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Don't Underestimate the Impact of Sovereign Wealth Funds

(June 12, 2008)

Note: As discussed in our following commentary, we will most likely go 50% long in our DJIA Timing System today (Thursday) assuming the stock market embark on a rip-roaring rally immediately after it opens.  At this time, I am not sure how long the holding period would be should we choose to initiate such a position.  Obviously, that will depend on the action of the market, our technical indicators, etc, going forward, as well as how the central banks and governments in the world react to the current rise in oil prices.  For now, I am still optimistic – but if things start to turn sour, we would not hesitate to treat this 50% long position as simply a trading (short-term) position.

Dear Subscribers and Readers,

In a recent blog post on the website of the Council on Foreign Relations, Brad Setser openly wondered if 1) China's State Administration of Foreign Exchange (SAFE) could be considered a sovereign wealth fund, given its recent investment in a private equity fund run by TPG (i.e. central banks and managers of central banks' assets typically hold foreign reserves in the form of currencies, government bonds, or US agency MBS), and 2) Given its recent TPG investment (along with its investments in BP, ANZ, and Commonwealth Bank of Australia), SAFE may now actually be holding a broader global equity portfolio.  In fact, this portfolio may actually be larger than all but five or the largest sovereign wealth funds – those being the Abu Dhabi Investment Authority, the Kuwait Investment Authority, Norway's Government Pension Fund, and possibly Singapore's Temasek Holdings and the Government of Singapore Investment Corporation.  Given that China has been growing its foreign reserves by $75 to $85 billion a month, such a shift into a global equity/private equity “mandate” for SAFE isn't a trivial development.  Besides, China already has ample foreign reserves in the form of currency and government bond holdings, so it makes perfect sense (from an asset allocation standpoint) to diversify a significant amount of new reserves into riskier asset classes, such as global equities, private equity, global real estate (REITs), infrastructure funds, emerging market debt, etc.

Assuming that SAFE assigns half of its foreign reserve growth (i.e. $40 billion a month) into a global market portfolio, it is not a stretch to assume that as much as 20% of these new funds are reinvested back into US equities (given that the total U.S. market cap is approximately 40% of the world's investable equity universe).  Even assuming that SAFE has the goal of reinvesting a significant amount of its proceeds back to China's own domestic infrastructure, there is still no doubt that US equities or US private equity funds are still an integral part of SAFE's “risky portfolio.”  That is, while an $8 billion inflow assumption may be overly optimistic, I would not be surprised if SAFE – through its New York or Hong Kong office – is actively buying US stocks on a monthly basis through its many secretive investment partnerships or stakes in commingled funds/separate accounts managed by the various institutional investment firms.  My guess?  We're probably looking at a steady $4 billion to $5 billion inflow into US equities from SAFE on a monthly basis.  A typical institutional “market portfolio” of a non-US centric fund (most US pension funds are still overweight US equities, as I mentioned in our June 1, 2008 commentary) would look something like the asset allocation of the Abu Dhabi Investment Authority, as shown below (courtesy of BusinessWeek):

Asset allocation of the Abu Dhabi Investment Authority

Here is where it gets interesting.  SAFE isn't usually included in a “who's who list” of sovereign wealth funds so its “risky” assets under management are not included in many of the mainstream estimates of sovereign wealth assets (one major reason for this, no doubt, is the secrecy surrounding what they do and what they are invested in).  Today, total global sovereign wealth assets under management are estimated to be about $3.4 trillion, and growing rapidly.  By 2010, this is estimated to grow to more than $5 trillion.  This is not difficult to fathom, considering that Saudi Arabia alone should bring in gross revenues of more than $450 billion over the next 12 months with crude oil at $135 a barrel.  More importantly, assuming half of the inflows into sovereign wealth funds (not including reserve accumulation at SAFE) are allocated to a global market portfolio (around $500 billion over the next two years), approximately $5.2 billion would also go into US stocks on a monthly basis.  Based on this simple and conservative math, one can infer that sovereign wealth funds and SAFE in general account for about $10 billion of inflows into US equities on a monthly basis.  More importantly, this amount is not trivial.  For example, until February 2000, net equity mutual fund inflows (this includes domestic and international funds!) never rose above $23 billion in any month.  Even at the peak of the bubble in early 2000, net inflows into equity mutual funds never rose above $40 billion.  The US stock market – just like any other auction market – is priced at the margins, so a consistent $10 billion monthly inflow into the US equity market definitely has a short-term impact on US stock prices.

The Stock Market

Turning to something of a more immediate concern, the stock market suffered another bout of panic in light of the continuing fear of more write-down losses (this time at Goldman Sachs and Morgan Stanley), potential further dilution of Lehman's common stock holders (and a fear that the US$6 billion offering won't get done), rising oil prices, and potentially rising inflationary pressures.  The fear of a tightening Fed has sent two-year yields rising by 20 basis points since the end of May, and by nearly 90 basis points over the last 30 days!  The easing of the credit crunch, combined with the fear of rising inflationary pressures and a tightening Fed has resulted in a flattening of the Treasury yield curve, as shown in the chart below:

Monthly Differences Between Ten and Two-Year Treasury Yields (January 1982 to June 2008*) - 1) * June 2008 rate = Rates as of June 11, 2008 Close 2) Average Yield Differential: 0.87%

Since the difference between the 10-year and 2-year Treasury yield peaked at 1.89% in March, the yield curve has flattened considerably.  As of yesterday at the close, the difference between 10 and 2-year Treasury yields shrank to 1.24%.  Fortunately, a 1.24% differential is still high on a historical basis (since January 1982, the monthly yield differential has averaged 0.87%) – and is thus still conducive to rebuilding banks' balance sheets and allowing them “reliquify” the US economy going forward.

With regards to the US$6 billion offering in Lehman's preferred and common shares, rest assured that the deal will get done at the close today, given that:

  1. There is simply too much at stake, not only for Lehman's employees and shareholders, but also for other investment banks, asset management firms, private equity firms, and to a lesser extent, the US economy as a whole.  Moreover, the investors who committed to the deal at $28 a share are for the most part long-term and fully-collateralized investors (and some no doubt already have a stake in Lehman's common stock or debt) – so it is difficult to imagine them squabbling over $2 or $3 a share at the risk of scuttling the deal, and potentially unraveling the US financial system as well.

  2. Unlike Bear Stearns, Lehman is generally well-liked by the Street (Bear Stearns has always had a reputation for being a maverick and was the only investment bank that did not help bail out Long Term Capital Management, despite them being LTCM's prime broker).  That is, not only are there monetary stakes on the line, but friendships and families as well.

  3. More importantly, Lehman is now much less leveraged than other investment banks – and is much better capitalized than Bear Stearns ever was.  Moreover, the establishment of the Primary Dealer Credit Facility in light of the Bear Stearns bailout means that Lehman can effectively monetized a significant part of its assets “at will” to meet redemptions if push comes to shove.

I expect to see Lehman stabilize after the market closes today – once everyone realizes that a deal has gotten done and once everyone realizes that Lehman will only go back to Korea as part of a strategic tie-up, as opposed to simply ask for more capital.

More importantly, the amount of “cash on the sidelines” waiting to be invested has just hit a new record high relative to the market cap of the S&P 500 (which comprises about 75% of total 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 June 2008 (note that the June data is only updated to yesterday, obviously):

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to June 2008) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash.  2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market which would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio makes an all-time high after dipping slightly during April and May due to a stagnation in the growth of money market assets and strength in the S&P 500. More important, this ratio is now at a record high (28.57%), surpassing the previous record highs set in March 2008 (28.34%) and month-end July 1982 (28.03%). This ratio continues to be supportive for stocks over the long-run. While this does not mean that this ratio cannot go higher, chances are that the market will be higher over the next several months.

As of Wednesday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 28.57% - an astronomically high level that broke all previous record highs – including the record high just set in month-end March 2008 (28.57%), the month-end February 2003 high (27.12%) and the month-end July 1982 high (28.03%).  The October 1990 high – the last time the U.S. stock market gave us a once-in-a-decade buying opportunity – has totally been “blown out of the water.”  Unless the S&P 500 rises substantially between now and month-end, and unless that is accompanied by a lack of growth in money market fund assets, this record is most likely to hold.  Moreover, subscribers should remember that the amount of global capital that is sitting on the sidelines waiting to be invested is also now at record highs, as exemplified by the amount of “Petrodollars” being recycled into Middle Eastern sovereign wealth funds and the amount of foreign reserve accumulation in China (note that a comparable amount of foreign 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 at a record 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.  Even if one is skeptical on the health of the US stock market, it is still best to stay away from the short side.

In short, I believe the latest sell-off is overdone in the short-run.  I am also optimistic that the current perception problem at Lehman Brothers will resolve itself by tonight as the US$6 billion offering gets done after the market closes.  Coupled with the resilience of the U.S. Dollar Index in the face of recent bad news (a hawkish ECB, troubles at Lehman, etc), my guess is that relative strength will rotate back to U.S. centric financial assets relatively soon – even though it may well be temporary.  For now, our indicators are telling us to initiate a 50% long position in our DJIA Timing System sometime today – preferably on further weakness.  Should the Dow Industrials rally strongly out of the gate, however, we will not chase it and will instead wait for more visibility before we initiate a 50% long position or go for a 100% long position again.

Signing off,

Henry To, CFA

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