Global Liquidity Still Challenged
(August 24, 2008)
Note: For those would like to learn more about Joseph Schumpeter and his economic philosophy, as well as how relevant it is to today's global economy, please read our latest book review of Professor Thomas McCraw's (past winner of the Pulitzer Prize) latest work, entitled “Prophet of Innovation: Joseph Schumpeter and Creative Destruction”
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 543.94 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 234.94 points as of Friday at the close.
What is liquidity? As we previously mentioned, liquidity is a curious thing. Just like flood insurance, it can be amply available one day; but gone the next. No global central banker, hedge fund speculator, shrewd investor, or policy maker has consistently been able to call the turning points in the global liquidity cycle over the long run. The long line of casualties speaks to this impossibility. Names such as Livermore, Irving Fisher, Arthur Cutten, and Soros. Even Bill Gross – who took off many risky bets in the PIMCO Total Return Fund starting in late 2005 – had to take a lot of lumps from his clients leading into the beginning of the subprime crisis in early 2007. Shrewd investors and policy makers like Warren Buffett, Robert Rubin, and Jim Simons don't even try. The only “crystal ball” that we could find (ironically) comes from Alan Greenspan, who famously remarked in 2006: “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” (The only problem with this quote is that it does not deal with the important matter of timing). Rather, the only thing we can do as investors is to observe global liquidity conditions – to do it objectively – and subsequently find a reasonable methodology to incorporate that into the management of our investment portfolios.
So how does one measure liquidity? The best study on liquidity conditions is the NY Fed study (entitled “Liquidity, Monetary Policy, and Financial Cycles”) we mentioned in our February 17, 2008 commentary (“Taylor Rule Targeting a Fed Funds Rate Below 2%?”). In particular, the NY Fed study asserts that rather than using money stock as a measure of liquidity (this indicator is only useful in a financial system dominated by deposit-funded banks), policymakers and analysts alike should instead pay heed to the growth rate of aggregated balance sheets of leveraged financial institutions, or outstanding repurchase agreements (this is why the Fed stopped publishing M-3 numbers, with the exception of one critical component: institutional money market funds). Moreover, the study asserts that based on empirical studies, repo growth can directly be attributed to the easing and tightening of monetary policy via the relation between the Fed Funds rate and the implied Fed Funds rate as dictated by the Taylor Rule. Quoting the NY Fed Study:
However, the ideal of a financial system dominated by deposit-funded banks may never have existed in its purest form, and it is becoming less relevant over time. Certainly, empirical evidence from the United States since the 1980s detects very little role for the money stock in explaining macroeconomic fluctuations. If the financial system is instead organized around the capital market, then conventional measures of money represent only a small proportion of the aggregate size of the leveraged sector. Nor is the quantity of deposits the most volatile component of the total aggregate liabilities of the financial system. In such a world, money is less useful as a measure of liquidity. The rapid move toward a market-based financial system in recent years has accelerated the trend toward greater reliance on nontraditional, non-deposit-based funding and toward greater use of the interbank market, the market for commercial paper, and asset-backed securities.
The concept of liquidity we proposed earlier—the growth rate of aggregate balance sheets or, more precisely, the growth rate of outstanding repurchase agreements—is a far better measure for a modern, market-based financial system than is the money stock. In this section, we focus on the question whether our preferred notion of liquidity has any bearing on monetary policy, and in particular whether the growth of repos is linked in a direct way with the easing or tightening of monetary policy. Our empirical tests of this relationship suggest that the answer to this question is a resounding “yes.” We find that repo growth is closely correlated with the ease or restrictiveness of monetary policy as measured by the Taylor rule. The Taylor rule specifies how a central bank should alter its targeted short-term interest rate (the federal funds rate in the United States) in response to evolving macroeconomic fundamentals—specifically, the divergence of current output from potential output and of current inflation from the desired rate of inflation. We show that when monetary policy is loose in the sense that the federal funds rate is lower than the rate implied by the Taylor rule, there is rapid growth in repos and financial market liquidity is high.
In other words, the decline in repo/liquidity growth due to the pro-cyclical policies of leveraged financial institutions can be directly arrested by monetary policy, as long as the Fed Funds rate is below the implicit Fed Funds rate as guided by the Taylor Rule, and as long as the Fed is able to credibly maintain the Fed Funds rate at that rate. It is to be noted here that in his editorial published earlier this year, George Soros implied that the Fed cannot credibly maintain such a low Fed Funds rate or a generally loose monetary policy, not because of inflationary pressures, but because he sees the end of the U.S. Dollar as the international reserve currency. In other words, Soros had believed that should the Fed continue to lower the Fed Funds rate or provide liquidity to the financial markets, there is a good chance that the U.S. Dollar Index could dramatically fall.
After the publication of our February 17, 2008 commentary, the U.S. Dollar Index did indeed decline – but has since recovered to a level similar (actually, slightly higher) to that when Soros penned his editorial. More importantly, it is to be noted that the “blowoff” in commodity prices cannot be solely attributed to the Fed's latest easing cycle (as a matter of fact, the St. Louis Adjusted Monetary Base – the only “monetary aggregate” that the Fed has direct control of – has experienced dismal growth since the second quarter of 2007), but also to the immensely loose monetary policy and liquidity creation in emerging markets across the world over the last few years, particularly in the BRIC countries, much of the Middle East, and in Eastern Europe. This loose monetary policy in the emerging countries has since been reversed. As a matter of fact, many emerging market countries are still in a tightening phase (the Bank Credit Analyst's emerging markets monetary condition indicator is now at the same level as it was in early January 1997 – and we all know what happened next). Finally, not only have consumer credit conditions been tightened in the United States, but also in the Euro Zone, Japan, and the UK as well (as shown in the following chart courtesy of PIMCO):
In light of the recent strength of the U.S. Dollar (not just against other developed countries' currencies but also against most emerging market currencies as well, including the Chinese Renminbi), and the continuing challenging global liquidity conditions, it makes every sense for the U.S. Treasury to come in and implement a “rescue plan” for the GSEs, as we discussed in the last half of our August 21st “MarketThoughts Special Update.” Realistically speaking, a direct equity injection by the US Treasury will provide the best “bang for the buck,” as this will not only allow the GSEs to survive, but will also allow them to buy mortgages on the secondary market (thus bringing in mortgage spreads) and to make significantly more mortgage loans as well. From the perspective of the NY Fed Study, this means the GSEs' balance sheets will explode higher – which will act as a necessary countervailing force to the deleveraging trend of the majority of the U.S. financial system, creating much-needed liquidity for the US financial system and the US housing market. At this point, the consensus is for a $25 to $30 billion preferred equity injection into the GSEs. Any amount below $25 billion will be a disappointment to the financial markets, but any amount above $30 billion will provided a tremendous boost to not only liquidity but to investors' confidence as well. Finally, any Treasury-led support to the US financial and housing markets should not be overly inflationary for commodity prices, as the rest of the world is still in a tightening phase, and as new energy supplies come online later this year and next, as we discussed in last weekend's commentary (note that a further decline in energy prices will also lower the marginal cost of production for other commodities as well).
From a relative standpoint, the US equity market should be the major “star performer” in the MSCI All-Country World Index over the next 6 to 12 months. Whether this relative outperformance could turn into good absolute performance will depend on the size of the Treasury-led rescue package for the GSEs, Fed monetary policy, and in U.S. productivity growth (read: continuing innovation in robotics, alternative energy technologies, etc.) in the same timeframe. From a currency standpoint, I also believe the U.S. Dollar will continue to outperform the majority of the world's currencies, with the possible exception of the Middle Eastern currencies unless crude oil prices decline to $90 a barrel or below. I also believe any appreciation in the Chinese Renminbi will be minimal over the next 6 to 12 months. Should the Euro Zone and the Bank of England fail to ease monetary policy before the end of this year, we could also very well witness a “hard landing” in some of the more “shaky” Eastern European countries – such as Latvia, Estonia, Bulgaria, Serbia, and Romania.
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 August 22, 2008, the Dow Industrials declined 31.84 points while the Dow Transports declined 96.71 points. While the latest two-week decline is disappointing – especially in light of the continuing weakness in oil prices – I don't believe subscribers should look too much into the decline at this point, as the stock market has already bounced substantially since the mid July lows. Moreover, given the close-to-inevitable rescue package for the GSEs, my sense is that the stock market attempt another rally sooner rather than later. That upcoming rally is the one to watch. Should upside breadth and volume impress in this subsequent rally, then we could see a retest of the May highs in the Dow Industrials and the S&P 500, if not the early October 2007 highs. Finally, the Dow Transports is still exhibiting relative strength, and should continue to do so as the price of crude oil continues its correction. Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I believe the line of least resistance for both the Dow Industrials and US stocks is still up. 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 or if our liquidity indicators weaken further.
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 increased again from of -12.2% to a -9.4% for the week ending August 22, 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 four-week increase in the four-week moving average (from -22.7% to -9.4%), my sense is that this indicator has reversed from the historically oversold reading of four weeks ago, when the four-week moving average hit its most oversold level since July 2002. Historically, the most bullish signal for the stock market comes when this indicator reverses from severely oversold levels – signaling that the line of least resistance for the stock market has reversed to the upside. Combined with the oversold conditions in the global stock market, decent global valuations, the ongoing correction in energy prices, the sheer amount of investable capital sitting on the sidelines, the record amount of short interest, and most importantly, the close-to-inevitable “rescue” of the GSEs by the US Treasury, this reading should be good for another four to five-week rally in the 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 our sentiment indicators get overbought or should our liquidity indicators weaken 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, my sense is that both the 20 DMA and the 50 DMA of the ISE Sentiment Index have now worked off most of their short-term overbought conditions. More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years, and the 20 DMA finally pierced the 50 DMA on the upside two weeks ago. This is conducive to a sustainable rally for at least over the next four to five weeks.
Conclusion: With global liquidity still waning, the time is now perfect for the US Treasury to intervene in the US financial and housing markets by putting together a rescue package for the GSEs. Make no mistake: The US Treasury and Federal Reserve is simply doing what JP Morgan, James Stillman, George Baker and Benjamin Strong had done 101 years ago to stem the liquidity and confidence crisis that permeated through the trust companies in Wall Street and the New York Stock Exchange. While the commercial banking system was relatively insulated (as much of it was backed by the New York Clearinghouse Association), this protection did not extend to the trust companies, which made up nearly half of the New York financial system immediately prior to the Panic of 1907. In the aftermath of the Panic of 1907, it became immensely clear that future financial crisis would become more difficult to resolve. Wall Street, along with the US economy, was simply “lucky” that JP Morgan had shown the leadership to bring together much of Wall Street to his cause. In subsequent crises, there would be no JP Morgan, and the US financial system has simply gotten too large and complex (and as wealth had become less concentrated) for any one banker to emerge as its leader. For those who relish the “good old days” of “hard money” and a laissez-faire market economy, let there be no mistake: There is no such thing such as the “good old days.” Folks like JP Morgan, the Rothschilds, and the Schroders have always advocated the Gold Standard, as a “hard money” currency keeps a country's wealth concentrated – mostly to the benefit of moneylenders who are satisfied with a 4% to 5% lending rate in a deflationary economy. A carefully managed, “flexible” currency, on the other hand, favors those who need credit – in other words, the entrepreneurs and companies who are the primary drives of the US economy and US productivity. As Joseph Schumpeter said, credit is the lifeblood of the capitalist economy. A “hard money” currency simply rewards those hoarders or moneylenders while the capitalists and entrepreneurs do all the hard work and risk-taking. Just like the utopian dream of Communism in the early 20th century, we have tried this before. It simply does not work in the real world.
At this time, I am still very constructive in US and Japanese equity prices – and believe that the former bottomed in mid July while the latter bottomed in mid March as long as the US Treasury comes up with a reasonable rescue package for the GSEs in the next couple of weeks (i.e. a direct equity injection of $30 billion or over). Within US stocks, I like the healthcare sector, the asset managers, the exchanges, and semiconductors. 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