The Reflation and Releveraging of Japan
(July 27, 2008)
Dear Subscribers and Readers,
Let us begin our commentary by reviewing 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 801.31 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 492.31 points as of Friday at the close.
Make no mistake: We are not particularly happy with the results of our DJIA Timing System over the last several months, even though our one-year performance as of June 30th was 17% above the performance of the Dow Jones Industrial Average. Obviously, no one can time the market or sub-sectors of the market perfectly – but given the recent correction (and diminishing Chinese and Indian demand growth) in energy prices, the weekend passage of the latest housing bill, the extremely oversold conditions, the unprecedented amount of capital sitting on the sidelines, and overall decent valuations in the global stock market, my sense is that we will see gains in our two latest buy signals sometime over the next few weeks. As I mentioned in our past couple of weekend commentaries, I anticipate at least a two-month rally going forward – although, I will, as always, continue to monitor the markets closely and inform our readers ASAP should we change our overall bullish stance. To paraphrase Keynes, we would not hesitate to change our stance should new market information come into conflict with our views. We're paid to adapt as well as predict.
Before we go on with our commentary about Japan, I would like to briefly discuss my thoughts on the GSEs – that is, Fannie Mae and Freddie Mac. First of all, the latest Financial Times column by Larry Summers on the GSEs is a must-read – as Dr. Summers' opinions are widely read by policy makers and institutional investors worldwide. Now, here are the facts as we know it on Sunday evening, July 27th:
- We know that the US Treasury and most other policymakers see nationalization (i.e. with Treasury directly injecting capital into the GSEs) as an option – but for now, it is to be used only as a last-resort option. In the meantime, Paulson and others have continued to urge the GSEs to raise more capital – not only to make sure the GSEs will remain solvent (on a fair value basis), but to also allow the GSEs to originate or buy more mortgages to rejuvenate the U.S. housing/mortgage market. The explicit guarantee by Congress and the latest short-selling rules are meant to prop up the prices of the GSEs' preferred and common stock – which would thus help them more easily raise capital going forward.
- In retrospect, there were two significant policy mistakes made with regards to the housing market over the past several months. First, Richard Syron, the CEO of Freddie Mac, had announced plans in May to raise $5.5 billion in capital (on top of the $13.5 billion raised last year) to prop up its balance sheet, but that he would not do the offering until August – as he was waiting for its lawyers to register with the SEC (this shows why you should never ask a lawyer for strategic advice). Since May, the cost of capital for both Freddie Mac and Fannie Mae have hit near debilitating levels. Second, Congress went back to its “merry ways” of dragging its feet and celebrated the July 4th long weekend without passing the $300 billion housing bill. Since the short-term bottom in stock prices in mid March, the global financial markets have been anticipating the bill to pass relatively quickly. To say that this was a disappointment is a major understatement. If Freddie Mac had raised the $5.5 billion two months ago, and if Congress has passed the $300 billion housing bill before the July 4th weekend, there is a good chance the US government may not be talking about a bailout today, although that is not to say it wouldn't happen down the road.
- Assuming Freddie Mac raises $10 billion in capital over the next several weeks, it is a near certainty that the GSEs would need to raise another $10 to $30 billion over the next 18 months in order to remain “solvent” on a fair value basis, given the current trend in foreclosure and delinquency rates. The $64 billion question is: Will the financial markets “cooperate” and allow the GSEs to raise such a high amount of capital (at 60% to 180% of the GSEs' total market cap today)?
More importantly, what fundamental analysis cannot cover is the fact that the GSEs also have a social function as stated in their charters. That is – even if the GSEs were able to raise enough capital to satisfy the OFHEO's (or more importantly, the market's) capital requirements – they would still need to drastically reduce lending and the purchase of mortgage securities in order to conserve capital. Assuming the idea of "cover bonds" (which Paulson is now pitching) does not become a popular vehicle of mortgage financing among private financial institutions, the decline in housing prices will reinforce itself – leading to more losses and housing price declines. Obviously, this is politically unacceptable given the "social mandate" of the GSEs. The $64 billion question then becomes: At what point will Treasury come in and effectively nationalize the GSEs by injecting a significant amount of equity capital (resulting in a severe dilution of the common), and flood the mortgage market with cheap loans? Will the Obama Administration be more willing to nationalize the GSEs and “kill off” the common and preferred shares (my guess is “yes”)?
If you are holding the common or preferred shares of the GSEs today, then these are all legitimate questions you should be asking. It is also a highly complex situation – as it not only involves financial, psychological, and economic variables, but political and social variables as well. However, what we know is this: The sooner the Administration recognizes that the GSEs are acting as a burden on the housing market (as opposed to its social mandate of liquefying the housing market during a general housing recession), the better off it is for the US stock market and the economy. Barring a significant recapitalization (>$50 billion), we know the GSEs cannot be both solvent and to have the ability to reliquify the mortgage market. Such a significant recapitalization will inevitably require a severe dilution of current common and preferred shareholders. Just like the Bear Stearns bailout, what is bad for the GSEs' common and preferred shareholders will be good for the U.S. stock market (and financial stocks) in general (at least in the short to intermediate term). At this point, however, I don't see nationalization or a significant recapitalization on the horizon.
Let us know discuss Japan. As long-time readers may know, we have had a bias towards the Japanese stock market (vs. both a global equity and a global bond/equity portfolio) since late January of this year, as we discussed in our January 31, 2008 and February 3, 2008 commentaries, and our discussion forum. Our arguments for having an overweight in Japan is still valid, as the Japanese stock market (as measured by the Nikkei) is still at the same level as it was during late January. Moreover, valuations continue to remain very decent, as Japanese banks have for the most part dodged the “subprime bullet” and as Japanese earnings have held up well despite a global economic slowdown.
More importantly, the Japanese stock market is the only major equity market in the world where a rise in consumer price inflation has generally preceded a rise in equity prices over the last ten years. Given the latest rise in global inflationary pressures, Japan is now the “equity market of choice” for investors. This is especially important since most institutional investors are still very much underweight Japan in their global equity basket. In addition, Japan is making incremental but sure steps to improving its corporate governance structure, as demonstrated by 1) The refusal of the Japan's Pension Fund Association to vote for the reelection of directors at firms that earn a ROE of less than 8% for three consecutive years (the average ROE of Japanese firms is around 10%, or just half of the ROE of US-based firms), 2) Some firms, such as Shiseido, the cosmetics company, and Nissen, a mail order company have opted to drop their takeover defenses, 3) Over the past 10 to 15 years, the Japanese commercial code has actually been overhauled to make corporate restructuring and thus M&A deals easier. Given that the average ROE of Japanese companies is only half that of US companies, just a slight improvement in corporate governance could propel Japanese earnings significantly higher going forward.
Finally, commercial real estate prices in Japan are now set to rise for the third year in a row – after coming off a 16-year consecutive decline since the stock and real estate market bubble popped in 1990. If there is any remaining doubt on the current “reflation and releveraging trend” in Japan, perhaps the following charts (courtesy of the Bank of Japan) will help dispel those doubts:
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 25, 2008, the Dow Industrials declined 125.88 points while the Dow Transports declined 44.95 points. At this point, the latest weekly decline looks more like a consolidation (after the run-up of the previous week) as opposed to a resumption of the downtrend. As I have mentioned, the Dow Transports is still holding up very well, as it is still only 9% away from its all-time high (versus 19% for the Dow Industrials). In addition, given the recent deleveraging by the airlines (and thus newfound pricing power) 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 is now declining as we speak. Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I expect both the Dow Industrials and US stocks in general to embark on a sustainable rally over the next two to three months. 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 overly 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 -21.7% to a historically oversold reading of -22.7% for the week ending July 25, 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 surpassed the historically oversold level of the week ending March 14, 2003 – right at the beginning of the stock market's major four-year bull run. In fact, the four-week MA reading of -22.7% is now at its most oversold level since July 2002, which in retrospect turned out to be a major low for many US and global stocks. Combined with the severe oversold condition in the US stock market, overall decent global valuations, the recent decline in energy prices, 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) this reading should be good 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 now worked off a significant chunk of its short-term overbought conditions (in fact, the 50 DMA just made another two-month low). 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: While both the Treasury and Congress have gone a long way in passing the $300 billion housing bill and providing a $1 trillion lifeline to the GSEs (this at the very least removes the “tail risk” within the US financial system), it is difficult to envision the housing market recovering in a major way until inventories and housing starts come down in a significant way. While the $7,500 tax credit will help, this bill does nothing for liquidity in the mortgage market as it does not directly dictate capital requirements nor mortgage lending requirement for the GSEs. At the very least, this author would like to see a >$30 billion recapitalization in both GSEs immediately in order to improve liquidity in the mortgage market. Given where the preferred and common stocks of the GSEs closed at on Friday, this would require a severely dilutive offering at the very least. In the worst-case scenario, we could see outright nationalization – although I do not see this happening under the Bush administration.
I also believe that Japanese equity prices bottomed in mid-March. Given global inflationary pressures as well as the reflationary and releveraging trends in Japan, I also expect the Japanese equity market to exhibit relative strength against a global equity portfolio over the next 12 to 18 months. As for the US stock market, I continue to believe that the sell-off in stock prices a couple of weeks ago marked an intermediate term bottom for the US stock market, and that it should give rise to at least a two to three-month rally going forward. I also expect both agency spreads and junk bond yield spreads to compress over the next few months – but should they fail to come down, I would not be surprised if the US Treasury 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. 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