Is The Cult of Equities Dead?
(February 15, 2009)
Dear Subscribers and Readers,
David Korn has invited me to be his guest commentator for this week. I am honored to be penning his guest commentary this week, and would like to welcome his subscribers to another edition of MarketThoughts! I also want to wish all of you (both my and David's subscribers) a great post-Valentine's Day 2009! Without further ado…
In early 2000, I penned a series of emails for my friends and family warning of an imminent crash in the global equity markets – specifically in technology stocks. I warned that a great boom such as what we experienced in the 1980s and 1990s always sows the seeds of a bust, as both investors and speculators engage in actions during bull markets that were not sustainable, such as buying stocks on margin, engaging in aggressive accounting or outright fraud, projecting infinite profits for highly competitive industries (such as the internet and telecom stocks of the late 1990s), or just being overconfident in general. In a bear market, all of this will unwind, starting with the leverage and the frauds, or the “first phase” of the bear market. During this “first phase,” shrewd investors typically distribute the most risky securities to other investors. In the case of the mortgage crisis, this has been going on since at least early 2006. Within the stock market – even though the Dow Industrials did not top out until October 2007 – stocks have been on a distribution phase since early 2007, as the subprime industry started to crash. The first phase most probably ended with the rescue of Bear Stearns by the US Treasury, Federal Reserve, and JP Morgan – as the Fed (primarily) came in and backstopped the Bear Stearns rescue and provided much-needed liquidity for the investment banks.
In the second phase of the bear market, investors typically lose confidence – not just in corporations' ability to maintain their earnings power but also their confidence in the global economy and our institutions. As investors take into account declining earnings power and labor productivity, equities and other risky assets are further discounted. Finally – in the third phase – stocks tend to sell at larger discounts then their “intrinsic value,” even though this “intrinsic value” has already taken into account the potential for further earnings deterioration. During the third phase, investors of all stripes sell their stocks into whatever prices they could get, as they either need to raise cash to fund their everyday living expenses or for regulatory requirements (such as insurance companies who were forced to dump stocks during the tail-end of the 1973 to 1974 bear market). It is during this phase when most investors swear they will never buy a stock again.
So Henry, where are we right now in this bear market?
I believe we're seeing elements of both the second and the third phase of a bear market. For example, the fact that the global economy is now experiencing its worst downturn at least since 1982 is well publicized. For example, the OECD leading economic indicators just plunged to their lowest levels since the oil shocks of the 1970s, as shown in the following chart:
More importantly, the outlook for the major non-OECD members countries have also deteriorated significantly. Even the bastion of strength, the Chinese economy, is projected to experience a dramatic slowdown over the next six months:
Moreover, investors have not only lost confidence in many CEOs in the Fortune 500 (and you thought Enron and Worldcom were bad), but other figures such as Bernie Madoff, Hank Paulson, and increasingly, the US Treasury. As with all bear markets, the US economy is also saddled with increasing government regulations (such as Sarbanes-Oxley in 2002). With an inevitable increase in government spending and government regulations, and with the ongoing deleveraging within the global economy, investors are now also factoring in decreasing ROEs across the US economy. According to Goldman Sachs, the ROE of the S&P 500 companies was as high as 20% in 2007, compared to 16.8% in Europe, 15.7% in Asia (excluding Japan), and a dismal 10.2% in Japan:
With the inevitable increase in government regulations, and with the era of cheap financing now ending, there is no doubt that ROE will come down and probably stay down for a sustained period of time. My sense is that the ROE of the S&P 500 will be closer to that of Europe's and Asia's (excluding Japan) over the next few years – or around 16%.
In terms of investors capitulating (the third phase of a bear market), we have already witnessed some of this in early October and late November of last year. During those periods, the market put up oversold readings not seen since the 1987 crash (such as the VIX), and in some ways, the 1973 to 1974 bear market (such as the McClellan Summation Index). Aside from retail investor liquidation, the liquidation of equities and other risky securities late last year has been further compounded by hedge fund and fund of funds redemptions. This liquidation has continued into this year, as exemplified by the elevated NYSE ARMS Index readings and the continuing decline in total margin debt outstanding (now down 50% from its peak in July 2007). No doubt, this immense liquidation over the last 18 months has resulted in a tremendous amount of cash sitting on the sidelines, as evident by the growing amount of US money market assets (which is one of many ways to measure cash levels). Interestingly, the amount of money market funds just set a record high relative to the S&P 500's market capitalization. This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge of how oversold the US stock market really is – as well as how sustainable a current rally may be. I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to February 2009:
As of last Friday at the close, the ratio of money market fund assets to the market cap of the S&P 500 stood at 49.74% - a historically high level that is more than 60% higher than the month-end March 2008, February 2003, October 1990, and the July 1982 highs. More importantly, subscribers should note that this only measures the amount of investable capital located in the United States. By many measures, the amount of global investable capital that is sitting on the sidelines is also still near record highs (such an amount of capital was virtually non-existent back in February 2003, let alone July 1982 or October 1990) – not just in sovereign wealth funds, but in private equity funds, private pension funds, and hedge funds as well. While this indicator is not a great short-term timing indicator, it is to be noted that this reading is now at an unprecedented level, and signals that we have already experienced a significant level of capitulation.
Whether the liquidation has ended or is nearly ending will depend on the actions of global policy makers over the next few months. As mentioned in our mid-week commentary, the Dow Jones Industrial Average made a significant bottom during FDR's inauguration and never looked back, as FDR embarked on an unprecedented “100 days” of policy-making – eventually ramming 15 bills through Congress from March to July 1933. While the Austrian economists would love to point out that FDR's spending did not do a thing to the economy, the fact of the matter is that both real GDP and industrial production bottomed in 1932. Of more importance were the social benefits that were provided during that time. While the 1930s was a brutal period, it did not result in a total disillusionment by the youngsters of that period, such as what an entire generation of Japanese has experienced (aka Japan's “lost generation”). I expect the Obama administration – with full cooperation from the Federal Reserve – to continue to find creative (and old) ways to reinflate the US economy. More importantly, the Bank of England has also promised to engage in a policy of “quantitative easing,” with the European Central Bank now signaling more of a will to do so (i.e. print money). Finally, China has also signaled it will continue to ease both fiscal and monetary policy (the Chinese authorities have a lot of leeway to do so). While I am optimistic that equities are in the midst of bottoming, it is still reasonable to put out some price targets based on various realistic assumptions.
I would now like to construct some possible targets for the S&P 500 for the next 6 to 12 months in an attempt to gauge the possibility of various “what-if” scenarios. In order to do so, it is important to gauge where the S&P 500's earnings would be after all the write-downs and deleveraging are done. Earnings have typically bounced back to peak levels within a few years, even during recessionary times. For example, by 2003, S&P reported earnings were back to its 2000 peak level, or around $50 a share. Of course, we realize that these are not “normal times.” As we mentioned before – primarily because of government re-regulation and higher financing costs, it makes sense to assume an ROE of 16% for US stocks going forward, as opposed to around 20% during the peak of this cycle. Because of this, we applied a discount factor to our assumed forward earnings (2010 to 2011) – i.e. 2004, 2005, and 2006 reported earnings of the S&P 500. We also assumed three levels of forward P/Es, 10, 15, and 20.
The following table shows the various price targets I am currently looking at over the next 6 to 12 months, based on the assumptions I have just mentioned:
We realize that assuming a 2010 or 2011 earnings of $83.11 may be extraordinary high (even with the 80% discount factor), since so much of the S&P 500's earnings during 2006 came from the financial sector. Because of this, it probably makes more sense to use the S&P 500's earnings in 2005, with an 80% discount factor. Assuming that deflation does not take hold, it also makes sense to apply a 15 P/E to the forward earnings of the S&P 500, given the relatively low inflation/interest rate environment. Based on this assumption, our “model” concludes that a S&P 500 level of 856 may be the “fair value” for the next 6 to 12 months – with the stock market of course swinging on either side of that level. Should global deflation or a global depression take hold, the S&P 500 could conceivably decline to 600, or below. Given the aggressive global policies currently in place, and given that global pension funds are set to rebalance back into equities over the next few months, such a scenario is not very likely. However, we will continue to keep an eye for such a possible occurrence, and will report back on any new findings.
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:
For the week ending February 13, 2009, the Dow Industrials declined 430.18 points while the Dow Transports declined 246.46 points. With the latest decline in both Dow indices, the Dow Transports is now just 49 points above its February 2nd bear market low of 2,908.67. Any decline in the Dow Transports below this level would indeed be detrimental to both the technical condition of the stock market and of global trade. However, with the latest bounce in the Baltic Dry Index and the Obama payroll tax cuts, the Dow Transports (and the Dow Industrials) should find support near current levels. With the market still waiting for further details of the Fed's bailout plan, the stock market is still a crossroads, though. As I mentioned before, the US financial system (in the form of banks' shares, corporate spreads, and securitized spreads) has been screaming for assistance. Now is the time for the Feds to be much more transparent and proactive in order to find a systematic solution, once and for all. Once that is settled, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending). Again, 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 decent valuations in the US equity market 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 declined from -13.3% to -13.8% for the week ending February 13, 2009. 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:
While the four-week moving average of our popular sentiment indicators could sink to a more oversold level, subscribers should note that this week's market action will be news-driven. My sense is that we would get more clarifications on the US Treasury's bank recapitalization scheme (along with the administration's plan to lower mortgage rates for struggling homeowners) over the next couple of weeks. Combined with the inevitable rebalancing into equities by institutional investors, my sense is that the market could very well embark on a rally over the few weeks. For now, we should continue to be cautious, but given the decent global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, we should definitely be more bullish than most. 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 its most recent low on February 4th, the 20 DMA has bounced back up strongly, but is still below its 50 DMA – signaling that bullish sentiment is still trending (which usually leads 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 be bottoming out (or have already bottomed last week). Assuming that the US Treasury clarifies its bank recapitalization plan over the next couple of weeks, equities should rally strongly over the next few weeks. As I have mentioned in a previous commentary, 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 good long-term buy at current levels.
Conclusion: Is the “cult of equities” dead? Since the confidence in equities as a long-term asset class peaked in early 2000, the pendulum has been trending towards the opposite extreme (with a brief correction from early 2003 to late 2007). With the latest bear market that began in early to mid 2007, the sentiment towards equities has clearly swung towards the other side. In many ways, investors are much less confident than they were in late 2002 to early 2003. One can seen this in the amount of cash sitting on the sidelines, the relatively low price-to-book ratios (the price-to-book value of the Dow Industrials is now at its lowest level since October 1990), and even mainstream denouncements of “runaway capitalism” over the last couple of years. Make no mistake: The capitalist and corporations can only survive and thrive if the majority let or tolerate them, and mainstream sentiment is now calling for a significant re-regulation of corporate America. With Enron, Worldcom, and the technology bust still fresh on everyone's minds, it is not a surprise to see this backlash, in light of the hundreds of billions dollars that were lost in the mortgage crisis and recession (along with the millions of dollars paid out in bonuses). While some of my “capitulation indicators” are still not flashing a “once-in-a-generation” oversold reading, they have come close. Unless the world enters into a depression, or unless the Obama administration does more to try to rein in corporate power, my sense is that the stock market has already bottomed or should be close to bottoming. With the US Treasury set to provide further clarifications on its bank recapitalization plans, subscribers should start thinking about what individual stocks to buy, and in what industries, etc. As discussed last week, to that end, it is important to find a good framework to evaluate your targeted companies' competitive advantage, and their industries – as well as finding the right tools and resources. Also, 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. 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 some clarification is provided regarding the bailout of the US banking system, 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 one of the best buying opportunities 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.
Henry To, CFA