Valuations Too Compelling to Ignore
(November 23, 2008)
Dear Subscribers and Readers,
The “Skyscraper Indicator” has struck again. Construction on the 1,968-foot Russia Tower (more than 200 feet taller than the Sears Tower) has halted, as developer Russian Land cannot find the means to pay for it or the tenants to fill it once it is complete in light of the global credit crunch. Make no mistake: The Skyscraper Indicator is not a coincidence – and is in fact, bounded in logic. Throughout modern history, societies have tended to build super-tall structures after a long period of prosperity and unprecedented success. Part of it is vanity, and part of it is complacency, but most of all, it is a monument to its success and signals that the society has “arrived.” More often than not (as poster rffrydr suggests), it leads to a reversal of the society's fortunes. A rather brief list of examples includes: The Empire State Building (plans finalized in 1929), Sears Tower (1969 - signaling not just the peak of the US stock market but also Sears the company), Malaysia's Petronas Towers (immediately preceding the Asian Crisis), the new Enron and Calpine buildings in the early 2000s, "The Cheesegrater" in London, and the Crown Las Vegas (2007). My next (and very obvious) guess? Definitely Dubai.
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 4,125.58 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 3,816.58 points as of Friday at the close.
Last Thursday, former hedge fund manager and prolific author Andy Kessler penned a Wall Street Journal article asserting why it may be prudent to defer stock purchases until February, due to ongoing liquidation of equities across the board. Specifically, Mr. Kessler details why the stock market will continue to be under pressure due to: 1) tax-loss selling, 2) mutual fund redemptions, 3) mutual fund capital gains distributions, 4) hedge fund redemptions, and 5) ongoing margin calls.
Don't get me wrong. I have been a general fan of Andy Kessler's writings and definitely respect his opinions. His points are very well taken. However, it is during times of great “inefficiency” and illiquidity that courageous and long investors make the most money over the long run. No doubt, there will be more tax selling over the next six weeks. Unfortunately, there is no way to track how much impact it will have on the equity markets. Secondly, I also want to question the magnitude of its impact, given: 1) the tax-loss selling that we already experienced (as exemplified by the recent spike in trading volume experienced by discount brokers), 2) the fact that the majority of retail investors no longer buy individual stocks, but rather mutual funds, and 3) the lack of its impact on stock prices during the last six weeks in 2001 and 2002, when the last bear market was still in full swing (and when more retail investors dabbled in individual stocks).
As for mutual fund redemptions, note that equity mutual fund cash levels as of September 30, 2008 was 4.7%, the highest level since June 2003, as shown in the following chart:
Obviously, this did not stop mutual fund redemptions from creating more havoc during October, but my sense is that mutual fund managers should now have sufficient cash to meet redemptions for the rest of the year. We will have the October month-end data by the end of this month (per ICI), and will update on this site accordingly. While I have been worried that newly-unemployed folks will liquidate their 401(k) or 403(b) accounts to fund their living expenses, Thursday's extension of unemployment benefits by President Bush should help alleviate any short to intermediate term selling pressure that arises out of this phenomenon.
Regarding hedge fund liquidations, Goldman Sachs recently estimated hedge funds' net long exposure in the US stock market to be around 17% as of September 30th, down from a 47% net long exposure a year ago and from 32% as of June 30, 2008. Since then, there has no doubt been further deleveraging by hedge funds (both to avoid further losses and to meet redemptions), as exemplified by the significant overperformance of Goldman's "least concentrated HF ownership basket" versus its "most concentrated HF ownership basket" (outperformance of 10% in 3Q and 9% during 4Q thus far). Given the deleveraging during 4Q so far, my sense is that hedge funds' net long exposure of US equities is now at 0% or even lower. At this point, I also believe that hedge funds are sitting on enough cash to meet redemptions over the next couple of months. Of course, I would not be surprised to see more hedge funds close shop in 2009, as many of them will not be able to cover their costs as assets dwindled (and given their high watermarks). At first glance, this could mean more liquidation but keep in mind that net long exposure is very minimal at this point (so hedge funds that liquidate will find themselves selling an amount of long positions equivalent to the amount of short positions that they are covering).
Finally, margin calls are more or less tied to hedge fund liquidations and the accounts of retail investors. As I mentioned, cash levels at hedge funds are now at all-time highs and should be sufficient to cover not just redemptions, but margin calls as well. Unfortunately, margin debt numbers for the end of October are still not available. They should be available sometime this week - I will post this in our mid-week commentary or on our discussion forum once it is updated by the NYSE and the NASD.
I feel we are getting very close to the end of the global liquidation, assuming Citigroup is rescued immediately (news flash: The federal government has agreed to take unprecedented steps to stabilize Citigroup by injecting $20 billion in preferred equity and guaranteeing over $300 billion in troubled assets weighing on the bank's books) and assuming Treasury Secretary Paulson reverses his decision last week not to tap into the second piece of the $700 billion TARP bailout pool. That being said, the latest volume and breadth data still show significant selling pressure, so we could still see some short-term weakness. I am currently reading up on as many industries as I can (more than 40 in all) in order to find long-term competitive advantages for certain companies or industries. In a sense, this is a blessing in disguise for well-managed companies in highly competitive industries, as many firms who were only marginally profitable (and who were pressuring ROEs for everyone in their respective industries) are now going out of business. Assuming the US does not experience a long recession, many industries (even retailers and restaurants) may be able to experience outsized profits for an extended period of time, as many lenders will be reluctant to lend to marginally profitable businesses for years to come. Best Buy in the consumer electronics industry is one example, as I discussed a couple of weeks ago (disclosure: I am currently long Best Buy).
There are also underlying forces developing in both the US and global economy that will drive much greater economic and productivity (Schumpeterian) growth over the next 5 to 15 years. Ongoing research in the biotechnology, high-performance computing (Nvidia just released a four-teraflop $10,000 “supercomputer on a desktop” machine that will democratize and bring high-speed computing to small and mid-size businesses and dramatically lower R&D costs across the US economy) , and nanotechnology industries are all yielding incremental (but ultimately highly impactful) advances. On a more immediate basis, look for the production of cellulosic ethanol to be commercialized as early as 2010 and for solar power to reach “grid parity” in parts of California and Texas as early as 2012 (assuming crude oil and natural gas prices move back to their 2006 to 2007 levels). Moreover, years and billions of R&D are now yielding significant advances in the field of personalized medicine – specifically on cancer treatment. The mapping of the human genome has not been in vain after all – even though early promises in rapid and effective drug development were not realized. Such advances in the use of genetic biomarkers is directly attribute to the knowledge gained from mapping of the human genome and would result in much more effective cancer and other disease treatments.
More importantly, the incoming Obama administration has promised more federal government funding for basic research in many fields, including a doubling of the NIH's and the NSF's budget over the next ten years – a radical departure from the Bush administration when federal investment in basic research in science declined for five straight years (also note that Bush did not confirm his chief science advisor, Dr. John Marburger, until 10 months into his first term). These underlying innovative forces in the US and global economy – as well as a heavy emphasis on scientific innovation by the new administration (especially after years of relative under-funding) – should greatly expand the potential of the US and global economy over the next 5 to 15 years. This should also greatly increase the earnings potential of the companies within the S&P 500, if not the MSCI World Index. As the value of the S&P 500 is ultimately tied to both current earnings and long-term earnings power, I am optimistic on both the US and the global stock markets, despite the current downturn in the global economy.
Of course, no analysis of the stock market is complete without a discussion on valuations. Driven by the unprecedented liquidation of global equities and other risky assets over the last two months, the dividend yield of the S&P 500 is now greater than the ten-year Treasury yield. The last time we have witnessed such a positive yield spread was August 1958 – or more than 50 years ago – as shown in the following monthly chart:
Even assuming the stock market does not move anywhere over the next ten years, it is still more profitable to invest in the S&P 500 than ten-year Treasuries. Moreover, if one is investing via a taxable account, then buying the SPY is much more profitable (i.e. tax efficient) – especially if one is in a high tax bracket – as the SPY (the ETF for the S&P 500) has not paid a capital gains distribution in the past ten years (it adopts a strategy where it is able to consistently increase its cost basis year in and year out). Assuming one is with a good broker and does not need the cash for at least three years, then choosing to buy either the SPY or parking the money into a taxable CD is a no-brainer at this point.
The extremely compelling valuations in the US stock market are also evident on a price-to-book value basis. Specifically, the P/B ratio of the Dow Jones Industrial Average is now at a mere 2.23, its lowest level since January 1991 (immediately preceding the great nine-year bull run in the US stock market) – as shown in the following weekly chart:
Given the most compelling valuations in at least two decades (if not five decades) – and given the productivity/Schumpeterian Growth forces that should be unleashed within the next 5 to 15 years – I sincerely believe that this is now the buying opportunity of our generation. Once the money and financial markets right themselves, the investment bankers and the venture capitalists (the conduits for investment capital) should come back with full force. The Y-gens would subsequently experience their own “bull market of their lifetimes.”
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 March 2003 to the present:
For the week ending November 21, 2008, the Dow Industrials declined 450.89 points while the Dow Transports declined 371.67 points. While both Dow indices broke through their October 10th and October 27th lows last week as a result of continuing global deleveraging/liquidation forces, I am still encouraged – as both hedge fund redemptions and investors' tax loss selling should abate greatly sometime over the next few years (not to mention the fact that the US government has just put a cushion under part of Citigroup's balance sheet in order to stem further liquidation in banks' balance sheets). Sure, the stock market can still retest or break through last week's lows, but given the compelling valuations in global equity markets and emerging global innovative/Schumpeterian growth forces, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis. We will remain 100% long in our DJIA Timing System (we would've moved to 150% long but the rules of our System does not allow us to do that).
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:
With the four-week moving average of our popular sentiment indicators reversing from a historically oversold reading of -21.5%, chances are that the deleveraging and liquidation forces are starting to abate – the latest travails of Citigroup notwithstanding. Combined with the compelling global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, I highly believe this is the buying opportunity of our generation, even though we could possibly retest or break through last week's lows. 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 most recent bottom of the 20 DMA of the ISE Sentiment Index in early October, the 20 DMA has reversed to the upside and is currently still above the 50 DMA. Moreover, as discussed in the last five weeks, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are still at oversold levels that are synonymous with a near 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 is now presenting itself as a once-in-a-generation buying opportunity. As long as one is under the age of 60 and is in a reasonable state of health, then one should be buying US equities aggressively with one's long-term savings.
Conclusion: As we discussed last week, it looks like credit conditions are finally starting to ease – as indicated by the recent decline in the TED spread, sovereign EM credit spreads, and the stabilization of the asset-backed commercial paper market. Outstanding loans and leases held under bank credit have also continued to grow. With the latest $20 billion equity injection into Citigroup and the government's insurance of more than $300 billion of a variety of the bank's assets, credit conditions should continue to ease in this upcoming week. While there will be ongoing liquidation pressures stemming from tax loss selling and hedge fund redemptions, I expect these forces to be relatively benign. More importantly, the compelling valuations in the US equity market are now too much to ignore. For those with a long-term timeframe, this represents the greatest buying opportunity of our generation.
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. We will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA