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2008 3Q Flow of Funds Update

(December 21, 2008)

Dear Subscribers and Readers,

First of all, I want to wish all our subscribers a merry Christmas (or Happy Holidays for those who don't celebrate Christmas)!  2008 has been one of the most eventful years in financial market history.  In many ways, this has been one of the most frightful experiences since the early 1930s for investors around the world.  It has certainly been an educational experience for us as well.  While we were steadfastly bearish on commodities during this summer, we erred by not anticipating the immense liquidation of global equities immediately after the Lehman Brothers bankruptcy.  True – the balance sheets and cash flows of most major corporations around the world remained relatively healthy (compared to past downturns), but the near-destruction of the global financial system – along with severe investment losses incurred by hedge funds, pension funds, foundations, and endowments – led to a dramatic increase in risk aversion by institutional and retail investors.  Agency mortgage-backed securities sold at a 200 basis point spread to Treasuries, despite an explicit guarantee from the US federal government.  Asian convertible bonds sold off even more than they did during the 1997 to 1998 Asian crisis, even though many companies were still reporting healthy cash flows (conversely, during the Asian Crisis, many companies literally went belly up).  In other words, the dramatic decline in equity value over the last few months has as much to do with a “buyer's strike” as with a dramatic slowdown in the global economy.

I now want to say “thank you” to our subscribers who have stuck with us in the latter part of this year as, contrary to our views, the US and global stock markets embarked on one of their most frightful declines in history.  In terms of the speed and magnitude, the mid September to late November liquidation definitely ranks as one of the most ferocious declines of all time – right up there with the early September to mid November 1929 crash, the 30% decline in the Dow Industrials during September 1930, the October 1987 crash, and the initial unwinding of the Japanese stock market bubble from January 1990 to August 1992.  I am truly grateful for the advice, dialogue, and the encouragement over the last six months.  As the calendar shifts to 2009, I anticipate working harder than ever to bring the most original thoughts and investment ideas to you all – and I sincerely want to thank you for staying with us as we chart towards an era of great uncertainty over the next 12 to 18 months (this new era of uncertainty will bring both danger and opportunities).  All the best to every one of you and your family in 2009!

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 3,592.89 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 3,283.89 points as of Friday at the close.

Let us now discuss the latest 2008 3Q Flow of Funds update from the Federal Reserve.  We last discussed the Flow of Funds report (as of 2007 4Q) in our March 23, 2008 commentary.  The Flow of Funds report is a quarterly publication from the Federal Reserve outlining all kinds of statistics for the U.S. economy (such as typical balance sheet and income statement data) and is broken down into the household, non-profit, corporate, and government sectors.  In essence, this publication is the “10-Q of the U.S. economy” and is therefore one of the most important documents that are published on the U.S. economy on a quarterly basis (even though it is somewhat backwards-looking since the data isn't usually released until nearly three months after the fact).  I want to focus on the balance sheet of U.S. households in this commentary – starting with a chart showing the absolute amount of net worth of U.S. households vs. their asset-to-liability ratio from 1Q 1952 to 3Q 2008:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 3Q 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 5.32 at the end 2007, to merely 4.88 today... 5) Household net worth declined by a massive $2.81 trillion during the third quarter - representing the greatest quarterly destruction of wealth in US modern history and on a year-over-year basis.. At the end of the third quarter, household net worth has declined by $7.09 trillion since its peak at the end of 3Q 2007. 6) The *dip* in net worth caused by the October 1987 stock market crash.

As mentioned on the above chart, total U.S. household net worth declined $7.09 trillion (or 11.14%) on a year-over-year basis to $56.5 trillion as of September 30, 2008, down from an all-time high of $63.6 trillion as of September 30, 2007.  Since September 30th, the world's equity and real estate markets have continued their free fall – meaning that total wealth destruction (measured in domestic terms) could be well over $10 trillion by the end of this year.  In a debt-laden economy such as the modern American economy, the last thing the Federal Reserve wants is a declining net worth, as this could easily trigger a deflationary depression.

On the surface, the US economy/households seem to be in dire straits, as US households' asset-to-liability ratio sank to an all-time low of 4.88 and as US households' net worth continues to decline.  A closer examination of the Flow of Funds statement, however, tells a different story.  As of September 30, 2008, the Fed's Flow of Funds statement indicates that US households' total liabilities rose from $14.15 trillion to $14.57 trillion on a year-over-year basis.  Obviously, this does not jive with what we have been witnessing in the financial markets over the last 12 to 18 months, as total write-downs of both mortgage and other asset-backed securities have so far totaled slightly more than $1 trillion.  Digging deeper into the Flow of Funds statement, we see that US households' home mortgages liabilities also increased from $10.41 trillion to $10.57 trillion during the same time period.  With hardly any new mortgage loans made over the last 12 months, this disparity between the Flow of Funds statement and the mortgage write-downs in the financial market can only mean one thing: The vast majority of households are still current with their mortgage payments, even as investment banks, hedge funds, and pension funds are being forced to “mark to market” their mortgage holdings.  Indeed, as a BlackRock portfolio manager recently claimed, the $30 billion Bear Stearns mortgage portfolio that is backed by the US government is still generating cash flow as initially expected.  Despite this, the Fed has been forced to write down this portfolio by $2 billion, due to its adherence to mark-to-market accounting.

In other words, the current asset-to-liability ratio of 4.88 is clearly understated.  If we adhere to mark-to-market accounting and write down $1 trillion worth of household liabilities, the asset-to-liability ratio rises back to 5.24 – a level comparable to its level at year-end 2007.  Conversely, if households remain current on their mortgage payments, financial institutions will ultimately “write up” their mortgage portfolios. Total assets will then increase by more than $1 trillion, given the many money multiplier effects stemming from a $1 trillion increase in banks' liquidity/equity.  My guess is that the market will eventually experience a combination of both households' liability write-downs and financial institutions' write-ups – suggesting that the amount of leverage on US households' balance sheets is currently overstated.  In the meantime, I expect to see more deleveraging within US households as unemployment continues to rise into the summer of 2009.  Over the longer-run, such deleveraging would be healthy for our economy, as both the current account deficit and household debt growth would decline. 


As I have covered many times recently, US stock market valuations remain very compelling.  Driven by the unprecedented liquidation of global equities and other risky assets over the last few months, the dividend yield of the S&P 500 exceeded the ten-year Treasury yield (for the first time in 50 years) last month and has since risen to a new 50-year high.  The last time the yield spread was at similar levels was June 1958 – or more than 50 years ago – as shown in the following monthly chart:

Dividend Yield Spread of S&P 500 over the Ten-Year U.S. Treasuries (April 1953 to December 2008*) - The diviend yield spread of the S&P 500 over the 10-year Treasuries closed at a new 50-year high reading of 0.99% last Friday. More importantly, the S&P 500 dividend yield is for the most part sustainable, as companies within the S&P 500 are generally flush with cash and have chosen to curb stock buybacks to conserve cash and to preserve the dividend.

Given such compelling valuations– and given the unprecedented global reflation efforts by our policy makers – I sincerely believe that this is 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.”  For now, however, we should be prepared for a bleak Christmas and for the unemployment rate to continue its ascent into at least the summer of 2009.

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (March 1, 2003 to December 19, 2008) - For the week ending December 19th, the Dow Industrials declined 50.57 points, while the Dow Transports rose 144.03 points. For now, it looks like global liquidation pressures are easing, given the >$20 billion bailout package (including US$3.29 billion from the Canadian government) for the Big Three automakers, the Fed's *quantitative easing* policy, the promise by the Bank of Japan to provide more liquidity to its corporate bond market. Over the longer-run, however, we will continue to be vigilant, given ongoing deleveraging in central and eastern Europe, along with deleveraging in the weakest companies in the US economy, such as newspaper publishers (Sam Zell's Tribune just filed for bankruptcy last week), certain retail stores, and highly indebted energy companies. However, with the immense amount of capitulation and very compelling valuations across the world - I believe we are now experiencing one of the greatest buying opportunities of our generation. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending December 19, 2008, the Dow Industrials declined 50.57 points while the Dow Transports rose 144.03 points.  With the US and Canadian government's $20 billion bailout of GM and Chrysler late last week, and with the Federal Reserve and the Bank of Japan both adopting a “quantitative easing” policy, global liquidation pressures should continue to ease into Christmas time.  I also continue to believe that the vast majority of the world's central banks (with the glaring exception of the European Central Bank) would do everything in their power to stem the liquidation pressures in the financial markets.  While there are still landmines in various emerging market countries (such as Russia and most of central and eastern Europe) and individual stock investments, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis, given the most compelling valuations in the US equity market in decades and the emerging innovative/Schumpeterian growth forces that will inevitably be unleashed in the next 5 to 15 years.  We 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 -18.6% to -15.5% for the week ending December 19, 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 December 19, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios increased from -18.6% to -15.5%. The latest reversal in bullish sentiment is a good sign for the bulls, as the market has typically performed well when this sentiment indicator reverses from an extremely oversold condition. Moreover, the 10-week MA (not shown) hit its most oversold level since early September 2002 two weeks ago, and has also since reversed to the upside. While sentiment can indeed get dark again, my sense is that global liquidation/deflationary pressures are now abating - suggesting that selling pressure has or will peak soon. For now, we will remain 100% long in our DJIA Timing System.

With the four-week moving average of our popular sentiment indicators declining to -18.6% last week and reversing back to the upside this week, chances are that the stock market will continue to rally into year-end, as the stock market has typically performed well when this sentiment indicator reverses direction from an extremely oversold condition.  Moreover, the ten-week MA has also reversed to the upside, after hitting an extremely oversold condition just two weeks ago – thus providing more “evidence” of further strength in the stock market over the next week or so.  Again, given the rescue package provided for the Big Three automakers, 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 believe this is the buying opportunity of our generation, even though we could possibly retest the late November lows over the next few months.  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 recent lows in mid October, both the 20 DMA and the 50 DMA of the ISE Sentiment Index have reversed to the upside (with the 20 DMA crossing above the 50 DMA in late November) - suggesting that the up trend in bullish sentiment is still infact. More importantly, relative to levels over the last five years, both the 20 and the 50 DMAs are still at slightly oversold levels, signaling that bullish sentiment still has potential to move up over the next few weeks . Given the immense liquidation in the global stock market in the last three months - combined with unprecedented public policy action all over the world - my sense is that the selling pressure in the US stock market is finally abating.

Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early to mid October, both the 20 DMA and the 50 DMA have reversed convincingly to the upside.  Historically, a reversal of the ISE Sentiment index from an immensely oversold level has been the most powerful indicator for an upcoming or a continuation of a rally.  While both the 20 DMA and the 50 DMA are bumping up against their most recent resistance levels, subscribers should note that they are still at slightly oversold levels relative to their historical readings over the last five years. Combined with the oversold level in our other sentiment indicators, extreme valuations and oversold levels in the equity markets, as well as an unprecedented global bailout package (note the Irish government just committed a 10 billion Euro bailout to its banking industry today), and assuming that the G-20 countries commit to more easing policies going forward, I believe US equities now present 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: While US households are still mired in a deleveraging phase, there is no doubt that the latest Flow of Funds data as published by the Federal Reserve is overstating the amount of leverage within US households.  While I believe US households (and certain countries and corporations) will deleverage further into the summer of 2009, this is no doubt a healthy development for the US economy over the long-run, as this would bring down the current account deficit, repair households' balance sheets, and provide a sound basis for the next US economic boom.  In the meantime, the Fed's unprecedented expansion of its balance sheet will provide the US economy a much “softer landing” than it otherwise would have under a classic “boom/bust” scenario.

Going into the end of the year, I expect global liquidation pressures to ease further, given the announced bailout of the Big Three automakers and the willingness of global policymakers to ease monetary policy and to provide fiscal stimulus.  More importantly, the compelling valuations in the US equity market are now too difficult to ignore.  For those with a long-term timeframe, this represents the greatest buying opportunity of our generation.  I am still 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.  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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