The Rules of Engagement
(February 24, 2008)
Note: There will be no mid-week commentary this Thursday morning, as I will be attending the annual CFA LA Society Forecast Dinner this Wednesday evening. Rather, I will type out my detailed notes and provide a brief overview of what was discussed on Thursday evening. Speakers include Alison Deans, the CIO of Lehman Brothers Private Investment Management, Don Straszheim, Vice Chairman of Roth Capital, and Tony Crescenzi, the Chief Bond Market Strategist of Miller Tabak + Co. In the meantime, you can find a summary of last year's forecast dinner in our discussion forum.
Dear Subscribers and Readers,
I want to begin our commentary by reviewing 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 loss of 248.98 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 666.02 points as of Friday at the close.
Under the Chairmanship of Alan Greenspan, the Federal Reserve shifted from a policy of planning and conducting monetary policy for the “most probable scenario” to the “worst case scenario” under reasonable and predictable circumstances. Robert Rubin, the former Secretary of the Treasury under President Clinton, had articulated this “doctrine” in his biography, “In an Uncertain World: Tough Choices from Wall Street to Washington” - justifying its adoption from his experience as an arbitrageur at Goldman Sachs. In short, the Fed Chairman and the Secretary of the Treasury, as guarantors of the U.S. financial system, need to have the following questions etched into their minds, especially during times of crisis:
- What is a probable worst-case scenario if the Fed or the Treasury does not tackle the problem or if it does not tackle the problem in an efficient manner? What are the potential economic or political ramifications?
- What are the most efficient tools, and more importantly, what tools are available to the Fed or the Treasury to counter the crisis with a “debilitating first strike” to restore confidence in the financial system?
- What other potential crises or “unknown unknowns” do we need to look out for? Given the complexity of today's global financial system, such variables are definitely much more prevalent than they used to be even ten years ago. Given this, should policy makers err on the side of caution and ease or flood the financial system with more liquidity than most participants expect?
With the mass development of nuclear weapons during the Cold War – and more importantly, with the development of three distinguished ways to deploy these weapons – the United States, for the first time in history, was able to deliver a debilitating “first strike” on an opponent's leadership and the bulk of its nuclear arsenal in as little as two hours during a wide scale war. Moreover, with three distinguished means of deploying these weapons (through land-based ICBMs, stealth bombers such as the B-2, and submarine-launched ballistic missiles), this also meant the Soviet Union could never have delivered a debilitating first strike on the United States. In other words, the doctrine of “mutually assured destruction” was actually fairly lopsided in favor of the US. Nonetheless, the concept of a “debilitating first strike” was extremely important in the event of war between the Soviet Union and the United States, for obvious reasons. While the annihilation of a sovereign country's leadership with a “first strike” was fairly new at the time, this concept could be partially extended back to earlier times, with one example being the Japanese bombing of Pearl Harbor.
Although the bombing of Pearl Harbor had been a military success for the Japanese, it did little to buy them much time for the ensuring war in the Pacific. Given the shallow waters in the harbor, many ships that were sunk were quickly raised and repaired. Moreover, with the benefit of hindsight, we now know that the commander of the Hawaii task force, Chuichi Nagumo (who reported to the designer and planner of the Pearl Harbor bombing, Admiral Yamamoto), was far too cautious. Indeed, given the successes and the little resistance encountered by the two waves of Japanese bombers, most historians argued that a third and final wave should have been sent to take out the repair facilities and fuel depots. Quoting Daniel Yergin's Pulitzer Prize winning book “The Prize”:
It was a strategic error with momentous reverberations. Every barrel of oil in Hawaii had been transported from the mainland. If the Japanese planes had knocked out the Pacific Fleet's fuel reserves and the tanks in which they were stored at Pearl Harbor, they would have immobilized every ship of the American Pacific Fleet, and not just those they actually destroyed. New petroleum supplies would only have been available from California, thousands of miles away. “All of the oil for the Fleet was in surface tanks at the time of Pearl Harbor,” Admiral Chester Nimitz, who became Commander in Chief of the Pacific Fleet, was later to say. “We had about 4 ½ million barrels of oil out there and all of it was vulnerable to .50 caliber bullets. Had the Japanese destroyed the oil,” he added, “it would have prolonged the war another two years.”
So Henry, what does this discussion have to do with the financial markets?
The purpose of this discussion is two-fold. Firstly, from a policy maker standpoint, it is important to tackle any developing financial crisis with a “debilitating first strike.” A good example was President Bill Clinton's response to the 1994 economic crisis in Mexico. Clinton, on the advice of Robert Rubin and Alan Greenspan, was instrumental in bailing out Mexico, spear-heading a $50 billion loan package – including a direct $20 billion loan through the Treasury's Exchange Stabilization Fund when the Mexican Stabilization Act failed to get through Congress. The speed and size of this loan was instrumental in derailing the crisis and preventing it from spreading further – not just from an economic but from a political standpoint as well. A counter-example is the West's lack of response to the devaluation of the Thai Baht in July 1997 – which was instrumental in triggering the “Asian Crisis,” taking down successive countries in the region such as Indonesia (which was actually running a current account surplus), Malaysia, South Korea, the Philippines, Hong Kong, and to a lesser extent, Singapore and Japan. Not only were the IMF slow to respond, it also forced countries to implement solutions that were hugely contractory in nature – which not only caused severe recessions, but also resulted in political and social chaos as well. Moreover, the collapse in the major Asian economies also led to the eventual collapse of oil prices and economic demand, and subsequently the Russian and Brazilian economies during the Fall of 1998. Many of these economies did not begin to recover until 4 to 5 years ago. Given that most of Asia was still reeling from the 1997 Asia Crisis, and given that European economic growth was still mediocre, it is thus of no surprise that Alan Greenspan and Ben Bernanke alike was hugely worried about the possibility of a US and worldwide deflationary depression during the darkest days in 2002 – when the US was still reeling from the aftermath of the popping of the technology bubble. Make no mistake: The world's central bankers will not let this happen again.
Secondly, and again from a policy maker standpoint, it is important to plan for all contingencies – and to do more than you initially plan to with your “debilitating first strike.” If Capital Nagumo had sent out a third wave of Japanese bombers, it would have taken many more months for the American Pacific Fleet to recover. Similarly, the Greenspan and Rubin “doctrine” of making policy for the “worst case” scenario is imperative when we are in the midst of a financial crisis, especially given the complexity of the financial markets today (the things that could go wrong have multiplied over the last ten years).
At this time, there is reason to believe that the Fed, the Treasury and Congress is collectively doing everything it can to stabilize the financial system – although as we mentioned in last weekend's commentary, monetary policy, as guided by the “Taylor Rule” (coincidentally, PIMCO's Paul McCulley also discussed the Taylor Rule in his latest monthly commentary) is still relatively tight with the Fed Funds rate at 3.0% (this tight monetary policy is also evident from the lack of growth in the monetary base and the reluctance of banks to expand their balance sheets). Like I mentioned before, and as demonstrated by many empirical studies, the Federal Reserve is not impotent. By dramatically lowering interest rates and subsequently LIBOR, the Fed, through the major US money center banks, can reliquify the economy. With the cooperation of Congress and the Administration (namely the $145 billion fiscal stimulus beginning in May), the Fed can dramatically cushion the economy from entering a severe recession, especially since: 1) The housing bubble was nowhere near as speculative as similar housing bubbles in the UK, Australia, and of course Japan in the late 1980s, and 2) There had been no corresponding bubble in the U.S. stock market – again, unlike Japan in the late 1980s. In other words, as long as the Federal Reserve of Congress is not targeting the U.S. housing market directly (such as by buying houses and shrinking supply by knocking them down), they are not “throwing good money after bad.” Furthermore, the Federal Reserve is very far away from exhausting its options, given the relatively attractive valuations in the U.S. stock market. By reliquifying the financial system and by collapsing short rates, the Federal Reserve could easily encourage investors and speculators to take risks again given the attractive valuations in the U.S. stock market – thus providing a boost to asset prices going forward.
In a more immediate sense, it is imperative that some kind of “rescue package” for the MBIA and Ambak be put together early this week. In an institutional conference call held by PIMCO's municipal bond managers last Friday, they emphasized that this was the darkest cloud over the municipal and the “auction-rate” markets today. Should the monoline insurers' issues be resolved early this week, this would restore tremendous liquidity, not only in the auction rate and municipal bond markets, but in the student loan asset-backed market as well. More importantly, this will remove a severe capital constraint on the major U.S. investment and commercial banks. My sense is that this will restore a tremendous amount of confidence – at least in the next couple of weeks. However, we are not out of the woods just yet. Given that the peak of subprime resets will hit next month (please see following chart courtesy of Bank of America and PIMCO), and given that subprime, jumbo, and Alt-A resets should remain elevated until October, it is imperative that the Fed should continue to aggressively ease going forward.
At this juncture, there is no reason to believe the Fed will “shy away” from its current easing campaign. After all, the Bernanke Fed – eager to be seen as an “inflation targeter” and to avoid any upcoming moral hazard problem – failed to ease more aggressively and to tackle much of the current liquidity problems early on during the September to October period of last year. Just as important, while it viewed itself as a credible “lender of last resort,” it failed to see that other financial institutions would be reluctant to directly borrow from the Fed through the discount window – and that more ominously, financial institutions would shrink their balance sheets and “hunker down” in order to stay solvent rather than borrow from the Fed and expand their balance sheets. Obviously, such a scenario is not acceptable from both the Fed's and the Administration's standpoint (when creditworthy students have a tough time getting their student loans renewed, it is time for the Fed to step in). Almost belatedly, the Fed has now realized this “pro-cyclicality” of the leveraged financial institutions – and is thus doing everything in its power to reverse this. As I have mentioned before, should the Fed lower the Fed Funds rate by 75 basis points on March 18th (and assuming that 6-month LIBOR follows – the Fed will make sure it does), the average adjustable subprime mortgage that resets after March 18th will effectively have its new interest rate frozen. Should the Fed follow that up with another 50 basis point cut in late April, subprime borrowers on average would actually see their payments decline when their interest rates reset after the late April Fed meeting! For now, the bears would have to throw away the “pushing on a string” mentality…
Assuming the Fed cuts by 75 basis points on March 18th, I continue to be bullish on the U.S. stock market. Moreover, I also believe that the recent rise in crude oil prices have been buoyed mostly by short-term supply concerns (such as the Exxon dispute with Venezuela, Nigeria, and the Turkey incursion into Iraq), short-covering among financial speculators, and pension fund money flowing into commodities. However, as shown by the amount of U.S. crude oil and gasoline stocks (following charts are courtesy of the Energy Information Administration): 1) the amount of U.S. crude oil stocks has been rising at a dramatic rate over the last two months, and 2) gasoline stocks are now 10 million barrels higher than the top-end of its five-year range.
More ominously for the crude oil bulls, both the amount of crude oil and gasoline stocks has risen to their current levels from the bottom end of its five-year range just two to three months ago! Unfortunately, we do not have updated numbers for total OECD stocks as of this time (the numbers are published by the IEA nearly two months after the fact), but given the collapse of various leading economic indicators in Western Europe, the UK, and Japan, I would not be surprised to see a similar rise in total OECD stocks over the last two months as well. Furthermore, as oil prices remain at current levels, the amount of government fuel subsidies all over the world will decline going forward – which should collapse crude oil demand in certain countries (Jordan has just removed its fuel subsidies; other notable countries that are maintaining unsustainable fuel subsidies include Argentina and Indonesia). Finally, given that non-OPEC supply is projected to rise by 900,000 barrels a day this year, my sense is that crude oil has no business being at $100 a barrel for a sustainable period of time. Should commodity investors shy away from short-term supply concerns, spot oil prices could easily decline back to $80 to $85 a barrel – which should also provide a tremendous amount of liquidity to U.S. consumers and the U.S. stock market going forward (a $10 decline in crude oil prices is equivalent to around 0.5% of US GDP).
In the meantime, the amount of “cash on the sidelines” waiting to be invested is now near a record amount relative to U.S. market cap. This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge of how oversold the US stock market really is – as well as how sustainable a current rally may be. I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to February 2008 (updated with February 22nd data for the month of February):
As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 25.96% - a level not seen since March 2003, and is now at a higher level than where it was in October 1990 – the last time the U.S. stock market gave us a once-in-a-decade buying opportunity. While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now extremely high on a historical basis and should be supportive for stock prices not only for over the next few years, but over the next few months as well. Even though the stock market can do anything over the short-run, my guess is that we have already seen the bottom in late January – which means that we will continue to remain 100% long in our DJIA Timing System for the time being, unless the Fed backs away from its current easing campaign.
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:
For the week ending February 22, 2008, the Dow Industrials rose 32.81 points while the Dow Transports declined 22.12 points as oil prices continued to rise. For the second week in a row, the Dow Transports has failed to confirm the Dow Industrials on the upside. That being said, the Dow Transports –with its 12% rise over the last four weeks - is still exhibiting greater relative strength than the Dow Industrials at this point, and given that the Dow Transports has been the leading index since this cyclical bull market began in October 2002, 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 bounced significantly from last week's reading of -8.3% to -5.8% for the week ending February 22, 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:
Given this significant reversal in sentiment, and given that it is bouncing from an extremely oversold level (most oversold since April 2003), there is a good chance that sentiment is reversing from its extremely pessimistic readings over the last few weeks – which should be bullish for the stock market in the short-run. Given this and the impending “rescue” of the monoline insurers, 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 Fed back away from its aggressive easing campaign.
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:
With the 20-day moving average of the ISE Sentiment Index declining to 96.2 and the 50-day moving average declining to 104.6 in the latest week, the ISE Sentiment Index is now extremely oversold and has “sold off” to a level that is very close to its October/November 2002 lows. Given the capitulation bottom that we saw on January 22nd, the immensely oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, the impending rescue of the monoline insurers, and the promise of more Fed easing, 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 only scale back if the Fed backs away from its easing campaign or if the monoline rescue fails to go through.
Conclusion: The “Rules of Engagement” – as articulated and reinforced by the Fed and the Administration's actions – changed substantially in early January. Instead of playing a passive role and offering its discount window as a “lender of last resort,” the Fed has actively stepped up to not only ease any upcoming shocks to the U.S. financial system, but to prevent any further shocks going forward. The cumulative 225-basis point cut in the Fed Funds rate since September is only its first line of offense. Given the continuing liquidity constraints in the financial system and given the collapse in various U.S. economic leading indicators over the last two months, there is no doubt the Fed easing campaign is still ongoing – and that, as we mentioned in last weekend's commentary, subscribers should not be surprised if the Fed eases the Fed Funds Rate to below 2% over the next few months. Even though the Fed missed its opportunity to launch a “debilitating first strike” on the subprime virus during the September to October period of last year, it is still not too late in the game. Make no mistake: The Fed will not make the same mistake all over again. They will ease and continue to ease until this has been convincingly contained. To the folks who are worried about inflation further down the road: One can only worry about this if the financial system remains intact! Giving the necessary “medicine” to the U.S. economy a la Jim Rogers' style would no doubt bring on a depression much more severe than the recessions witnessed during 1974 to 1975 and 1982. Not only will a significant chunk of the Middle Class be wiped out, there would also be significant social ramifications – much like what Japan's “lost generation” is enduring today.
For now, we continue to be bullish on the U.S. stock market, given that the vast majority of our contrarian/sentiment indicators have hit multi-year lows, and given the Fed's accommodative stance and the immense amount of cash currently on the sidelines. While anything can happen in the short-run, we believe that there is a little downside in U.S. (and Japanese) equities at current levels. For long-term investors especially, the market continues to be a “buy.”
Henry To, CFA