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The Collapse of the “Institutional Model”

(October 12, 2008)

Dear Subscribers and Readers,

We (finally!) posted our review of Benjamin Graham's “The Intelligent Investor” last night in our “Favorite Books” section.  Penned in 1949 (with subsequent revisions by Graham to 1973), this timeless work has been called “the best book on investing ever written” by Warren Buffett – and remains all the more relevant given today's challenging investment environment.  I urge all subscribers to read this “investing bible” at least once – there is something in there for both the layperson and professional investors. It is readily available in all major bookstores as well as in online stores.

Chapter 8, entitled “The Investor and Market Fluctuations” is an especially good read for our subscribers, as it pertains to the dangers of stock market timing and forecasting (there is even a page devoted to the Dow Theory).  It is particularly relevant given the recent crash (there is just no other to put this) in the global equity markets.  For those who are long-term optimists of the US and global capitalist system – and for those who like to think of themselves as long-term investors, Graham has this to say regarding the day-to-day volatility of the markets and what they should mean to you (this is the most important paragraph in Chapter 8, if not the book):

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard upon it only to the extent that it suits his book, and no more.  Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.  That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.

While I am not happy with the losses incurred in our long position in our DJIA Timing System, I am confident that – given the market's historic oversold conditions and the greatest values we have seen since the 1990 to 1991 period – a diversified portfolio of US and global equities will pan out over the long-run, as long as one can withstand the continuing volatility over the next 6 to 12 months.  More importantly, the world's central banks and finance ministers are now acting in a bold and unprecedented manner in cushioning our financial system – at a price that is shareholder-friendly – a policy which will inevitably attract a significant amount of cash into recapitalizing the banks (and the equity markets) that has accumulated on the sidelines since the beginning of this year.  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 3,720.81 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 3,411.81 points as of Friday at the close.

Again, while I am not happy with our losses, I do want to point out that – at our last performance update on June 30th – our DJIA Timing System was outperforming the Dow Jones Industrial Average by more than 18% over the preceding 12 months.  When we decided to go long in our DJIA Timing System back in mid to late June, our assessment of the global financial markets suggested that the value of US equities were trading at decent levels.  Combined with the willingness of the Federal Reserve to provide much-needed liquidity – along with the significant recapitalization of US financial institutions since late last year – our sense was that the US stock market would trade higher over the next 6 to 12 months.  Alas, this did not occur.  While putting the GSEs into conservatorship remained a good move, there is no doubt (as we covered in our September 28th commentary) that letting Lehman Brothers file for bankruptcy was a great mistake from a public policy and financial market standpoint.  Of course – just as the House voted against the $700 billion TARP program the next day – the US Treasury was only giving the general population what they wanted: i.e. they wanted to punish not just the bankers, but the folks who have just recently helped recapitalize Lehman, the GSEs, AIG, Washington Mutual, and other notable financial institutions.  Not only did this “demonization” wipe out many existing shareholders, this policy also scared the heck out of potential investors (those that could help recapitalize the global financial system) and existing investors of other financial institutions – eventually wiping out over $2.5 trillion in US market cap over the last couple of weeks.  As we have mentioned time and time again, folks should be careful what they wish for – we just might get it.

In short, the modern “institutional model” of our global markets completely broke down last week.  Gone were the $10 billion in sovereign wealth fund monthly inflows to the US equity markets, the immense corporate and insider buybacks, the quarterly defined benefits pension fund inflows, and the steady bi-weekly inflows into equities from 401(k), 403(b), and IRA accounts all across the nation.  Moreover, the majority of global hedge funds have been forced to raise cash over the last few weeks in order to meet potential redemptions over the next few weeks.  Reliable sources assert that as much as one-third ($600 billion) of all hedge fund assets is now sitting in cash.  Finally, with the rise in borrowing costs and the dismal performance of recent investments, many private equity firms have simply been sitting on cash – reluctant to enter the market in a substantial way.  With panic sweeping through the entire world, what began with investors selling into a “no-bid market” turned into an avalanche, as the selling triggered margin calls, which in turn caused more panic and widespread liquidation.  The collapse of the “institutional model” is evident in the immense spike of the “TED Spread” (the difference between three-month LIBOR and three-month Treasury yields) over the last couple of weeks, as shown in the below chart:

5-Day Simple Moving Average of the TED Spread (January 1986 to Present) - The TED spread hit a new 34-year high late last week, surpassing previous spikes during the inflationary bust of the 1980s and the LDC crisis, as well as during the October 1987 crash! The modern *institutional model* has completely broken down...

As noted in the above chart, the spike in the five-day moving average of the TED Spread over the last few weeks was the most violent since July 1974 – surpassing that of the early 1980s inflationary bust (when the entire US financial system was essentially insolvent twice over as a result of LDC loan defaults) and the October 1987 crash.  The violent spike up in the TED Spread, along with the unprecedented liquidation of global equities last week, signaled to global policy makers that they were not doing enough (or in the US case, implementing very ineffective policies) to revive global financial liquidity, recapitalize banks, and to induce them to lend again.

Again, make no mistake: The unprecedented liquidation last week has resulted in one of the most immensely oversold condition in the US stock market.  One measure – the 10-day moving average of the NYSE High-Low Differential Ratio – is now at its most oversold level since records have been kept going back to March 1965, as shown in the following chart! 

10-Day Moving Average of the NYSE High-Low Differential Ratio (March 1965 to the Present) - Over the last 43 years, there has only been two instances (not including last's readings) where the NYSE High-Low Differential Ratio had hit a level of -30% or below...

Of course, in a bear market, we all know that an oversold condition can turn into an even more oversold condition.  However, my sense is that policy makers are now – for the first time ever – being proactive and putting themselves ahead of the crisis in a coordinated manner.  The key policy move, aside from a European meeting of finance ministers during the weekend, has been Treasury Secretary Paulson's “about-face” to commit to buying non-voting shares in various US financial institutions to prop up their balance sheets and support share prices.  On a more immediate note, we now know that both the US Treasury and the Japanese government have been actively involved with the renegotiation of the purchase of a 20% stake in Morgan Stanley by Mitsubishi UFJ Financial Group.

Finally, the Federal Reserve has continued to increase the size of its balance sheets (i.e. printing money) like there is no tomorrow.  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 latest four-week 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:

US Monetary Base Suggests A Stronger Stock Market in the Next Few Months... - Primary liquidity conditions are now immensely bullish for stock prices - as the Fed is now printing money (through the increase in the US monetary base) like there is no tomorrow.

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, and 6.66% on September 24th.  For the two weeks leading into October 8th, however, the year-over-year growth in the St. Louis Adjusted Monetary Base exploded to 14.71% as the Federal Reserve sought to prevent a full-blown panic in the financial markets - a rate of growth not seen since Alan Greenspan started running the printing presses in anticipation of the “Y2K-induced recession” in late 1999!  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.

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 April 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (April 1, 2003 to October 10, 2008) - For the week ending October 12th, the Dow Industrials crashed by 1,874.19 points (its worst-performing week in the index's 112-year history) while the Dow Transports declined 389.81 points (after declining a whooping 616.31 points in the week prior). The Dow Industrials is now at its lowest level since April 2003, while the Dow Transports is doing relatively better - holding at its October 2005 level. Last week's unprecedented selling was as a result of a near-total breakdown of the modern financial system. With global policy makers now adopting a more shareholder-friendly *bailout approach,* there is a good chance that global equity markets have made a good solid bottom, for now. Given the more aggressive stance of global policy makers - as well as the immense amount of capitulation - I expect both the broad market and the Dow Industrials embark on substantial rally lasting into Christmas. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending October 10, 2008, the Dow Industrials crashed by 1,874.19 points (there is no other way to put it) while the Dow Transports declined 389.81 points (after declining 616.31 points the week prior), despite the passage of the Treasury's plans to create a $700 billion pool to absorb illiquid assets, the Fed's creation of an entity to purchase commercial paper on the open markets, and a coordinated interest rate cut by many of the world's central banks.  Given the immense oversold condition in the markets – combined with the radical (and shareholder-friendly) policies that global policy makers have adopted to jump start the financial and equity markets – my sense is that the stock market has made a solid bottom.  While there will inevitably be more volatility going forward, my sense is that we will at least rally into Christmastime.  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 -17.6% to -20.4% for the week ending October 10, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending October 10, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios declined from -17.6% to -20.4%. Subscribers should note that this indicator is now close to a historically oversold level. While sentiment can indeed get darker (and will probably get darker this week), my sense is that the market should has reached a capitulation bottom last week. For now, we will remain 100% long in our DJIA Timing System.

While the four-week moving average of our popular sentiment indicators now at a reading of -20.4%, subscribers should note that we are now at a historically oversold level.  Combined with the historic oversold conditions in the global stock market, immense easing of global monetary policies, an unprecedented global bailout package, an extremely undervalued global equity market, and the sheer amount of investable capital sitting on the sidelines, this reading should be sufficient for a meaningfully rally in US and global equities potentially lasting into Christmastime.  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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - After breaking out of its 3-month consolildation phase, the 20 DMA of the ISE Sentiment Index has stalled and reversed back to the downside - breaking below its 50 DMA a four weeks ago. Regardless, relative to levels over the last five years, both the 20 and the 50 DMAs are at very oversold levels, signaling that sentiment is much closer to a bottom than a top. Given the immense selling in the stock market last week - combined with unprecedented public policy action - my sense is that the stock market made a capitulation bottom last Friday.

Since the short-term peak in the 20 DMA of the ISE Sentiment Index in late August, it has again “sold off” to oversold territory – readings we have not seen since 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.  Combined with the extreme valuations and oversold levels in the equity markets, as well as unprecedented global bailout package, I highly believe the stock market has made a capitulation bottom last Friday – and we will thus remain 100% long in our DJIA Timing System.

Conclusion: Nearly 60 years ago, Benjamin Graham – in his seminal work, “The Intelligent Investor” – warned that fluctuations and unexplainable declines in stock market quotations were a routine hazard that investors will have to deal with.  Obviously, each investor will react to a decline differently, but as Graham warned, retails investors should not turn their basic advantage over institutional investors (such as hedge funds and mutual funds that have been forced to liquidate stocks over the last couple of weeks) into a disadvantage, i.e. by selling their equity holdings at near bottom prices by panicking during or after a significant decline.  On the contrary, such declines, aside from the great September 1929 to July 1932 bear market, have all been great long-term buying opportunities.  Given that the world's governments and central banks have begun to implement a more radical and shareholder-friendly approach to “bail out” the global financial system, my sense is that we have reached a capitulation bottom last Friday.  Assuming that consumer price inflation subsidies and that the European Central Bank and the Bank of England will continue to ease monetary policy, I expect this upcoming rally to last at least until Christmastime.

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.  For now, we will stay with our 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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