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What's Next for Financials?

(July 6, 2008)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 10 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;

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

9th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 943.46 points as of Friday at the close.

10th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 634.46 points as of Friday at the close.

We will update (and “clean up” our above text) our DJIA Timing System's performance as of the end of the 2nd quarter for our readers in next weekend's commentary, and then subsequently move to a semi-annual update schedule.  Please refer to our subscribers' area for our March 31st update.  As of Friday at the close, our DJIA Timing System is still beating our benchmark, the Dow Jones Industrials Average, on all timeframes since the inception of our system.

As I mentioned in our mid-week commentary, this commentary is going to be brief, as Thursday's trading session was relatively uneventful, and as we had to prepare for our two-day trip to Catalina Island tomorrow morning. 

A recent study released by Keefe, Bruyette & Woods suggests that US banks (excluding investment banks) would need to raise another $30 billion in “coming years” as the “multiplier effects” of the recent subprime problems spread across the US economy.  Bank of America is at the top of the list.  In a “worst case scenario,” KBW estimates that Bank of America would need to raise $10 billion in capital, as it struggles to digests its recent acquisition of Countrywide Financial.

A July 4th article on Bloomberg featured Goldman's latest estimates of total capital raisings required by European banks.  According to Goldman, approximately US$95 to US$140 billion would be needed by all European banks over the coming years in order to raise their Tier 1 capital ratio to 9%.  Goldman estimates that the upper range of US$140 billion would be needed if we experience a scenario reminiscent of the early 1990s credit crisis/global recession.

Over the next few days, look for more reporting on Merrill Lynch, as rumors continue to swirl regarding an inevitable divesture of its holdings in Bloomberg (Merrill is reportedly asking $5 billion) and part of its $12 billion holding in BlackRock in order to cover more projected write-downs in its earnings report in the middle of this month.  Total write-downs for the second quarter for Merrill estimated to be from $3 billion to $6 billion.

Meanwhile, Deutsche Bank has now emerged as the sole bidder for Citigroup's retail banking operations in Germany, as Citigroup continues to deleverage and shore up its capital base in anticipation of further write-downs for the second quarter.  Such a sale is estimated to fetch US$6.3 to US$7.9 billion.  Second quarter write-downs for Citigroup is estimated to range from “as little” as US$5 billion, to as much as US$12.2 billion (this final estimate is courtesy of Meredith Whitney from Oppenheimer).

Assuming both Merrill's and Citigroup's sales of go through over the next couple of weeks (right before the announcement of their second quarter earnings), chances are that both will have little need to raise more capital in the immediate future.  However, given Goldman's latest assessment of the health (or lack thereof) of the European financial system, and given the slowing global economy and tightening monetary policies around the world, there is no doubt that both the US and global financial system continues to remain under stress.  For example, on a year-to-date basis, the S&P 500 financials index is down about 30%.  During the second quarter alone, the S&P 500 financials index declined nearly 20%, despite the barrage of rate cuts an the creation of the Primary Dealer Credit Facility by the Federal Reserve in light of the collapse and subsequent takeover of Bear Stearns.  This “elevated stress” in our financial system can be witnessed in the stubborningly high levels of the “TED Spread,” as shown in the following chart:

5-Day Simple Moving Average of the TED Spread (January 1998 to Present) - The TED spread hit a 20-year high in mid December - making a lower high in mid March - and has since declined back to the 1.2% level on the back of the recent easing and liquidity injections by the Fed. Despite the 225 bps ease by the Fed since the beginning of this year, the 5-day MA of the TED spread remains at a relatively high level of 1.18% - suggesting that the bank liquidity conditions are still relatively tight. There is no doubt the Fed would like to see this back below the 1.0% level, which is where it has been over the long-run. Unfortunately, the recent spike in headline inflation is preventing the Fed to ease any further - but by the same token, the continued stress in the US banking system also suggests that the Fed won't be hiking anytime soon.

Despite the 225 basis point easing by the Fed since the beginning of this year, and over $320 billion in global capital easing since August of last year, the 5-day moving average of the TED spread still remains at an elevated level of 1.18%.  While this spread is down from the >2% rate in mid December of last year, there is no doubt that liquidity conditions still remain tight among many banks across the globe.  Unfortunately, the recent spike in headline inflation is preventing the Fed and other major central banks from easing any further.  That in turn means any immediate relief will need to come from more capital raises – as many banks are not projected to retain profitability anytime soon.

Fortunately – as covered in our prior commentaries – unlike past downturns in the US banking/economic cycle, there is now an unprecedented amount of capital sitting on the balance sheets of private equity funds, sovereign wealth funds, distressed debt funds, and “vulture investors” intended to scoop up much of these assets of ownership in financial institutions once some of the smoke in the US housing sector and US economy starts to clear out.  Moreover, private equity funds have shown substantial interest in putting more capital to work in many US financial institutions once the Fed clarifies some of its ownership rules surrounding bank holding companies, while Japanese financial institutions (which for most part emerged unscathed from the subprime crisis) are now also expressing an interest in recapitalizing many global financial institutions – with an eye to expanding their global reach over the next three to five years.  For those financial institutions who do not want to tap “strategic investors” such as private equity or Japanese financial institutions for more capital, they can always raise more funds from the secondary market, as both institutional and retail investors have for the most part kept buying financial ETFs and financial mutual funds over the last few weeks, even as the share prices of many companies in financial sector continued to decline.

This author expects relative strength to rotate back to US, Japanese, Taiwanese, Hong Kong, and South Korean equities over the next few months – especially as global pension funds and sovereign wealth funds “rebalance” their portfolios over the next few weeks in response to the recent run-up in commodity prices and the decline in equity prices (having institutional investors buying commodity futures is a double-edged sword).  With respect to US equities, I continue to like the technology and healthcare sectors in general (I also like the biotech industry for those who want to buy a specific industry fund).  I also expect both the financial and consumer discretionary sectors to outperform the S&P 500, as these two sectors are now severely oversold (while both sectors are still in the midst of deleveraging, the “pendulum” has definitely swung too far into the bearish side).  To put this in perspective, let us take a look at our Overbought/Oversold Model for the various S&P 500 sectors (this model is constructed using the same methodology as utilized by our Global Overbought/Oversold Model, which is discussed in our December 6, 2007 commentary).:

S&P 500 Sectors Overbought/Oversold Model as of June 30, 2008

Using this methodology, the financials sector is now at its most oversold level going back to the beginning of 1998 (this model uses historical data going back to 1998), with the exception of its three-month moving average (its most oversold level on a three-month basis came in August 1998).  Meanwhile, the consumer discretionary sector also remains oversold in all timeframes, while industrials have also suffered given the recent global economic slowdown (although I predict more general weakness in industrials for the next few months).  Not surprisingly, I expect both the energy and the materials sectors to underperform the S&P 500 over the next few months.

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 July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2006 to July 3, 2008) - For the week ending July 3, 2008, the Dow Industrials declined 117.97 points while the Dow Transports declined 230.37 points. The Dow Industrials - coming off a 1,750-point decline over the last seven weeks - is now immensely oversold. At the same time, the Dow Transports has remained resilient (despite its latest weekly decline), as it is still over 12% above its January lows and over 6% above its March lows. Moreover, given the continued cutbacks in airline capacity over the last five weeks, and given that the bulk of the transportation group still has pricing power, I expect the Dow Transports to make another all-time high sometime in the next few months. Given the resilience of the Dow Transports, and given that it has led the broad market since October 2002, I expect the Dow Industrials to bottom sometime in the next couple of weeks and embark on a significant rally. Bottom line: While the Dow Industrials is still technically weak, it is unreasonable to think we are about to embark on a new cyclical bear market especially given the immense amount of investable capital on the sidelines and the overall decent valuations. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending July 3, 2008, the Dow Industrials declined 117.97 points while the Dow Transports declined 230.37 points.  While the Dow Industrials made a new low for the move (retracing its gains over the last 22 ½ months), the Dow Transports is still holding up relatively well, as it is still more than 6% above its mid March lows and more than 12% above its mid January lows.  In addition, given the newfound pricing power by the airlines and the continuing bottlenecks in the US transportation infrastructure, I expect the Dow Transports to remain resilient, especially as the global demand for oil now seems to be tapping down.  Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I now highly expect the Dow Industrials to bounce substantially in the next couple of weeks.  For now, we will remain 100% long in our DJIA Timing System – and will only seek to pare back our position if the market becomes more overbought or if our sentiment indicators become more bullish again.

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 decreased again from last week's reading of -4.5% to -11.0% for the week ending July 3, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending July 3, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios declined from -4.5% to -11.0% - representing the 6th weekly decline coming off the nine-week bounce from the March lows. This reading has now gotten much more oversold since last week's reading - and with the exception of its plunge earlier this year - is now at its most oversold level since the first week of April 2003. For now, we will remain 100% long in our DJIA Timing System - and will only reduce our position should this sentiment and other technical indicators rise to more overbought levels again sometime later this year.

With the latest decline in the four-week MA, this sentiment indicator has again declined to a severely oversold condition.  As a matter of fact, with the exception of the plunge in sentiment earlier this year, this indicator is now at its most oversold level since the first week of April 2003.  While both the stock market and our sentiment indicators can get more oversold, I do not believe the stock market (in particular, the Dow Industrials) could decline much lower given the extremely oversold conditions, the record amount of short interest, the decline in global oil consumption, and the immense amount of investable capital sitting on the sidelines.  For now, I am still comfortable with our 100% long in our DJIA Timing System, and will only pare back our position should the stock market or should our sentiment indicators get overbought again.

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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - The 20 DMA of the ISE Sentiment Index has been consolildating at current levels over the last seven weeks since its dramatic two-month rise off the mid March lows. More importantly, this seven-week consolidation has worked off a significant amount of its short-term overbought conditions, and is sufficient to provide *fuel* for a sustainable stock market rally going forward, especially since current readings are still oversold relative to readings over the last five years. Bottom line: The 20 DMA and the 50 DMA have reversed from historically oversold levels - and are now sufficiently oversold for the market to embark on a sustainable rally.

While the ISE Sentiment Index has reversed dramatically since its mid March low, the 20 DMA of the ISE Sentiment Index has consolidated over the last seven weeks and has now worked off a significant chunk of its short-term overbought conditions.  More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years.  Given this, the probability for much further downside is minimal, and is actually conducive to a sustainable rally over the next several months.

Conclusion: Even though the global financial system is still suffering from the fallout of the subprime crisis, my sense is that the pendulum has now swing too far to the bearish side, given that there is little immediate need to raise more capital among US financial institutions over the next couple of months (although this may be a different story in Western Europe).  More importantly, there remains a substantial amount of investable capital that remain interested in recapitalizing global financial institutions – whether it is in the form of private equity funds, Japanese financial institutions, or US institutional and retail investors.  For now, given the immensely oversold condition of US financials and consumer discretionary shares, I expect a significant bounce in both sectors – along with US technology and healthcare stocks – over the next several months. 

Aside from US equities (mainly technology and biotechnology firms), I continue to like Japanese equities (especially Japanese small caps), Taiwanese, Hong Kong, and South Korean equities.  In the meantime, I still do not expect a sustainable bottom in emerging market equities, although I do expect some kind of general bounce over the next few months.  For now, we will stay with our 100% long position in our DJIA Timing System, and will only seek to pare back our long position once the stock market gets overbought again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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