The Global Bailouts
(September 28, 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 1,028.87 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 719.87 points as of Friday at the close.
In the aftermath of Lehman Brothers' bankruptcy filing two weeks ago, the global financial markets went into “full panic/liquidation mode,” as investors fled from all asset classes that had any semblance of risk – including non-US Treasury money market funds, commercial paper, credit card and auto loan asset-backed securities, bank deposits at Washington Mutual, Wachovia, and National City, municipal bonds, corporate bonds, and global equities. Despite all the efforts made by the Federal Reserve and the US Treasury to contain the current financial crisis – including the 3.25% in cumulative Fed rate cuts, the creation of the numerous Fed's lending/credit facilities, the bailout of Bear Stearns, and putting the GSEs into Conservatorship – everything started to unravel in front of their eyes as they listened to the do-nothing “free market” proponents and donned on their “moral hazard hats.” As the Lehman bankruptcy threatened to unravel the rest of the global financial system, both the Federal Reserve and the US Treasury had to do an about-face. The Fed was subsequently forced to provide $85 billion in loans to AIG. Merrill Lynch was forced into an acquisition by Bank of America. Washington Mutual was taken over by JP Morgan last Friday. Goldman Sachs and Morgan Stanley applied to become bank holding companies – an act which allowed them to immediately take out direct loans from the New York Fed, and allowing them to use a greater variety of securities as collateral. As I am writing this, Wells Fargo and Citigroup are now rumored to be engaged in a bidding war for Wachovia – although as the New York Times reported, any bid would most likely be (significantly) below where Wachovia's stock price closed last Friday. This series of events culminated into this weekend's tense negotiations in Congress regarding the creation of a government-funded $700 billion pool to absorb illiquid assets from banks' balance sheets. While House Democrats and House Republicans have come to a fundamental agreement, the upcoming vote in the House will still most likely be close.
Moreover, as I am writing this commentary, the Australian government announced that it would purchase US$3.3 billion work of mortgage-backed securities in an effort to lower mortgage rates and increase borrowing in the Australian housing/mortgage market. Over the weekend, the UK government announced that it would effectively nationalize Bradford & Bingley – one of the country's largest mortgage lenders – and saddling the government with £50 billion of mortgage securities. Coupled with the Northern Rock nationalization, the UK government will be “on the hook” for approximately £150 billion in mortgage securities. On the other side of the pond, the Belgian banking and insurance giant, Fortis, received a total of $16.4 billion in equity injections from the governments of Belgium, Luxembourg, and the Netherlands over the weekend – as the firm became the largest European financial institution to be bailed out. Look for both the Bank of England and the European Central Bank to start to ease monetary policy in a more aggressive way by the end of this year.
Even though S&P 500 futures are down 14 points as I am typing this, I continue to believe that the inevitable passage of the $700 billion bill have put in a good floor in the US stock market – which should be good for at least a six to eight-week rally. Again, 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. The Federal Reserve, on the other hand, has begun to increase its balance sheets in a dramatic way. As a matter of fact, the Federal Reserve is finally starting to run the “printing presses” – a dramatic turnaround from its relative restraint over the last 15 months, as demonstrated by the recent spike in the growth of 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. With the latest panic in the global financial markets, the Federal Reserve has staged a dramatic turnaround, as signaled by the latest year-over-year growth in the US monetary base shown 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). The year-over-year growth ticked up to 2.59% on September 10th. For the two weeks leading into September 24th, however, the year-over-year growth in the St. Louis Adjusted Monetary Base exploded to 6.66% as the Federal Reserve sought to prevent a full-blown panic in the financial markets - a rate of growth not seen since late May 2003! Assuming that the Fed continues to be as accommodative, such a rate of growth in primary liquidity suggests not only a solid bottom in the US stock market, but a sustainable rally that could last well into Christmas.
In the meantime, the continuing debt liquidation – as covered before – has not been unique to the credit markets. As shown in the following chart, the total amount of margin debt outstanding on both the NYSE and the NASD has declined approximately 23% from its peak in July 2007 – a rate of margin debt liquidation not seen since the late 2001 to early 2002 period:
With the latest monthly (August 2008) decline in total margin debt outstanding ($21.2 billion), total margin debt outstanding is now at a level not seen since March 2007. More importantly, margin debt liquidation, no doubt, has continued during this month as both the US and global stock markets remained very weak. By the end of this month, I would not be surprised if total margin debt outstanding declines to below $300 billion, although we won't really know until the middle of October (when margin debt data is usually released). Assuming that margin debt outstanding declines to below $300 billion, this would put us at a level consistent with where we were in November 2006. The amount of immense liquidation in margin debt since July 2007 suggests that we are now trading at or close to a sustainable bottom.
In last weekend's commentary, I stated that from a valuation standpoint, the current environment 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, we discussed the fact that the Dow Industrials was trading at a P/B ratio of 2.95, a level not seen since February 2003! Since then, the P/B ratio of the Dow Industrials (as seen below) has declined yet further, to a ratio of 2.93!
Again, 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 indeed 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 26, 2008, the Dow Industrials declined 245.31 points while the Dow Transports declined a whooping 349.45 points, after Treasury's plans to create a $700 billion pool to absorb illiquid assets was stalled by House Republicans. 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 (although initial indicators from the Fed look promising). In the meantime, from a Dow Theory perspective, the Dow Transports is still holding up relatively week, despite last week's immense decline (it is still above its July 15th low). 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 -14.5% to -15.0% for the week ending September 26, 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 -15.0% is still very oversold under normal circumstances. Moreover, the 10-week moving average (not shown) – now at -12.5% - has reversed to the upside from one of its most oversold levels in history (it hit -15.2%, a reading not seen since early April 2003, just four weeks ago). Combined with the oversold conditions in the global stock market, an easing of monetary policies around the world, 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:
Since the short-term peak in the 20 DMA of the ISE Sentiment Index in late August, it has declined to a reading of 103.3, an oversold level not seen since mid April earlier this year. As discussed last week, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are 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 has already made a significant bottom – and we will remain 100% long in our DJIA Timing System until our indicators tell us otherwise.
Conclusion: With the world's governments and central banks starting to ease monetary policies and engage in a “coordinated” round of bank bailouts and equity injections, my sense is that we have reached an “inflection point” where global policy makers are saying, “enough is enough.” Assuming that President Bush signs into law the $700 billion “bailout bill,” sometime this week, and coupled with the latest spike up in primary liquidity (the St. Louis Adjusted Monetary Base), this should translate into at least a six to eight-week rally. Whether this translates into a more sustainable rally will depend on the future actions the Federal Reserve, the European Central Bank, the Bank of England, and the People's Bank of China. 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, as the world starts to focus on sustainable, Schumpeterian Growth vs. Ricardian Growth over the next few years. Within US stocks, I still like the healthcare sector, the asset managers, and the exchanges. I continue to 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