Cash on the Sidelines
(July 31, 2008)
Dear Subscribers and Readers,
I will let you in on a secret – I do not claim to have exceptional forecasting abilities when it comes to the financial markets (or anything, except the obvious such as “the sun will rise tomorrow”) – but luckily for us, neither does anyone else. Rather, the art of forecasting intermediate or long-term movements of the US and global stock markets involve replaying possible scenarios over and over and assigning the appropriate probabilities to each scenario. These scenarios and probabilities also change on a daily basis – and are themselves subjected to factors outside of the balance sheets and the current earning power of the companies within the particular stock markets, such as political, environmental, psychological, and “Acts of God” variables – the latter of which could include a major earthquake (knock on wood) such as the 1906 San Francisco Earthquake, or the commercialization of a paradigm-changing technology, such as the World Wide Web or railroads.
This author spends an enormous amount of time reading and thinking about these scenarios and probabilities on a daily basis. Aside from the “exogenous” variables that I just discussed, I also keep track of the many indicators that have been reliable at calling intermediate/major bottoms or tops in the past, such as the NYSE CSO A/D Line, the NYSE McClellan Oscillator and Summation Index, leverage within the financial system, the various sentiment indicators, the amount of cash sitting on the sidelines, valuations, forward-looking earnings power, potential productivity growth over the next few years, what the “asset allocators” such as pension funds and sovereign wealth funds are doing, and of course, the constant struggle between “capital” and “labor” and its impact on profit margins and ROEs. As I have mentioned in our previous commentaries over the last few months – given what we are seeing today – chances are that the stock market will be higher over the next two to three months, and I remain convinced of this as of Thursday morning, July 31st.
No doubt things look bleak today. But things are always darkest before the dawn. For example, in 1982, the entire US financial system was effectively insolvent twice over after many “LDCs” defaulted on their loans. Coming off a severe tightening phase by the Volcker-led Federal Reserve, the US unemployment rate also soared to a post-Depression high of 10.8% in November of that year. Unfortunately for the bears, the Dow Jones Industrial Average actually bottomed out in early August 1982, and would embark on a multi-year bull market that would break nearly all records (the Dow Industrials also rose 25% in the two months immediately after the August 1982 bottom). Today, there are still reasons to be optimistic on US housing and subprime mortgage securities, as Tom Brown has articulated in a previous Bankstocks.com article. Moreover – in a recent paper by two managing directors at Goldman Sachs Asset Management (James Cielinski, Head of Global Investment Grade Credit, and Thomas Teles, Head of the Mortgage and Asset-Backed Securities team) – the authors articulated that “extreme pricing dislocations” had occurred across many asset classes previously considered low risk, including triple-A rated and super senior securities. More importantly, the authors concluded that this major dislocation was driven mostly by an unprecedented lack of liquidity and deleveraging – and that many of these securities are now pricing in a severe recession (if not depression) scenario. Given what the Federal Reserve and the US government are doing to restore liquidity and “order” to the financial markets, the authors believe policy makers will ultimately succeed in stabilizing the markets, although the process could still take a little while. For those with a two to three-year holding period, however, now is definitely the time to buy.
It is also interesting to note what Benjamin Graham had to say with regards to market timing by the majority of investors/speculators in the final edition that he penned in 1972. No doubt Benjamin Graham is an investing legend – but these words are even more hard-hitting considering that he invested through the Great Depression and considering that his mother lost her entire savings during the Panic of 1907. Following are his words from Chapter 8 in “The Intelligent Investor”:
We lack space here to discuss in detail the pros and cons of market forecasting. A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stock-market analysts. But it is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at a given signal, rushes to sell out at a profit? If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.
Finally, given the unprecedented amount of capital sitting on the sidelines, there is every reason to expect mortgage securities and stock market prices to make a come back once the US housing market starts to stabilize or if the US Treasury/Congress take more aggressive steps to cushion the fall in the housing market, such as buying agency MBS on the open market or increasing the amount of tax credit (now at US$7.500) for first-time homebuyers. For example, even though the last 12 months has been a tough environment for private equity funds, US private equity funds still managed to raise $132.7 billion in the first half of this year, just 3% shy of the record raised in the first half of last year (if the US was entering a severe recession or depression, this would be closer to zero). Not surprisingly, US buyout funds did not have a very strong showing (fund raising is down 20% from last year), but this was offset by very strong fund-raising by mezzanine funds and the continued interest in venture capital funds (the top three investment categories for venture capital during 2Q 2008 were “Web 2.0” firms, life sciences, and “clean tech”).
In addition – as we have previously mentioned – there is also an unprecedented amount of investable capital sitting in money market fund accounts, sovereign wealth funds, and cash in investment brokerage accounts. Note only that – even equity mutual fund managers have been raising cash in their portfolios, as the percentage of cash in equity mutual funds just hit 4.5%, its highest level since November 2004!
The greatest long-term treat to the US economy remains high energy prices – not the deflating US housing market as both the Federal Reserve and Congress still have very powerful (and yet un-used) tools to fight the deflationary forces in the US housing market as long as they have the political will and the foreign capital to back up this will. As the eminent historian, Arnold Toynbee wrote decades ago, whether the US economy can move on to the next boom or the next stage of her progress would depend on our ability to meet our major challenges. Almost always, it is the “creative minorities” that tend to derive solutions to these challenges – while others in positions of power then follow. Obviously, our challenge is not just high energy prices – but all the accompanying problems that come with high energy or commodity prices, such as social and race inequality, the empowering of hostile (and close-to-totalitarian) States such as Russia and Iran, and the re-proliferation of poverty around the globe – factors which all tend to be destabilizing to long-term economic/productivity growth and global social harmony. The widespread adoption of cheap solar technologies, for example, will bring decentralization to the power grid and allow every household to be a capitalist. Should cheap energy ultimately become limitless – this will not only propel US technological/productivity growth to the “stratosphere” (think of the tens of millions of dollars that are needed annually to run and cool the fastest supercomputer in the world today) but will also go a long way to eradicating poverty in the United States and ultimately to most capitalistic countries around the world. This is the goal we should all be aiming and hoping for.
Henry To, CFA