The End of “Market Fundamentalism”
(April 6, 2008)
Dear Subscribers and Readers,
Before we begin our commentary, I want to update our DJIA Timing System's performance to March 31, 2008, in addition to reviewing our 7 most recent signals. While our historical performance could be calculated by tallying up all our signals going back to the inception (August 18, 2004) of our system, such a task for subscribers would been very tedious. Moreover, even though it is obvious that we had done well in our timing system in the last year or so, it is more difficult to quantify our performance during 2006 and prior, given that there were significantly more buy and sell (including sell-short) signals during 2005 and 2006. So without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to March 31, 2008:
To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way. We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500), given that most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market. In addition, the Dow Industrials has a rich history and has been computed since 1896, while the S&P 500 was only created in 1957 (although it has been retroactively calculated back to 1926).
Looking at our most recent performance and performance since inception, it is clear that most of our outperformance was due to our positioning over the last year or so – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and our subsequent shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956. Put another way, subscribers should remember that:
- It is the major movements that count. Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;
- Capital preservation during times of excesses is the key to outperforming the stock market over the long-run. That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth we have been witnessing and that is still projected for the foreseeable future. I am not going to change my mind on this until/unless I see 1) a major policy mistake from the Fed, 2) the potential emergence of an inflationary spiral, or 3) extreme overvaluations in the U.S. stock market. At this point, I do not see any threat to the stock market on all three counts (versus late last year, when valuations were overly high and when the Fed was reluctant to cut rates) – although I would definitely let you know as soon as I see anything on the horizon (similar to my calls from February to April 2000).
Also note that our (annualized daily) volatility levels are also substantially lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in extremely good Sharpe Ratio readings across all time periods. However, given my belief the stock market made a sustainable bottom during the late January to mid March period, subscribers should not expect any outperformance from our DJIA Timing System for the foreseeable future. We will update the performance of our DJIA Timing System at June 30, 2008, and subsequently move to a semi-annual reporting schedule thereafter.
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 20.58 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 894.42 points as of last week at the close.
Let us now get on with our commentary.
In his latest book “The New Paradigm for Financial Markets” (the e-book was released last Thursday, with the print edition not available until next month), George Soros chronicles the current credit crunch as well as argues that the period of stability since the early 1980s, based on the dominance of the United States as a global power and the U.S. Dollar as the world's reserve currency is now ending. In the short-run, he continues to see a period of relative financial and political instability. He does not attempt to make any concrete predictions, however – other than that at some point, he believes the Administration will jump in and attempt to arrest the decline in U.S. housing prices. Quoting Soros:
Eventually, the U.S. government will have to use taxpayers' money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent, thus reinforcing both the recession and flight from the dollar. The Bush administration and most economic forecasters do not understand that markets can be self-reinforcing on the downside as well as the upside. They are waiting for the housing market to find a bottom on its own, but it is further away than they think. The Bust administration resists using taxpayers' money because of its market fundamentalist ideology and its reluctance to yield power to Congress. It has left the conduct of policy largely to the Federal Reserve. This has put too much burden on institution designed to deal with liquidity, not solvency, problems. With the Bear Stearns rescue operation and the latest term security lending facility, the Fed has puts its own balance sheet at risk. I expect better of the next administration. Until then, I foresee many policy turns and changes in market direction since current policies are inadequate. It will be difficult to stay ahead of the curve.
Soros' new book is a must-read for those who have not read “The Alchemy of Finance” (a book that I have read five times, three times in print, and twice in audio format; the only other book which I had read more often was “Reminiscences of a Stock Operator”). His discussion on his concept of “radical fallibility” is worth the entire price of the book. I agree with Soros' take on where the Administration is heading over the next several months. While he does not attempt to make straight predictions in his book, the title of his book suggests that there would be a new “regime” going forward, not only globally but within the U.S. financial system as well. In our August 30, 2007 commentary, I remarked that the current credit crisis is analogous to the “Panic of 1907” in a very important way – a watershed panic that led to the creation of the Federal Reserve in 1913 (see the following 1999 Federal Reserve Bank of Atlanta's paper “Why Didn't the United States Establish a Central Bank until after the Panic of 1907?” for some background).
Quoting our August 30, 2007 commentary:
Finally, at this time, there is good reason to believe that both the major central banks and investment banks of the world still don't have a clear view of where all the subprime or leverage exposure is, even though all their risk books are, for the most part, consolidated. Remember, as of the end of June, the total amount of money controlled by hedge funds around the world amounted to a range of US$1.7 to US$2.0 trillion. Utilizing a leverage ratio and an annual turnover ratio of 4-to-1 (which is very conceivable since half of all trading on the U.S. stock exchanges and more than one-third of all bond trading are done by hedge funds), the amount of hedge fund “efficiency capital” rises to a whooping US$27 to US$36 trillion, or nearly three times U.S. GDP. How could the world's central banks make policy (or even more of a stretch, provide specific solutions) if they (and their contacts at Goldman, Morgan, etc.) have no idea what half of the financial system is doing? In the Fall of 1998, many folks in NYC know that the problem was LTCM – today, not only has the problem gotten bigger, but it has spread to many more, heterogeneous, participants as well. In this way, the current crisis is analogous to the “Panic of 1907,” as during the “Panic of 1907,” much of the crisis had initiated in and spread around the NYC trust companies, as opposed to the national and NYC banking system, who were members of the New York Clearing House. Indeed, the Panic of 1907 was one of the most serious liquidity squeezes in US history, mainly because of 1) the explosion in NYC trust companies and assets in the 10 to 12 years prior to 1907, 2) the fact that they were not members of the New York Clearing House, and thus no legal or regulatory responsibility to hold sufficient reserves in order to stave off a general run, and 3) members of the New York Clearing House, who were lenders of the last resort in 1907, were reluctant to “bail out” many of the trust companies since they had never disclosed their books. Moreover, while trust companies were relatively conservative at first, they gradually evolved into more speculative institutions as the owners of the trusts “discovered” that they were able to invest in more risky assets, such as real estate and stocks, unlike banks who were strictly prohibited from doing so. The hedge fund industry today is analogous to the trust companies in 1907.
In retrospect, not only was the hedge fund industry analogous to the trust companies in 1907, so was most of the investment banks that are not under the regulation of the Federal Reserve. However, with the Fed "backstopping" the 20 primary dealers with the NY Fed three weeks ago - essentially bailing out the entire U.S. financial system – the so-called “paradigm” has definitely changed. Just like small businesses paying "protection money," there would be great consequences going down the road for the broker/dealer community. The Fed has now put its people in all the major investment banks and are analyzing all credit instruments, getting the names of managers, analyzing liquidity, and so forth. Of course, we are not going back to the regulations we saw in the 1930s but there is no doubt the government will have a heavy hand in the financial sector at least over the next 5 to 7 years. For those who believe this would destroy New York City as the world's premier financial center, I would argue otherwise since the latest financial crisis had been global in nature, and thus there is no doubt that all the G-7 finance ministers and central bank governors would sign on to this "pact." It would be interesting to see how China and India respond but given their culture and and the way that they are handling things and directing policies in the financial markets today, my sense is that they would be relatively content with more coordinated, government intervention going forward, as long as they are “invited to play.” Moreover, the heads of all major investment banks and money managers should also sign on to this deal, given: 1) the former (along with the majority of their paper wealth) had just been “saved” from a potential collapse, 2) they are essentially part of the “establishment” anyway, given that they move freely between the public and the private sectors and given their influence on policymakers around the world, and can essentially make money no matter what environment we are in. On the contrary, they should gain even more financial power (taken from the hedge funds and the "quants" that had thrived over the last 10 years) under the revamped system.
Speaking of the bank system, it is interesting to note that U.S. commercial banks have continued to lend freely over the last six months, despite the fact that we have been in a genuine credit crunch (as exemplified by the blowout of credit spreads and a general lack of access to credit over the last six months). Following is a monthly chart showing the year-over-year change in loans and leases under commercial bank credit from January 1948 to March 2008 (source: Federal Reserve):
Note that four of the last six recessions over the last 60 years were preceded by a significant plunge in the year-over-year growth in loans and leases under bank credit down to the zero line. The remaining two recessions were preceded by a decline in the year-over-year growth in the 5% range. Interestingly, as of March 2008, the year-over-year growth in loans and leases under bank credit sat at slightly over 12% - a number that is hardly recessionary or in “credit crunch” territory. There are three possible/probable explanations for this interesting phenomenon. Firstly, much of the lending over the last 5 years has been done through securitization or the “shadow banking system” (as coined by PIMCO's Paul McCulley) – the latter of which consists of hedge funds, mortgage brokers, sovereign wealth funds, institutional investors, and high net worth individuals who invested in subprime mortgages or commercial mortgage backed securities. As indicated in news headlines (and soon, in the balance sheets of investment banks) and in the general blowout of credit spreads, such lending has grinded to a near halt. Secondly, while the banks have restricted lending to U.S. households, this has not been the case with commercial and industrial loans. Part of the reason is that in general, the balance sheets of many Fortune 1000 corporations are still very sound. The other reason is that many corporations are now drawing down credit lines that were put in place before the current credit crisis – credit lines that they may not have gotten in this environment. Finally, many banks are now being forced to put their previously off-balance-sheet SIV obligations back onto the balance sheets – thus forcing their own balance sheets to expand even in this contractionary environment. This is a phenomenon that is definitely worth tracking going forward, as this author does not see a long and protracted recession in the U.S. unless this declines to the 0% to 5% range, despite the fact that lending and borrowing in the “shadow banking system” has grinded to a halt.
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 April 4, 2008, the Dow Industrials rose 393.02 points while the Dow Transports rose a whooping 222.29 points, despite the continued troubles in the airline industry. The continued strength in the Dow Transports was again “on show” last week (and the week prior), as it is now more than 19% above its January closing low, and slightly less than 9% away from its all-time closing high. In addition, the Dow Transports rose above its October 5th closing high last Thursday – when it hit 4,999.33, a closing high not seen since August 13, 2007 – and is now also trading above both its 50-day and 200-day simple moving averages. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, the strength in the Dow Transports suggests that sooner or later, both the Dow Industrials and the broad market would follow. Again, one of the themes discussed (the old adages of “Don't fight the Fed,” and “Don't fight the tape”) in our commentary two weeks ago 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 G-7 now getting more aggressive in terms of coordinated global action to avoid further deleveraging, it remains a dangerous time to stay short, especially given the unprecedented amount of global investment-ready capital sitting on the sidelines. 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 increased (for the second week) from last week's reading of -13.1% to -10.0% for the week ending April 4, 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 two-week up tick in this sentiment indicator (by far the most important reversal signal in the stock market 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 mentioned a couple of weeks ago, 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, Congress, or the G-7 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 last two weeks 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, and am now expecting the Dow Industrials to rise above the 13,000 level sometime in the next few weeks. 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 obvious “failed experiment” of securitization and the wide-reaching tentacles of the “shadow banking system” to dissipate risks across the world, there is now no doubt that the financial system as we know it today would be significantly revamped. As a response of the Panic of 1907 (which was very similar to the current credit crisis in a very important away), the Federal Reserve was created in 1913. While I do not envision the creation of a “global oversight committee” or a “global lender of last resort” (there are many reasons why this would not work, as I will cover in a later commentary), there is now no doubt that reform would be the order of the day over the next 6 to 12 months, despite the fact that this is an election year. At some point, I also expect Congress to provide significant relief to subprime homeowners – as the Federal Reserve can only go so far. As for the U.S. and global financial system, the event to watch would be the upcoming G-7 meeting in Washington D.C. this weekend. As a first step, I expect the Financial Stability Forum to advocate for a consistent and effective way for the world's investment banks to disclose all their balance sheet risks and liabilities as soon as feasible. I also expect a greater call to raise capital, as well as a “blue print” to regulate investment banks and the hedge fund industry, along with some kind of regulatory capital requirements proposal. It would be an interesting weekend.
For now, we are still 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” and I expect the Dow Industrials to close above the 13,000 level sometime over the next few weeks.
Henry To, CFA