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Liquidity Pressures Waning?

(November 16, 2008)

Dear Subscribers and Readers,

Following our recent commentary on Best Buy (BBY), some subscribers have requested for an update of our valuation ratios comparisons for the company.  Following is the latest valuation comparisons of Best Buy with other hardline retailers, based on data as of last Friday's close (note that earnings estimates were obtained from Reuters):

Hardline Retailers - Comparable Company Analysis with Best Buy Co. Inc. (as of November 14, 2008)
* Click on image to view larger image

As we discussed in our mid-week commentary, valuations for Best Buy look very compelling, as both its forward P/E and EV/EBITDA ratios are trading at the low end of the range within our comparison analysis.  Best Buy looks doubly compelling when one considers that: 1) It remains the undisputed leader and “category killer” in the consumer electronics industry, 2) It is poised to gain market share from Circuit City as the latter closes 155 of its stores (most likely, Circuit will liquidate more or all of its stores come 2009), 3) It is an extremely well-run company, as demonstrated by its historically high ROA and ROE, and 4) It has further potential to grow in other offerings (e.g. Geek Squad), as well as in overseas markets, especially China.  Disclosure: This author is currently long BBY.

Let us now 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 3,674.69 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 3,365.69 points as of Friday at the close.

The latest statement released by the G-20 after its meeting this weekend was slightly disappointing, as it was very light on details (although the G-20 commitment to free trade policies was uplifting).  But then, no one was expecting much anyway.  Despite the waves of coordination among the G-20 countries over the last 15 months, it is difficult to envision each country agreeing to details such as specific tax policies, stimulus thresholds, or “radical” policies such as further bank equity injections or even governmental intervention in the corporate bond/equities markets.  Thankfully, as we will later discuss, both the money and financial markets around the world are showing signs of “calming down,” although that is not to say things won't get worse again if there is a major policy mistake, such as a lack of follow-through in the ECB's current rate cut campaign or should one of the “Big 3” automakers file for bankruptcy.

Should one of the Big 3 automakers fail, there is no doubt we will see mass layoffs in the US autos & auto parts industry and a “domino effect” in the financial markets as GMAC, Ford Motor Credit, and Chrysler Financial are all integral parts of the global financial system.  Even the smallest of the three, Chrysler Financial, manages $70 billion portfolio of assets.  Should Chrysler fail, this should reignite stress in the system and cause the TED spread and credit spreads to blow out once again.  In such a scenario, I would not be surprised to see this spreading to GM or Ford (note that Ford Motor Credit manages approximately $150 billion worth of assets).  Even without further stress in the system, I do not see how GM could avoid filing for bankruptcy by the end of the year, unless they receive an equity injection or a massive low-interest rate loan (>$10 billion) from the federal government.  Coupled with the latest reading of the ECRI Weekly Leading Indicator, I would not be surprised to see a >10% unemployment reading by the end of 2009 should the Big 3 automakers all file for bankruptcy.

That is not my “base case,” however.  As I discussed last week, there is significant political backing for some kind of bailout for the Big Three automakers.  One can see this with the lack of dissent to the government's more generous lifeline to AIG, the widespread support among US citizens for some kind of Big 3 bailout, and Obama's talk of doing “whatever it takes” to revive the US economy and to not worry about the budget deficit “next year or the year after.”   As we discussed in last weekend's commentary:

Fortunately (for the bulls), unlike the Japanese, Americans shaping our policies (baby boomers, the X-gens, and the Y-gens who have seen nothing but inflation – and the latter credit cards as opposed to cold, hard cash) will not tolerate or allow a Japanese 1990s-style deflationary bust.  Immediately after the 777.68-point decline in the Dow Industrials on September 29th, sentiment immediately shifted in favor of the TARP.  From a populist standpoint, the government's $125 billion recapitalization of the nine largest banks in the US also went surprisingly well.  We have also not heard a single objection to the possible appointment of current NY Fed Governor Timothy Geithner as US Treasury Secretary under the Obama administration – even though Geithner is regarded as one of the most dovish Fed governors in Federal Reserve history.  And this just in: The US government is now set to revise its $85 billion lifeline to AIG – giving them far more generous terms, benefit AIG's shareholders in a major way.  More significantly, this will encourage US investors to come back into the equity and debt markets and to help recapitalize the US financial system.

In other words, US citizens have now given the “green light” to the Federal Reserve and the Treasury Secretary to “inflate at all costs” to rejuvenate the world's largest economy.  Already we're talking about a second, if not a third round of fiscal stimulus.  A strategy that epitomizes the willingness to “inflate at all costs” is the recent expansion of the Federal Reserve's balance sheet.  Over the last two months, the Federal Reserve has been “printing money” like there is no tomorrow…

Thankfully, there is now some evidence that liquidity conditions are finally easing.  Back in mid October – when we were chronicling the demise of the “institutional model,” the TED Spread (the difference between three-month LIBOR and three-month Treasury yields) was making 34-year highs.  Since then, the TED spread has declined by 300 basis points and is now back to levels prior to the demise of Lehman Brothers, as shown in the following chart chronicling the five-day moving average of the Ted Spread from January 1998 to the present:

5-Day Simple Moving Average of the TED Spread (January 1998 to Present) - The TED spread hit a 34-year high last month as the *institutional model* completely broken down with the demise of Lehman Brothers. Since then, however, it has declined back to the 2.5% level thanks to further global central bank easing and liquidity injections.  There is no doubt the Fed would like to see this back below the 2.0% level, but for now, this decline in the TED spread should be a tailwind as opposed to a headwind for global financial and equity markets.

Aside from easing conditions in the US and developed world's money markets, we are also seeing signs of easing in the emerging world's money markets, as shown in the following chart courtesy of


Thanks to swap lines from the Federal Reserve and the European Central, sovereign credit spreads in emerging markets have eased over the last five weeks.  With the IMF promising to lend to more countries with less strings attached, I do not expect emerging market sovereign spreads to hit a new high.  What I would like to see over the next few weeks is: 1) More and larger swap lines from the Federal Reserve and the European Central Bank, especially to the Reserve Bank of India, 2) The creation of a Yen swap line by the Bank of Japan to ease Yen funding to emerging market countries and investors alike, and 3) More aggressive easing from the European Central Bank, with at least a 50 basis point move in the next few weeks.

Furthermore, we are also now seeing a meaningful thawing in the asset-backed commercial paper market.  For the first time since August 2007 (right before the implosion of the Bear Stearns' subprime mortgage hedge funds), the amount of asset-backed commercial paper outstanding increase three weeks in a row, as shown in the following chart courtesy of ABS Market Statistics:

Asset-backed commercial paper outstanding

Given that the “shadow banking system” (as coined by PIMCO's Paul McCulley) has been responsible for much of the credit/liquidity generation over the last five years, such a thawing in the commercial paper market is a very significant development.  Furthermore, despite the fact that commercial banks have indicated that they will tighten credit, we are still seeing meaningful year-over-year growth in loans and leases held under bank credit, as illustrated by the following chart:

Year-Over-Year Change in Loans and Leases Held Under Bank Credit (January 1948 to October 2008) - Four of the last six recessions over the last 60 years were preceded by a significant plunge and a subsequent dive to the zero line in the growth of loans and leases held under commercial bank credit. So far, we have not see much evidence that commercial banks are shrinking their balance sheets dramatically - but from the spike in credit spreads and continuing write-downs, it is obvious that the *shadow banking system* has been actively shrinking its collective balance sheet.

Note that year-over-year growth in loans and leases outstanding in the commercial banking system grew 8.85% during October – a rate of increase not seen since June!  Of course, much of this is due to companies tapping their previously agreed upon credit lines, but at the same time, we are still seeing strong year-over-year growth in real estate and consumer lending by commercial banks.  This is very encouraging, indeed, and shows that the recent bank recapitalizations and easing of monetary policy is not totally incompetent.  Again, I now believe we are seeing significant signs of easing credit.  Assuming none of the Big 3 automakers file for bankruptcy, my sense is that the global equity markets should have already bottomed and should rally into Christmas and early next year.

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 November 14, 2008) - For the week ending November 14th, the Dow Industrials declined 446.50 points, while the Dow Transports declined 171.60 points. Although the jury is still out, it looks like both the Dow Industrials and the Dow Transports mounted a successful retest of its October 10th and October 27th lows last Thursday. Immediate resistance levels are the Dow Industrials' and the Dow Transports' closings last Thursday (8.835.25 and 3,692.57, respectively). Note that the Dow Transports has continued to exhibit relative strength over the last five weeks. Given that the Dow Transports has led the broad market since October 2002 - and given more global central bank easing and coordination going forward (as implied by the G-20 statement this week), there is a good chance that global equity markets have already made a solid and tradeable bottom. Coupled with the immense amount of capitulation and very decent valuations across the world - I continue to expect both the broad market and the Dow Industrials to enjoy a rally lasting into Christmas. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending November 14, 2008, the Dow Industrials declined 446.50 points while the Dow Transports declined 171.60 points.  While both Dow indices exhibited weakness last week, it is good to see them mounting successful retests of their October 10th and October 27th lows last Thursday.  Moreover, the Dow Transports again exhibited relative strength, as it has done so for the last six weeks and ever since the current credit crisis began.  Given that the Dow Transports has lead the broader markets since October 2002, and given that the G-20 countries have committed to more easing, my sense is that the stock market has mounted a successful retest and should rally from 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 increased from -14.3% to -12.8% for the week ending November 14, 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 November 14, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios increased from -14.3% to -12.8%. While bullish sentiment jumped in the last two weeks, this does not mean that investors have capitulated to the bull side. Rather, subscribers should note that a reversal from a very oversold sentiment level has typically been one of the most reliable signals preceding and accompanying a major rally.  While sentiment can indeed get darker again, my sense is that the market has hammered out a capitulation bottom. For now, we will remain 100% long in our DJIA Timing System.

With the four-week moving average of our popular sentiment indicators reversing from a historically oversold reading of -21.5% (note that the ten-week moving average, not shown, has also now reversed to the upside), chances are that the stock market has hammered in a bottom as long as the federal aid is provided to the Big 3 automakers before the end of this year.  Combined with the depressed global valuations, the recent correction in commodity prices, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, 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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting its most oversold level in six months a few weeks ago, the 20 DMA of the ISE Sentiment Index has reversed to the upside, and has now broken above its 50 DMA. More importantly, relative to levels over the last five years, both the 20 and the 50 DMAs are still at very oversold levels (the 50 DMA is now at its most oversold level since early May), signaling that sentiment is much closer to a bottom than a top. Given the immense selling in the global stock market in the last five weeks - combined with unprecedented public policy action all over the world - my sense is that the stock market has hammered out a capitulation bottom and should rally into Christmastime.

Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early October, the 20 DMA has reversed to the upside and has convincingly broken above the 50 DMA.  Moreover, as discussed in the last four weeks, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are still 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, and assuming that the G-20 countries commit to more easing policies going forward, I believe the stock market has successfully retested its lows last Thursday and should now rally into Christmas and the beginning of 2009.

Conclusion: As the hits continue to come – the latest being a potential cash/liquidity crunch at the Big 3 automakers – global policy makers are vowing to stay on top of things and to continue to ease monetary and fiscal policies over the next few months to tackle the ongoing credit crisis.  Fortunately, as indicated by the recent decline in the TED spread, sovereign EM credit spreads, and the latest spike in asset-backed commercial paper outstanding and loans and leases held under bank credit, it now looks like credit conditions are finally starting to ease.  Going forward, I expect the federal government to intervene and to bail out the Big 3 automakers (most notably GM) and for the world's central banks to continue to ease into Christmas.  Again, I believe the stock market made a successful retest of its lows late last week and is now set to rally into Christmas and early 2009.

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.  Over the intermediate term, I am still bullish on gold miners – specifically, the GDX.  Given the announcement and the recent clarification of the Chinese fiscal stimulus, I also expect a short-term bounce in commodities for the next four to six weeks.  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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