The Great Deleveraging – Part II
(April 13, 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 304.58 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 610.42 points as of last week at the close.
As of the close last Friday, our two latest buy signals in our DJIA Timing System are collectively in the green. Readers who are interested in the historical performance (as of March 31, 2008) of our DJIA Timing System can refer to our comments from last week (The End of “Market Fundamentalism”). Excluding dividends, our DJIA Timing System returned 13.76% over the last 12 months, beating the Dow Industrials return of -0.74%, and with lower volatility. Again, our next update would be for the period ending June 30, 2008 – with a move to a semi-annual update schedule thereafter.
Let us now expand on our prior discussions on the upcoming “deleveraging phase.” We first raised this issue in our March 23, 2008 commentary (“The Great Deleveraging”). In that commentary, I stated:
“… 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.”
I also stated that the demise of Bear Stearns – along with Carlyle Capital and the near-demise of Thornburg Mortgage – represented the end of the first phase of the deleveraging. Since then, other players who have depended on cheap financing to sustain their business models have continued to fall – with the airlines being the “poster child” of the latest deleveraging phase (this includes Hong Kong to London carrier Oasis Airlines). Again, I expect most of the players/businesses who have traditionally relied on cheap and ample financing to fail or to take a significant hit going forward – this not only includes businesses, but certain hedge funds, private equity funds, and even certain sovereign countries (Iceland may only be the first casualty in a line of about two or three more countries, especially given the recent record high food prices).
While the “first phase” of the deleveraging is now over, there is no way to tell when the “second phase” will start. Sure, many banks have bulked up their balance sheets lately by raising capital (Wachovia is the latest financial institution to do so) – but there is no doubt that lending and risk-taking would be significantly dampened, at least in the commercial and investment banking industries over the next 12 to 24 months. Given the tremendous amount of global capital sitting on the sidelines, however, I expect this deleveraging to be relatively benign compared to pass deleveraging cycles, but this would not preclude the necessary “washing out” phase of the marginal consumer (i.e. the overleveraged and overextended subprime borrower) or the marginal business. Going forward, whatever lending or leveraging up that will occur over the next 12 to 24 months would be carefully scrutinized. For example, the majority of the lending in the U.S. mortgage sector would be done via “government-sponsored” institutions such as the FHA, Freddie Mac, and Fannie Mae. As we move towards the summer purchase season, I expect close to 90% of all U.S. mortgages would be originated with the help of these institutions. Another sector that could see some significant lending over the next 12 to 24 months may be the credit card sector, given that credit card charge-off rates have held up well (traditionally, the credit card sector was a good leading indicator of other default rates and of a U.S. recession) and as U.S. consumers become more desperate for credit. In this sector, I expect the share prices of Discover Financial (disclosure, I am long Discover Financial in my personal portfolio) and American Express to do very well, given their decent valuations and given the fact that many mutual fund managers who have to maintain a benchmark weighting to the financial sector would probably be buying these stocks, as opposed to investment banks or even commercial banks.
In a recent hedge fund summit organized by Reuters, the consensus “around the table” is that there will be a giant shakeout in the hedge fund industry over the next few years. More specifically, the major industry players, consultants, and investors all expect the number of hedge funds to shrink “a few thousand” from around 10,000 today. Normally, this author (as most subscribers would expect) would treat this “consensus” as a contrarian indicator, but there are now many strong and irreversible forces that are now going against the “marginal hedge fund,” such as:
- The unprecedented rise in margin requirements instituted by all major prime brokers in recent months. This would not only force various fixed income or “credit” hedge funds to continue to deleverage, but would also depress hedge fund profit margins as cheap and ample financing is now being severely curtailed. Following is a table courtesy of the latest IMF Financial Stability Report summarizing the change in margin requirements for various instruments over the last 12 to 16 months (note that initial margin requirements for U.S. Treasuries have gone up more than ten times!):
- From an investment consultant or investor's perspective, the call is now to find a better way to screen better-performing funds going forward. One way to do this would be to seek out certain fund of funds vehicles. Another way would be to develop tighter screens, such as (typically) a screen that requires more assets under management and a longer track record. The word is that all the major hedge fund investors would not even consider a fund unless it has over $1 billion under management as well as at least a five-year track record. This would further exacerbate the “cash crunch” of the smaller and more marginal out funds.
- The calls to regulate the hedge fund industry have trickled in over the last couple of years but they have now reached a crescendo – even among those who have previously rejected regulation, such as the Federal Reserve. A more stringent regulatory environment would obviously result in a much higher cost of doing business in the hedge fund industry, thus changing the economics of some of the smaller hedge funds or resulting in further consolidation.
Aside from a general shakeout in the hedge fund industry, I also expect the majority of “quant” hedge funds to disappear. Even though margin requirements for equities have not risen significantly, many quant hedge funds (and this includes 130/30 mutual funds) have simply not performed as expected, even excluding their underperformance from the “quant fund crisis” during those fateful six-sigma days in August/September of last year. This is not surprising, as many of these funds are practically using the same underlying data, the same investment strategies, and the same risk management models. There will still be some funds that could overperform (such as Jim Simons' Renaissance Technologies) but the vast majority of the quant hedge fund industry is now saturated. Until the inevitable shakeout occurs, I expect this sector to continue to underperform. For those subscribers who were thinking of getting that Masters degree in financial engineering (such a degree usually only takes 12 months on top of your Bachelors degree), I would advice you to hold off – until after the inevitable shakeout occurs, or preferably once we start seeing signs of the next boom in structured finance (a la Robert Shiller's “The New Financial Order”), the latter of which may not arrive until at least three to five years from now.
The G-7 Meeting
The latest meeting of the G-7 finance ministers and central bankers concluded in Washington DC over the weekend. Participants (which included heads of major Western banks) discussed and debated the latest recommendations from the Financial Stability Forum. Not surprisingly, the group agreed that the following three major recommendations were the most urgent: 1) The urgent need for the financial sector to raise more capital, 2) The urgent need for greater transparency in banks' balance sheets, accompanied by a shift away from mark-to-market accounting during times of financial stress (such as what we have been experiencing over the last six months), and 3) The need to enhance the regulatory framework, coupled with a new “global standard” for capital requirements of structured credit and off-balance sheet activities. However, from the market's perspective, the two most invaluable “take-aways” were 1) the cooperative spirit of the meeting – not only between the world's finance ministers and central bankers but between them and the heads of the major commercial and investment banks as well, and 2) its firmer stance on the recent decline of the U.S. Dollar against the major trading currencies in the world.
While I anticipate the U.S. Dollar to do well in the short-run given this latest statement from the G-7, I don't believe the U.S. Dollar Index could sustain a multi-month appreciation against the Euro unless at least one of the following three conditions are satisfied: 1) The European Central Bank becomes more dovish, once it is clear that the Euro Zone is slowing down as much as the United States, or 2) There is a more concerted effort of supporting the U.S. Dollar through an outright intervention by the world's major central banks, including, at the very least, the Federal Reserve and the European Central Bank, and 3) The market takes the decline of the U.S. Dollar to its logical conclusion, i.e. downright capitulation. Even though almost everyone and his neighbors are now bearish on the U.S. Dollar (see the latest McDonalds “one dollar menu” ad), I don't believe we have achieved capitulation yet. One indicator that is arguing against capitulation in the U.S. Dollar Index at this stage is the Goldman Sachs Sentiment Index on the U.S. Dollar against the Euro:
According to Goldman, its sentiment indicator on the Euro/US$ exchange rate is compiled by looking at its deviation from its 200-day moving average, the IMM positioning as indicated in the Commitment of Traders reports, and the amount of bullish/bearish stories on the Euro/US$ exchange rate in major news wires. At this point, the Goldman Sachs Sentiment Index on the Euro is actually slightly tilted towards the bearish side. From a contrarian standpoint, I would rate this to be neutral to slightly bullish for the Euro over the longer-run – although given the latest G-7 statement; I still believe the U.S. Dollar could exert some strength over the next few weeks.
I also anticipate this strength in the U.S. Dollar to translate to a lower crude oil price over the next few weeks. While the latest U.S. crude oil stocks surprised on the downside last Wednesday, it is important to keep in mind that it was all due to an unexpected decline in crude oil imports. For the week ending April 4, 2008, crude oil imports were down more than 600,000 barrels a day compared to the same time period in 2007. This translates to a weekly decline of over 4.2 million barrels – which was significantly greater than the weekly draw of 2.8 million barrels. More importantly, U.S. gasoline consumption dropped by 0.4% in the fourth quarter of 2007 and a whooping 0.6% in the first quarter of 2008 compared to the same periods the 2006 and 2007, respectively, suggesting that U.S. crude oil stocks should surprise on the upside during the summer.
More important to U.S. oil stocks however, subscribers should note that OECD commercial oil stocks are now at the highest end of its five-year min/max range. According to the EIA, OECD Commercial Oil Stocks are now about 50 million barrels over its five-year average. Following is a chart courtesy of the EIA showing the Days of Supply of OECD Commercial Oil Stocks since January 2003:
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 11, 2008, the Dow Industrials 284.00 points while the Dow Transports declined 162.53 points. Despite the strong downdraft last week, both of the popular Dow indices managed to stay above their closing highs from two weeks ago, as well as stay positive for the month of April. Moreover, the Dow Transports remains the stronger index, as it is still more than 15% above its January closing low, and less than 12% away from its all-time closing high. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, the resilience in the Dow Transports is encouraging, especially given the continued strength in crude oil prices last week. Moreover, April 15th is the quarterly contribution deadline for underfunded calendar-year defined benefits pension plans. With this additional liquidity from pension funds, we could probably see some significant equity mutual fund inflows later this week. Finally, with the G-7 now getting more aggressive in terms of coordinated global action to achieve more transparency and to encourage capital-raising among the financial sector, 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 third consecutive week) from last week's reading of -10.0% to -3.9% for the week ending April 11, 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 three-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 at the time of the Bear Stearns collapse, the relative strength in the Dow Transports, quarterly contributions coming in from calendar-year defined benefits plans, 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 couple of 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 reversing from its historically oversold reading of three weeks ago – and given that it has now rose above its 50-day moving average – 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, the approaching “fiscal stimulus” starting in early May, 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 by the end of April. 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: Even though phase one of the “Great Deleveraging” is probably going to dissipate over the next several months, there is no doubt that things are going to get worst for the marginal players in corporate America, as well as marginal homeowners, hedge fund, and private equity investors. My sense is that this will hit the hedge fund industry especially hard. Much like the deleveraging cycle in the technology/telecom sector during 2000 to 2002, this would result in a significant amount of consolidation and closings – especially given the inevitable regulatory environment that hedge funds will be facing over the next 12 months. I would not be surprised if we see a 50% failure rate in the hedge fund industry over the next two to three years. For those who are contemplating a Masters degree in financial engineering, I urge you to take a “wait and see” approach and wait until next year before thinking of applying.
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 “fiscal stimulus” set to arrive in early May, 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 by the end of April.
Henry To, CFA