Reflections and Black Swans
(April 27, 2008)
Dear Subscribers and Readers,
Let us begin our commentary with a review of 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 gain of 261.86 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 1,176.86 points as of last week at the close.
As of the close last Friday, both our latest buy signals in our DJIA Timing System are 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 a couple of weeks ago (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 begin our commentary. The events over the last year or so have been a surprise for many – and are certainly worth reflecting on. While we all know that a “black swan” will pay a visit to the financial markets more often than most financial models suggest, the latest liquidity crisis – once it came – took many of us by surprise in terms of its ferocity. As our former Fed Chairman Greenspan stated in late 2005, “History has not dealt kindly with the aftermath of protracted periods of low risk premiums,” the swing, once it did came, swung to the other side of the pendulum very quickly from the historical lows in junk bond, emerging market bond, mortgage-backed, commercial mortgage-backed, and asset-backed securities yield spreads in early 2006.
Over the past 15 months, many companies whose business models have depended on cheap financing have either floundered or gone out of business altogether. An example is First Marblehead (FMD) – a company that has been featured in both Value Investors Digest and in the Motley Fool over the last couple of years. The company had been dependent on access to financing in the student loan asset-backed security market, and with the decimation of the asset-backed security market late last year, has effectively seen its core business shut down about six months ago. At the time of this writing – despite the fact that Congress is now trying to revive the student loan market – the credit markets for student loan asset-backed securities is still effectively closed. First Marblehead has been a small cap value investor's favorite over the last couple of years (except that of Barron's)– but only in hindsight did many value investors 1) realize that its long-term business model was shaky at best, and 2) found out that they did not really understand its business model and strategy. I believe this is a good lesson for us all!
The first obvious lesson here is the necessity of diversification – especially for the majority of us who do not have the stock-picking prowess (or the ability to directly influence the capital structure or improve the solvency of a company) of Warren Buffett. Keep in mind, however, that one can still run a relatively diversified portfolio with 10 to 15 positions (disclosure: my personal portfolio has 14 (all long) positions). The second lesson here is “don't be a hero” – especially so in an environment that is deleveraging. If one wants to be a hero (on the other hand, this is the only way one could expect to make tremendous gains in the stock market without managing money for others), then:
- Only do so in blue-chip names (GM doesn't count), such as American Express in 1964, IBM in 1993, or Phillip Morris in 2000;
- Only in names where most players (most importantly, the US government) have a vested interest in seeing the companies in question survive, such as Fannie Mae and Freddie Mac today;
- Only do so if you have the ability to directly improve the capital situation of the company (for most of us, this would not apply), such as the recent capital injections into investment banks by sovereign wealth funds and private equity investors.
Both of these “lessons” are valuable – as long as one learns from them and don't make the same mistakes in the future (we could all wish, can we?). However, there is really no fun in discussing one's mistakes, so let us know discuss our take on the financial markets today and over the next 12 to 24 months.
What pessimists on the U.S. stock market today miss is that the performance of the stock market is not directly tied to the performance of the economy in the short and intermediate term. According to JP Morgan, since 1900, the U.S. stock market returned on average +1.4% during the times the economy was in recession (+2.1% if we ignore the sell-off from the stock market's severely high overvaluation during the 2001 recession). In addition, the U.S. economy actually grew faster in the 1970s than the 1980s, and yet the stock market enjoyed significantly better returns (an understatement) in the 1980s than the 1970s. Over the long run, the U.S. stock market is directly tied to earnings and more importantly, projected future earnings power. Today, this earnings stream is just not relegated to income from US customers, but all over the world, as about 50% of all income from members of the S&P 500 now comes from overseas markets. This makes projected future earnings power much more difficult to model, but we can always try.
I would argue that projected future earnings power (on an EPS basis – this is very important, as will be evident later) is directly based on:
- Projected corporate profit margins, or more specifically, corporate pricing power and expenses (wages, pension expenses, etc.);
- Projected corporate tax rates around the world;
- Projected financing costs, or cost of capital;
- Projected “float” of the global stock market (given that capital is very mobile today) – as expressed in the dollar value of shares that are available to investors today;
- Projected productivity, employment, and population growth – all of which have a direct impact to the build-up of global wealth;
- The ability and willingness of governments around the world to protect private capital and to allow capital to move freely around the world;
- The freedom to trade and the projected increase in trade flows around the world (Ricardo's law of comparative advantage).
Each of the above has a more direct impact on U.S. and global stock prices than projected GDP growth alone. More importantly, the effects of each of the above could be more easily quantified, unlike the “mixture of stuff” that is ever changing in every GDP computation (or in China's case, a make-believe number).
Furthermore, each of the above is not independent of each other. For example, both the cost of capital and corporate tax rates has a direct impact on corporate profit margins. I included corporate tax rates as a separate line item simply because it does not have a uniform effect on all companies. One example is corporate tax breaks for certain industries. When it comes to cost of capital – it is important to note that in a credit “seizure” such as what we are having now – the cost of capital for certain (highly credit worthy) companies will eventually decline as the Federal Reserve lowers rates, while increasing to near infinity to those which are assumed to be at the margin, such as First Marblehead, Bear Stearns (before its announced takeover by JP Morgan), or Thornburg Mortgage (it had to do an equity offering of around four times its market cap in order to survive). As some of these marginal companies go out of business due to the lack of financing options, corporate profit margins for the companies that survive would dramatically increase as competitors are taken out in their respective industries.
Secondly, the above seven points are meant to be sweeping in nature. For example, the ability of governments to project private capital does not only mean protection from government confiscation or theft, but from foreign invasion as well. Through the U.S. central bank and FDIC, our system has also built in a significant “safety net” that prevents private bankers from seizing our deposits or mortgaged-assets during a liquidity or a solvency crisis in our financial system (the latter of which is a far cry from the 1970s). Another example is projected productivity growth. Embedded within this statement is the assumption that capitalism will not only survive, but will continue to thrive. The reason is this: The best economic system that allows for sustained productivity growth is capitalism, and nothing else (Joseph Schumpeter went as far as associating technological advances directly with capitalism).
It is to be said here that investors' perceptions of future earnings power are almost as important as actual future earnings power, at least in the short to intermediate term. This is one factor that drives P/E contraction or expansion – and which also determines the cost of capital of companies via equity offerings (IPOs or secondaries). Note that this perception also takes into account financial transparency – as investors' perceptions of future earnings power will be clouded if company's balance sheets or income statements are perceived to be deceiving in nature. Another factor that drives future P/Es is, obviously, today's P/Es, as well as the valuation (and availability) of other liquid asset classes that are available to investors around the world, such as corporate bonds, government bonds, cash, REITs, commodities, etc. Speaking of “availability,” the “supply” of equities (measured by the dollar value of the global equity market “float”) is also important. A recent example was the significant divergence in the value of the Chinese “A shares” relative to their “H share” counterparts in Hong Kong, or ADRs being traded on the U.S. stock exchanges last year. The “poster boy” was the debut of PetroChina's shares in the Shanghai stock market in November 2007. At the time of the debut, only a little more than 2% of its shares were listed on the Shanghai stock exchange. Driven by the bidding frenzy in Shanghai, the stock traded debuted at a P/E of around 55, versus 22 in the Hong Kong Stock Exchange.
Where Are We Right Now?
Using the above “model” as a basis, we now have a clearer picture of where stock prices may go over the next 12 to 24 months. Moreover, following are some trends that I believe could have an impact on the U.S. and global stock markets (especially individual stocks in certain industries) during this timeframe:
- The general deleveraging in the U.S. economy that began in early 2007 is set to continue. While credit spreads have declined tremendously over the last few weeks, the major leading economic indicators, as well as the trend in housing prices, suggest that both US corporations and households will continue to deleverage for the foreseeable future. Sure, commercial bank credit has continued to increase over the last few months, but most of it is probably due to “forced lending” to companies that have established lines of credit prior to the credit crisis early last year.
- The threat of protectionist policies or increase in corporate tax rates or capital gains taxes should a Democratic candidate win the Presidency later this year. Note that even the perception of a less business-friendly Administration is enough to drive stock prices lower. Given that most analysts have not discussed this potential threat to stock prices, I would argue that this is more of a danger to stock prices than either the subprime crisis or the general deleveraging in the U.S. economy.
- One of the main trends that we have witnessed over the last few years has been the “diversification” away from domestic equities into foreign and emerging market equities and “alternative asset classes” by pension plans, endowments, and foundations. With the recent decline in equity prices, this trend is now accelerating (defined benefits pension plans still have about 60% of their assets in U.S. and foreign equities) – especially as it pertains to hedge funds, private equity funds, and “liability-driven” investing strategies.
- The threat to US and global productivity growth stemming from record high energy and food prices. The rise in crude oil is especially troubling as this diverts resources away from the private sector into the many corrupt and inefficient governments around the world, such as Iran and Venezuela.
On the other side of the coin, there are now several benign trends that are supportive for the equity markets:
- The Fed's response to the general deleveraging in the U.S. economy, i.e. lower borrowing rates, will eventually filter through to the businesses that are left standing after the deleveraging phase is over. Once the general deleveraging is over, the “survivors” will also enjoy more pricing power and thus higher corporate profit margins as their weakest competitors scale back or go into liquidation mode (bankruptcy financing will no longer be as lax as it used to be either).
- Annualized monthly housing starts are now below the one million mark – a mark that has marked the end of past housing busts in the US. Moreover, there are other trends that are supportive for housing prices – trends that were not in place in the last housing bust in the early 1990s. This includes demographics (baby boomers continuing to buy second homes, while the Y-Gens are expected to create an additional 150,000 households a year relative to the X-Gens), the build-up of global wealth, and the relatively low U.S. Dollar. Specifically, the latter two trends are spurring significant foreign buying, especially in coastal areas such as San Francisco, Los Angeles , New York, and parts of Florida. As long as the emerging markets economies do not sink into a recession, the latter two trends will continue to be supportive for U.S. housing prices for the next 10 to 15 years. If Congress passes a bill that provides tax credits for first-time homebuyers, this would create a significant (and more importantly, current) amount of demand among the large pool of Y-gens or those who have sat on the sidelines over the last few years waiting for a good entry point in residential real estate. While I continue to expect housing prices to decline this year, I expect housing to be much less of a headwind for the financial markets and for the global economy 6 to 9 months from now.
- The unprecedented amount of investable capital sitting on the sidelines waiting to be deployed into the financial markets once the credit markets calm down. The $3.5 trillion sitting in U.S. money market funds - as a percentage of the U.S. stock market's market cap – is now the highest in history. More importantly, the amount of interest being paid on money market funds have been declining – and should again decline if the Federal Reserve institutes a 25 basis point cut in the intended Fed Funds rate this Wednesday. This build-up in money market assets does not include the significant amount of capital sitting in the balance sheets of sovereign wealth funds, non-financial U.S. corporations, private equity funds, and in savings accounts in Japan (still the second largest pool of savings in the world), China, India, Western Europe, and many other emerging market countries. This is literally unprecedented in history. As I previously mentioned, the only industry that is cash poor is the financial industry – and while the financial industry is the “grease” that drives the global capitalistic economy, such a cash deficiency is not the end of the world, as 1) the amount of losses are not high given the idle capital around the world, and 2) it is in everyone's interest to quickly reliquify the global financial sector.
- As usual, the death of the U.S. consumer has been greatly exaggerated. Despite what the official “savings rate” says, U.S. household net worth actually increased from $42.3 trillion as of December 31, 1999 to $57.7 trillion as of December 31, 2007, despite the U.S. stock market experiencing one of the worst bear markets in history from 2000 to 2002. No doubt, the current measurement of the U.S. savings rate is fundamentally flawed. The bears would argue that the U.S. savings rate was hugely positive 20 years ago, but what they fail to catch is that the dynamics of the U.S. economy have changed significantly over the last 20 years. For example, in the last 20 years, the number of small businesses has risen dramatically – rising more than three-fold during that time. While it is straightforward to measure the savings for employees in a typical Fortune 1000 corporation (wages plus contributions to pension plans, etc.), it is not so straightforward for entrepreneurs that start their own businesses, since much of their savings are deployed back into their own businesses. Think about the two co-founders of Google – Larry Page and Sergey Brin – who worked day and night at the Stanford campus to develop the groundbreaking search engine that we call Google today. Today, their combined net worth is approximately $30 billion, but virtually none of their working hours over the last seven years are counted as savings according to the official definition – even though they have managed to build Google from the ground-up into a $170 billion company today. To add salt to the wound – whenever one of them (or another insider) sell their shares on the open market, the capital gains taxes are treated as an expense, and therefore is counted as an offset against savings. That is, there is no corresponding entry on the income side even though there is an entry on the expense side! This scenario is consistent with the secular decline in the savings rate since the early 1980s.
- The record amount of company buybacks over the last few years – this has been the one “saving grace” for EPS growth of the S&P 500 over the last 12 months. This has also removed a significant amount of “float” or in other words, supply of common shares on the U.S. stock exchanges. All else being equal, the removal of floating shares should not only increase the EPS of the S&P 500, but would also directly impact share prices as well.
Obviously, we should continue to respect the general deleveraging in the U.S. economy for the next 12 to 24 months, as well as the potential change in U.S. public policy towards businesses should a Democratic candidate be elected President later this year. The continuing “diversification” by institutional investors away from equities and into hedge funds, private equity funds, and other alternative asset classes will also continue to be a short-term drag. That being said, there are now significant countervailing forces that are setting up U.S. stocks for a tremendous bull market sometime in the next 12 to 24 months. Ironically, the general deleveraging in the U.S. economy will ultimately prove to be very bullish for share prices (as long as you pick the right stocks, of course) – as the marginal companies are liquidated, resulting in higher corporate profit margins (more pricing power, lower wages, access to cheaper financing, lower rents, etc.) for the companies that remain.
Over the next 12 to 24 months, I expect the true growth companies to outperform “value” plays – as investors begin to discriminate between companies that can grow earnings on a consistent basis versus companies that are in highly cyclical industries or that are heavily in debt. The time for “turnaround plays” will come, but until the majority of the deleveraging is over (many US regional banks and Western European financial companies still haven't fully disclosed their losses), I would not buy potential turnaround situations just yet. In terms of the major market indices, I also would not be surprised to see the Dow Industrials or the S&P 500 retesting its January 22nd lows sometime in the next 12 to 24 months. For now, the intermediate trend remains up for U.S. stocks, and we will continue to remain 100% long in our DJIA Timing System until at least the majority of our sentiment indicators becomes overbought.
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 25, 2008, the Dow Industrials rose 42.50 points while the Dow Transports rose 17.29 points. With the latest rise in the two popular indices last week, both the Dow Industrials and the Dow Transports are now firmly above their February 1st closing highs. Again, the Dow Transports remains the stronger index, as it is now more than 22% above its January closing low, and only 6.0% away from its all-time closing high. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, the strength in the Dow Transports is very encouraging, especially given record high crude oil prices last week. Moreover, with the latest decline in credit spreads across the world, and with further capital-raising within the global 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 -2.0% to 0.1% for the week ending April 25, 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 latest five-week uptrend in this sentiment indicator from a historically oversold condition (by far the most important reversal signal in the stock market is when this indicator reverses from a very oversold situation), there is no question that the broader market has already bottomed and that the line of least resistance continues to be up. 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, the latest decline in credit spreads, the imminent implementation of the fiscal stimulus plan, 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 find more solutions to cushion the decline in U.S. housing prices going forward.
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 both the 20-day and 50-day moving averages of the ISE Sentiment Index reversing from their historically oversold readings – and given that both the 20 DMA and the 50 DMA are now firmly in established uptrends – probability suggests that the stock market has already bottomed and should continue to rally for the foreseeable future. Given this reversal from a historically oversold condition of the stock market, the Fed “backstopping” the majority of the U.S. financial sector, the mailing out of the “fiscal stimulus” starting tomorrow, 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.
Conclusion: With danger comes opportunity. While there are certain forces within the financial sector and the public policy arena that could pose a significant hurdle for stock prices going forward, chances are that – once this is all over – that the companies left standing would inherit an environment of lower borrowing costs, less competition, and as a result, higher profit margins and greater growth opportunities going forward. Should the general deleveraging in the economy or should public policy drive the stock market to lower prices later this year or in 2009, chances are that it would be a great buying opportunity – given the unprecedented amount of global capital and wealth, as well as the continuing adoption of capitalist ideas in many emerging markets around the world.
For now, we continue to be bullish on the U.S. stock market, at least until the majority of our sentiment indicators start to become overbought. In the meantime, I will continue to be vigilant and inform our subscribers should we see a gathering storm that would impact the global equity markets, such as the current rise in food prices, global discontent among the world's poor, or the threat of a more vicious corporate or capital gains tax policy leading up to the U.S. Presidential election later this year.
Henry To, CFA