An Instinct to Swarm
(March 30, 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 413.60 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 501.40 points as of last week at the close.
I will update our inception-to-date performance for the end of March in our next weekend commentary. 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 still collectively in the black. I continue to 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.
In a typical risk tolerance survey conducted by financial planners, one typical question tends to be:
Assuming you have a significant amount of savings invested in the stock market, how much of a decline in the stock market would cause you to make a change?
- More than 50%
- About 50%
- About 30%
- About 15%
- About 5%
From a profit maximization standpoint, and given the history of stock market returns, the general optimistic outlook on global capitalism and productivity gains of the companies within the S&P 500, and given that the vast majority of individual investors cannot reliably time the stock market, the logical answer should have been “buy more” on all levels (note that this is essentially “dollar cost averaging” with a slight twist, as only declines, and not rallies, are bought). However, as most financial planners would no doubt realize (the answer to the above question determines how much equities the client can tolerate in his/her portfolio), human nature does not work that way, in that we tend to extrapolate recent events into the indefinite future – or in the case of the recent events in the financial markets, we tend to swarm to cash (safety) during times of uncertainty – comforted by the fact that most the “experts” in the mainstream media are also doing the same thing. This instinct to swarm, as documented by scientists is common to many species in the animal kingdom – and is a variant of the trait and tendency of humans to “follow the leader.” In extreme cases – these two tendencies of human nature, combined with other traits such as nationalism and racism, have led to rather unfortunate events such as genocide and mass killings. Expressed in the financial markets, these two tendencies – combined with the two extreme psychological tendency of fear and greed, tend to result in crashes and manias, respectively, both of which result in severe mispricing of risk and assets in the downside and upside, respectively.
Such “instinct to swarm” has now resulted in catastrophic scenarios being priced into the financial markets, such as:
- A historical 200 basis point spread between Agency (Freddie and Fannie) MBS and Treasuries. In the current environment, there is little doubt that the “implicit guarantee” of the U.S. government behind this $4.5 trillion market (the underlying collateral is based on houses with average loan-to-value ratio of around 60%) has turned into an “explicit guarantee.” As I mentioned in our discussion forum, there is no way that the Federal Reserve or the U.S. government can justify walking away from this market given that they have previously bailed out LTCM, Bear Stearns, and have just effectively backstopped the entire U.S. financial system. Factor in 65 to 75 basis points to compensate for prepayment risks, and you effectively have a riskless (over the long-run) carry of 125 to 135 basis points (especially since the marginal buyer of agency MBS, Carlyle Capital, has been liquidated).
- Junk bond yield spreads of close to 900 basis points – in essence already factoring in a 1990 style recession with an 8% default rate. Despite the credit crunch since August/September of last year, the junk bond default rate so far has been only about 1%. Moody's is currently forecasting a 5% junk bond default rate over the next 12 months. Investment-grade corporate yield spreads are even more bizarre – as investors have already factored in a scenario much worse than the prices at their troughs in 1990 and 2002.
- The unprecedented inflows into money market funds over the last 12 months, despite an easing campaign that has taken the Fed Funds rate from 5.25% to 2.25% over the last six months. BlackRock alone experienced a $100 billion inflow into its money market funds over the last 12 months. Based on data from the Federal Reserve, total money market fund assets increased over 43% on a year-over-year basis – a truly unprecedented increase unless one goes back to the early 1980s when the product was first incepted.
Of course, the “efficient market hypothesis” crowd can always argue that the market is efficient and thus risks are adequately priced, etc. But if one talks to any money manager that is well-connected, one would find out that every manager would agree that there are a lot of bargains in the financial markets today – but that those same folks are taking a very cautious approach since no one want to stick their necks out and “be a hero” in the current liquidity-constrained environment (and especially since we are approaching the end of the quarter). Moreover, such an argument would mean that risks were priced correctly as well during the up cycle – which as we argued back in our June 7, 2007 commentary (“Mid-Week Liquidity Update: A Discussion of High Yields”) and which is now so evident – were non-sensical.
The “instinct to swarm” and the “follow the leader” mentality of human beings also manifest in each of us the tendency to follow the “guru” that have gotten his or her calls correctly in the latest cycle. A current example is the popularity of CIBC sell-side analyst Meredith Whitney. She has now gained a well-deserved following in light of her calls late last year on the potential downside of Citigroup, as well as its need to raise more capital and cut its dividend. Last week, she remarked that she is still bearish on Citigroup and many of the banks (including Wachovia and Bank of America) – although she is still constructive on many of the broker/dealers (with the exception of Merrill Lynch). I have read both her November 2007 and her recent report. She has done a great deal of sound and historical analysis (especially with regards to her comparison of today's losses and potential downside relative to those in 1990) – but as always, you need to look behind the language and dig through the assumptions and disclaimers and make an informed decision of your own. For example, forecasting more write-offs going forward is definitely a sound methodology given the continued decline in the popular structured finance indices such as the ABX and the CMBX, but most informed individuals would know that these indices are relatively illiquid and are already pricing in a very pessimistic scenario relative to what is going on in the “real economy” today (e.g. at its peak, the CMBX indices were pricing in a CMBS default rate of more than 30 times the actual current rate). Moreover, she – just like other human beings – is not infallible. In particular, she had an “outperform” call on Lehman Brothers with a target price of $79 a share as recently as January – and only retracted her call after the stock's most recent slide. Finally, both Whitney and other sell-side analysts do not have detailed information on each bank's structured finance products holdings, other than what has been disclosed in public filings. In other words, all her calculations are “back of the envelope” calculations, so to speak. Her current “50% downside” call is a “worst-case scenario” call, and is no way reflective of the most probable scenario, especially now that every investment bank and other primary dealer would be looking for a depository institution to acquire over the next 12 months. In light of Bear Stearns' dramatic collapse, guaranteed direct access to the Fed's discount window is now much more glamorous and certainly one of the most prized possessions in the (leveraged) financial community today.
Speaking of the subject of liquidity, and turning to the domestic stock market, the amount of “cash on the sidelines” waiting to be invested has continued to increase at a dramatic rate (43% year-over-year) and is now at 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 28.02% - 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.” Unless the S&P 500 rises by more than 2% on Monday, this record is most likely to hold. Moreover, subscribers should remember that the amount global capital that is sitting on the sidelines waiting to be invested is also now at record highs (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. My sense 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 Administration or Congress backs away from their current “housing bailout” plans, which I am not currently 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 28, 2008, the Dow Industrials declined 144.92 points while the Dow Transports rose 46.45 points. The continued strength in the Dow Transports was again “on show” last week, as it is now more than 13% above its January closing low, despite the up tick in crude oil prices last week. More importantly, The Dow Transports rose above its February 26th closing high last Tuesday – when it hit 4,901.06, a closing high not seen since December 10, 2007. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, this latest development suggests that sooner or later, both the Dow Industrials and the broad market would follow. One of the themes discussed (the old adages of “Don't fight the Fed,” and “Don't fight the tape”) in our commentary last weekend no doubt continue to apply – and with the latest strength in the Dow Transports, the adage of “Don't fight the tape” has just gotten a little stronger. Moreover, with the Administration now getting behind a more aggressive plan to “bail out” underwater homeowners and to avoid further deleveraging, we can potentially add a new adage of “Don't fight the government.” In light of all this “firing power,” 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 (finally) increased from last week's reading of -13.9% to -13.1% for the week ending March 28, 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 and more importantly, given the latest up tick in this sentiment indicator (by far the most important reversal signal is when this indicator reverses from a very oversold situation), my sense is that the broader market has already bottomed and should embark on a significant uptrend over the next several months. Given the readings of this sentiment indicator, the positive divergences we previously last week, the higher high in the Dow Transports, 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 and the 50-day moving average of the ISE Sentiment Index having reversed in the latest week from an historically oversold level, chances are that the stock market has already bottomed and is set for a sustainable rally over the next several months. Given this reversal from a historically oversold condition of the stock market, the Fed “backstopping” the majority of the U.S. financial sector (not to mention a dramatic policy change that is expected from the Bank of England), the Administration's proposal to pursue a more aggressive strategy to “bail out” homeowners, and the unprecedented amount of capital sitting on the sidelines, 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.
Let us now update a contrarian/sentiment indicator that we have discussed in the past – but which we have not updated as frequently for our readers. Newer readers may not know this, but the Conference Board's Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint. While it has always been significantly better in calling bottoms during a bear market, it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market – with one of its most successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90. During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points. More recently, the Consumer Confidence Index gave us a “strong buy” signal during October 2005, and foretold the beginning of a bear market with its “rounding top” during the first half of 2007. Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to March 2008:
The last time the Consumer Confidence Index gave us such an oversold reading was at the end of March 2003, when it hit a reading of 61.4 (compared to today's 64.5 reading) – the Dow Industrials would go on to rally nearly 30% over the next 12 months. The fact that this reading is now at a similar level to that of March 2003 suggests that subscribers who are still cautious should start to think about implementing long positions in the stock market, if you had not done so already. This signal is especially powerful given the once-in-a-decade/generation oversold readings that we saw in the stock market (as exemplified by the new 52-week high/low readings, the NYSE ARMS Index, % of stocks above their 200-day EMAs on both the NYSE and the NASDAQ, etc.) during late January.
Conclusion: The “instinct to swarm” on the part of both institutional and retail investors have resulted in one of the biggest liquidity crises of the current generation, with the exception of the October 1987 crash. While the U.S. economy would continue to deleverage going forward, it is to be remembered that global growth still remains respectable – and given that 50% of all corporate profits in the S&P 500 now come from foreign countries, there is no reason to expect that aggregate earnings would drop off the cliff, so to speak. Furthermore, while some banks and broker/dealers still have some capital concerns, these would not result Armageddon-like scenarios, given the unprecedented of investment-ready capital sitting on the sidelines. In the worst-case scenario, many of these companies (such as Citigroup, Merrill Lynch, UBS, etc.) can simply do secondary offerings via the open market or sell existing “non-core” businesses in order to raise capital. Given Henry Paulson's past comments, and given the latest recommendations by the Financial Stability Forum, such a scenario of “mass capital raising” looks more likely by the day. Not only would this solve the ongoing solvency concerns once and for all, this would also replenish balance sheets en masse and serve to cushion the deleveraging process in the U.S. economy.
For now, we continue to be bullish on the U.S. stock market, given the reversal of our contrarian/sentiment indicators from multi-year or historically oversold levels, the Administration's new willingness to cushion the deleveraging housing market, 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