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Deleveraging Gets a Reprieve

(November 27, 2008)

Note: There will be no “full-blown” commentary this weekend, as I will be taking some much-needed time off for the Thanksgiving holiday weekend.  In lieu of a full-blown commentary, I may send an “ad hoc” email to you, dear subscribers.  Please also watch for continued updates and comments in our discussion forum.

Dear Subscribers and Readers,

For all our American subscribers, I want to wish you all a happy and safe Thanksgiving holiday.  I realize 2008 has been a difficult time for the vast majority of you.  While the US and global economy will experience more jitters and weakness in 2009 (I expect unemployment to peak at 8% to 9% sometime over the next 12 to 18 months), I continue to believe that we are in the midst of the greatest buying opportunity in our generation.  Obviously (especially with the recent downdraft in commercial real estate), the deleveraging within pockets of the US economy isn't over yet, but as I've mentioned before, this shakeout was necessary.  It is a “cleaning house,” if you will – as many companies who have no right to exist (in a market devoid of cheap financing) will finally get the boot.  Over the longer run, this will create higher margins for well-run companies – possibly even those in the highly competitive restaurant and automotive industries.

As I mentioned in our last weekend's commentary, I believe that hedge fund and retail investor liquidations were getting to their final stages – at least for this cycle.  Unfortunately, neither the NYSE nor NASD has been able to publish end-month October margin debt data (one of the best indicators for hedge fund and retail investor liquidation) at the time.  Four weeks after the end of October, the NYSE and the NASD have finally gotten around to publishing the data.  As seen in the following monthly chart showing the Wilshire 5000 versus the 3-, 6-, and 12-month change in margin debt, there has been a great deal of liquidation of margin debt during October alone:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to May 2008)

Over the last three months, the total amount of margin debt outstanding declined by approximately $80 billion – the great 3-month margin debt liquidation in history!  Over the last six months, total margin debt outstanding declined by approximately $70 billion – its greatest six-month decline since the six months ending April 2001.  Over the last 12 months, total margin debt outstanding declined by approximately $114 billion – its greatest 12-month decline since the 12 months ending March 2001.  No matter how you slice and dice the numbers, there is no getting around the fact that this latest decline in margin debt represented one of the great periods of deleveraging/liquidation in modern history!  Given the market action in November so far, my sense is that margin debt outstanding declined still further during November.  Unfortunately, we will probably have to wait another four weeks for the November margin debt data to be released.

As for mutual fund redemptions (another topic that we discussed in our weekend commentary), the latest ICI data shows that investors cashed out more than $72 billion from equity mutual funds in October, up from $56 billion in September.  On a year-to-date basis to month-end October, net cash outflows from equity mutual funds totaled a record-breaking $195 billion!  As of October of last year, equity mutual funds actually received a net cash inflow of over $100 billion on a year-to-date basis!  Given the historic cash outflows from equity mutual funds on a YTD basis, and given further redemptions during November, it is more than likely that any further mutual fund redemptions (due to tax loss selling) will have a minimal impact on the market for the rest of the year.  This argument is backed up further by the following chart showing the latest equity mutual fund cash levels as of October 31, 2008:

Monthly Equity Mutual Fund Cash Levels (January 1996 to October 2008) - Cash levels at equity mutual funds spiked to 5.3% at the end of October - its highest level since April 2002!

As mentioned in the above chart, cash levels at equity mutual funds spiked to 5.3% as of the end of October – representing its highest level since April 2002!  Given the redemptions we have seen so far ($195 billion YTD as of October 31, 2008), and given the large cash cushion at equity mutual funds, it is highly unlikely that any further tax-loss selling will have a meaningful impact on the stock market for the rest of this year.  For now, the ongoing deleveraging in both the financial markets and US economy will most likely get at least a temporary reprieve.

As I am writing this, we learned that the People's Bank of China just enacted its fourth interest rate cut since September.  The interest rate cut of 1.08% exceeded nearly all expectations and represents the Chinese central bank's largest rate cut in 11 years.  While this will no doubt spur lending in the Chinese economy, what bears watching was the Feds' latest announcement on Tuesday morning – promising to purchase $500 billion in agency MBS and $100 billion in agency debt in the secondary markets.  The $500 billion purchase of agency MBS represents 10% of the entire agency mortgage-backed securities market and should significantly bring in fixed-rate 15-year and 30-year mortgage rates.  Not surprisingly, the average 30-year conforming rate has already declined by approximately 50 basis points since Monday evening, as shown in the following chart courtesy of the Wall Street Journal:

Government acts to boost consumer lending and lower mortgage rates

Already, mortgage brokers and bankers have reported a significant spike in mortgage refinancing and financing activity.  The combination of this announcement, the Chinese interest cuts, the Citigroup mortgage, the six-year high in equity mutual fund cash levels, and the latest historic decline of margin debt outstanding – all suggest that we are close to the final stages of the deleveraging that we have witnessed in the financial markets over the last 18 months.  At the very least, we should see a temporary reprieve for the next few months.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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