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Capitulation Phase

(July 10, 2008)

Dear Subscribers and Readers,

I hope every one of you had a great weekend – and for our American subscribers, a great July 4th long weekend/vacation.  My “self-imposed exile” (as one subscriber and friend put it) at Catalina Island turned out to be just the right medicine and the perfect place to get some R&R – as it is always difficult to detach oneself from the financial markets unless there is some sense of isolation.  The one-hour ferry ride to an island that is for the most part undeveloped allowed me to get away from the daily noise in the stock market – and more importantly, to focus on the long-term trends that are now playing out in the global economy and business world.

The stock market kicked off Monday morning with tremendous selling in the GSEs (Freddie Mac and Fannie Mae), and financial stocks in general.  Even with a $5 decline in crude oil prices and a general bounce in the afternoon, the S&P 500 still closed down by 0.84%, with financials leading the way with a decline of more than 3%, followed by a 2.3% decline in the S&P 500 energy index.  The selling in the GSEs continued yesterday, despite the OFHEO's reassuring remarks on Tuesday evening that capital requirements at both Freddie and Fannie were sufficient.  Moreover, for the umpteenth time over the last three years, former St. Louis Fed governor William Poole again made disparaging remarks on the GSEs (never mind that these statements could cause a systemic dislocation not just in the global financial sector, but within the global economy as well, starting with middle class Americans).  My take on this: If the GSEs can make it through the next 12 months, then these two entities will have a market share of over 90% of the US mortgage market in a couple of years - and will literally print money as they would have an effective monopoly for a long time to come as the origination of private mortgages would not make a comeback for a decade or more.  The question, of course, is whether the regulators (OFHEO) and auditors can “look the other way” and allow them to keep operating and borrowing money even though they may have negative equity on a FASB “fair value” basis.  The OFHEO has stated that they will not force the GSEs to implement fair value accounting, and is currently discussing this issue with FASB.  Once the GSEs get through these 12 months with their credit rating intact, they can then inflate their way out of their problems.  This is not without precedent.  Indeed, the vast majority of US money center banks were technically insolvent (coming off the LDC defaults in the early 1980s) for most of the 1980s – and yet, both the stock market bull and the bull market in financial stocks remained intact for the rest of the decade (until the S&L crisis hit full blast).  Even should the GSEs get in trouble (they will only do so if their cost of capital becomes too debilitating to borrow any money and to make new loans), there is no reason to believe this will pose a risk to the US financial system or economy, as it is inconceivable to me that Congress would stay on the sidelines and not bail out the GSEs.

In the meantime, there is no doubt in my mind that global equity investors are now capitulating.  You can see it in the overbought/oversold indicators, the sentiment indicators (the bulls-bears% differential in the latest Investors Intelligence readings just hit a low not seen since the week ending December 23, 1994), the amount of capital sitting on the sidelines, and the fact that many equity markets in the world are still decently valued, especially in developed countries such as Japan, Hong Kong, Taiwan, and South Korea.  Unfortunately, as is typical of all capitulation periods in the financial markets, the selling has been intense and indiscriminate – and until we get some visibility on the US financial sector, it is too early to make a case for a sustainable rally just yet.

On the other hand – with the latest $10 decline in crude oil prices (and the probability that the decline still has some ways to go) – the world's major central banks are now under less pressure to tighten their monetary policies going forward.  More importantly, the Fed, the European Central Bank, and the Bank of Japan have all shown in the past ten months that they are willing to deal with deflationary pressures in the global financial markets – as exemplified by: 1) The Fed's aggressive easing policy since September of last year, 2) the direct lending done and the implementation of USD swap lines by the European Central Bank, and 3) The fact that the Bank of Japan have kept overnight rates at 0.5%, despite rising inflationary pressures in the Japanese economy.  Finally, the latest decline in crude oil prices will directly benefit profit margins of the vast majority of the US economy, beginning with the transportation industry, as shown below in our daily chart of the Dow Jones Industrial vs. the Dow Transports from July 1, 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2006 to July 9, 2008) - For the week so far, the Dow Industrials declined 81.10 points while the Dow Transports rose 125.82 points. The Dow Industrials - coming off a 1,800-point decline over the last two months - is now immensely oversold. At the same time, the Dow Transports has remained resilient (it is actually up for the week), as it is still over 15% above its January lows and over 9% above its March lows. Given the resilience and the latest bounce 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.

As mentioned on the above chart, the Dow Transports did not confirm the Dow Industrials on the downside this week.  Instead, it has risen 125.82 points as crude oil declined $10 a barrel over the last three days.  In the meantime, the Dow Industrials – coming off a two-month decline of over 1,800 points – is now immensely oversold.  The latest non-confirmation of the Dow Industrials by the Dow Transports, combined with the hugely oversold conditions in the stock market and the immense amount of capital sitting on the sidelines, is a bullish development for the broad market and suggests an imminent reversal in the U.S. stock market over the next couple of weeks.

Speaking of the amount of cash sitting on the sidelines, the amount of investable capital as measured by US money market fund assets has continued to increase at a dramatic rate (over 38% year-over-year) and is now at a record amount relative to 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 July 2008 (note that the July data is only extended into yesterday, obviously):

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to July 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 spikes to another 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. This ratio is now at a record high of 30.25% - after taking into account the latest dip in the S&P 500 in July, and 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, suggesting 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 spiked to 30.25% - an astronomically high level that again broke all previous record highs – including the month-end March 2008, February 2003, and the July 1982 highs.  The October 1990 high – the last time the U.S. stock market gave us a once-in-a-decade buying opportunity – has now been completely blown out of the water.  Unless the S&P 500 rises by dramatically over the next several weeks, this record will most likely hold.  More importantly, subscribers should note that the amount of global investable capital that is sitting on the sidelines is also now at record highs (such an amount of capital was virtually non-existent back in February 2003, let alone July 1982 or October 1990) – not just in sovereign wealth funds, but in private equity funds and hedge funds as well.  While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now extremely 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. My sense is that we have already seen the bottom – which means that we will continue to remain 100% long in our DJIA Timing System in the immediate future.

Finally, the valuation factor of the entire universe of stocks (over 2,000) covered by the competent analysts at Morningstar just hit a multi-year low of 0.82 on Monday (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”).  The last time Morningstar's valuation factor hit such an oversold level was early October 2002, just as the US stock market was coming out of its last cyclical bear market (as shown in the following chart, courtesy of Morningstar). 

Market Valuation Graph

Again, while the above chart isn't a perfect timing indicator, what it does show is that if one has a long-term horizon, then buying US stocks at current levels will eventually turn out to be a great decision.  Given the amount of capitulation that we have been witnessing over the last couple of weeks, however, I now believe a tradable/sustainable bottom is imminent – and will most likely come in the next couple of weeks.

Signing off,

Henry To, CFA

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