The Greatest Bank Restructuring Since Glass-Steagall
(September 21, 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 783.56 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 474.56 points as of Friday at the close.
Since the beginning of September, we have seen the GSEs gone into Conservatorship, Lehman Brothers (America's fourth largest investment bank) filed for bankruptcy, and Merrill Lynch acquired by Bank of America. Tonight, we learned that the Federal Reserve has granted the request of Goldman Sachs and Morgan Stanley – America's remaining two investment banks – to become bank holding companies. Going forward, both institutions will be allowed to take FDIC-insured deposits – an act that will tremendously improve the liquidity of their balance sheets. In the short-run, this act will also increase the ability of both institutions to take out direct loans from the New York Fed, allowing them to use a greater variety of securities as collateral. Assuming Congress moves quickly on the bill to create a government-funded $700 billion pool to absorb illiquid assets from banks' balance sheets (initial reports have the Treasury engaging in some kind of reverse auction), this final Act completes the greatest restructuring of the US financial system since the Glass-Steagall Act of 1933. While we still do not have any details on how the Treasury will conduct its “reverse auctions” for illiquid securities and whether it will conduct “loan workouts” for the mortgages held in its future portfolio, there is no doubt that this $700 billion pool will “unclog” the financial markets and pave the way for various financial institutions to further recapitalize their balance sheets (the lack of future write-downs will embolden private equity investors, retail investors and sovereign wealth funds to start injecting capital into financial institutions again) and to start lending more freely again.
Re-regulation, deregulation, restructuring, etc. – it all does not matter in the long run. As George Soros discussed in “The Alchemy of Finance (1987),” the optimum or equilibrium amount of regulation within an economy with a “market mechanism” can never be achieved. Quoting Soros:
Once we recognize that the optimum is unattainable, we are in a better position to evaluate the merits and shortcomings of the market mechanism … I want to focus on one particular weakness of the market mechanism: its innate instability. Its cause has been identified: it derives from the two-way connection between thinking and reality that I have labeled reflexivity. It is not in operation in all markets at all times; but if and when it occurs, there is no limit to how far away both perceptions and events can move from anything that could be considered equilibrium.
Instability is not necessarily harmful; indeed, if it were described as dynamic adjustment, it would sound positively benign. But carried to extremes, it can give rise to sudden reversals that may take on catastrophic proportions. That is particularly the case where credit is involved, because the liquidation of collateral can lead to sudden compression of market prices. The prevention of excessive instability is therefore a necessary condition for the smooth functioning of the market mechanism. It is not a condition that the market mechanism can ensure on its own. On the contrary, I have presented evidence that unregulated financial markets tend to become progressively more unstable. The evidence is most clear-cut in the currency markets, but it is also quite persuasive with regard to the expansion and contraction of credit.
Ayn Rand's 1946 book on capitalism is titled “Capitalism: The Unknown Ideal” – a title which is still very appropriate in today's markets. Capitalism - for (and because of) all its ideals - does not function that well outside of textbooks and in our pragmatic world. For all its nostalgia, the 19th century series of boom/bust cycles in the US (the closest that America came to adopting a pure capitalist system) - all rooted in our 19th century "gold standard" currency system, only worked well for those in the most upper echelons of the US banking system and industrial trusts. I assure you that it is not feasible system – and nor do we revert to such a system. Time after time, we liquidated the stock market and real estate speculators. We liquidated the biggest firms, banks, and brokerages that failed. We liquidated the farmers. The folks that suffered the most were the ones least able to defend themselves in our society - i.e. the least educated, the least intelligent, and the least connected. And yet, the boom/bust cycles never ceased and were as strong as ever. These cycles are all inherent in our human tendencies that are impossible to avoid within the construct of a capitalist system. One can only "legislate" a society out of future bubbles by imposing a dictatorship or a communist system. Even if everyone had donned on their “eliminate moral hazards risk” hats and allowed Morgan Stanley or AIG to fail, I can assure you that this will again happen in the future - assuming capitalism as we know it still exists going forward.
In addition, if the Fed did not step in, there is no doubt a significant portion of our most able entrepreneurs and professionals will leave the country - leaving the US with an "empty shell" full of those who are only going to draw upon our social services and add to our current account deficits. China/Taiwan/Hong Kong, for example, would love to see Jerry Yang and other Chinese entrepreneurs/professionals migrate back to their "home countries." These folks have too many things to worry about without having to worry about whether it makes sense for them to stay in the US and do business in the long run if the government chooses to not intervene and make our financial markets fully functional again. Finally, as the US economy/capitalist system grows in size, it becomes infinitely harder for the private sector to put a floor under a bust cycle - something all too evident during the 1930s and in Japan during the 1990s. So in this sense, and almost by definition, a capitalist society is self-defeating as time goes on, since one needs a very strong lender of last resort to stabilize and put a floor under the system in times of need. And the only entity that can fulfill that role (a role that John Pierpont Morgan played in 1893 and 1907) today is the US government, the global central banks, and other institutions such as the IMF and the World Bank.
For now, I believe the latest “restructuring” and the inevitable passage of the $700 billion bill have put in a good floor in the US stock market. According to Lowry's latest analysis, as of last Wednesday, the NYSE experienced four 90% downside days over a 20-day period. Since 1950, there have been only 17 such periods. On 14 of those occasions, the series of four 90% downside days was followed by a 90% upside day within a one-week period. On all 14 occasions, the stock market embarked on at least a tradable rally – with some of these signaling the end of the bear market. Last Thursday, the NYSE registered a 90% upside day. A 90% upside day – coming after four 90% downside days over a 20-day period – not only suggests a fully oversold stock market but also meaningful demand for equities within a fully oversold market. More importantly, according to Lowry's analysis, a 90% upside day is more meaningful if it occurs soon after the registration of the final 90% downside day. Given that the latest 90% upside day occurred the day immediately after the 90% downside day, my sense is that the stock market will at least embark on a six to eight-week rally from last week's lows, if not more. Whether that will turn into something more sustainable will depend on whether the vicious deleveraging cycle of last week can be avoided in the future. For now – with the inevitable passing of the $700 billion bill by Congress – things look brighter than they have been for the last 18 months.
In order for the global stock market rally to sustain itself, my sense is that we would need to see more easing from the European Central Bank and the Bank of England over the next three to six months. Based on current energy and food prices – as well as the “slack” in the developed economies generated by the global economic slowdown – both headline and core inflation in the G-3 economies (US, Euro Zone, and Japan) most likely topped out during July to August. Assuming crude oil prices remain below $120 a barrel for the rest of the year and into 2009, headline inflation (currently over 5% in the US) in the G-3 economies should revert back to 3% or below by January 2009. By July 2009, headline inflation in the G-3 economies has a good chance of hitting the 2% level – again assuming that oil remains below $120 a barrel and that global food prices remain tame. Such a decline in headline inflation will at least allow the European Central Bank and the Bank of England to ease monetary policy, if not the Federal Reserve as well. With respect to the Federal Reserve, it is interesting to note that it has been acting in relative restraint over the last 15 months, as demonstrated by the abysmal growth in the St. Louis Adjusted Monetary Base (the only liquidity indicator that is directly controlled by the Fed). As we have covered here before, the Fed has been draining liquidity (by selling Treasuries to the public) on the one hand, while swapping illiquid instruments in return for Treasuries with the various commercial and investment banks on the other. That means that even a targeted Fed Funds rate of 2% hasn't been sufficiently low to generate demand for funds. In the meantime, however, the latest year-over-year growth in the US monetary base suggests that we should at least see a decent rally in the Dow Industrials and in the broader markets – as exemplified in the following chart:
As shown in the above chart, the year-over-year change in the St. Louis Adjusted Monetary Base (four-week moving average) bottomed out at 0.70% in early May (note that the green line showing the change in monetary base has been advanced by 12 weeks) and has since ticked up to 2.60% on September 10th. Bottom line: While the Federal Reserve has become somewhat more accommodative in recent weeks, this is still not enough to support new all-time highs in the stock market, although it is probably good enough for a meaningful rally that could take the Dow Industrials to the 13,000 to 13,500 level. For now, however, we will simply take it.
From a valuation standpoint, the current environment definitely bodes well for at least a meaningful rally. No matter how one measures the valuation of the broader stock market (such as the “Fed Model,” Morningstar's aggregate of its valuation of over 1,000 stocks, etc.) the stock market is still trading at decent valuations. Using the price-to-book ratio of the Dow Industrials (as seen below), however, we find that the Dow Industrials is now trading at a valuation (P/B ratio of 2.95) not seen since February 1993, and significantly lower than the 20-year average of 4.04!
While valuations are a horrible short-term timing indicator, the P/B ratio of the Dow Industrials suggests that the chances of a sustainable rally in both the Dow Industrials and the broader stock market are quite high.
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 September 19, 2008, the Dow Industrials declined 33.55 points while the Dow Transports actually rose 26.24 points, after the Treasury announced the creation of a $700 billion pool to absorb illiquid assets and the SEC announced a ban on short-selling in 799 financial stocks. Whether this current rally will develop into something more sustainable (or longer-lasting than a couple of months) will depend on monetary policies around the world – in particular, the policies of the European Central Bank and the Bank of England. In the meantime, from a Dow Theory perspective, the Dow Transports has held up very well. Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I continue to believe that the Dow Industrials and the broad market will embark on at least a six to eight-week rally from last week's lows. For now, we will remain 100% long in our DJIA Timing System.
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 from -11.1% to -14.5% for the week ending September 19, 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:
While the latest reversal of the four-week moving average is slightly disappointing (historically, this sentiment indicator has moved in the same direction in the markets, and is only useful as a contrarian indicator during oversold/overbought conditions), subscribers should keep in mind that a reading of -14.5% is still very oversold under normal circumstances. Moreover, the 10-week moving average (not shown) – now at -14.2% - has reversed to the upside from one of its most oversold levels in history, now at -14.2%. Combined with the oversold conditions in the global stock market during last Wednesday, decent global valuations, the sheer amount of investable capital sitting on the sidelines, and the record amount of short interest, this reading should now be good for at least a six to eight-week “meaningfully” rally in US and global equities For now, we will remain 100% long in our DJIA Timing System.
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 and has since stalled, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are still at oversold levels that are synonymous with a tradable bottom in the stock market. While we could see both the 20 DMA and the 50 DMA sell off to more oversold levels this week, my sense is that this will not be accompanied by a sizeable correction in the US stock market. Again, I believe the stock market made a significant bottom last Wednesday – and we will remain 100% long in our DJIA Timing System until our indicators tell us otherwise.
Conclusion: Prior to last weekend's commentary, there were four “bulge bracket” investment banks in the United States. With the demise of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America, and the transformation of Goldman Sachs and Morgan Stanley into bank holding companies, the “investment bank model,” as we know it, has ceased to exist. For now, Treasury's creation of a $700 billion pool to absorb illiquid assets from global financial institutions most probably put a decent bottom in the stock market last week. Whether this translates into a more sustainable rally will depend on the future actions of the US government, the Federal Reserve, the European Central Bank, and the Bank of England. With a substantial easing of inflationary pressures for the rest of the year and going into next summer, I expect the European Central Bank and the Bank of England to start easing monetary policy by Christmas. In addition, the Fed also has more room to ease should the stock market or our economic leading indicators head for trouble once again.
Going forward, I am still very constructive on US and Japanese equity prices in the longer-run. 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 last few weeks. Within US stocks, I still like the healthcare sector, the asset managers, and the exchanges. I also believe that the energy sector is now going through a tradable bounce. For now, we will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA