just fewer than four years:
The problem for the financial market analyst is always this: How to differentiate the above volume into either hedging volume or speculative volume? In other words, which contracts add to the systematic risk of a financial meltdown and which contracts contribute to the integrity of the system? Even for folks who have good intentions, it is not clear how these contracts will function in a period of financial distress. E.g. Assume you have default insurance on certain GM debt obligations. Should there be a period of financial distress (coinciding with GM entering into Chapter 11, for example), there is no certainty that this insurance will ever be paid, given that some insurance companies out there may also be experiencing financial distress at the same time. Moreover – in an age of securitization, the counter-party that is on the other side of the insurance contract may very well be a hedge fund, and not any type of insurance company. Given that the popularity of hedge funds is now on the wane, there is a high likelihood that we will see some kind of shake-out in the hedge fund industry in the months ahead. Taking a page from “Hedge Hogging,” Barton Biggs noted that during the bear market in the 1970s: “Although the hedge funds in the 1970s never reached anywhere near the size and influence they have today, they crashed and burned in the secular bear market. Most failed to preserve their investors' capital in a bear market by having substantial short positions, as they had advertised. In reality, they were just leveraged long funds; in other words, they had borrowed money to buy stocks but had not hedged by selling other stocks short.”
So you can bet that this author is worried – but the BIS quarterly review does provide some additional insights, such as:
The increase in activity was particularly strong on Asian derivatives exchanges. Turnover surged by 71% in Korea to $12 trillion, overtaking the United States as the world's busiest market for stock index derivatives … Individual investors [in Korea] account for approximately two thirds of trading in options and one half of trading in futures on the KOSPI 200, far higher than in other markets … Korean pension funds were not permitted to hold equities, let alone equity derivatives, until early 2004, after which this outright prohibition was replaced by ceilings on their holdings of equity instruments.
While many of the Asian markets are still undervalued compared to the markets in the United States or Europe (and with promise of higher growth going forward), such a development (the huge increase in retail investor speculative volume on the derivative markets) in the Korean market is definitely troubling. From both a U.S. standpoint and from a local standpoint, speculation in emerging markets is now highly rampant. From a contrarian standpoint, pension funds entering the equity markets aren't a good sign either. Make no mistake: Pension funds – no matter which part of the world you are in – are usually a contrarian indicator when it comes to making investment decisions.
As an aside, further confirmation of the highly speculative sentiment in emerging markets can also be witnessed in the premium/discount rates of the India Fund – a closed-end fund that specializes in investing in Indian equities. Following is a chart showing the historical premium/discount of the fund relative to its NAV since inception, courtesy of Nuveen Investments:
As one can see, the premium of the India Fund relative to its NAV is now at nearly 30% - an all-time high (if I recall correctly, the highest premium that a closed-end fund achieved in recent times was the China Fund when it traded at an amazing 55% premium over its NAV in December 2003). Note that the India Fund has been trading at a discount for most of its life since inception – and was trading at a discount as recently as June 2005. Folks – such bullish sentiment does not bode well for emerging markets for the foreseeable future, especially since both the Fed and the ECB are now done with hiking rates just yet. For folks who are invested in the India fund, I suggest putting a tight stop loss under your position, especially given that the presence of Bird Flu has now been detected in India as well.
Another troubling sign in the derivatives world comes in the form of the credit default swap market. Quoting the BIS report:
Growth in the market for credit default swaps in the first half of 2005 weathered the sell-off in credit markets in the wake of the US auto downgrades in spring. Notional amounts outstanding increased by 60% to $10 trillion, far outpacing growth in the underlying credit contracts. This has increased the risk of squeezes, since most contracts stipulate physical delivery of the reference entity's debt in the case of a credit event. In addition, the assignment of trades without notifying counterparties has contributed to a backlog in trade confirmations. While market participants have promised to address these problems, it is still too early to assess the degree of progress.
What is troubling to this author is the fact that many trades in the credit default swap market is now unaccounted for. As stated by the BIS report, “this backlog is related to the fact that derivatives are mostly processed manually, often involving extensive paperwork.” In times of financial distress (where physical delivery is required in the case of a credit event), there is a high chance that it may take an extended period of time to identify counter-parties in certain credit contracts. In an age of electronic and instantaneous processing (and involving such huge sums of credit), such a time lag is unforgivable – even though this author realizes that many of these contracts are “exotic” and customized contracts. This sloppiness should only serve to undermine confidence further in a period of financial distress.
Going back to the domestic market, the most direct reflection of the immense leverage in the financial markets can be observed by looking at the total amount of margin debt outstanding of both members of the NYSE and the NASD. Following is the monthly chart showing the Wilshire 5000 vs. total margin debt vs. the margin debt to Wilshire 5000 ratio from January 1997 to January 2006:
Please note that total margin debt outstanding (approximately $255 billion) at the end of January 2006 represents the highest amount of leverage held by members of the NYSE and the NASD since September 2000. The $10.5 billion increase in margin debt during January is also the highest monthly increase since September of last year (immediately before the big October correction). At the same time, the margin debt to Wilshire 5000 ratio is also at a high not seen since November 2000. Given that the Wilshire 5000 closed at a level very close to the level at the end of January, it can be assumed that the $255 billion number remains true as of today. Folks who are currently long should take heed.
Let's now go on and continue our discussion of divergences in the stock market – which is basically a continuation of our weekend commentary from last week. With this said, this author believes that it is imperative that our readers study the Q&As (Part I and Part II) between TheStreet.com and Paul Desmond, the President of Lowry's Reports. In particular, Part II of the interview discusses the themes that are consistent with the market tracing out a top – with the main theme being the lack of participation of many stocks in the stock market just as the Dow Jones Industrial Average is topping out. In other words, the topping of the major market indices is always preceded by divergences, and in this case, it means that many stocks have already topped out before the major market indices. Quoting from the interview:
Well, I had a group of professional portfolio managers that we were addressing, and I wanted to tell them about this new study that we had just done. And I asked them, 'What percentage of stocks would you expect would be making new highs at the top day of the bull market?' In other words, when the Dow Jones was making its absolute high, what percentage of stocks were also making new highs?
I asked, 'How about 80%?' and there were a lot of hands. Then I said, 'How about 70%?' and there were a slightly smaller number of hands. 'How about 60%?' and smaller number yet. And I think I took it down to about 50% or so.
And I said, 'would you believe 6%?' There was this complete silence in the room. Of the 14 major market tops, between 1929 and 2000, inclusive, when the Dow Jones Industrial Average reached its absolute peak, the average percentage of stocks also making new highs on that day was 5.98%.
[Interviewer:] How about within a few points of their highs?
Well we also looked at stocks within 2% or less of their highs. That number was 16.88% on average for these 14 occasions. Now those numbers range significantly, the lowest point was 6.23% up to a high of 22%. But that still meant that 80% of stocks were not making new highs at the same time the Dow Jones Industrial Average was at its high.
And you also point out that a significant number of stocks not only were not make making highs but had already dropped more than 20% from those highs.
Yes, that's right. On average, the number of stocks making new highs along with the Dow was 5.98%, but the number of stocks that were off 20% or more from their highs was almost 22%. And in the 2000 case -- which I thought was particularly interesting -- as the Dow Jones Industrial Average made its all-time high on Jan. 14, 2000, 55.33% of stocks were already off 20% or more from their highs. So that meant that the bear market had really started substantially before, at least many months before, the Dow Jones Industrial Average reached its peak.
Desmond then goes on to discuss that we may be on the verge of forming such a top – given that the number of new highs have been weakening substantially in the face of the most recent rally since the beginning of 2006. Whether the mid caps or the small caps can rally in the days ahead – Desmond argues – will be crucial in determining whether this bull market will be further extended. Whatever the case may be, Desmond does not see a good 2006 up ahead, which is what this author is seeing as well. Following is a three-year chart showing the NYSE Composite vs. the ten-day moving average of the NYSE high-low differential, courtesy of Decisionpoint.com:
As the above chart confirms, the number of new highs vs. new lows has already been declining in the last two years. This also applies when one looks at the number of new highs vs. new lows on the NASDAQ. Desmond, however, hedges his conclusion a little bit by stating that the Dow Industrials can still go higher. While this is certainly possible, and while this author certainly does concede that the Dow Industrials can rise further to the 11,300 to the 11,500 level, I believe the days of this cyclical bull market are now numbered. In the interview, Desmond states that on the day the Dow Industrials top out: “On average, the number of stocks making new highs along with the Dow was 5.98%, but the number of stocks that were off 20% or more from their highs was almost 22%.” What Desmond does not discuss, however, is that during the 1968 and 1976 tops, the number of stocks making new highs along with the Dow was at 9.43% and 10.97%, respectively (courtesy of Lowry's actual study published on January 14, 2006). These numbers are significantly higher than the average of 5.98% - but more importantly, these numbers were made in the midst of a small cap and mid cap bull market (see our January 29th commentary entitled “Will Small Cap Out-Performance Continue?”) – such as the one we are currently experiencing. My point is that this current cyclical bull market could very well top out even as breadth numbers are still relatively strong compared to the January 2000 top or the August 1987 top. The recent topping out of Google and Apple (two of the “generals” of the current bull market) in the weeks leading up to their earnings reports is a further sign that the market is in the midst of topping out.
Let's now cut to the chase and discuss the most recent action of the stock market – starting with the following chart showing the Dow Industrials vs. the Dow Transports. I want to reiterate to our readers to focus on the long-run in these emotional times, when even the bears have gotten on the ride because of the “breakout” of both the Dow Industrials and the Dow Transports. Such “breakouts” have been much celebrated by the bulls over the last couple of years, and in all cases, the market has come right back and suffered a correction. This author believes that a secular bear market began in the spring of 2000 – a secular bear market which still shows no signs of exhaustion. In a secular bear market, primary non-confirmations on the upside should be taken seriously. And so far, the Dow Industrials has still failed to confirm the Dow Transports on the upside by bettering its all-time high of 11,723 established at the close on January 14, 2000:
Over the last week, the Dow Industrials gained 196 points while the Dow Transports gained 82 points. Such action in the stock market is definitely impressive, but again, this author believes that given the many divergences, deteriorating liquidity, and the extreme complacency we are witnessing, readers should focus more on the “primary non-confirmation” by the Dow Industrials at this time instead of the day-to-day action in the two popular Dow indices. Going back to the Lowry's interview, Paul Desmond stated: “This past week, we took a look at the Dow Jones Industrial Average stocks, the 30 component stocks of the Dow, and what we found was that there were, based on our way of analyzing individual stocks, three of the 30 stocks in strong uptrend patterns -- just 10%. And 20 out of the 30 stocks were in well-defined downtrend patterns. So you can see the selectivity that is present there, with 3 of the 30 stocks in uptrends, 20 in well-defined downtrends.” Think of it – just 10% of the 30 DJIA components are in well-defined uptrends! At some point, the DJIA will give, and my guess is that it will be sooner than later.
It is always difficult when one studies a daily chart, but please keep in mind that an astute investor should always take into account “the big picture” before making an investment decision. As the above chart mentioned, the “big picture” story according to the Dow Theory right now is the “primary non-confirmation” of the Dow Transports on the upside by the Dow Industrials. This is something this author has been discussing since the Dow Transports broke its previous all-time high way back in December 2004. Such a “primary non-confirmation” also acted as an early warning to the impending end of the October 1966 to 1968 and the May 1970 to 1972 cyclical bull markets (within the secular bear market of 1966 to 1974). In order for this cyclical bull market to resume, the Dow Industrials will have to confirm on the upside by breaking its all-time high of 11,723 established at the close on January 14, 2000. And given the dismal performance of the DJIA McClellan Oscillator and Summation Index in recent months (as you will see below) – this is not likely to occur.
Let's now discuss our most popular sentiment indicators and start with the American Association of Individual Investors (AAII) Survey. During the latest week, the Bulls-Bears% Differential in the AAII survey declined slightly from a reading of 5% to 4% – which qualifies as a pretty oversold weekly reading but one which does not signify a sustainable bottom. Readers should recall that the AAII survey is “selling off” from an extremely overbought level, and therefore should have more downside to go before bottoming. At the same time, the ten-week moving average declined from 14.6% to 11.9% - signaling that the survey is still in a downtrend, although this longer-term indicator is now getting pretty oversold as well. Following is the weekly chart showing the Bulls-Bears% Differential in the AAII Survey vs. the Dow Industrials from January 2003 to the present:
At this point, our longer-term indicator (the 10-week moving average) is still signaling for us to stay short – so for now, we will remain 50% short in our DJIA Timing System until the AAII survey “sells off” to an oversold area (which will most probably involve more weekly negative readings and a ten-week moving average at the 5% to 10% level or even below 5%). Readers should recall here that significant corrections in the stock market tend to occur while the AAII survey is in an oversold condition (such as what we are experiencing now). No matter what happens, we will most probably not start to cover until we have seen a significant correction in both the Dow Industrials and in the broader market.
The Bulls-Bears% Differential readings in the Investors Intelligence Survey are also telling us to stay short for now, as the current readings of this survey suggests that it is still in a downtrend, with the latest weekly reading declining slightly from 26.3% to 21.2% and the longer-term ten-week moving average declining from 32.8% to 31.5% in the latest week. This current downtrend is doubly authoritative given that both the weekly readings and the ten-week moving average are turning down from very overbought levels, and given that both the weekly and the ten-week moving average readings are still not close to being oversold. Following is the weekly chart showing the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the Dow Industrials:
Last week, I stated: “Given that the readings of the AAII survey is still mired in a downtrend, and given the weakness in the DJIA McClellan Oscillator and the DJIA McClellan Summation Index (despite the rally in early January), there is a strong chance that the readings in the Investors Intelligence Survey (and thus, the stock market) will not reverse to the upside again until we start getting very oversold readings in this survey again. Moreover, readers should keep in mind that the most serious stock market corrections have come in the midst of an oversold reading in the AAII survey – which is consistent with what is currently occurring. For now, we remain comfortable with the 50% short position in our DJIA Timing System.” The recent rally in the Dow Industrials is not all too surprising, given that the major market indices historically do not top out until after many of the stocks on both the NYSE and the NASDAQ have witnessed significant declines. Given that only 10% of the issues on the Dow Industrials is still in defined uptrends, this author believes that the 50% short position in our DJIA Timing System will work out in due time.
Meanwhile, the Market Vane's Bullish Consensus finally reversed to the downside last week and has continued to go down in the latest week – with the ten-week moving average declining to from an extremely overbought reading of 69.7% two weeks ago (the most overbought reading since August 1997) to 69.4%. Meanwhile, the weekly reading declined again rose back to an extremely overbought reading of 69% after declining to a “more neutral” level of 66% the week before. Such a reversal from such a highly overbought reading in the Market Vane's Bullish Consensus is an indication that the market has made a significant top. Following is the weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:
Given that all three of our popular sentiment indicators have reversed from very highly overbought levels, and given that the AAII survey is now oversold (history has indicated that market corrections tend to occur while the AAII survey is oversold), we will remain 50% short in our DJIA Timing System until the readings of these surveys decline back to at least a moderately oversold level again. At this point, the author still believes the market has yet to finish its downside correction and thus is very vulnerable to a multi-week decline.
Conclusion: Last week, the theme was “divergences, divergences, and divergences.” This week is more of the same, but given that there is now a high degree of leverage both in the domestic stock market and in the international financial markets, this author believes that buying stocks here is now highly dangerous. I have not previously mentioned this before, but shorting the “logical stocks” such as GM is now highly dangerous as well, given the huge amount of short interest in that stock. Should there be a mass hedge fund redemption (which is now relatively likely given that hedge fund inflows have now turned negative – something that has not happened since a decade ago), some of the market-neutral hedge funds may ultimately be forced to sell their long positions and cover their short positions – thus creating irrational moves where we could see GM spiking up and the low short-interest large caps such as Cisco, Dell, and GE tanking on the same day. As indicated by our technical indicators and by Lowry's latest research, many stocks are also already mired in their own bear markets – including names such as Google and Apple. Given that we are now in a tightening liquidity environment, both mid caps and small caps should also underperform large caps going forward.
At this point, our most objective longer-term technical and sentiment indicators are still telling us that the top is at hand – and so we will remain 50% short in our DJIA Timing System until we start getting more oversold readings in our technical and sentiment indicators. In fact, our indicators are now virtually telling us to “get the heck out.” The theme does not change from last week: Readers should continue to forgo or hesitate from buying “risky assets” going forward in 2006 – said risky assets including small and mid caps stocks, emerging market equities, and energy and metal commodities.
Henry K. To, CFA