Financial Deleveraging Now in a Maturing Phase
(August 31, 2008)
Dear Subscribers and Readers,
Before we begin our commentary, I would like to make a brief announcement. As I mentioned in our “Special Update” on August 21st, I am now preparing to enter the MBA program at the UCLA Anderson business school on a full-time basis. The next couple of weeks will be a very hectic time. In addition, the last year or so has been a stressful time for me and for most of our subscribers. Given this and my hectic schedule over the next couple of weeks, I plan to take the next weekend off unless something unforeseen in the market occurs. On Thursday morning, you will receive Bill Rempel's guest commentary in your mailbox as usual (Bill provides a monthly guest commentary for us on the first Wednesday evening of every month). In the meantime, I would still be very active at our MarketThoughts discussion forum.
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 628.45 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 319.45 points as of Friday at the close.
In the aftermath of the Great Lisbon Earthquake of 1755, many theologians struggled to explain the immense destruction away in the context of the “optimism” of the era – in particular, Leibniz's view of this world as being “the best of all possible worlds.” Starting in the late 1740s, Voltaire, in particular, became increasingly dissatisfied with this view of the world. Voltaire's philosophical optimism that came into being after his exile in England during 1726 to 1728 (made all the more powerful after his contact with Sir Isaac Newton and his ideas of a “divinely ordered human condition”) gradually turned into pessimism – and after the Great Lisbon Earthquake, the transformation was complete. Many events that occurred during the 20th century, such as World War I and II, the Great Depression, the Holocaust, the mass slaughters in Russia and China, the widespread adoption of Communism, etc. – the “Century of Horrors” in many ways – further discredited the optimist's view of the world.
The destruction of the optimist's philosophy means that as freethinking and independent individuals, we would need to take our destiny into our own hands. Adam Smith's metaphor of an “Invisible Hand” – where self-interest maximizes the wealth of a community – does not always hold (read: subprime brokers). An economic boom, in a laissez-faire economy does not always have to follow a bust, if the entire capitalist economic system disintegrates in the process. Even some of the folks in New Orleans – those who have traditionally held “hurricane parties” – no longer feel they are immune in light of what happened during Hurricane Katrina in 2005. More than 200 years after the death of Voltaire, these folks are finally starting to take responsibility (or bear the consequences) for their own actions.
In light of this and our subsequent experiences in the 19th and 20th centuries, it is obvious that the criticisms directed to the prospect of a GSE “bailout” is a non-starter. The “market mechanism,” as we know it, is still working well. A month ago, market signals were mega phoning to the world that the GSEs need an explicit government guarantee, and that they needed it right at that moment. The same went for the Bear Stearns rescue. Lehman and other investment banks were tottering at the edge of collapse, as the common stock prices and the CDS spreads were signaling to the market. It is to be noted that the collapse of Bear Stearns occurred right in the midst of a significant deleveraging process in the global financial system. If the Bear Stearns collapse had occurred a few years earlier, there would have been no need for a “bailout” or a “backstop” by the Federal Reserve (e.g. the collapse in Amaranth and Refco left no significant marks in our financial markets when they occurred). If the Fed has not provided sufficient support for the rescue of Bear Stearns, the backstopping of the primary dealers, or the GSEs, this would have leaf the door for something more sinister going forward. In such an extremely open-ended scenario, the major risks are to the extreme downside, as the Great Depression and the subsequent near-destruction of capitalism had demonstrated. For those who are concerned about moral hazard issues, I would simply advocate dragging Chuck Prince, Stan O'Neal, and Angelo Mozilo in front of the Senate Finance Committee and subject them to years-long investigations and interrogations. I doubt any CEO at a financial company would suffer from moral hazard issues going forward. The folks who worked at non-executive roles at Bear Stearns have already been punished enough.
As I have mentioned before, in order to tackle the current problems in our capitalist society (such as poverty, high commodity food prices, etc), we need a functional financial system. This could be in the form of new funding for research projects in the alternative energy sector, more drought resistant genetically modified seeds, or in new “nanotech” materials such as carbon nanotubes, etc. But one thing is for sure: The VCs and entrepreneurs will not invest unless the cost of capital is relatively low - and hiking interest rates (like what the ECB is doing) will just not cut it. Hiking interest rates will cut down our leverage and depress commodity prices (interestingly, the Bank of England has been killing the UK economy but it has not brought down supply-driven inflation since commodity prices are determined by marginal supply/demand in the US, the BRICs, OPEC, etc. - whatever the UK does has no effect on commodity prices) but it will be suicidal - especially for the lower-to-middle and Middle Class of the United States. Finally, in order for the US economy to function effectively and for innovation to flourish, the US financial system needs to get back on its feet again - and right now, repairing the GSEs will give us the best "bang for the buck." Ever since the end of World War II, both the US government and the Federal Reserve have favored the capitalists (especially those with business debts) and risk-takers over the risk-averse such as those who stuff their money under their mattresses. I see no reason to change this policy now.
My sense is that we are now approaching a point where the Administration will have no choice but to bail out the GSEs – and in the process, flood the US mortgage and financial system with much-needed liquidity. There are three major reasons: 1) The GSEs will need to roll over about $200 billion in debt over the next four weeks. Despite the strength we saw in the GSEs last week, it is hard-pressed to see this continuing over the next four weeks, especially given the continuing deterioration in housing prices; 2) the market has effectively lost confidence in the GSEs' leadership. Both CEOs will have to go, and it is difficult see anyone willing to take over the CEOs' roles at the GSEs, short of a substantial injection by the Treasury or private equity funds; and 3) the cost of capital of the GSEs is now prohibitively high. A preferred offering to existing or private equity investors is now out of the question, as the preferred dividend will be too high for the GSEs to effectively function going forward. Finally, while an extremely dilutive common stock offering can (in theory) be done, it is difficult to envision any investor stepping onto the “plate” at this point, unlike a month ago when many investors would have still been willing.
However, from both a political and a legal perspective, we are still not yet at the “bail out” stage. Given the criticisms directed against a bailout, as well as the market's current willingness to fund the operations of the GSEs, it still does not logically make sense for Treasury to impose a bailout. In a few weeks, this may be a different story. Short of Warren Buffett indicating his willingness to invest in the GSEs, a bailout is still very likely by the end of September.
Make no mistake: A GSE bailout would do wonders for the financial markets. This is especially important given that both the US households and the vast majority of the financial sector (including the GSEs themselves, even though it is against their “social objectives” as specified in their charters) are still in the midst of either deleveraging or restricting balance sheet growth. True, the US government is still expanding its balance sheet (as demonstrated by the recent fiscal stimulus), and US commercial banking sector is still quietly humming along. However, with respect to the latter, we are now seeing some slowdown in US commercial banking sector lending, as shown in the following chart showing the year-over-year growth in loans and leases held under bank credit:
The month-end data for August hasn't been released yet, but even extrapolating recent lending trends, the year-over-year growth in loans and leases in the commercial banking sector has now declined below 8% - its first sub-8% level since August 2004! More importantly, in light of the results of the recent bank lending surveys, it is safe to say that this will continue to trend down over the next three to six months. Since we are on the verge of an acceleration in the deleveraging of the US financial sector, my sense is that the current Administration will step in sooner rather than later.
Interestingly, even the do-nothing UK government has now recognized the need for further interest rate cuts as well as a potential fiscal stimulus/bailout for the UK consumers/mortgage sector. Should the UK decide to provide substantial liquidity to its mortgage sector, there is a good chance that global credit spreads will narrow, although it is difficult to guess to what extent. No matter what the UK government or the Bank of England does (such as lowering rates dramatically), this should continue to benefit the US dollar and the relative performance of US equities.
Should credit spreads narrow across the globe, general risk-aversion would also undoubtedly decrease. Given the tremendous amount of cash sitting on the sidelines, both the US and the global equity markets should also do well. One way to measure cash levels is by looking at the amount US money market fund assets. As has been the trend since January 2008, the amount of money market funds has continued to increase at a dramatic rate (now at over 33% year-over-year, after peaking at 42% in early June) and is still at a record amount relative to U.S. market cap, despite the rally in the S&P 500 off of the mid July bottom. 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 August 2008:
As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 stood at 29.78% - an astronomically high level that is only 0.10% lower than the July month-end record high of 29.88%, and higher than 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. More importantly, subscribers should note that this only measures the amount of investable capital located in the United States. By many measures, 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 in mid July – which means that we will continue to remain 100% long in our DJIA Timing System in the immediate future.
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 29, 2008, the Dow Industrials declined 84.51 points while the Dow Transports rose 46.50 points. While the continuing weakness (now three weeks long) in the Dow Industrials is disappointing, subscribers should note that the latest weekly decline in the Dow Industrials was not confirmed by the Dow Transports. The latest weekly rise in the Dow Transports, in light of the threat of Hurricane Gustav on the production of crude oil and natural gas in the Gulf of Mexico, is very reassuring for the bulls. Moreover, given the close-to-inevitable rescue package for the GSEs, and the record amount of investable capital sitting on the sidelines, my sense is that the stock market will mount another rally sooner rather than later. Again, 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 substantially.
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 -9.4% to -8.8% for the week ending August 29, 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 five-week increase in the four-week moving average (from -22.7% to -8.8%), this indicator has undoubtedly reversed from the historically oversold reading of five 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 a further rally in US and global equities. I am still 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 three weeks ago. As indicated by the ISE Sentiment Index, the line of least resistance for the stock market remains to the upside.
Conclusion: With US liquidity at the breaking point – and with global liquidity still waning – the time is now getting close for the US Treasury to intervene in the US financial and housing markets by putting together a rescue package for the GSEs, the success of the upcoming UK fiscal “stimulus package” not withstanding. Over two centuries of empirical evidence suggests that a pro-active approach –while taking into account moral hazard concerns – is much more beneficial to the capitalist society both in the short and the long run. Moreover, ever since the end of World War II, both the US government and the Federal Reserve have favored the capitalists (especially those with business debts) and risk-takers over the risk-averse such as those who stuff their money under their mattresses. I see no reason to change this policy now or in the future.
At this time, I am still very constructive on 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 before the third quarter is over. I also believe UK financial stocks may be good for a trade on the long side, in light of the more “dovish” views as expressed by the UK government over the weekend. Within US stocks, I still 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