The Black Swan
(August 26, 2007)
Dear Subscribers and Readers,
Before we begin our commentary, I just want to clear up one thing. In a certain blog last week – as a response to Bill Gross' (of PIMCO) comments asking for government intervention in the mortgage space in his September commentary – one prominent blogger stated that it was purely in PIMCO's interest for a government bailout and that PIMCO badly needed it, given the severe underperformance of PIMCO's funds (he specifically mentioned the PIMCO Total Return Fund) over the last few years. While we can argue all day whether it is in PIMCO's interest for the government to “bail out” subprime homeowners or subprime mortgages (note that PIMCO has historically out performed its peers in adverse market periods), the latter cannot be further from the truth. First of all, it is important to know that all the PIMCO funds were designed for institutional investors - such as pension funds, endowments, and foundations - and thus each of their funds will have to fit under a certain category (typically a Morningstar's category), just like how every mutual fund family structure their funds. If one invests in the Dodge & Cox stock fund, for example, one certainly doesn't expect the manager to shift into >20% cash even if one believes the world will end tomorrow. Within a pension fund, the investment consultants and the pension committee is responsible for that - the mutual fund themselves are tied to a benchmark (in this case, the Lehman US Aggregate) and to a certain category (US Intermediate bonds) – and while the PIMCO Total Return fund is allowed some leeway (e.g. it has substantially cut is credit exposure over the last 18 months and had invested in Agency securities instead) none of us expect the fund to, for example, invest in emerging market bonds.
If one measures the performance of the Total Return Fund with the Lehman Aggregate or with other funds in its peer universe (intermediate bonds), the fund has done very well over the last three and five years. Over the last 18 months, it has substantially cut back its risks to both the corporate and the lower-rated mortgage sector. That is the reason why it had underperformed substantially on a 12-month basis ending June 30, 2007. Over the last seven weeks however, its fortune has reversed dramatically given its conservatism - and is now one of the best-performing fund in its category on a YTD basis. 2006 is still a blemish, however, precisely because it took less risk than virtually all its peers did. When it comes to picking a bond fund, PIMCO is clearly the favorite among many institutional clients when it comes to active exposure (and Vanguard or Fidelity for passive exposure). Fidelity has taken a hit lately because of its subprime exposure - but it is still doing well against most other bond funds. Vanguard, however, is as pure as can be - and its reputation has again increased lately primarily because of this. As for PIMCO, many folks were having their doubts over the last 12 to 18 months, but now, they have proven that they are again the undisputed bond king of the world. I have also been on several PIMCO institutional conference calls over the last few months – and I can attest that the mortgage securities being held in the PIMCO Total Return fund will not lose a cent of principal unless we enter a “Great Depression” scenario. Moreover, PIMCO has a separate mortgage-backed fund (I spent nearly the whole day on Friday doing analysis on their mortgage-backed fund versus other offerings), and I have to say that these guys are really the best in the industry after looking at both performance and risk-adjusted returns both in the short-term and since the inception of their mortgage-back fund (along with their GNMA fund).
About 12 months ago, PIMCO started sending their credit analysts for "ride-alongs." That is, they asked their credit analysts to physically go "undercover" and see houses with real estate agents, mortgage brokers, etc, to see what kind of deals these folks were cutting and to gauge how loose the borrowing was. That - combined with their macro views - convinced them to cut back severely on both their riskier mortgage exposure and overall credit exposure. In the meantime, I am sure that they have no subprime or Alt-A exposure in their portfolios - and most probably, no "prime" exposure of either the 2005 and 2006 vintage either. The US mortgage market is a $4 trillion market, so there are a lot of investments to go around even if you choose to not invest in either the 2005 or 2006 vintage. They have also done a lot of original research on both originators and servicers - and will only buy the mortgages that came from the relatively conservative originators. These guys also have the best and brightest PhDs working for them and I am sure that they were able to reverse-engineer Moody's and S&P ratings models - in order to confirm that much of these AAA-rated subprime securities were really junk. Like I mentioned before, these guys are really the pros.
Let us now begin our commentary by first providing update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As of Sunday evening on August 26th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link).
For those who have always wanted to pick up an “entertaining book” on the financial markets, I would highly recommend Nassim Taleb's “The Black Swan: The Impact of the Highly Improbable.” In “The Black Swan,” Mr. Taleb (who also authored “Fooled by Randomness”) asserts that historical events of the world (not only in the financial markets) – are driven by rare and unpredictable, but high-impact events, such as 9/11, the October 19, 1987 stock market crash, The Great Depression, and so forth. Mr. Taleb calls these “black swans,” which is a reference to the pre-17th century “scientific truth” in Europe that “all swans were white,” – primarily because all swans Europeans have observed, up to that point were white ones. That is, up until 1697, when black swans were discovered in Australia.
In one of the earlier chapters, the book ventures into a semi-digression into the philosophy of the 18th century philosopher and historian, David Hume. According to Hume, there are only two kinds of human reasoning: 1) Relation of Matters, 2) Matters of fact. In the former category, deductive reasoning reigns – and conclusions that are reached within this category can be considered 100% true (such as the fact that “All rectangles have four sides and have all four of its angles as right-angles. The square has four sides and four right-angles. Therefore, a square is a rectangle.”). In the latter category, inductive reasoning is used – and it is within this category where both David Hume and Nassim Taleb focused on.
More specifically, inductive reasoning assumes that what has occurred in the past acts as a reliable guide to the future, or that a sequence of events will always occur just as they have occurred in the past. A commonly cited example is that since the sun has always risen in the east and set in the west, it can be inferred – by induction – that the sun will also rise in the east and set in the west tomorrow, next week, and next year (however, five billion years from now, it will not be true, as the Earth will most likely not exist). Another example is the “Three Laws of Motion” as postulated by Isaac Newton – a world that came to an end with Einstein's Special Theory of Relativity in 1905.
An example that is closer to our hearts is the state of the world on the Friday before October 19, 1987. Since the inception of the Dow Jones Industrial Average in May 1896 as a means to keep track of the performance of the overall stock market, the DJIA has never experienced a one-day decline of more than 20%. Indeed, we have had some close calls, such as the 8.3% decline on March 14, 1907, the 12.8% decline on October 28, 1929, the 11.7% decline on October 29, 1929, the 9.9% decline on November 6, 1929, and the 8.4% decline on August 12, 1932. Not even during the dark days of World War II, the Monday after the Eisenhower heart attack, the days of the Cuban Missile Crisis, or during the biggest down days of the 1973 to 1974 bear market have we experienced a one-day decline of more than 8%, let alone over 20%. And yet – driven by an immense amount of leverage within the financial system, overvaluations, and the advent of “portfolio insurance,” the market did, indeed, decline 22% during that fateful day on October 19, 1987, despite the fact that the Dow Industrials had already declined by more than 17% from its peak on August 25, 1987 to the previous Friday on a closing basis.
In a way, inductive reasoning – when it comes to virtually all our daily activities – is very reasonable, in that, on a day-to-day basis, there are usually no major disruptions in our lives. Aside from my earlier example of the sun, most people can expect to stay in the same home, job, and drive the same car on a day-to-day basis. Most can also assume that his or her home will appreciate in price on a year-to-year basis (after all, CPI inflation is still trotting along at a 2% to 3% every year) – and that, despite the current wars in both Afghanistan and Iraq, another world war will most likely not break out anytime soon (note that when French soldiers initially embarked to fight in the “Great War,” the majority expected to be back at home within a few months – which in retrospect, turned out to be unfounded, as most never came back). More importantly, such reasoning can usually be forgiven, as 1) not many of us possess the necessary simultaneous expertise in political science, military strategy, economic and military history, and human psychology to accurately predict outcomes in these areas, and 2) in the absence of sufficient knowledge, it is just human nature to utilize inductive reasoning – especially when one is working over 40 hours a day at a day job that is paying middle class or minimum wages.
However, when it comes to rationalizing one's stock or financial markets forecasts by utilizing inductive reasoning, it is unacceptable – pure and simple. First of all, it is well documented that both the short and long-term pricing patterns of the stock and financial markets do not follow a normal distribution. One does not need an MBA or even a BA in finance or economics to know this. Second of all, it is not any government official's job to ensure one is able to achieve the necessary returns for retirement or other purposes. Ever since the development of defined contribution plans, this responsibility has increasingly fallen onto the individual's hands. Finally, it is amazing to see so many professionals fall into the same trap of assuming log-normality or that “historical performance is indicative of the future,” – traps that even Bear Stearns partners fell into when a great number of them invested in the two Bear Stearns subprime hedge funds that had recently collapsed. Apparently, they believed that 40 months of positive performance would mean an endless run of limitless profits going forward. If it was so easy, the collective net worth of the original partners of LTCM would have be greater than the net worth of Warren Buffett by now (assuming 40% annualized returns since 1997). Look – they do not call this the most difficult game and stressful profession if all one needs to do is to look at historical price behavior – and conclude that we will start going up now simply because we just had our 10% correction. Even Jesse Livermore – the ultimate numbers cruncher, trader, and insider – who were doing this with much less competition over 100 years ago, had to take many lumps along the way. And as the story goes, the game ultimately beat him when he committed suicide in 1940 (the reason why he still lived in relative luxury just before he died was because he had the foresight to set up trust funds for both him and his family before he lost it all trading during the early 1930s).
Most of the time, however, looking at historical price behavior – along with following our favorite technical and sentiment indicators – is usually enough for bottom-calling purposes. We did that in the summer correction of last year – more than 2,000 Dow points lower, when many folks had warned us not to, citing reasons such as the inevitable recession of that will start in late 2006/early 2007, the inevitable “mid-cycle low,” not to mention the inevitable October bottom, a bottom that many folks now expect ever year. At that time, the economy was still running at full-speed ahead, while both long-term treasury and corporate interest rates were lower (the latter substantially lower). On the liquidity side, the U.S. stock market also experienced unprecedented corporate buybacks. Combined with the endless funding going into LBO funds, and stock market liquidity was probably at its highest since the late 1990s, when retail investors rushed en masse into U.S. technology stocks.
Fast forward to today. The economy is no longer flying on all cylinders. Domestic profit growth during the second quarter within the S&P 500 was non-existent. Rather, virtually all the profit growth had come from overseas operations. For the first time in a long time, third quarter of earnings of the financials sector (which made up 30% of the earnings and 20% of the market capitalization in the S&P 500 over the last 12 months) is expected to be negative on a year-over-year basis. The only question now is: How bad would earnings get in the third quarter (we will find out next month)? For that, we will need to turn to the international operations of the companies within the S&P 500 – and after the latest GDP numbers, the housing bust in Ireland and Spain – not to mention the 100 basis points in interest rate hikes from the European Central Bank and the Bank of England since that time, and my guess is that profit growth from European operations would most probably be disappointing as well. S&P 500 profit growth, if any, in the third quarter will instead need to rely on continuing strength from Asia ex. Japan, emerging Europe, and the Middle East. As mentioned in this UK Telegraph article, not only are Ireland and Spain experiencing their own housing busts, but also France is now experiencing falling residential real estate prices. Meanwhile, Eastern European real estate has been in a “monster bubble” (housing prices in the greater Riga region of Latvia surpassed those of Berlin's earlier this year, and all of the mortgages were financed in Yen, Swiss Francs, and Euros) and is also most probably in the midst of bursting.
In terms of the liquidity picture, the lingering subprime problems and the upcoming resets – along with commercial paper liquidity in both the US and Europe, has now been well-advertised (please see our July 11, 2007 commentary “Is the Correction Here?” for a schedule and size of subprime resets through the end of 2008, courtesy of Lehman Brothers). What hasn't been as well advertised, however, is the true credit composition of these subprime loans – especially the much-talked about 2004 to 2006 vintage. Following is a table showing the composition of both subprime and Alt-A mortgage loans from 2001 to 2006, courtesy of Lawler Economic and Housing Research, and as cited by Goldman Sachs:
As is obvious from the above table, approximately 90% of all subprime mortgages that were originated from 2004 to 2006 will be eventually subjected to resets – with a peak of sometime in the spring of next year. Given that 1) less than 50% are “full doc” loans, 2) About 25% to 30% are interest-only ARM loans, and that 3) the average combined loan-to-value ratio is about 92% to 95% - when the 2004 to 2006 vintages reset over the next 18 months, it is going to be vicious. Of course, all the above won't matter too much if we are still in an era of rising house prices and easy financing – but as everyone and his neighbor should now know, that era is now over. As stated in the New York Times over the weekend, economists are now expecting U.S. median housing prices to decline 1% to 2% on a year-over-year basis (as tracked by the OFHEO HPI, to be released this week) – something that has not occurred since records were kept in the 1950s. Meanwhile, Global Insight is now expecting median housing prices to eventually decline about 4% from the peak earlier this year to the trough – sometime in 2009 – and for Californian housing prices to generally decline about 16%. This is serious and no laughing matter, as approximately 5% of all households in the United States (about 5.5 million households) have negative equity in their houses, per the following study from First American CoreLogic, and as cited by Goldman Sachs:
Note that the above study utilized numbers as of the end of 2006. Chances are, more households would now have negative equity in their houses, given recent price declines as well as the recent popularity of interest-only and negative amortization loans. If Global Insight's projections are correct (a 4% median housing nominal price decline from peak to trough looks tame when one compares to Gary Shilling's forecast for a 25% decline all across the board) – then, according to the above table, nearly another 4% of American households (or 4.4 million households) will experience negative equity in their homes. The optimists would argue that this is a non-issue, given that houses are long-duration in nature and are now tradable assets. No, but it will affect 1) consumer behavior on the margins, as folks ratchet down their expectations for housing appreciation going forward, and 2) for subprime borrowers who just want to “dump their homes” on the market to sell their houses and pay off their loans, it would have become infinitely difficult to do so, given the illiquidity of the housing market and given that they most likely will have negative equity in their houses. They will also have no ability to refinance either, as no lender will now touch these borrowers (and probably won't for many months to come). Bottom line: Foreclosures will dramatically increase over the next 18 months, and the credit histories of many people will be destroyed and will probably never recover.
As for stock market liquidity, it is important to note that approximately $300 billion in LBO paper are still waiting on the sidelines – to be dumped on the markets at the first sign of a recovery. At the same time, the number of announced LBOs has pretty much come to a screeching halt over the last six weeks, as shown on the following table courtesy of Dealogic and the WSJ:
Moreover, it is also reasonable to believe that the corporations who have been so intent on buying back their own shares over the last few years will be more conservative going forward, as they try to conserve cash in the current challenging liquidity and credit environment. If profits and/or cashflows get more challenging going forward relative to the 2nd quarter, then corporate buybacks could also very well come to a screeching halt. Given that retail participation in the current bull market has been relatively muted (ironically, I believe the current bust in the housing market will eventually be bullish for the stock market, as speculators come back to dabble in stocks again as opposed to flipping houses in Arizona or Florida over the last few years), and given the big round of hedge fund redemptions during the latest quarter (the deadline for hedge funds to pay redemptions is September 30th), it is thus reasonable to expect the equity environment (especially emerging markets) to continue to be tough, at least from now until the end of September.
And yet, many of the same folks who emailed me last summer asking me why I was long in the stock market are now asking me why I am not long in the stock market – after a rally of over 2,000 Dow points and after the bursting of a great real estate and subprime bubble, not just in the US, but also in Ireland, Spain, and Eastern Europe as well. The current liquidity and credit-constrained, and oversold environment provides the perfect conditions for the occurrence of a “Black Swan,” and yet many are still lured into a false sense of security simply because “we just had our 10% correction.” Given that these are high-impact events when they occur (many folks who sat through the 2000 to 2002 bear market would agree that it was life-changing and that it probably made them more risk-averse to invest in stocks in the future, even though they need to invest in equities for retirement purposes) – and given that an overreaching goal of MarketThoughts.com is to promote capital preservation, this author would like to adopt a “wait-and-see” approach before going long.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present:
For the week ending August 24, 2007, the Dow Industrials rose by 299.79 points while the Dow Transports rose 147.97 points. While the Dow Industrials has more than retraced its decline from the previous two weeks, the Dow Transports is still nearly 1% away from its close two Fridays ago, and as thus, has continued to remain the weaker index ever since the latest peak on July 19th. Given that the Dow Transports has nearly always been the stronger index – as well as a leading indicator – ever since the cyclical bull market began in October 2002, subscribers should continue to be cautious here. Moreover, in last weekend's commentary, I stated “However, as of late Thursday, the decline had definitely gotten ahead of itself – and as I have mentioned earlier, chances are that the market will continue to bounce over the upcoming week. Whether this latest rally will turn into something more sustainable, however, will depend on both the health of both market breadth and volume during any upcoming rally. For now, the jury is still out, but given that I do not believe the selling has reached “fever pitch” levels just yet, we will continue to remain neutral in our DJIA Timing System for now.” Well, we did get our bounce – and while the quality of the rally is still in question, my current indicators are saying that wasn't enough – and most likely, we should not take any current rally seriously until most of the mutual fund managers (most hedge fund managers have probably canceled their vacations from the Hamptons or have a high-speed connection and Bloomberg Terminal set up in their hotel rooms) come back from vacation during the first week after Labor Day weekend.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators again decreased significantly – from last week's 13.0% to 7.8% for the week ending August 24, 2007. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Note that the four-week MA is now at its most oversold level since the week ending August 18, 2006. However, as I have mentioned in the last few commentaries, this author would prefer to see an oversold reading similar to what we experienced the June 2006 (1.7%) bottom before we go long in our DJIA Timing System. For now, we are still reluctant – given the many reasons we have cited above, as sentiment is mostly a secondary indicator and is only meant as a confirmatory signal for other more important indicators, such as breadth and volume of the stock market, as well as liquidity and credit availability. For now, these latter indicators are still not flashing buy signals, and as such, we will continue to hold off. Given the bearish readings in our most popular sentiment indicators, however, it will not take much for us to go long once our liquidity and most of our technical indicators are “in place.” For now, we are still not there yet.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. For the history buffs out there, you may notice that we have extended our study period further back from November 1, 2002 to May 1, 2002. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
Over the last week, the 20-day moving average of the ISE Sentiment declined substantially to from 103.5 to 100.5 points – the most oversold level since November 4, 2002 – after just hitting a 14-month high of 152.9 as recently as late July. While the freefall in the 20-day moving average is suggesting that retail sentiment has turned very bearish in the short-run (and therefore bullish from a contrarian standpoint), this author isn't going long just yet – as the 50-day moving average is still not close to being very oversold, and chances are that we will need at least a couple of more weeks to see an oversold reading in the 50-day moving average. Until or unless the 50-day moving average decline to a similar level we witnessed during recent bottoms (approximately 120), we will continue to avoid a long position our DJIA Timing System.
Conclusion: In conclusion, I want to reiterate one of the primary goals of MarketThoughts.com. That is, “helping our readers to maximize returns in favorable investment climates and protecting assets in unfavorable climates.” In setting up this website, we also realize that not many folks can be as disciplined as say, Bill Rempel, when it comes to risk management, and as such, we would prefer to be out of the stock market right now, given our number one concern for capital preservation and trading profits second. Moreover, it is important to remember that profits and losses alike in the stock market usually come in the form of a “Black Swan” (this is especially true if one is trading individual stocks, as many money managers can attest to). How many times have you heard the phrases “if it wasn't for this one loss during this year, I would have substantially outperformed the market, or if it wasn't because of “Black Monday,” or the 2000 to 2002 bear market, I would have been retired by now?” While these – in itself – are low probability events, they do occur relatively often by statistical standards, and when they do, these could be life-changing. Given the current liquidity/credit-constrained environment, and given the overwhelming fear in the global financial markets right now, this author believes that the environment is now ripe for a “Black Swan” to occur, and as thus, we will continue to sit out the current stock market. At some point over the next several weeks, I will most probably write more on long ideas in preparation for the inevitable bottom. For now, we will just take it one day at a time, and be glad that we have not been caught in the latest downdraft and volatility.
Henry To, CFA