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Where is the Irish Bailout?

(October 19, 2008)

Dear Subscribers and Readers,

We (finally!) posted our review of Benjamin Graham's “The Intelligent Investor” last week 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.

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 3,319.78 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 3,010.78 points as of Friday at the close.

As I mentioned in last weekend's commentary, while I am not happy with our losses, I am confident that the US stock market will be significantly higher over the next 6 to 12 months – as the market's historic oversold conditions and the Fed's and Treasury's willingness to provide support to the financial markets should boost investors' confidence for the foreseeable future.  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 (unlike the “demonization” atmosphere of bank equity shareholders that existed prior to the Lehman bankruptcy) – 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.

As of Sunday evening, we learned that the South Korean government would implement a $130 billion bailout (equivalent to 14% of its GDP) for its financial system – providing a $100 billion, three-year guarantee for its banks' foreign currency debt and a $30 billion in U.S. dollar funds to the local currency swap markets.  In addition, the South Korean government will provide tax benefits for shareholders who hold on to their shares for more than three years.  Given the substantial decline in crude oil prices (the greatest contribution to its current account deficit), and given that the Bank of Korea is now expected to ease monetary policy as soon as next month, my sense is that the South Korean stock market is now in the midst of hammering in a substantial bottom (the MSCI Korea Index is down 55% on a YTD basis in USD terms).

We also learned that ING will receive a US$13.4 billion bailout from the Dutch government in the form of an equity injection via non-voting preferred shares.  As reported by Bloomberg, this will boost ING's Tier 1 capital ratio from 6.5% as of September 30th to approximately 8.0%.  With the vast majority of the world's developed countries receiving bank bailouts from their governments (with the notable exception of Japan) – the question now becomes: What is the Irish government thinking?  On September 29th, as the world's financial system was beginning to collapse, the Irish government unilaterally put in a two-year government guarantee to safeguard all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II) of six major domestic financial institutions.  While this move was extreme at the time, it has been since supplanted by the direct equity injections of many of its regional competitors.  Most notably, the Tier 1 capital ratios of many UK banks are now hovering at around 10%, while those of Irish banks are in the range of 6% to 7%.  In other words, Irish banks are now at a severe disadvantage, especially since the Irish economy has no doubt entered a recession (the first developed economy to do so) – which will exacerbate credit and mortgage losses going forward.  Not surprisingly, the MSCI Ireland Index (denominated in US$) has underperformed all developed stock markets on a YTD, one-, three-, five-, and ten-year basis, as exemplified by the following table:

Country Performance - Annualized as of October 17, 2008

To further compound its lack of response since September 29th, the Irish government has announced it will enact tax hikes and cut government spending in order to narrow its budget deficit in the coming year – a move that will no doubt exacerbate the recession in Ireland and in Western Europe in general.  At this point, there are only three major levers that the Irish government can rely on to “jump start” its domestic economy: lower interest/borrowing rates, a lower currency (Euro), and the availability of more credit for its businesses and consumers.  While the ECB's new easing campaign should result in lower borrowing rates and a cheaper currency going forward, this is more or less outside of the Irish government's control.  More importantly, further ECB easing may not mean much if its domestic banks cut back on its lending or if the rest of the world's economies continue to slow down (resulting in lower potential exports).  As an Irish policymaker,  I would rely on the “third lever,” – that of directly injecting equity into its major financial institutions so that they could jump start lending and cushion the Irish economy and the impact of a slowdown/recession in the vast majority of the world's economies.  Note that a direct equity injection will have no impact on Ireland's budget – and in theory, would also allow the government to participate in the appreciation of the participating banks' share prices going forward.  In my opinion, this option will provide the “best bang for the buck” for the Irish economy and Irish taxpayers.

In the meantime, the Federal Reserve will be “fighting tooth and nail” to prevent the US economy from sinking into a deflationary/depressionary spiral.  In our March 23, 2008 commentary (“The Great Deleveraging”), we stated that the US economy would most likely continue to deleverage.  Quoting our March 23, 2008 commentary:

In an institutional conference call late last week, Bill Miller of the Legg Mason Value Trust Fund remarked that global debt had also been growing at twice the pace of global GDP over the last few years.  As such, he expects a significant part of the world would also enter a deleveraging phase over the next couple of years.  In my humble opinion, the marginal players – such as Bear Stearns, Carlyle Capital, Thornburg Mortgage, and the subprime mortgage originators – were the first casualties.  While the demise of Bear Stearns marked the end of the first phase of the deleveraging process, I expect other players to start falling as general financing gets more difficult and expensive to obtain over time.  Over the longer-run, such deleveraging would be healthy for our economy, as current account deficits and household debt growth would decline. 


Note that I mentioned “certain players” would be hurt by the deleveraging.  Who would those be?  In a nutshell, those would be companies whose business models relied on cheap financing – such as SIVs, a significant number of mortgage REITs, certain private mortgage lenders, certain private student loan lenders, much of the private equity industry, and a significant portion of hedge funds who were involved in either the currency or credit carry trades.  Note that I am not expecting a significant blowup over the next 12 to 24 months, but I do expect a “slow but certain death” for many of these companies, as credit lines are pulled and as investors withdraw en masse from some of these sectors (such as hedge funds).  With respect to hedge funds, I expect many of them to fail as hedge fund investors bail out as financing gets tight and as the various carry trades (Yen, Swiss, Rand, NZD, and Icelandic Krona crosses, etc) go out of fashion.  Furthermore, many former hedge fund investors will learn that "true alpha" is really elusive in the first place, and thus will move back into the traditional "beta strategies" - such as buying, for the most part - the unlevered and the well-managed companies in the Russell 3000 or EM equities. The UK and Eastern Europe will also dramatically go out of style, as some of the overly-extended countries (countries that have a significant amount of foreign bank credit and a significant current account deficit) such as Latvia, Estonia, Hungary, Lithuania, and Romania, go bust.

Since then, we have found out “in spades” how deleveraging within the US financial sector and economy could have such severe repercussions throughout the global economy.  Not only have certain private investment vehicles (such as SIVs) have gone bust, so have major financial institutions and even sovereign countries, as the fall of Iceland and now Pakistan have clearly demonstrated.  Given that the asset-to-liability ratio of U.S. households (see chart below) is now at a historically low level of 4.86 (at the end 2Q2008), down from 5.03 at the end of the fourth quarter of 2007 (see below chart), any further deleveraging within the US economy from current levels could have much wider global repercussions.  Countries that are hugely depending on oil exports, such as Iran, Venezuela, Russia, Kuwait, and Saudi Arabia, for example, would encounter significant economic difficulties should crude oil prices stay below $75 a barrel, as global deleveraging discourages energy spending. 

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 2Q 2008) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to 5.03 at the end 2007, to merely 4.86 today... 5) Household net worth dipped by $438 billion during the second quarter - representing the second consecutive Y-o-Y drop (3.5%) since 1Q 2003. At the end of the second quarter, household net worth has declined by $2.69 trillion since its peak at the end of 3Q 2007. 6) The *dip* in net worth caused by the October 1987 stock market crash.

With the asset-to-liability ratio of US households at an all-time low, it is no surprise to see the Federal Reserve increasing the size of its balance sheet (i.e. printing money) at a historically high rate, as we discussed in last weekend's commentary.  No doubt, the Fed should also get a lot of help as well, as the ECB, Bank of England, and the People's Bank of China are now projected to continue to ease monetary policy as we head into Christmastime.  Make no mistake: A very disappointing (as opposed to merely “disappointing”) Christmas season would wreck havoc on many retailers' hiring plans for 2009 and beyond.  For now, the jury is still out – but that the global central banks continue to be as accommodative, I am optimistic about the stock market's prospect for the next 6 to 12 months.

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 17, 2008) - For the week ending October 17th, the Dow Industrials rose 401.03 points while the Dow Transports declined 52.01 points (after declining a whooping 1,006.12 points in the previous two weeks). At the most recent bottom, the Dow Industrials touched its lowest level since April 2003, while the Dow Transports has done relatively better - holding at its October 2005 level. The unprecedented selling and volatility over the last two weeks was 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 17, 2008, the Dow Industrials bounced slightly from the week's prior decline – rising by 401.03 points while the Dow Transports declined 52.01 points (after declining 1,006.12 points in the previous two weeks).  At the most recent bottom, the Dow Industrials touched its lowest level since April 2003.  Given the immensely 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 (LIBOR is projected to decline to 4% on Monday, down from 4.8% at the beginning of last week) – 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 increased from -20.4% to -20.1% for the week ending October 17, 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 17, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios rose slightly from -20.4% to -20.1%. Subscribers should note that this indicator is now at a historically oversold level, but is probably in the midst of reversing as well. Historically, this (a reversal from a very oversold sentiment level) has been one of the most reliable signal preceding a major rally.  While sentiment can indeed get darker, my sense is that the market should have hammered a capitulation bottom over the last six trading days. For now, we will remain 100% long in our DJIA Timing System.

While the four-week moving average of our popular sentiment indicators increase from a historically oversold reading of -20.4%, chances are that the stock market should continue to rise for the foreseeable future.  Historically, the most bullish signal for the stock market comes when this indicator reverses from severely oversold levels – signaling that the line of least resistance for the stock market has reversed to the upside.  Combined with the oversold conditions in the global stock market, depressed global valuations, the ongoing correction in energy prices, the sheer amount of global investable capital sitting on the sidelines, unprecedented global bailout packages, these latest readings 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:

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 – with readings 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 hammered out a capitulation bottom over the last six trading days – and we will thus remain 100% long in our DJIA Timing System.

Conclusion: With the rest of the developed world providing shareholder-friendly equity injections to their respective domestic financial institutions, my sense is that the Irish government will need to follow suit, as Irish financial institutions are now clearly at a disadvantage.  As discussed in our above commentary, such a move will provide the Irish government the “best bang for the buck,” as an investment by the government will not adversely impact its budget.  On the contrary, an equity injection into its financial institutions will also allow its taxpayers to share in some of the inevitable upside, as Irish financial institutions are now trading at severely depressed prices.  Again, as Benjamin Graham warned 60 years ago in his seminal work, “The Intelligent Investor,” 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 hammered out a capitulation bottom over the last six trading days.  Assuming that consumer price inflation subsides 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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