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Following the British Lead?

(October 9, 2008)

Dear Subscribers and Readers,

As we have alluded to in our earlier commentaries, the latest unraveling of the US and global stock markets began when Lehman Brothers filed for bankruptcy nearly three weeks ago.  Not only did the US Treasury and the Federal Reserve donned on their “moral hazard” hats and allow equity and bondholders to be effectively wiped out, they also did not move quickly enough to prevent a systemic run from the global financial markets and from “risky asset classes” around the world.  While the stock market held out hope that Hank Paulson would react swiftly with his $700 billion “rescue package” proposal for global financial institutions, much of that hope was dashed when it became apparent that he had no formal plans for the $700 billion government-funded pool, even as he was asking Congress to write Treasury a “blank check.”  Even as some of his plans were made public – many strategists and analysts, including George Soros – were skeptical, as no part of his plan discussed his steps of recapitalizing US financial institutions.  This is a very important point, as investors have totally shied away from injecting fresh equity into our financial institutions given the losses they have incurred over the last 12 months.  More importantly, many of these fresh investors have been demonized by politicians and the mainstream media, despite their roles of helping to cushion our financial system.  After all, why would anyone choose to invest in US financial institutions when the government is allowed unilaterally take control and wipe out equity holders with no warning (such as what happened with the GSEs)?  When the House of Representatives initially balked at Paulson's $700 billion TARP bill on September 29th, investors liquidated risky assets with full force, as it became “apparent” that both the Treasury and Congress either had no credible plans or idea on how to put a stop to this financial crisis.

This subsequent elevated “market risk premium” is still with us, of course, despite the fact that a revised TARP bill was passed last Friday.  Global financial markets stabilized somewhat yesterday, as global central banks (which included the Federal Reserve, the ECB, the Bank of England, the Bank of Canada, the People's Bank of China, Sweden's Riksbank, and the Swiss National Bank) sought to reassure investors that they were working closely together to solve the financial crisis by slashing central bank policy rates in a coordinated manner.  More glaringly, the UK government announced a £50 billion plan to help recapitalize UK financial institutions (without wiping out equity shareholders) – as well as a £200 billion government lending facility for well-capitalized UK financial institutions to meet redemption demands of either their depositors or creditors.  Proportional to the size of the US economy, this £200 billion government lending facility (approximately 18% of UK GDP!) is equivalent to a US$2.4 trillion pool that serves to guarantee all deposits and to prevent runs on UK financial institutions.  Compared to the “piecemeal” approach that the Federal Reserve and the Treasury has adopted so far, this UK “Bailout Plan” is very well designed.  In fact, word is that Italy, Spain, Denmark, and Sweden will adopt similar measures in the coming days.

The British has now fired the first serious shot in a global salvo to rescue the financial system.  With the announcement of this unprecedented bailout of the UK financial system, the British government has demonstrated that there may be enough political will/support for other developed countries to adopt similar plans – and importantly, at a price that does not punish current equity shareholders (if there are still any equity shareholders left in our banks).  Both the Fed and the US Treasury need to take their “moral hazard” hats off, as only this will encourage private investors to inject equity into global financial institutions to help recapitalize the financial system, which is ultimately where we want to go (for private individuals and institutions to invest alongside with the government).  Encouragingly, it looks like that Hank Paulson is now entertaining such an idea.  I expect some kind of formal announcement on bank recapitalizations – from both Paulson and various G20 countries – after the emergency G20 meeting at Washington DC this Saturday.  Assuming the US Treasury adopts similar measures, this should create a sustainable bottom in both the US and global equity markets.

In the meantime, there's no other way to put this, but the US stock market is now massively, and historically oversold, and ready to rally.  For example, the Lowry's Short-Term Buying Index has been at its most oversold level over the last three days since March 1980, the latter of which preceded a 13-month, 35% rally in the Dow Industrials.  More over, the 21-day moving average of the NASDAQ High-Low Differential Ratio (as shown in the following chart) just hit a reading of -9.53%, surpassing its prior record low of -8.80% that was made of November 11, 1987 – in the aftermath of the “Black Monday” crash on October 19, 1987:

21-Day Moving Average of the NASDAQ High-Low Differential Ratio vs. the NASDAQ Comp (January 1978 to Present) - The 21 DMA of the NASDAQ Comp High-Low Differential Ratio touched a reading of -9.53% on October 8th, the lowest reading in the history of the NASDAQ, breaking the previous record low that occurred on November 11, 1987 (In the aftermath of *Black Monday*), when it touched a record low of -8.80%.

Another way to look at the overbought/oversold condition of the U.S. stock market is through the percentage of NYSE stocks above their 200-day exponential moving averages, as illustrated in the following weekly chart (courtesy of

Percent of NYSE Stocks Above Their 200/50/20-EMA (Long-Term)

As can be seen in the chart above, the percentage of NYSE stocks above their 200-EMAs is now at its most oversold level since the aftermath of the October 1987 crash.  Prior to yesterday's reading, the last time this percentage came close to the October 1987 oversold level was October 2002 – when US investors were capitulating en masse in the aftermath of the late 1990s technology/telecom bubble.  Similar oversold readings (as circled in the above chart) occurred during October 1990, October 1990, December 1994, and October 1998.  All four episodes preceded major rallies and were ultimately very profitable who bought – even if one was a few weeks early.

Finally, the valuation factor of the entire universe of stocks (over 2,000) covered by the competent analysts at Morningstar just hit an all-time low of 0.69 yesterday (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”) – a reading that is significantly more oversold than the readings we witnessed during October 2002, just as the US stock market was coming out of its last cyclical bear market (as shown in the following chart, courtesy of Morningstar). 

Market Valuation Graph

While the above chart isn't a perfect timing indicator, what it does show is that if one has a long-term horizon, then buying US stocks at current levels will eventually turn out to be a great decision.  As long as the commercial paper market is revived, and as long as global financial institutions are quickly recapitalized, there is no reason to expect earnings power to be hit over the long-run (note that financial stocks now only make up 15% of the S&P 500's market cap). 

Signing off,

Henry To, CFA

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