The Global Bailouts, Part II
(October 5, 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 1,846.62 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 1,537.62 points as of Friday at the close.
We began last weekend's commentary (“The Global Bailouts”) with an assessment of market intervention policies by governments around the world, starting with the policy of the United States. Even before the $700 billion TARP bill was put to a vote in the House of Representatives last Monday, it was clear that governments around the world were taking a significantly more active role in our financial markets. At the time, we stated:
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.
This was, of course, written before the failure of the original $700 billion TARP bill to pass through the House. While the bill eventually became law last Friday, the initial failure of the bill triggered another wave of selling in the financial markets, as investors lost further confidence in the ability of our policy makers to put a stop to this financial crisis/liquidation. By the end of the week, both Greece and Ireland broke with the rest of the EU – deciding to guarantee all banking deposits held by their domestic financial institutions. In addition, Hypo Real Estate had to be bailed out – twice, as it turned out. The State of California revealed that it might need to borrow as much as US$7 billion from the Federal Reserve to keep its services running. Iceland stood at the edge of the abyss, with the Iceland Krona down more than 40% against the Euro on a year-to-date basis, and down 10% last week alone. Unless Iceland can raise liquidity sometime this week (either by liquidating its pension assets in foreign securities or obtaining a loan from other Nordic banks or the IMF), Iceland's economy could very well spiral into a depression. Even Germany – which had criticized Ireland and Greece for acting unilaterally – was forced into guaranteeing all domestic retail deposits starting this Monday. The UK government, on the other hand, has revealed that it is contemplating a scheme to recapitalize UK banks using government funds – presumably with the blessing of Mervyn King, the Governor of the Bank of England. Finally, the Japanese government is set to provide a $100 billion fiscal stimulus to the Japanese economy – which could come as early as the end of this month.
With the global financial markets still in liquidation/panic mode (Goldman Sachs noted that hedge funds' equity holdings were disproportionally hit last month and during the third quarter), it is obvious that, in retrospect, policy makers were not aggressive enough or in the case of UK and Western European policy makers, asleep at the wheel. As we previously mentioned, policy rates at both the Bank of England and the European Central Bank need to be at least 200 basis points lower in order to turn around their respective economies (this will give the banks a much steeper yield curve to work with). Both the Bank of England and the European Central Bank need to cut rates – and they need to do it now. Investors currently expect the Bank of England to cut by at least 25 basis points this Thursday – but I would argue (in the absence of an aggressive government-run recapitalization plan) that only a cut of 75 basis points or higher would inspire investor confidence in the UK financial markets.
With the global credit and equity markets in disarray – and with several large financial institutions having already failed (and with Iceland on the edge of an abyss) – I expect policy makers to take a more decisive role to rejuvenate the global financial markets over the next several weeks. Given that policies so far have failed to do that, I expect more radical/aggressive policies to be implemented, such as an Irish-like blanket guarantee of banking deposits, bank recapitalization plans spearheaded by sovereign governments, direct government lending (the 5% interest rate loans to the “Big 3” automakers set an important precedent), more central bank easing (Fed Funds futures are now pricing in a 50 basis point rate hike on October 29th), and the implementation of more fiscal stimulus plans. With the global equity markets now massively oversold, the global equity markets is now at a natural point for it to embark on at least a six to eight-week rally sometime in the next several weeks. The massively oversold conditions of the global, regional, and country-specific equity markets are evident in the latest readings of our Global Overbought/Oversold model. Under normal circumstances, we usually use our monthly Global Overbought/Oversold Model as cues to either go long in a substantial way or cut back on long positions (overbought indicators are notoriously bad timing indicators), and this is what we are going to do in this instance. This model was first discussed in our August 2, 2007 commentary. The inner workings of this global overbought/oversold “model” are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility. We also added the CRB Total Return Index in our August 2, 2008 commentary. Following is our Global Overbought/Oversold Model as of the close on September 30, 2008:
Since our last model update on September 11th, the world's equity markets have gotten much more oversold (the cells highlighted in yellow represent readings below the 15th percentile, or approximately one standard deviation below the average). In light of the recent strength in the U.S. Dollar and the collapse of several banks in Western Europe, many Western European equity markets (such as the Austrian, Belgian, Irish, Italian, and Norwegian markets) have sold off to a level that is as oversold as they have ever been. Moreover, with commodity prices still weakening, the commodity-focused countries, such as Australia, Canada, and New Zealand, have also continued to sell off. Even China – which adopted an easing monetary policy and intervened in the equity markets by buying bank stocks last month – has continued to weaken. For the first time in the current bull cycle, commodities (as exemplified by the CRB Total Return Index) are now oversold on a short-term basis. As global policy makers start to implement more aggressive policies to ease the current strains in the credit markets, I expect commodities to regain strength, but for now, the CRB Total Return Index probably still has further room to fall (I expect crude oil prices to bottom out in the $80 to $90 a barrel range).
Again, the continuing liquidation in international and emerging market equities has more to do with increasing risk-aversion – a trend that began with the subprime market in the US and that spread into the rest of the global financial sector – further compounded by tightening central bank policies around the world as a response to rising inflationary pressures. The latest liquidation in credit instruments and equities has been further compounded by hedge fund and fund of funds redemptions (word is that global hedge funds have raised about $600 billion in cash, or as much as one-third of all global hedge fund assets under management). This immense liquidation over the last 12 months has resulted in a tremendous amount of cash sitting on the sidelines, as evident by the growing amount of US money market assets (which is one of many ways to measure cash levels). Despite the recent stampede out of money market funds in the aftermath of Lehman's bankruptcy, the amount of money market funds just set a record high relative to the S&P 500's market capitalization. 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 September 2008:
As of September 30th at the close, the ratio between money market fund assets and the market cap of the S&P 500 stood at 31.08% - a historically high level that is 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 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 still near 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, private pension funds, and hedge funds as well (note that more than a dozen potential buyers have expressed an interesting in bidding for AIG's assets around the world). While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now at an unprecedented level and should be supportive for stock prices not only for over the next few years, but over the next 6 to 12 months as well. My sense is that we are now witnessing a major capitulation in global equity prices.
In our last two weekend commentaries, I stated that from a valuation standpoint, the market is setting up for 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 2.93 last week, a level not seen since February 1993. Since then, the P/B ratio of the Dow Industrials (as seen below) has declined still further, to a ratio of 2.85 – a level not seen since October 1992!
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 over the next several weeks 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 October 3, 2008, the Dow Industrials declined 817.75 points while the Dow Transports literally crashed during the week, declining 616.31 points, despite the passage of the Treasury's plans to create a $700 billion pool to absorb illiquid assets. While global equity markets should bounce (given their massively oversold levels) soon, whether the market will manage to rally in a sustainable rally will depend on both government and monetary policies around the world – in particular, the monetary policies of the European Central Bank, the Bank of England, and the People's Bank of China, and whether the UK's recapitalization plan for the country's banks will go through. In the meantime, from a Dow Theory perspective, the Dow Transports is sitting right on support that stretches back to August 2006. Given that the Dow Transports has been a leading indicator of the broad market since October 2002, it is very important for the Dow Transports to hold at current levels. 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 declined from -15.0% to -17.6% for the week ending October 3, 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 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 -17.6% is now close to a historically oversold level. 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 more aggressive global public policies to ease the credit crisis, this reading should be good for at least a six to eight-week “meaningful” rally in US and global equities sometime in the next several weeks. 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 101.8, 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 both the ISE Sentiment indicator and the stock market could continue to sell off, my sense is that we are now rapidly approaching levels that are conducive for a meaningful rally sometime in the next several weeks. I highly believe the stock market is now making 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 take a more “radical” and aggressive approach to “bail out” the global financial system, my sense is that we have reached an “inflection point” where global policy makers are saying, “enough is enough.” Assuming the Bank of England cuts its policy rates by at least 50 basis points this Thursday, and assuming that there are more aggressive policies to come (such as a government-funded recapitalization of the UK banking system), this should translate into at least a six to eight-week rally sometime in the next several weeks. 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 ease monetary policy aggressively over the next three to six months. In addition, I also expect the Federal Reserve to lower the Fed Funds rate by 50 basis points at its October 29th meeting.
Going forward, I continue to be constructive on US, Japanese, and Chinese 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 also expect crude oil prices to make an intermediate bottom in the $80 to $90 a barrel range. For now, we will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA