The Great Deleveraging
(March 23, 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 268.68 points as of last week at the close.
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 646.32 points as of last week at the close.
I will provide an update of our inception-to-date performance after the end of this month. Suffice it to say, our long-term track record remains good – especially relative to our benchmark, the Dow Industrials Industrial Average. Moreover, our last two signals – which collectively brought us from a neutral to a 100% long position in our DJIA Timing System, are again collectively in the black. I expect the Dow Industrials and other major market indices, such as the S&P 500, the Dow Transports, the Russell 3000, and the Russell 2000 indices to continue their ascent over the next several months.
Let us now get on with our commentary.
What a difference a week makes. This time last week, as the Bear Stearns acquisition was announced, many folks were staring at the edge of the abyss, as the value of many broker/dealers' shares were being openly questioned. After all, if Bear Stearns was valued at only $2 a share (or $240 million), how much could Lehman, Merrill, or Morgan Stanley be really worth, especially in a credit crunch environment? Even though the $2 a share offer was initially shocking, it wasn't a total surprise, as Bear Stearns really had little say in the price of the offer, given the Federal Reserve and the Administration's push to get some kind of deal put together last weekend (in hindsight, it turned out that the Fed instructed JP Morgan to not pay more than $2 a share, as the Fed did not want to give the impression that it had bailed out Bear Stearns). Soon after the market opened, however, this question became irrelevant, as the price of JP Morgan's shares tacked on more than 10% in a down market, which essentially meant that the Bear Stearns acquisition was adding value to the tune of over $100 a share on the Bear Stearns common. Moreover, with the Fed's 25 basis point cut of the discount rate, as well as its promise to “backstop” the 20 primary dealers by allowing them access to the discount window, the Fed had ended the liquidity crisis with a single stroke. While there will be tremors as the financial sector continues to deleverage (think Thornburg Mortgage and CIT Group), systematic risk had significantly declined with the implementation of the Fed's 6-month “liquidity put” for the 20 primary dealers.
Subscribers should remember that these “boom/bust” cycles are an inherent part of our capitalist society. For the most part, the social and political atmosphere of the United States ever since her founding has allowed the “animal spirits” in all of us to express themselves – whether it is in entrepreneurship, business, investment, speculation, adventure, or in sports. Such “animal spirits” will no doubt exaggerate themselves at various times – and it is such “exaggerations” that bring about our boom/bust cycles. Moreover, such expression of “animal spirits” is not only inherent but is necessary to further advance the capitalist society. As John Maynard Keynes expressed in Chapter 12, “The State of Long-Term Expectation” in his book “The General Theory of Employment , Interest, and Money” in 1936:
Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; - though fears of loss may have a basis no more reasonable than hopes of profit had before.
It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and use them, is put aside as a healthy man puts aside the expectation of death.
This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man.
Hyman Minsky – a student of Joseph Schumpeter – took Keynes' thesis to its logical conclusion by laying out a typical roadmap of such boom/bust cycles in capitalistic societies – or what we would call the “Minsky framework” today (I highly recommend reading his books “John Maynard Keynes” and “Stabilizing an Unstable Economy” for more of his insights). More importantly, Minsky believed that capitalism in itself is inherently unstable – and that the Federal Reserve should come in as a lender of last resort and to set/slash interest rates in order to stabilize a financial crisis or a severe economic downturn. Fans of the Austrian economists (note that Joseph Schumpeter was never an advocate of Austrian economics) would no doubt disagree with this view. But it really does not matter. We have had a Federal Reserve since 1913 and there is no political will to dismantle it. Moreover, our Fed Chairman, Ben Bernanke, and the NY Fed's President Timothy Geithner (the second most powerful figure, and the Vice Chairman of the FOMC) have essentially embraced these beliefs – and most importantly, have acted according to their beliefs over the last ten weeks. This is a major reason why (along with historically oversold readings in both our technical and sentiment indicators) we started turning bullish during the second week of January – and ultimately going 100% long in our DJIA Timing System during the intraday lows of January 22nd.
Given the lengths that the Federal Reserve has gone to “back stop” our financial system, and given its series of rate cuts since January 22nd (200 basis points in the Fed Funds and 225 basis points in the discount rate over the last two months alone), the old adage “Don't fight the Fed” certainly applies here. Moreover, given the stock market's historically oversold status over the last couple of months (in terms of relative valuations, technicals, and sentiment) – and given the many positive divergences we are now witnessing (such as the strength in the Dow Transports over the last few weeks, the higher lows in the NYSE McClellan Summation Index, and the higher lows in new highs vs. new lows on both the NYSE and the NASDAQ), the other important old adage, “Don't fight the tape” also applies. If you are still a U.S. stock market bear at this point, you are doing both – and it has NEVER paid to simultaneously “fight the Fed” and to “fight the tape.” Following is an example of a positive divergence (the chart courtesy of Decisionpoint.com) – as the number of 52-week lows for common stock issues on the NYSE during the recent decline did not get anywhere close to that during the late January decline:
Given the many severe oversold conditions we have discussed over the last few weeks (not to mention very bullish insider buying, as well as the fact that domestic equity mutual funds are now due to see their 10th consecutive monthly outflow, surpassing the previous eight-month streak following the October 1987 crash), the record amount of investment-ready capital sitting on the sidelines, and very decent valuations, I am now bullish on the U.S. stock market for at least the next few months.
That being said, there is no doubt that a “new era” of finance is now upon us. While I am still bullish on the financial industry and its ability to create new risk-hedging/speculation products over the long-run, there is no doubt that some “shakeout” over the next 12 to 24 months is imminent. This is simply human nature – as financing had been too lax and too cheap over the last few years due to the “anything goes” environment and the widespread belief that securitization would dilute risk from the financial sector to the overall global economy. To some certain, that argument was valid, but unknowingly – especially to those who invested in Citigroup, Merrill Lynch, or Bear Stearns – the financial sector had also kept a significant portion of this “toxic waste” paper on their balance sheets. Now that the “animal spirits” of financial sector CEOs and Harvard MBA students are being slapped down by the market place – and now that the politicians are screaming for more regulations, the appetite for risk-taking in the financial sector is past us, and probability suggests that a significant part of this sector will deleverage going forward.
In an institutional conference call late last week, Bill Miller of the Legg Mason Value Trust Fund remarked that global debt had also been growing at twice the pace of global GDP over the last few years. As such, he expects a significant part of the world would also enter a deleveraging phase over the next couple of years. In my humble opinion, the marginal players – such as Bear Stearns, Carlyle Capital, Thornburg Mortgage, and the subprime mortgage originators – were the first casualties. While the demise of Bear Stearns marked the end of the first phase of the deleveraging process, I expect other players to start falling as general financing gets more difficult and expensive to obtain over time. Over the longer-run, such deleveraging would be healthy for our economy, as current account deficits and household debt growth would decline. In the meantime, any significant amount of deleveraging would be painful for certain players, as the asset-to-liability ratio of U.S. households (see chart below) is now at a historically low level of 5.02 (at the end 4Q2007), down from 5.12 at the end of the third quarter of 2007:
Note that I mentioned “certain players” would be hurt by the deleveraging. Who would those be? In a nutshell, those would be companies whose business models relied on cheap financing – such as SIVs, a significant number of mortgage REITs, certain private mortgage lenders, certain private student loan lenders, much of the private equity industry, and a significant portion of hedge funds who were involved in either the currency or credit carry trades. Note that I am not expecting a significant blowup over the next 12 to 24 months, but I do expect a “slow but certain death” for many of these companies, as credit lines are pulled and as investors withdraw en masse from some of these sectors (such as hedge funds). With respect to hedge funds, I expect many of them to fail as hedge fund investors bail out as financing gets tight and as the various carry trades (Yen, Swiss, Rand, NZD, and Icelandic Krona crosses, etc) go out of fashion. Furthermore, many former hedge fund investors will learn that "true alpha" is really elusive in the first place, and thus will move back into the traditional "beta strategies" - such as buying, for the most part - the unlevered and the well-managed companies in the Russell 3000 or EM equities. The UK and Eastern Europe will also dramatically go out of style, as some of the overly-extended countries (countries that have a significant amount of foreign bank credit and a significant current account deficit) such as Latvia, Estonia,, Hungary, Lithuania, and Romania, go bust.
For folks who solely invest in individual stocks in the U.S. stock market, I now expect severe divergences going down the road – as investors will no longer indiscriminately buy companies across the debt-to-equity spectrum. Given the end of this record “cheap finance era,” I recommend staying away from all heavily-indebted companies or industries. This includes the utility sector (note that the Dow Utilities has remained very weak even as the Dow Industrials and Dow Transports bounced significantly), the steel industry, the domestic automotive industry, much of the telecom sector, highly indebted retailers (Borders, Kroger, Revlon, etc), and any mortgage or student loan lender whose lending practices did not pass “the sniff test” over the last couple of years. Ironically, the only sector in the financial industry that had maintained any kind of lending discipline during the latest credit crunch had been the credit card sector – which had typically been the leading source of stress in previous economic downturns. We did not see this kind of lending discipline in the mortgage, auto finance, or student loan industries. On the institutional side, things also got carried away with lax lending in the hedge fund and private equity industries. Five years ago, if anyone had told me that Visa could have even done an IPO two days after the demise of Bear Stearns, I would have called the mental asylum. Not only that, but MasterCard is now only 3% away from its all-time high. Finally, Discover Financial actually beat analysts' consensus last week, ignoring the write-off from the sale of its Goldfish subsidiary during the quarter. Moreover, unlike past economic downturns, folks are now paying their credit cards first rather than defending their homes at all costs (in past downturns, credit card payments were the first to go). Furthermore, consumer credit growth had been slower than nominal GDP growth since 2003 - suggesting that there has been "no bubble" in credit card debt growth over the last five years. Now that the home ATM is gone, folks would also have no choice but to fall back on their credit cards (see the following chart showing the increase in revolving debt over the last 15 months). Relatively speaking, I am constructive on the credit card sector, especially American Express and Discover Financial, purely from a valuation and business model standpoint (disclosure: I am long Discover Financial in my personal portfolio).
Again, I cannot emphasize the importance of the upcoming deleveraging phase. As financing becomes more elusive and more expensive, the companies that are relatively unlevered and who have strong cash flows will gain a significant advantage. For companies who are heavily indebted, not only will earnings and cash flows be depressed by higher financing costs going forward, but extra effort and time would be required to negotiate with creditors (such as those who provide vendor financing) and to tackle other financial issues going forward. This will take away valuable time from the CEO and the COO – time that could be spent on operational or management issues. On the extreme end, many companies whose business model relied on cheap financing would no longer be able to function. While I am bullish on the U.S. stock market for at least the next several months, subscribers who pick stocks for a living should keep this etched into their minds.
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 20, 2008, the Dow Industrials rose 410.23 points while the Dow Transports rose 201.08 points. For the first time since late January, both the Dow Industrials and the Dow Transports rose together for the second consecutive week. More importantly, the resilience in the Dow Transports resulted in a non-confirmation of the Dow Industrials on the downside on March 10th by the Dow Transports. The continued strength in the Dow Transports was again “on show” last week, as it is now more than 12% above its January closing low, despite the failure of the Delta-Northwest merger and a crude oil price over $100 a barrel. 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 -10.8% to -13.9% for the week ending March 20, 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 now bottomed out and should embark on a significant uptrend over the next several months. Given the readings of this sentiment indicator, the positive divergences we previously mentioned, as well as an essential guarantee by the Fed for most of the U.S. financial system, 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 or Congress fail to do more to ease the wide spreads in the mortgage and the credit market over the next few weeks.
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. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. 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 83.4 and the 50-day moving average declining to 90.8 in the latest week, the ISE Sentiment Index again hit a record low for the week, and are now significantly more oversold than where they were at the October 2002 lows. Given the historically oversold condition of the stock market, the Fed “backstopping” the majority of the U.S. financial sector, the severely pessimistic sentiment on the part of retail investors, the unprecedented amount of capital sitting on the sidelines, and the promise of more market-friendly moves by Congress, I continue to 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 once the market becomes significantly overbought or if sentiment turns rampantly bullish again.
Conclusion: Given the Fed's actions since late January, and given the many positive divergences in the U.S. stock market, the two popular adages, “Don't fight the Fed” and “Don't fight the tape” are now very relevant, indeed – at least over the next several months. However, given that the deleveraging process most probably still have another 12 to 24 months to go (although the first phase of the deleveraging phase is now over with the demise of Bear Stearns) – folks who are buying individual stocks at this juncture should be very selective in what they buy – namely, avoid stocks and industries that are highly leveraged or whose business models depend on cheap financing to function. Firms who are relatively unlevered or who generate significant and sustainable cash flows will gain significant market share going forward, as their higher-levered competitors would lose their ability to compete. I also expect a significant shakeout in both the hedge fund and the private equity industries over the next 12 to 24 months – although I only expect a slow death (as opposed to several large blow-ups) as hedge fund and private equity investors withdraw from these two “asset classes” instead. As investors realize that achieving “alpha” is indeed ever-elusive, they would in all likelihood start to move back into pure “beta strategies” such as index funds or no-load actively managed mutual funds. In today's world of restrictive financing, the 2/20 model suddenly isn't that attractive anymore.
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 guarantee on most of the U.S. financial system, 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