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The Continuing Deleveraging in the U.S. Stock Market

(May 29, 2008)

Dear Subscribers and Readers,

We last discussed the continuing deleveraging process in the U.S. stock market in our May 1, 2008 commentary.  At the time, we asserted that given the improved outlook for stock prices and lower margin rates (as a result of the cut in the Fed Funds rate and consequently the prime rate), chances were that the deleveraging in the U.S. stock market was over for now, as long as the U.S. stock market does not enter a 2000 to 2002 style bear market.  In order to ensure releveraging, however, we asserted that stock market volatility would first have to calm down.

Since the end of March (the margin debt data we showed in our May 1st commentary ended in March 31, 2008), not only has stock market volatility calm down, but general financial market volatility has as well.  More importantly, both the U.S. and the global stock markets recovered nicely during April, with the S&P 500 rallying 5% and the MSCI All Country World Index rallying 4.5%.  Under normal circumstances, the total amount of margin debt outstanding should have increased, as retail investors take advantage of lower margin rates and higher stock prices.  Interestingly, this did not happen, as evident on the following monthly chart showing the Wilshire 5000 vs. the change in margin debt from January 1998 to April 2008:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to April 2008)

Total margin debt outstanding actually decreased by over $16 billion during April.  For the three months ending in April, margin debt outstanding is down about $32 billion.  Over the last six and 12 months, margin debt outstanding is down by approximately $44 billion and $9 billion, respectively.  Note that the 3-, 6-, and 12-month change in margin debt outstanding hasn't simultaneously gone into negative territory since the month ending October 2002, right at the bottom of the last bear market.  Even during the historic July to October 1998 bull market correction, the 12-month change in margin debt remained positive.  The $64 billion question is: Are we closer to the bottom, or are we in a full-blown bear market (I am sure our subscribers will have widely disparate views on this)?

Thankfully for the bulls, as shown in the following monthly chart illustrating the amount of cash levels in brokerage accounts – directly investable funds as a percentage of margin debt have surged to an all-time high, while directly investable funds on both an absolute basis and as a percentage of the Wilshire 5000 are still near all-time high levels.  Given this substantial amount of idle cash sitting in brokerage accounts (which are only getting paid a miniscule amount of interest), and assuming stock market volatility continues to remain relatively low over the next couple of months, probability still calls for a substantial releveraging in the U.S. stock market sometime this summer.

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to April 2008) - Cash levels as a ratio of margin debt again hit an all-time high as of the end of April 2008!

In the meantime, we realize that there are still substantial headwinds for a releveraging in the U.S. stock market.  Aside from the continuing squeeze on the consumer through inevitably higher unemployment levels (many folk who have been laid off are no doubt relying on their 401(k) accounts for day-to-day expenses) and rising energy prices, Wall Street banks and prime brokers have dramatically pared back their margin extension to both hedge funds and individual investors alike.  This is partly because of the ongoing liquidity/capital constraints at many brokerages, and partly because of a general aversion to extend funds for clients to speculate in such an environment.  This increase in prime brokerage “haircut” was documented by a recent issue of the IMF Stability Report and in our April 13, 2008 commentary (“The Great Deleveraging – Part II”).  Following is a reproduction of the table comparing typical prime brokerage “haircuts” during the early parts of 2007 versus where they were last month:

Typical prime brokerage haircuts January-May 2007 versus April 2008

My sense is that the U.S. stock market will not rise substantially until prime brokerage margin requirements are relaxed.  It is difficult to get a sense of when this will occur, but given the ongoing capital raising efforts by commercial and investment banks alike, margin requirements should eventually come down, as long as U.S. housing prices cooperate (or better yet, if a substantial amount of mortgages are taken off of banks' balance sheets).  Moreover, it is naïve to assume that higher margin requirements for junk bond holdings, for example, won't have a meaningful impact on stock prices, given the positive correlation between junk bonds and U.S. stocks (historically, junk bond prices have acted more like stock prices than investment grade bond prices).

For now, given that the Fed has effectively adopted a neutral stance going into the June 24/25 FOMC two-day meeting, and given rising global energy prices, investors are starting to believe that the Fed is now effectively out of the picture.  While this does not mean that the Fed won't intervene should we again see signs of increasing systematic risk, what it does mean is that the Fed will probably do little should the stock market weaken substantially from current levels, similar to what occurred during mid January and mid March.  In other words, the “Bernanke Put” on the S&P 500 and on the financial and consumer discretionary sectors is no longer in place.  While we will look to re-establish our long position in our DJIA Timing System, it is only prudent to respect both the deteriorating fundamentals and technicals of the U.S. stock market and the components within the S&P 500 – despite the amount of idle cash sitting on the sidelines and dramatically lower margin rates compared to just 12 months ago.  Most likely, we won't re-establish our long position in our DJIA Timing System again until we see both our sentiment and the majority of our technical indicators in oversold territory again.  I would also like to see another spike in both investment grade and junk bond yield spreads.  We will discuss this in more detail in our upcoming weekend commentary.

Yours truly,

Henry To, CFA

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