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This Game of Musical Chairs

(March 27, 2008)

Dear Subscribers and Readers,

It now looks increasingly likely that the G-7 countries will announce some kind of coordinated action to tackle the liquidity problems in the global financial markets during the upcoming April 11th meeting (this date has yet to be confirmed, however) between finance ministers and central bank governors of the G-7 countries.  In the statement issued at the last meeting between the G-7 finance ministers and central bank governors on February 9th, the first four paragraphs were devoted to the fallout from the US subprime crisis – with particular emphasis on 1) ongoing coordination to mitigate the fallout from the crisis, 2) necessary reforms to restore confidence in the system and to ensure future stability, and 3) the emphasis on the final findings of the Financial Stability Forum, along with its recommended actions and initiatives.

A preliminary report was published by the Financial Stability Forum at the February 9th meeting.  While the final report won't be published until the April 11th meeting, the conclusions of that report would most likely resemble to what was discussed in the preliminary report, especially in light of recent statements by the Bank of England, as well as a couple of “fast track” housing “bailout” plans that are currently in the works in Congress.  At this point, the European Central Bank is still the lone hold-out (curiously, Trichet just reiterated his stance on combating inflation earlier yesterday) – but there is no reason that the European Central Bank won't “come around” should the Financial Stability Forum recommend more explicit or specific central bank/fiscal actions in order to stabilize the global financial markets.  More importantly, there is everyone reason to believe the final report will contain more urgent recommendations, given the rise in credit spreads and distress in the global financial system since the February 9th meeting.

On a very immediate basis, the implications of the April 11th G-7 meeting and the simultaneous publication of the Financial Stability Forum report will be two-fold.  First of all – by virtue of the fact that the various European finance ministers and the European Central Bank have committed to the findings of the Financial Stability Forum's report, there is a good chance that the European Central Bank would either commit to a more dovish monetary policy, or most likely commit to a more “creative” solution to restore liquidity in the financial markets, such as buying prime mortgage securities or other AAA fixed income securities, such as AAA corporate bonds.  If the European Central Bank rebuffs the findings and shy away from a more active policy stance, then the effectiveness of the Financial Stability Forum would be openly questioned.  At this point of the crisis, the world's central banks and regulators just cannot and will not let this happen.  Second of all, both the Financial Stability Forum and the U.S. Secretary of the Treasury, Henry Paulson, have gone on record asking the financial sector to raise more capital to act as a “liquidity buffer” – so as to avoid future solvency crises and to restore confidence in the balance sheets of the world's major financial services companies.  Given the inevitability of a more stringent regulatory environment, many of these companies would have no choice but to raise more capital in the months ahead – thus further diluting the share holdings of common stock holders in many of these companies, including the majority of the 19 primary dealers (excluding Bear Stearns) that have been “backstopped” by the Federal Reserve.

Over the next couple of weeks, there will be continued “market chatter” anticipating the results of the April 11th G-7 meeting.  In the meantime, both the U.S. Congress and the Bank of England should continue to find innovative solutions to ease the liquidity crunch in the financial markets.  Given the prevailing bearish sentiment of retail and institutional investors alike – as well as an unprecedented amount of investment-ready capital sitting on the sidelines – my sense is that the stock market would continue to rally into the April 11th G-7 meeting.  Should the G-7's finance ministers and central bank governors announce or have intention to announce some sort of coordinated action, then the bullish bias should continue – especially if the $170 billion fiscal stimulus is implemented in time (starting in early May).

The above somewhat summarizes our timeline for the next few weeks – as we continue this “game of musical chairs” in a world (at least within many of the OECD countries) that should continue to deleverage over the next 12 to 24 months.  While I understand the continuing dangers of staying 100% long in our DJIA Timing System (the DJIA Timing System is the most efficient way to communicate to our subscribers our current position on the U.S. stock market) in a world that is deleveraging, history has dictated that it does not have to be a disaster for stocks in general.  As a matter of fact, companies with relatively low debt-to-tangible-equity ratios and extremely reliable and growing cash flows from operations have tended to do very well in this environment as their higher-leveraged rivals falter.  The following chart showing the financial obligations ratios of U.S. Households from 1Q 1980 to 4Q 2007 illustrates this perfectly:

Financial Obligations Ratio of U.S. Households (1Q 1980 to 4Q 2007) - Even though the financial obligation ratio (FOR) for U.S. renters have been trending down since 4Q 2001, the total FOR has been steadily rising - and is currently still near all-time highs.

After the October 1987 crash, U.S. households' balance sheets deleveraged significantly as a significant amount of households' net worth was wiped out.  E.g. During the first quarter of 1988, the asset-to-liability ratio of U.S. households (not shown) increased from 6.88 to 6.95 – as households became worried and started building up their balance sheets.  This also directly translated to a slight dip in the households' financial obligation ratio from 3Q1987 onwards, as shown in the above chart.  Interestingly, the performance of both the Dow Industrials and the S&P 500 remained respectable after the October 1987 crash, even though a significant part of the U.S. economy was still deleveraging for weeks afterwards.

A better example would be the deleveraging phase starting in the fourth quarter of 1990 as the U.S. entered a recession and as the last S&L crisis swung into high gear.  During the six months ending the first quarter of 1991, the assets-to-liability ratio of U.S. households (not shown) increased from 6.41 to 6.62.  By the first quarter of 1993, this ratio was still at 6.59.  Per the above chart, the financial obligation ratio of U.S. households decreased dramatically during the first three years of the 1990s as U.S. households deleveraged.  Note that the impact on the financial obligation ratio of U.S. households was further cushioned by dramatic interest rate cuts during that time.  Again, even though U.S. households deleveraged dramatically during the first three years of the 1990s, stock market prices actually bottomed in early October 1990 and never looked back.

The key to trading through the current crisis, of course, is to anticipate two very important things:

  1. As described above and in our previous commentaries, it is imperative that we continue to monitor the future actions of global central banks and fiscal policies.  A major reason for us staying short during the last three months of 2007 and the first nine days of 2008 was because of the Fed's reluctance to significantly ease monetary policy and to take an active stance towards resolving the ongoing “credit crunch” in the U.S. economy.  Similarly, a major reason for us covering our short position and actually going long in our DJIA Timing System was precisely because of a major policy shift by the Federal Reserve.

  2. For market-timing purposes, it is very important to anticipate where the speculators will head next – whether it is in cash, on the short side, or on the long side.  In the “General Theory…” Keynes discussed the concept of skilled investment as anticipating “conventional valuation a few months hence … For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs – a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops … Or, to change the metaphor slightly, a professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself funds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.  It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.  We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.  And there are some, I believe, who practice the fourth, fifth, and higher degrees.”

While I know many of you do not like Keyes the economist, his record and knowledge as a speculator cannot be discounted.  The above method of speculation or investment, as discussed by Keynes, is a method that we have been utilizing at over the last few years to anticipate continuing momentum or turning points in the U.S. stock market – and sometimes, other sectors as well, such as foreign exchange, commodities, and the Treasury markets.  This methodology is dependent on fund flows, sentiment polls, options volumes, liquidity/cash analysis, and ongoing central bank and fiscal policy actions.  If you really want me to rate our view of the U.S. economy or the global economy on our scale of dependability as a leading indicator of the U.S. stock market, I would have to rank that close to the bottom of our list.  For example, if you had known in October 1990 that GDP growth would be -3.0% for 4Q1990, and -2.0% for 1Q1991, what would you have done as an investor?  Would you have sold your S&P 500 index fund?  That would have been the most logical choice, but yet, stock prices actually bottomed in early October 1990 and had never looked back since.  In fact, buying stocks in early October 1990 would have been one of the greatest investment decisions of a lifetime (Of course that is assuming that one could predict where GDP would be this quarter and the next.  Given the severe complexity of the U.S. economy and its complex interactions with the global economy, the “armchair economists” who believe they can predict GDP growth on an ongoing basis is essentially playing a losing game.)

As I have mentioned before, I don't believe one can make a credible connection between the prospective valuations of the stock market versus that of the housing market.  In broader terms, as investment professionals all like to say, past performance or correlations do not guarantee similar future results.  We see these in all disclosure documents but our mind and human nature always discard that belief and rely on what has (recently) occurred in the past.  We need this in order to plan our daily lives (e.g. we get up from the same side of the bed every morning and we commute via the same route to work, go the same office, etc.), but this is a sure way to the poor house if you apply this philosophy to the financial markets (as subprime investors found out to their dismay).  Moreover, human beings tend to make connections between two different events even if there weren't and aren't any - and even if there were, we tend to make the wrong connections.

This idea inherent in human nature was first raised by David Hume.  Quoting the Cambridge Companion to Hume:

"We have experienced the constant conjunction (the invariant succession of paired objects or events) of particular causes and effects, and, although our experience never includes even a glimpse of causal connection, it does arouse in us an expectation that a particular event (a "cause") will be followed by another event (an "effect") previously and constantly associated with it.  Regularities of experience give rise to these feelings and thus determine the mind to transfer its attention from a present impression to the idea of an absent but associated object.  The idea of necessary connection is copied from these feelings."

Again, at this point, the housing to stock market prices connection looks weak to me, especially since many investors have now factored in more housing prices declines for the rest of this year and into early 2009.  Based on what I have studied so far, there is no question that a stronger connection exists between prospective stock prices versus many of the indicators that we have used and continue to use, such as money market mutual fund assets as a percentage of domestic market cap, government bond yields vs. prospective earnings yield (2009 and beyond), investor sentiment, the amount of foreign capital sitting on cash and that can be reasonably expected to be invested in stocks going forward, and prospective global/domestic monetary policies and fiscal policies.  Based on these five points, the stock market still looks bullish at least leading up to the April 11th G-7 meeting.

Signing off,

Henry To, CFA

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