The Lender of Last Resort
(July 13, 2008)
Quote of the Week: He who sells what isn't his'n; Must buy it back or go to prison. – Daniel Drew, who ironically lost the bulk of his fortune in 1870 when his short-selling campaign in the Erie Railroad went horribly wrong.
Dear Subscribers and Readers,
Before we begin our commentary, I want to update our DJIA Timing System's performance to June 30, 2008, in addition to reviewing our 7 most recent signals. While our historical performance could be calculated by tallying up all our signals going back to the inception (August 18, 2004) of our system, such a task for subscribers would be very tedious. Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to June 30, 2008:
To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way. We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500), given that most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market. In addition, the Dow Industrials has a rich history and has been computed since 1896, while the S&P 500 was only created in 1957 (although it has been retroactively calculated back to 1926).
Looking at our most recent performance and performance since inception, it is clear that most of our outperformance was due to our positioning over the last year or so – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and our subsequent shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956. While we have stayed on the long side for the most part since mid January, we have also made a couple of timely tactical moves in order to minimize recent losses due to the weak US stock market. Today, we remain 100% long in our DJIA Timing System. Subscribers should remember that:
- It is the major movements that count. Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;
- Capital preservation during times of excesses is the key to outperforming the stock market over the long-run. That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth we have been witnessing and that is still projected for the foreseeable future. I am not going to change my mind on this until/unless I see 1) a major policy mistake from the Fed, 2) the potential emergence of an inflationary spiral, or 3) extreme overvaluations in the U.S. stock market. At this point, I do not see any threat to the stock market on all three counts (versus late last year, when valuations were overly high and when the Fed was reluctant to cut rates) – although I would definitely let you know as soon as I see anything on the horizon (similar to my calls from February to April 2000).
Also note that our (annualized daily) volatility levels continue to be substantially lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods. However, given my belief the stock market has probably made a solid bottom late last week (the Daniel Drew quote should provide a good clue), subscribers should not expect any outperformance from our DJIA Timing System for the foreseeable future. We have now moved to a semi-reporting schedule, and will again update the performance of our DJIA Timing System at December 31, 2008.
Let us know review our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 1071.46 points as of Friday at the close.
7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 762.46 points as of Friday at the close.
As I discussed in our most mid-week commentary and on the MarketThoughts.com discussion forum – while Congress could've done more to provide stability to the housing market by passing its $300 billion housing bill prior to the July 4th weekend – it is inconceivable (and naïve) to even think for a minute that the GSEs would not be bailed out by the US Treasury, the Fed, of Congress if “push came to shove,” as evident last week when global investors started to lose confidence in the GSEs' capital position and their ability to function going forward. As mentioned in Freddie Mac's charter, three of the four primary goals of the GSEs include providing stability, liquidity, and “ongoing assistance” to the secondary market for residential mortgages, as well as serving a “social function” by promoting “access to mortgage credit throughout the nation (including central cities, rural areas, and underserved areas).” In other words, the primary goal of the GSEs is to act as a “counter-cyclical” institution during a mortgage/housing downturn by flooding the mortgage market with liquidity. If either GSE fails, it would have ironically added further fuel to the housing fire as it would further damage the housing market by increasing mortgage costs and restricting mortgage access.
In a recent CNN poll, 64% of all voters indicated their distaste for a Fed bailout of the GSEs in the event of a potential collapse. Obviously, everyone is entitled to his or her own opinions, but removing the GSEs' charters and the implicit backing of the government during a housing crisis – especially when foreigners now own the majority of agency instruments – is definitely not conducive to an economic recovery and will certainly not elevate the US' standing/credibility in the world today. Should the Feds allow the GSEs to fail, my “base case scenario” would be a wholesale wipeout of a significant chunk of American's middle class (not unlike the aftermath of the 1997 Asian Crisis in many Asian emerging market countries), as housing prices, stocks, and bonds decline yet further. In this extreme scenario, even U.S. Treasury yields would rise, as foreign central banks and investors exit the U.S. capital markets en masse. This would also bring on the most severe recession since 1982, when the unemployment rate hit a high of 12%. Charities would be overwhelmed. Riots would spark in most major US cities. Whole classes of MBA/law school/PhD/undergraduate students would be unemployed. The US housing market – and the U.S. economy – would probably take over a decade to recover, not similar to that of the Japanese experience over the last 18 years. All in all – unless one has over a million dollars in the bank and owns a self-sufficient farm - one should be happy to see Ben Bernanke, Tim Geithner, and Henry Paulson heading up the Fed, the NY Fed, and the Treasury, respectively. The former two are regarded as extreme doves out of the many Fed Presidents over the last 10 to 15 years. As for Henry Paulson, I don't know of any other candidate that have as many connections within the Street and as much financial/market knowledge as he does. One has to appreciate how fortuitous the American middle class is that neither Paul O'Neill nor John Snow are in the Treasury Secretary post anymore (if either had been, we would still be short stocks). Sure, the GSEs will need fixing going forward, but now is neither the time nor the place.
Deep in our hearts - especially those that have studied financial history and financial bubbles - we all know that the worst-case scenario usually occurs at the final unwinding. The Panic of 1907 ended with the near closing of the NYSE (and the wholesale collapse of stocks) while the telecom bubble ended with the bankruptcies of Global Crossing and Worldcom. So this is not a total surprise, although many punters thought the failure of Bear Stearns signaled the end, as opposed to the near collapse of the GSE's. Make no mistake: The near collapse of the GSEs has to be the “whale.” With $1.5 trillion in agency debt and over $5 trillion in agency MBS outstanding, they don't come much bigger (the collapse of Bear Stearns and IndyMac are mere footnotes compared to a potential collapse of the GSEs). More importantly, most analysts and investors out there are misguided in believing that the near-collapse of the GSEs are bearish for the stock and housing markets. This would only be true if the Feds do not act. This near-collapse has now compelled the Treasury, Fed, and now Congress (they should have passed the $300 billion housing bill before July 4th) to finally be proactive and put a cushion under US housing. That is, perversely, the near-collapse of the GSEs is actually bullish for the US financials and general stock market, as – given the latest “backstop” by the Federal Reserve and US Treasury (note Paulson can act without Congress' approval as there is more than $41 billion in the Exchange Stabilization Fund at his immediate disposal) – there is no doubt that the Feds will flood the US mortgage/housing market with more liquidity over the next several months. Given that much of the US financials (and structured finance indices such as the ABX indices) has now discounted the worst-case scenario, my sense is that we have now put in a sustainable bottom for the S&P. This bottom should at least provide us a solid two to three-month rally. Finally, just like with all financial crises, the lender of the last resort - in providing liquidity to a market that is in an extreme sense of panic - will eventually make money on its "investments." Just ask JP Morgan and his father, Junius Morgan, the Hong Kong Monetary Authority when it intervened and bought stocks on the Hong Kong Stock Exchange in August 1998, and of course, Warren Buffett, who provided life-saving liquidity to GEICO in 1976 and small cap market other issues during the mid 1970s.
In our June 12, 2008 commentary (“Don't Underestimate the Impact of Sovereign Wealth Funds”) regarding the importance of sovereign wealth funds, we estimated (conservatively) that as much as $10 billion are flowing into US equities from SWFs on a monthly basis, given the rate of reserves accumulation and the asset allocation strategies of most major sovereign wealth funds. These asset allocation strategies – combined with the fact that the vast majority of US equity mutual funds are expected to hold minimal cash in their portfolios – can act as a significant stabilizer during times of crises or panic in the financial markets. It is only when this asset allocation discipline breaks down (such as late 1990s when many pension funds went into 100% equities) or when these entities are led to believe that their portfolios are fully hedged (such as during 1987 when “portfolio insurance” came into vogue), when financial dislocations can and will occur. It is not a coincidence that – aside from the periods 1987 and 2000 to 2002 – the general stock market hasn't experienced any severe dislocations since 1973 to 1974, right after the enactment of ERISA (the Employee Retirement Income Security Act) in September 1974, effectively forcing plan sponsors of private defined benefits pension funds to consistently make contributions to their pension plans, which led to a consistent inflow into the US stock market year in and year out.
With the recent popularity of “alternative asset classes” and strategies such as hedge funds, liability-driven investing, and commodities, DB pension fund inflows into US equities are currently nowhere near as high as their peaks during the 1990s. Fortunately, as previously discussed, much of this “slack” is now being taken over by sovereign wealth funds, assuming our $10 billion inflow estimate is correct. In addition, given the recent popularity of lifecycle and lifestyle funds among participants of defined contribution plans (e.g. 401(k) and 403(b) plans) and IRAs, much of the investment allocation decisions are no longer controlled by fickle retail investors, but by fund managers who have similar asset allocation strategies (read: minimal cash) as the sovereign wealth funds. The popularity of these “lifecycle” and “lifestyle” funds is evident in the following chart, courtesy of ICI:
In other words, with a significant number of folks investing in lifecycle and lifestyle funds (401(k) participants are now “defaulted” to these options if they fail to choose an investment in their plans), US equities are now virtually guaranteed a consistent monthly inflow, as long as the US economy does not suffer a severe recession. Moreover, with the adoption of “automatic enrollment” among many major 401(k) plans, individuals are now saving more and putting more funds into the stock market, even relative to as recent as 12 months ago. This – combined with the Feds backstopping the GSEs, the quarterly contributions from calendar-year pension plans (due on July 15th) and the consistent inflows from sovereign wealth funds – will help the stock market put in a sustainable bottom over the next several days (if it had not bottomed last Friday already).
Before we go to our usual discussion on the Dow Theory (most recent action of the Dow Industrials vs. the Dow Transports), I want to bring your attention to an overbought/oversold indicator that we last discussed in our January 24, 2008 commentary – that of the 21-day moving average of the NASDAQ Composite's high-low differential ratio, the last time it was making record oversold levels. To put the current oversold condition into perspective, subscribers should note that the 21 DMA of the NASDAQ Composite's high-low differential ratio just hit a level of -7.69% last Friday – far more oversold than its mid March levels and only comparable with the oversold readings in September 1981, October 1987, September 1998, October 2002, and of course, January 2008. This can be seen in the chart below:
More importantly, prior to its latest spike down into extremely oversold territory, the 21 DMA of the NASDAQ Comp's high-low differential ratio had made two similar down moves into oversold territory – those being August 2007 and late January 2008. We have not seen these many spikes into extreme oversold territory since the unwinding of the NASDAQ bubble during late 2000 to late 2002. To top it all off, we are also now getting more extreme readings than the 2000 to 2002 period, and these spikes on the downside have occurred in a tighter timeframe as well. Make no mistake: The NASDAQ Composite is now at an unprecedented oversold condition. Be prepared for a sustainable rally over the next several 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:
For the week ending July 11, 2008, the Dow Industrials declined 128.00 points while the Dow Transports rose 97.99 points. While the Dow Industrials made a new low for the move (retracing its gains over the last two years), the Dow Transports is still holding up very well, as it is still more than 14% above its mid January lows and more than 8% above its mid March 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 growth in global demand for oil now seems to be calming 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 starting sometime this week. 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 -11.0% to an immensely oversold reading of -15.9% for the week ending July 11, 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:
With the latest decline in the four-week MA, this sentiment indicator has now declined below its March lows and is now at its most oversold level since late March 2003. Even if we are stuck in a new cyclical bear market, such an oversold reading should be good enough (especially combined with the sheer amount of investable capital sitting on the sidelines, the record amount of short interest, and the backstopping of the GSEs by the Feds) for at least a two to three-month bounce in the US stock market. For now, I am very 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 once 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:
While the ISE Sentiment Index has bounced substantially since its mid March lows, the 20 DMA of the ISE Sentiment Index has been consolidating over the last two months 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 thus conducive to a sustainable rally over the next several months.
Conclusion: Contrary to popular belief, the near collapse of the GSEs should be regarded as a bullish development for the US stock market, since it has now forced the US Treasury, the Federal Reserve, and now Congress to take more of a proactive approach to “put a cushion” under the US financial system and the housing market, as the GSEs would now be able to better provide liquidity and mortgage access to the primary and secondary mortgage market. Assuming that Congress is able to pass its $300 billion housing bill over the next couple of weeks, we should embark on a sustainable rally from current levels. Moreover, I do not expect any capital raisings from major US financial institutions in the near future, aside from a possible dividend cut at Bank of America (it is now paying a near $10 billion annual dividend for a 12% yield). Furthermore, I expect a dividend cut of at least $5 billion at Bank of America to be bullish for US financials in general, as this would allow Bank of America to continue to expand its business without having to worry about conserving capital. At the same time, I would not be surprised if the US Treasury, with the backing of Congress, decides to intervene in the debt markets by purchasing agency mortgage-backed securities in order to compress general credit spreads and bring down mortgage rates. It is going to be a rough, but exciting ride over the next several weeks.
Finally, 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.
Henry To, CFA