The Prospective Yield of Capital
(March 16, 2008)
Dear Subscribers and Readers,
Before we begin our commentary, let us now 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 loss of 678.91 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 236.09 points as of Friday at the close.
While I am not happy with our performance in our DJIA Timing System over the last couple of months, I continue to have confidence in our position. Moreover, our long-term track record remains sound, as demonstrated in our signals going back to both 2006 and the inception of the system (I will provide an update on inception-to-date performance later this month).
Let us now get on with our commentary. Chapter 11 of John Maynard Keynes' “The General Theory of Employment, Interest, and Money” defines the “prospective yield” of an investment as the following:
“When a man buys an investment or capita-asset, he purchases the right to the series of prospective returns, which he expects to obtain from selling its output, after deducting the running expenses of obtaining that output, during the life of the asset. This series of annuities Q1, Q2, … , Qn it is convenient to call the prospective yield of the investment.”
Furthermore, the price of an investment can be defined as the following:
“If Qr is the prospective yield from an asset at time r, and dr is the present value of $1 deferred r years at the current rate of interest, ∑Qrdr is the demand price of the investment…”
This is the discount of earnings/cashflows model that most fundamental and value investors still use today – although with the advent of modern computing technology, such models today are infinitely more robust. For example, today, one can easily come up with more than a hundred different scenarios to model a company's future cash flows or earnings, assign a probability to each scenario, and come up with a probability distribution of where future earnings and thus present value may lie. Such an undertaking would have involved hundreds of hours of manual labor in Keynes' and Benjamin Graham's time.
More importantly, the “prospective yield” of capital or of an asset depends on two important trends:
- The prospective cost of production, “whether these changes are expected to come from changes in labor cost, i.e. in the wage-unit, or from inventions and new technique.”
- The prospective value of the output as dictated by the markets.
This basic framework is directly relevant to the markets today – especially in the financial sector. Using this basic framework, it is easy to see why the takeover of Bear Stearns by JP Morgan is ultimately bullish for the financial sector, especially for commercial and investment banks.
Firstly, Bear Stearns is (or was) one of premier investment banks, prime brokers, and asset managers in the global financial industry, with more than 14,000 employees worldwide. With the JP Morgan takeover, there will no doubt be an excess number of (skilled) workers in the financial industry starting tomorrow. While some of these folks are already being “snapped up” by competitors, it will be difficult for the entire financial industry to “digest” so many employees – not just next week but over the next few years as well. Moreover, with the “Class of 2008” graduating in a couple of months (MBAs as well as undergraduate business students), this will – at least for the next 12 months – severely depress wages or wage increases. This would also scale back the salary/bonus expectations of many Wall Streeters – at least until the next financial bubble starts to build up. In other words, with the JP Morgan takeover of Bear Stearns, the “prospective cost of production” in Wall Street most probably will significantly decline going forward.
Secondly, one of the best competitors of Wall Street and in the global financial industry will no longer be competing. Investment banking fees, asset management fees, and prime brokerage fees would most likely be higher. Moreover, with the dissolution of Bear Stearns in such a quick manner, the expansion and risk-taking mentality of many Wall Street firms are now gone. This will have the effect of raising prices of financial services for many firms – and will be doubly beneficial to those firms who: 1) do not have to sell assets in order to raise capital, and 2) actually have the capital and “guts” to expand their operations over the next few years. More importantly, as long as Wall Street is still standing tomorrow (I have no doubt it will), Wall Street as a whole should benefit from the takeover of Bear Stearns as competition recedes across the board.
As a result, the takeover of Bear Stearns by JP Morgan should raise the prospective yield of capital on virtually all of Wall Street – both from an input (labor) standpoint and from an output (higher prices) standpoint. Once the Bear Stearns takeover is final, and assuming that it does not cause further systematic risks (Bear Stearns is a very unique case in that it invested in the most risky and toxic mortgage securities), the valuation of Wall Street as a whole should rise, not decline. In particular, as I am typing this, it has been confirmed that Bear Stearns would now be bought for $2 a share (or $235 million). Given that the Bear Stearns building is worth $1.5 billion alone in this environment, I would say that JP Morgan is definitely getting a great deal (not dissimilar to when Pierpont Morgan brokered the takeover of Tennessee Iron & Coal by U.S. Steel in the midst of the Panic of 1907).
Furthermore, with the Fed expected to ease the Fed Funds rate by as much as 100 basis points next Tuesday – and with a promise of more rate cuts to come – the discount factor at time r, dr, should also decrease. Moreover, a further ease would raise the margins of both commercial and investment banks, as the cost of funding would generally decline, especially for traditional commercial banking activities where the bankers “borrow short” (from depositors) and “lend long.”
Bottom line: The dissolution and takeover of Bear Stearns by JP Morgan should be bullish for the vast majority of commercial and investment banks, as: 1) it means less competition and lower labor prices going forward, thus increasing the prospective yield of capital, and 2) it created another incentive for the Federal Reserve to lower the Fed Funds rate, resulting in a lower discount rate (higher valuations for stocks in general), and a lower cost of funding for both commercial and investment banks. While the ultimate and exact effects on profit margins and cost of capital are unknowable, there is no doubt that – as illustrated by my above framework – this latest Bear Stearns crisis is actually bullish for the stock prices of commercial and investment banks alike, especially over the long-run.
The March 18th Federal Reserve Meeting
As I am typing this, it looks like that the Fed has again lowered the discount rate without lowering the Fed Funds rate. The discount rate is now at 3.25%, versus a Fed Funds rate of 3.00%. It has also been announced that a lending facility for investment banks has been created by the Federal Reserve, although details are not known at this stage. It is now a certainty that the Federal Reserve will cut by at least 75 basis points on March 18th, but my current bet is 100 basis points. Many analysts and traders will be disappointed if the Fed “only cut” by 75 basis points.
Again, there is no way the Federal Reserve will only cut by 50 basis points on Tuesday. As this hour of crisis, the Federal Reserve has to exert leadership and credibility. For those who have read Ben Bernanke's “Essays on the Great Depression,” it is obvious that (at least from our Fed Chairman's standpoint) one of the main causes of the Great Depression in the aftermath of the crash of 1929 was the leadership vacuum created by the death of Benjamin Strong (who was Pierpont Morgan's right-hand man during the Panic of 1907), the NY Fed Governor, in 1928. The Clearing House, which provided liquidity to the U.S. banking sector in 1907 – believing (rightly) that the Federal Reserve was in charge, never took action to ease the liquidity crisis in either the stock market or the financial markets. Conversely, the Federal Reserve, without the leadership of Benjamin Strong, fell behind the curve substantially by not lowering the discount rate and providing enough liquidity to the banks to stem firstly, the stock market crisis, and secondly, the banking crisis that swept the nation starting in early 1931. Obviously, the fragmented nature of our banking system during the 1930s did not help either – as the Fed never had the manpower (even if they wanted to) to audit all the banks and provide liquidity – unlike today's targeted efforts of the Fed on Bear Stearns.
Given that the Federal Reserve had previously communicated doing all it can to stem the crisis and to err on the dovish side, folks who are looking for a mere 50 bps cut are dead wrong. Moreover, as discussed by a recent paper by Alan Meltzer on the “Origins of the Great Inflation” of the 1970s, one of the reasons why the country was mired in a stagflationary period during the late 1970s was that the Federal Reserve, under the “leadership” of Arthur Burns and William Miller, constantly “flip-flopped” between fighting inflation and promoting economic and monetary growth. That is, the Federal Reserve never had a coherent policy during that time and lacked credibility. Moreover, many of the decisions were “ad hoc” and were never based on sound analyses. Given the Fed's communications so far, it is thus non-sensical to expect the Fed to only cut by 50 basis points and to start focusing on inflation so soon in the game. At the earliest, I do not expect any change in official policy or communications until the second half of 2008.
Turning to the domestic stock market, the amount of “cash on the sidelines” waiting to be invested has increased again from last week and is now very close to 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 March 2008 (note that the March data is only extended into last Friday, obviously):
As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 28.15% - an astronomically high level that broke all previous record highs – including the month-end February 2003 high and the month-end July 1982 highs. The October 1990 high – the last time the U.S. stock market gave us a once-in-a-decade buying opportunity – has now been “blown out of the water.” Moreover, subscribers should remember that the global capital that is sitting on the sidelines waiting to be invested is also now at record highs (in fact, such an amount of capital was virtually non-existent back in February 2003, let alone July 1982 or October 1990). 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 – 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 on Tuesday, which is not something I am expecting.
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 March 14, 2008, the Dow Industrials rose 57.40 points while the Dow Transports rose 16.33 points. For the first time since late January, both the Dow Industrials and the Dow Transports rose in the same week. More importantly, the continued strength in the Dow Transports also resulted in a non-confirmation of the Dow Industrials on the downside last Monday by the Dow Transports, as the latter is still more than 7% above its January closing low, despite the failure of the Delta-Northwest merger and record high crude oil prices. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, this latest development suggests that the recent weakness in both the Dow Industrials and the broad market is overdone. 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 declined from last week's reading of -7.0% to -10.8% for the week ending March 14, 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 the historically oversold condition in this sentiment indicator, my sense is that the broader market has either bottomed out or will bottom over the next couple of weeks. Given the readings of this sentiment indicator, the successful takeover of Bear Stearns by JP Morgan before most of Asia opened tonight, 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 87.1 and the 50-day moving average declining to 92.6 in the latest week, the ISE Sentiment Index again has again hit a record low for the week – i.e. even more oversold than where they were at the October 2002 lows. Given the historically oversold condition of the stock market, the takeover of Bear Stearns by JP Morgan, the severely pessimistic sentiment on the part of retail investors, the unprecedented amount of capital sitting on the sidelines, and the promise of more Fed easing, I continue to believe we have already witnessed (or are witnessing) 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 Bear Stearns takeover ultimately fails to go through.
Conclusion: The demise and takeover of Bear Stearns by JP Morgan is ultimately bullish for the financial sector, as it would increase profit margins across the financial industry for two reasons: 1) Less competition - resulting in higher output prices, and 2) More "slack" in the labor market in the financial sector - resulting in lower input prices. Moreover, given that the Federal Reserve is still worried over the lack of confidence in our financial markets, the Fed will most likely cut the Fed Funds rate by 100 basis points this Tuesday and continue to adopt a dovish policy – which would ultimately be bullish for the financial sector as it would lower funding costs (which also result in a steeper yield curve) for commercial and investment banks. Moreover, the $2 a share offer of Bear Stearns would not result in any significant moral hazard problems down the road, as shareholders (including employees who hold most of their net worth in Bear Stearns stock and who were prevented to sell their shares because of a lockup period last week) have essentially been wiped out.
For now, we continue to be bullish on the U.S. stock market, given that the vast majority of our contrarian/sentiment indicators have been hitting multi-year lows day after day, and given the Fed's continuing accommodative stance, the successful takeover of Bear Stearns by JP Morgan, 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