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A Dislocation in Europe?

(February 1, 2009)

Dear Subscribers and Readers,

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 4,171.14 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 3,862.14 points as of Friday at the close.

The deleveraging in the US retail industry continues – as Home Depot decides to close all 34 of its money-losing upscale Expo stores (which never did well even during the housing boom) – reducing headcount by 7,000 people, and as Williams-Sonoma reduces its company staff by 1,400 positions, in a bid to cut overhead costs by $75 million.  The New York Times ran a story this weekend entitled “Our Love Affair With Shopping Malls Is on the Rocks” – it is an amusing read.  Within another part of the consumer discretionary sector – the casual dining industry – we also learned a couple of weeks ago that the parent company of Black Angus Steakhouse restaurants (69 in all, with 3,600 employees) filed for Chapter 11 bankruptcy.  At this point, there is no word on what will happen to the chain, although I highly doubt that most of these restaurants will be operating (most of them are located in the epicenters of the US mortgage crisis) by the summer.  At some point, perhaps later this year, the most profitable, efficient, and the best brand names within the retail and the restaurants industries will be a good long-term (3 to 5 years) buy as the competition dwindles, but for now, we are still sitting on the sidelines (with the exception of our Best Buy purchase back in late November/early December).

In our latest mid-week commentary, we promised that we would devote some space to Europe, as we believe that for now, the “Black Swan” scenario still lies within the region.  Our timing could not be better – as the European Central Bank has indicated that it is in the midst of drafting “bank bailout” guidelines for the governments within the Euro Zone (that means the ECB is anticipating more bailouts in the region soon).  Since the financial market in the Euro Zone is less deep than that of their counterparts in the US and UK, any government-financed bailout of its banks should have (relatively) more of an impact on domestic liquidity.  That is, while banks in the US are still (in general) lending, any liquidity creation within the US is being offset by the shrinkage in the asset-backed securities market, the commercial paper market, and the deleveraging within Goldman's, Morgan Stanley's, and the hedge funds' balance sheets.  Paradoxically (and this is even more true within Japan and China), the fact that the Euro Zone had a “less developed” financial market means that they have been less vulnerable to a systemic crisis – at least one that cannot be quickly stemmed by the government.

But as always – both in economics and in real life – not all is what they seem to be.  Taking a closer look at the balance sheets of banks in the Euro Zone, it is obvious that many banks are overextended.  That is, they have lent out sums to foreign borrowers that have exceeded their governments' ability to bail them out.  For example, both the banks headquartered in Netherlands (e.g. ING) and Belgium (e.g. Fortis, KBC, etc.) have foreign exposure of approximately 300% of their GDPs, as shown in the below chart, courtesy of the BIS and the OECD:

Foreign exposures of domestically headquartered banks

We would have to wait for the ECB's latest guidelines to obtain a clearer view, but should a “systemically important” bank based in Belgium or the Netherlands fail, then it may be beyond the ability of those governments to bail them out.  In such a scenario, it would make more sense for other sovereign governments to bail out their foreign subsidiaries, similar to what the Canadian and the German governments did for General Motors.  Under the current charter, the European Central Bank has no obligation to bail out banks within the Euro Zone – or for that matter, sovereign governments (this is the main reason why Euro-denominated bonds issued by the Italian government have been selling off relative to their German counterparts).  This, and to a lesser extent, the potential breakup of the Euro Zone, is the “Black Swan” scenario we have been worrying about.

The following table (also courtesy of the OECD) shows the 40 largest banks in Europe, with their total exposures measured relative to the GDP of their home countries:

Weight in the national economy of selected systemically important globally active banks: selected balance sheet items, stock-market listed institutions only, end-2007

In the meantime, it is imperative for the European Central Bank to continue to ease its monetary policy over the next few months, as its primary export markets, such as the US, China, Central, and Eastern Europe are now dramatically slowing down.  Finally, while western European banks do not have significant exposures (on an absolute basis) to Central and Eastern Europe, they do have tremendous relative exposure to the region.  In fact, the Central and Eastern European financial markets are dominated by Western European banks.  Quoting a recent Goldman Sachs' study on the region:

Major European banks now control nearly 90% of bank assets in Estonia and Croatia; around three-quarters of bank assets in Bosnia, Lithuania, Romania and Slovakia; well over half of the assets in Albania, Bulgaria, the Czech Republic, Hungary, Latvia and Serbia; and just under half in Poland. Overall, we estimate that European banks control half of the banking assets of CEE [Central and Eastern Europe] excluding Russia and Kazakhstan, and a third of assets including those two countries. Some of these bank stakes are small relative to the size of the banks' overall balance sheets and to their home country's total bank assets. But in a few cases, western European banks control assets in central and eastern Europe that are extremely large … Austria's banks, for example, control bank assets in CEE amounting to 63% of Austrian GDP; Swedish and Belgian banks control CEE bank assets of around 20% of their respective GDPs; and Italian and Greek banks control CEE bank assets of 10% of GDP.

In the same study, Goldman studied what this exposure may mean if the Central and Eastern European region suffered a classic banking crisis.  Assuming an “Armageddon scenario” akin to the 1997/1998 Asian Crisis, Goldman calculated that bank losses in the region could total over 110 billion Euros, with Austria having the greatest exposure at 26 billion Euros, or 9.3% of its GDP.  On an absolute basis, Italy comes second, with exposure of 23 billion Euros, or 1.5% of GDP.  Another country with significant exposure is Hungary, with a 7.7 billion Euro exposure, or 7.3% of its GDP.  While I am hopeful that we could avoid an Asian-crisis like scenario within the region, I am not holding my breath.  But it is to be noted that even in the “worst case” scenario, Western European banks' exposure to the Central and Eastern European region could still be contained.  While countries like Austria and Italy may need external help – either from other Euro Zone countries or the IMF – a severe banking crisis within the Central and Eastern European region isn't totally debilitating.  The greater concerns lie within the Euro Zone itself – where we have seen deterioration in its productivity, demographics, and an overly high reliability on exports to drive GDP growth.  We will continue to keep an eye on the region as things develop over the next few months, but I believe that more bank bailouts in the region is inevitable.

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 July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 2006 to January 30, 2009) - For the week ending January 30th, the Dow Industrials declined 76.70points, while the Dow Transports declined 0.20 point. With the Dow Transports again below its November 20, ,2008 bear market lows, things are now looking bad for global trade and for the export-led economies, such as Japan, Germany, and to a lesser extent, China. In the meantime, the stock market is still at a crossroads, with the Dow Industrials holding above its November 20, 2008 bear market low of 7,552.29 by 5.9%. As with last week, any action int he next week or so will be driven by the actions of the Obama economic team, including talk of a RTC-style fund to absorb toxic assets or a system-wide *backstop* of banks' balance sheets. The $825 billion Obama fiscal stimulus is not enough - and neither can the US rely on the Europeans or the Japanese to lift the global economy out of recession. With the immense amount of capitulation and very compelling valuations across the world - I still believe we are in the midst of one of the greatest buying opportunities of our generation, but should the latest plans fail to stem the liquidation in financial stocks once and for all, there's a chance we could break the November 20, 2008 lows in all the major indices. For now, we will maintain our 100% long position in our DJIA Timing System, but will continue to be cautious on the stock market until we see some stronger policies from US or UK policy makers.

For the week ending January 30, 2009, the Dow Industrials declined 76.70 points while the Dow Transports declined 0.20 point.  With the Dow Transports closing below its November 20, 2008 bear market low for the second consecutive week, things are now looking very bad for global trade and for the export-driven economies, including Japan, Germany, and to a lesser extent, China (the Chinese government has ample room to stimulate its economy through social safety nets and other spending given its huge budget surplus).  Aside from the Dow Transports, another good leading indicator of global trade is the stock price of the largest global supply-chain management company (in terms of value of goods sourced), Li & Fung, whose stock price peaked at HK$37.45 a share in early November 2007, and closed at HK$15.72 last Friday.  With the market waiting for a system-wide bailout of the US banking system, the stock market is now at a crossroads.  Even though the Dow Industrials is still 5.9% above its bear market low, we could very well see another breakdown if the government does not come up with a workable solution for a system-wide bailout soon – something akin to the RTC-style fund to absorb toxic assets or a system-wide backstop of banks' balance sheets.  With tax-loss selling and hedge fund liquidation now over, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending) once/if any broad rescue plan is announced.  That said, while there are still landmines in various emerging market countries (such as 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 remained steady at -9.0% for the week ending January 30, 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 January 30, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios remained steady at -9.0%. No doubt, the latest rise in bullish sentiment is now stalling - and is in fact, in danger of reversing to the downside (which is bearish for the stock market in the short-run). However, most of the upcoming week's market action will again be news-driven. Until we get some concrete news of a systematic-wide bailout, sentiment can indeed get darker, but for now, we will remain 100% long in our DJIA Timing System.

With the stock market at a cross-roads, the four-week moving average of our popular sentiment indicators could sink to a more oversold level before turning back up.  Again, this week's market action will be news-driven, given ongoing jitters about the Western banking system and fourth quarter earnings reports.  For now, we should continue to be cautious, but given the upcoming release of the remaining $350 billion in TARP funds, 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 still believe we are in the midst of the biggest buying opportunity of our generation.  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 its most recent high on January 8th, the 20 DMA of the ISE Sentiment has quickly declined, and is now at its lowest level since mid December. More importantly, the uptrend in bullish sentiment is no longer intact, suggesting that both sentiment and the market is now biased towards the downside. However, relative to levels over the last five years, both the 20 and the 50 DMAs are again at oversold levels, signaling that bullish sentiment is bottoming. With the immense liquidation in the global stock market in the last four months, my sense is that the selling pressure in the US stock market has peaked, but until we get some concrete news of a systematic-wide bailout, we could see more weakness in the short run.

Since its most recent high on January 8th, the 20 DMA has reversed to the downside.  More ominously, it has now declined below the 50 DMA, signaling that investors are now getting more bearish (which would lead to short-term weakness in the stock market).  That said, the 20 DMA of the ISE Sentiment Index is now at a somewhat oversold level – suggesting that the market could easily bottom again over the next couple of weeks, assuming we witness another sell-off.  As I have mentioned before, as long as one is under the age of 60 and is in a reasonable state of health, I believe US equities are still a great long-term buy at current levels.

Conclusion: As the world continues to sink into recession, it is obvious that there are still lingering problems within the global financial system, especially within banks in the Euro Zone.  While the net exposure of these banks are scary, they could be contained as long as the Euro Zone's sovereign governments have the political will to do so.  This would include “bailing out” subsidiaries of foreign banks, or foreign subsidiaries of local banks, or both.  Given the dominance of Western European banks within Central and Eastern Europe, we could very well see an “Asian Crisis like” capital flight in the latter should Western European banks are compelled by their governments to quit or par back their foreign lending (this is happening now in the UK, as we speak, as the British taxpayers have little incentives to subsidize borrowing by Russian Oligarchs, for example).  Again, within one's global equity portfolio, I highly recommend an overweighting of US equities and emerging markets at the expense of international developed (mostly Western European and Japanese) equities for the next 12 months.  And with the US stock and financial markets at a crossroads, and with the UK government leading the way, I expect the Obama administration to announce a system-wide bailout solution sometime this week – starting with more concrete plans on how to spend the remaining $350 billion TARP funds, and ending with an announcement of a broader plan to bail out the US banking system.  With global economic leading indicators still heading south – and with the OECD economies plunging into deflation – there is no time to lose.  Given the immense amount of cash sitting on the sidelines (including the amount of cash assets on commercial banks' balance sheets), any official government “backstopping” of the US banking system would create an immediate incentive for fresh lending.  Such a move would also bring a lot of risk capital back into the financial markets – starting with the corporate bond market, and moving on to the high yield and equity markets.  However, subscribers should be very selective if buying individual stocks, given the ongoing deleveraging phase in the OECD economies.  As I mentioned before, subscribers will also need to be very careful with buying “yesterday's winners,” as the stock market's “favorites” tend to change in a new bull market.

Assuming a system-wide bailout of the US banking system is announced, I expect a dramatic easing of global liquidation pressures, although there are still further “shoes to drop” – primarily in Central & Eastern Europe, and in the commercial real estate market.  For those with a long-term timeframe, the stock market still represents the greatest buying opportunity of our generation.  I am still constructive on US and Chinese equities.  Unfortunately, I am no longer overweight in Japanese equities, as both the Japanese government and corporate CEOs have shown continued reluctance for structural reforms.  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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