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Looking Beyond a Recession

(February 3, 2008)

Dear Subscribers and Readers,

As many Chinese starts to prepare for Chinese New Year's – and as many of them prepare to converge on Las Vegas over the next few days – it is instructive to note that the majority of the gambling had already been done in the global equity markets over the last few weeks, as opposed to within the Sands, MGM, or Wynn.  While Las Vegas (and Macau) should again see a record-breaking Chinese New Year's, I would argue that the “main course” has already been served and eaten.  Again, the last few weeks have been by far the most difficult market for retail investors since we started writing regularly in August 2004.  For the majority of investors, this is a time when one should just shut off their CNN and ask your ISP to block all financial websites to your IP address.  After all, if they had not warned about the current market downdraft ahead of time, it is not worth your while to ask them for financial advice going forward.  Given the 7-year highs in domestic equity mutual fund cash levels (per Morningstar, as opposed to cash levels at all equity mutual funds, including domestic and foreign funds per ICI), the Fed's continuing easing bias, the promise of a fiscal stimulus from Congress, the inevitable raising of the GSE limits, the high probability of a bailout of the bond insurers, sentiment levels not seen since 2002 to early 2003, or in some cases, October 1990, and decent valuations on the S&P 500, chances are that the Dow Industrials and the S&P 500 will be higher by the end of this year.  My inclination is to be able to hold our 100% long position in our DJIA Timing System for as long as we can – but of course, we will let you know right away if we start to see worrying signs of an impending top.  For now, we are not there yet.

Before we go on, let us know review our 7 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.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a gain of 113.19 points as of Friday at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 1,028.19 points as of Friday at the close.

Before we get to the “gist” of our commentary, I want to discuss a phrase which has been very popular among some of the mainstream press as well as “armchair economists” over the last few weeks – that being “deflationary recession” or “depression,” or the possibility that the U.S. economy would endure one of those sometime over the next 12 to 36 months.  First of all, one has to realize that this, in itself, is an extremely low-probability event, and is an event that no one can credibly predict.  There are many economists (including our current Fed Chairman), analysts, hedge fund managers, and finance ministers alike around the world who have studied the Great Depression, and not a single one can understand all the intrinsic details of the causes of such a complex event. Those who claimed that they understand it – along with the millions of inputs that had to “go right” to lead to such an event, and to be able to predict such future scenarios going forward (much like the next Dark Ages, the “Black Death,” and so forth)– are either not telling the truth or are arrogant to the extreme.  The financial markets and global economy have always been very complex creatures – and are not subjects that are easily understandable – all the more so given that none of us are studying these in a detached manner.  That is, every decision that you and I make – along with every observation, to the extent that those observations are being broadcasted over the internet or to your friends and relatives – will have an impact on the final results.

That being said, let us now go through some of the factors which may lead to something more serious than a mild recession going forward.  From a macro or global standpoint, I believe many of these have to be in place before we can stamp a high probability of a depression: 1) Higher taxes, 2) A major policy mistake by either the Fed or Congress, such as an overly tight monetary policy, or a policy leading to an overly rigid labor market, tight immigration laws (especially those who have the ability to obtain a bachelor's degree or a PhD) or a more difficult regulatory business environment.  Does anyone seriously believe the U.S. will dominate the internet search market today if it wasn't for Jerry Yang or Sergey Brin?  3) Protectionism – whether it is in the form of trade or financial flows, 4) A serious military buildup leading to a wide scale war, or a war itself, 5) A global economy in tatters, such as in the aftermath of World War I and during the 1930s, or during 1998 to 1999 in the aftermath of the Asian Crisis, the Russian Crisis, and the Brazilian Crisis.  Interestingly, from this standpoint (especially point number 5), the U.S. – in the aftermath of the technology/telecom bubble – actually had a greater probability of entering a “second Great Depression” during the 2001 to 2002 period (especially in the aftermath of the September 11th attacks) than where we are right now, given the immense hardships and “slack” in the global economy at that time, compared to where we are today.  In a March 5, 2000 (five days before the ultimate peak in the NASDAQ Composite) email (“The Blowoff Phase”) to my family, friends, and acquaintances, I had implied that there was a real probability that we will enter into a depression scenario over the next few years.  Even with Greenspan's aggressive easing – as well as significant tax cuts and fiscal stimulus from the Bush Administration - a more significant downturn than what eventually transpired could not have been averted without the “cooperation” of central banks and governments around the world.

While I believe the Euro Zone, Japan, Australia, and New Zealand will continue to slow down in the months ahead, the global economy and financial markets are now more dynamic than they were during 2000 to 2002.  Moreover, U.S. corporate cash levels are still close to all-time highs (the exact opposite to where they were in 2000, when many technology and telecom companies were loaded up with debt).  As for the debt of the U.S. federal government, subscribers should remember that in terms of GDP, our federal government debt at about 65% of GDP (or about US$9 trillion in dollar terms) is currently below that of other major industrialized countries, such as Japan, Italy, Greece, Singapore, Belgium, Germany, and France.  Also, while a public debt amount of $9 trillion is nothing to sneeze at (this comes out to be approximately $30,000 for every person in the U.S. today), subscribers should note that U.S. households' net worth increased by slightly more than $9 trillion over the last 2 ½ years (according to the U.S. Flow of Funds).  Moreover, even with the latest fiscal stimulus factored in, the 2008 federal budget deficit is only projected to be 2.5% of GDP (1.5% as projected by the CBO, plus a fiscal stimulus amount equal to 1% of GDP) – which is lower than the annual budget deficits during 2003 to 2005.  For some historical context, following is a chart showing the Federal public debt as a percentage of GDP from 1791 to 2006:

Federal public debt as a percentage of GDP from 1791 to 2006

Interestingly, the national public debt level as a percentage of GDP is actually below where it was during the early to mid 1990s – and is significantly below where it was during the mid 1940s to early 1950s (during and in the aftermath of World War II).  The fear-mongers would obviously blow this out of proportion, especially once you factor in projections of Social Security and Medicare going forward.  But as history has shown, what cannot go on indefinitely will not go on.  It is important to keep in mind that projections are not predictions, and that most likely, such liability projections will not hold true (actuarial projections come with too many unpredictable variables).  One thing is for sure: A significant chunk of the baby boomers will have to work longer and retire much later than age 65.  The Gen Xers and the Gen Yers will not foot the bill.  Besides, if one factors in social security and health care liabilities, then many of the countries that have been previously discussed will be in even more dire shape than the United States going forward.

As for the U.S. household sector, subscribers should note that households' net worth just hit a new all-time high of $58.6 trillion as of the end of the third quarter 2007.  We will know whether the recent housing downturn has impacted total households' net worth once the 4Q Flow of Funds data is released early next month.  Following is a quarterly chart showing households' net worth vs. the asset-to-liability ratio of households from 1Q 1952 to 3Q 2007:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 3Q 2007) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.14 today... 5) Household net worth rose 7.3% on a year-over-year basis to an all-time high of $58.6 trillion. 6) The *dip* in net worth caused by the October 1987 stock market crash.

As I have pointed out before, households' net worth has never suffered a meaningful slowdown both on an absolute and on a percentage basis since the end of World War II, with the exception of the 2000 to 2002 period (even the vicious 1973 to 1974 bear market in stocks did not bring about such a decline).  In a capitalist and debt-laden based society such as the US, deflation can have widespread ramifications.  That is why Alan Greenspan and the rest of the Federal Reserve embarked on an aggressive easing cycle during 2001 to mid 2003.  However – at this point – based on the above numbers and an asset-to-liability ratio of 5.14, it is definitely too soon to be calling for a depression here.  In fact, given the state of our federal budget today, high cash levels of U.S. corporations, as well as a huge amount of liquid foreign capital, those who are looking for a severe recession or a depression is clearly off the mark.  Moreover, even though an asset-to-liability ratio of 5.14 is very low on a historical basis, subscribers should keep in mind that it is still a relatively high number (for every dollar of debt, U.S. households have $5.14 in assets), especially compared with the asset-to-debt ratio of U.S. corporations.  Finally, this ratio does not take into account those: 1) who took cash advances from their credit card at a 0% interest rate and put the proceeds into a savings account or a CD (I bet many subscribers did this), 2) MBA, law school, and medical school students who took out huge loans to fund their educations – presumably, the present value of their net worth will be very positive going forward, even though they are “up to their eyeballs” in student loan debt right now, and 3) the increase in homeownership, with a corresponding increase in home sizes over the last 50 years.  In other words, until or unless the amount of U.S. households' liabilities starts to increase more than U.S. households' assets, this author would not be looking for a severe recession just yet, let alone a depression.

As for our current views on the U.S. stock market and economy – as the title of our commentary implies, we are now already looking ahead, and beyond the recession, assuming that we are already in one.  As I mentioned in my previous commentaries and in our discussion forum, the S&P 500, at the most recent bottom, had already discounted a mild U.S. recession (and a global economic slowdown), based on corporate spreads, LIBOR futures, and the mainstream media's use of the word “recession” over the last few weeks (see the Bank Credit Analyst's view on this).  Moreover, the 2008 “recession futures” being traded on hit a level of nearly 80% a couple of weeks ago.  This is not surprising, as information now travel much more quickly than it has ever been, including during the 2001 recession, not to mention the July 1990 to March 2001 recession.  Speaking of the July 1990 to March 2001 recession, it is instructive to note that annualized GDP growth actually did not decline until the fourth quarter of 1990, as circled below:

GDP 1990 to 1991

More importantly, as implied by the above table showing GDP growth (or lack thereof) during 1990, even assuming that a recession has already started (that is, negative GDP growth for the first quarter of 2008, as well as the second quarter), it does not mean that the U.S. stock market will head lower in the future.  Consider that GDP growth first became negative during 4Q 1990, and then consider the following chart of the Dow Industrials during that period (courtesy of

Dow Jones Industrial Average - Interestingly, the Dow Industrials actually made a significant bottom near the beginning of the 1990 to 1991 recession.  In other words, the stock market had already discounted a recession before most analysts even realized there was one – and that was before the days of the internet!

As mentioned on the above chart, the Dow Industrials actually made a significant bottom right in the beginning of the fourth quarter of 1990 – the quarter when GDP growth first became negative!  In other words, the Dow Industrials, one of the ultimate leading indicators, had already discounted a U.S. recession well before most retail investors realized that we were already in a recession.  Assuming that the U.S. economy realizes negative GDP growth in the first quarter of 2008, it is not too far of a stretch to assert that we have already seen the bottom in the U.S. stock market a couple of weeks ago – unless, of course, something more serious develops going forward.  Given the Fed's aggressive easing cycle, the fiscal stimulus, the raising of the GSE limits, as well as the rescue of the major bond insurers (note that taken together, these measures are unprecedented in modern U.S. history), the probability of a lower low sometime this year is relatively remote.  More importantly, subscribers should remember that – unlike the 2000 to 2002 period – we are now witnessing the aftermath of a bubble in U.S. housing, not in U.S. stocks.  To the extent that the Fed and the administration is targeting their policies at the average American, this should be bullish for U.S. equities – similar to the effects of Greenspan's “easy” monetary policies and the Bush tax cuts on U.S. housing and general real estate during 2001 to 2002.  In other words, U.S. stocks can very well continue to rise even as housing prices continue to decline.

Finally, I would like to share a few newspaper headlines and stories, courtesy of this Motley Fool article:

  • Banking companies continue to be mauled in the financial markets as investors worry about rising losses from real estate lending and the growing risk of defaults on other loans. Five of the 10 most active stocks on the New York Stock Exchange yesterday were banking companies, and all of them declined. Some of the sharpest drops were for California banks, as some analysts warned that losses on real estate loans in that state will soon begin to rise." (The New York Times)

  • "Investment advisers have become downright bearish. ... Talk of recession is rampant, with many market players cautioning investors not to do anything rash -- to take no new positions, sell on rallies, and be heavily invested in cash." (The Denver Post)

  • "'The continued weakness in [the purchasing managers' report] signals no relief in the near future,' said Robert J. Bretz, chairman of the association's business survey committee and director of materials management at Pitney Bowes. 'Coupled with sharply rising prices for petroleum-related products ... the immediate outlook appears to be the worst of all combinations, a declining economy with rising inflation.'" (The New York Times)

As the author of this Motley Fool article asserted, do the above headlines and stories sound familiar?  The above articles were all published in October 1990 – the month when the U.S. stock market made a significant bottom, and immediately before a 350% rise in the S&P 500 over the next 10 years.  Again, the best thing that one can do to his/her financial health right now is to stop watching CNBC and to stop reading the business section of newspapers.

Total Capitulation in Japanese Equities

As I mentioned in our mid-week commentary, I had promised to write more about Japan in this commentary.  Let us now recap and discuss the Japanese equity market:

  1. With the latest sell-off over the last few weeks, the percentage of Japanese companies selling for below book value has jumped to 60%. Moreover, over 5% of companies in the Japanese universe are selling for below cash levels.

  2. Dividend yield now less than the yield of the 10-year JGBs. Whenever this has occurred, the Japanese stock market has always put in a substantial bottom (with the exception late 2002).

  3. Japan's P/E is now at a 33-year low. The average P/B is at 1.37. The historic low was 1.2 at the bottom in March 2003.

  4. ROE is approximately 10 - or 2/3 of that in the Euro Zone and 1/2 of that here in the US. If the Japanese starts to embrace or allow more foreign investments or more efficiency, then this could easily take off - meaning that its current P/E can quickly compress.

In addition, as shown in the following chart courtesy of the Bank of Japan, the only meaningful buying of Japanese equities since mid 2006 had come from overseas investors:

Net trading value by investor segment

In other words, domestic investors had been bailing out of Japanese equities en masse – one could even argue going back to January 2004, as many Japanese investors opted for a domestic yield of 1.5% or chose to invest in Australian or New Zealand dollar-denominated bonds/savings instead.  In such an environment, a mass-scale bailing out by foreign investors would definitely crash the markets, and that is what we witnessed during the last two quarters of 2007, as foreign investors sold Japanese equities for an unprecedented (at least in the current bull market) two consecutive quarters, as shown in the below chart courtesy of Goldman Sachs:

Net purchases by foreign investors

Again, my guess is that we have just witnessed “total capitulation” in the Japanese equity markets, and while I am still looking for a “trigger” for higher Japanese equity prices going forward, my sense is that there is not too much downside risk from current levels, especially in those companies who have no significant currency risks or who don't compete with China or South Korea in the global export markets.  As a group, Japanese small caps (which are even more oversold than Japanese large caps) comes to mind.

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 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2006 to February 1, 2008) - For the week ending February 1, 2008, both the Dow Industrials and the Dow Transports enjoyed substantial rallies - with the former rising 536.02 points and the latter 332.53 points, or more than 4% and 7%, respectively. The recent strength of the Dow Transports (which enjoyed a rally of over 15% in the last two weeks), - is very reassuring from a Dow Theory standpoint, as the Dow Transports had been a major leading index of this bull market since October 2002. Once again, this author is now bullish on the major US market indices, based on two overriding ideas: 1) The fact that we have seen a capitulation* in the US financials and consumer discretionary sectors, as well as in the European markets where we saw a liquidation of a $72 billion position two weeks ago, and 2) Our view that the Fed and Congress will continue to have an easing bias on the economy going forward. Bottom line: Subscribers should continue to be cautious, but I believe we have at least made an important intermediate-term bottom as of January 22, 2008.

For the week ending February 1, 2008, both the Dow Industrials and the Dow Transports enjoyed substantial rallies – with the former rising 536.02 points and the latter rising 332.53 points, or more than 4% and 7%, respectively.  Again, the strength of the Dow Transports over the last three weeks is very telling (especially in light of continuing high oil prices), as the Dow Transports has been the leading index since this cyclical bull market began in October 2002.  Coupled with the severe oversold condition in the U.S. and global stock markets two weeks ago there is a very good chance that we have already seen a bottom on January 22nd, even though retail investors should continue to be jittery over the next several months.  For now, we will stay 100% long in our DJIA Timing System.

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 decreased from last week's -6.1% to -8.4% for the week ending February 1, 2008.   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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending February 1, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios made another major low - declining from -6.1% to -8.4%, and is now further below its five-year *trading range.* Specifically, this reading is now at an oversold level not witnessed since early April 2003. Moreover, the 10-week MA (not shown) is now at 1.8% - representing the most oversold reading since May 2003. Given the immense strength in the Dow Transports we witnessed in the last three weeks, along with the SoGen liquidation of its $72 bilion position in the European markets, I expect the market to have bottomed out two weeks and to enjoy a substantial rally over the next several months. At this point, we will stay 100% long in our DJIA Timing System.

With the reading at -8.4%, the four-week MA is now at its most oversold level since April 2003, and is now approaching its “lows” of March 2003.  Given this and other factors we have previously discussed, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should the fiscal stimulus fail to pass the Senate in time (which I highly doubt).

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.  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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting a 3-month high of 143.4 on October 15th, the 20 DMA of the ISE Sentiment has declined to the 97.9 level, an oversold level not seen since October 30, 2002.  Not only are the 20 DMA and the 50 DMA now at an oversold condition consistent with levels achieved during various market bottoms over the last 18 months, they are now also at a level close to the market bottom in October 2002 . Should the 50 DMA decline another point, then the 50 DMA would be at a low not seen since November 2002. I continue to believe that there is little downside here. For now, we will stay 100% long in our DJIA TIming System.

With the 20-day moving average of the ISE Sentiment Index declining to 97.9 (its most oversold level since October 30, 2002) and the 50-day moving average to 111.8 in the latest week, the ISE Sentiment Index is now extremely oversold and has “sold off” to a level that is close to multi-year lows.  Given the capitulation bottom that we saw on January 22nd, and given the immensely oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, I believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500.  For now, we will stay with our 100% position in our DJIA Timing System, and will most likely only scale back if we get a spike in our most popular sentiment indicators.

Conclusion: Even assuming the U.S. has already entered a mild economic recession, chances are that we have already seen a bottom in equity prices on January 22nd, given the severely oversold conditions on that day (and the preceding two weeks), as well as the fact that many other financial assets had already discounted such a scenario two weeks ago.  Such a bottom would also be consistent with the late 1990 to early 1991 recession – when the Dow Industrials bottomed out during the first month of the first quarter (i.e. October 1990) that the U.S. economy experienced negative GDP growth.  In terms of our sentiment indicators (based on what we normally use, as well as newspaper headlines and the frequency of the word “recession” in the mainstream media), there is no doubt that the January 22nd bottom had also discounted a mild U.S. recession as well.

Moreover, many folks had conveniently forgotten that we just had a bubble in U.S. housing, not in U.S. equities.  Since the Federal Reserve, the Administration, and Congress are essentially targeting the “average American” when it comes to Fed easing and the fiscal stimulus – as opposed to extended/subprime U.S. homeowners, it is not inconceivable to see some of this “excess liquidity” spill over into the U.S. equity markets – similar to what housing experienced during the last easing cycle from early 2001 to mid 2003, even as U.S. stocks continued to deflate.  For now, we will stay with our 100% long position in our DJIA Timing System.  I also continue to be bullish on U.S. consumer discretionary and certain financial shares (please see Rick Konrad's latest guest commentary for some suggestions on the consumer discretionary/retail side).  We will only look to par down our positions should our most popular sentiment indicators start to get overbought, or should liquidity levels start to wane.  Finally, given the tremendous valuations (not to mention its hugely oversold condition) we are now seeing in the Japanese stock market, I think it is now time to start nibbling on Japanese equities, especially Japanese small caps.

Signing off,

Henry To, CFA

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