Fund Flows Starting to Look Positive
(March 1, 2009)
Dear Subscribers and Readers,
Before we begin our commentary, I want to provide an update on the “great deleveraging” trends that are occurring within the US economy. We first discussed the concept of the “Great Deleveraging” in our March 23, 2008 commentary. Beginning in the most marginal companies in the financial sector (such as Bear Stearns, SIVs, mortgage REITs, and many of the smaller players in the hedge fund industry), I argued that this would eventually spread to certain highly-indebted industries or companies. Quoting our March 23, 2008 commentary:
For folks who solely invest in individual stocks in the U.S. stock market, I now expect severe divergences going down the road – as investors will no longer indiscriminately buy companies across the debt-to-equity spectrum. Given the end of this record “cheap finance era,” I recommend staying away from all heavily-indebted companies or industries. This includes the utility sector (note that the Dow Utilities has remained very weak even as the Dow Industrials and Dow Transports bounced significantly), the steel industry, the domestic automotive industry, much of the telecom sector, highly indebted retailers (Borders, Kroger, Revlon, etc), and any mortgage or student loan lender whose lending practices did not pass “the sniff test” over the last couple of years.
The “Great Deleveraging” has since played out in a rather violent manner – not only within the US but around the world (in some ways, it has been a more violent “unwind” in other parts of the world). Within the US, personal bankruptcies jumped by over 30% in 2008, with 1.06 million consumers filing for bankruptcy during the year. This comes on top of a 40% spike in bankruptcy filings in 2007. As housing values and employment continues to decline (most likely, the unemployment rate won't peak until Thanksgiving at the earliest), bankruptcy filings in 2009 are expected to rise yet again.
Within the corporate sector, total Chapter 7 and Chapter 11 bankruptcies have surged to 33 for the first two months of 2009, up from 14 at this point last year. More glaringly, the combined assets of these 33 companies totaled a whooping $66 billion, or seven times higher than the $9 billion held by the 14 companies at this point last year. Perhaps the most “famous” filing this year is that of Trump Entertainment Resorts, which filed for Chapter 11 for the third time – one of the more prolific “serial filers” on this side of the Atlantic. Given the highly indebted (and optimistic cash flow forecasts) of many LBOs in 2006 and 2007 – along with many corporations going into debt to fund shareholder buybacks during the same time period – there is no doubt that corporate bankruptcy filings will increase further over the next six to nine months. In a just-released report, Moody's predicts that corporate bankruptcy filings around the world will triple this year to about 300, up from 101 last year (on $280 billion of debt). This translates to a junk bond default rate of about 15% in the US, and about 19% in Europe.
In light of this uncertain economic environment – as well as the recent declines in housing and equity prices – there is no doubt the US savings rate will continue to rise for the rest of 2009. Based on the financial crises in Norway (1987), Finland (1991), and Sweden (1991) (which, taken alone, have the greatest similarities with the US financial crisis today), the US savings rate should ultimately increase to a range of 5% to 10% over the next few years. The most vulnerable sectors are those that are the most indebted and have been the most dependent on consumer discretionary spending – such as airlines, the auto industry, casino operators, and various companies in the retail and casual dining industries. Moreover, the “great deleveraging” will also accelerate the declines of the newspaper industry, as well as various cities in the “Rust Belt” such as Detroit, Cleveland, and St. Louis. The “Y-gens” will lose their sense of entitlement, while their parents, the baby boomers, will work harder than ever and postpone their retirements (which will ultimately lead to higher productivity for the US and global economy). On the other hand – only a decent domestic savings rate would allow the US to invest in its future, starting with the education of our children, to basic research in our greatest scientific institutions, and finally, to commercialization of paradigm-changing technologies, such as those in the computing, alternative energy, and biotechnology industries. As long as Americans confront our challenges head-on, I believe the opportunities available to our children in the future will be well worth the current sacrifices.
Let us now begin our commentary by reviewing our 8 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 5,109.57 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 4,800.07 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a loss of 187.07 points as of Friday at the close.
In last weekend's commentary, we discussed that while a strict interpretation of the “mechanical version” of the Dow Theory looked downright ominous, the valuation and technical conditions of the US stock market was far from that. Specifically, as I discussed in our original “primer” on the Dow Theory and in subsequent commentaries and posts on our discussion forum – the concept of valuations override virtually every other technical signal that emulates from the Dow Theory. Moreover, while the Dow Transports did decline below its recent bear market low, it was still trading significantly above its March 2003 low – suggesting that both global trade the influence of global Ricardian growth remained intact (even though it has been damaged by the pullback of the US consumer). Combined with many positive divergences in the stock market, as well as more unconventional central bank policies coming down the pipeline, we suggested that it was a good time to break with tradition and go for a swing trade on the long side, and initiate an additional 25% in our DJIA Timing System – thus bringing us to a 125% long position.
While this would bring us to a leveraged position, we believe that this position contains minimal risk at this point. Again, I want to emphasize: We have always been very conscious of risk and will continue to be. We believe we are minimizing our risk by: 1) limiting the additional long position to only 25%, such that a further 30% or even a 40% decline should not cause long-term damage to our performance, 2) limiting our holding period to only a few weeks – but maybe longer if the market exhibits strong breadth and volume on any snapback rally, and 3) implementing this position ahead of institutional investors who will no doubt rebalance into equities over the next two to three months.
Speaking of rebalancing, there are indications that investors are shifting back into riskier assets. The most likely motivation is the record low money market fund yields – with retail prime money market funds now yielding only 0.67% and institutional prime money market funds yielding only 0.86% (obviously, the government money market funds are yielding significantly lower). The spread between money market and CD yields have now grown to a high of 175 basis points. Moreover, credit funds received approximately $30 billion in inflows for the first two months of this year as investors start to take advantage of the record bond spreads. This is a significant turnaround compared to the $62 billion in outflows from credit funds during the final quarter of last year. In addition, a recent survey of institutional investment consultants suggests that many institutional investors are now seriously thinking of taking more risk in their fixed income portfolios over the next three to six months. Following is a chart showing bond (credit) fund flows over the last eight years, courtesy of Goldman Sachs:
Part of the relentless selling in the financial markets had to do with the hedge fund redemption requests since the beginning of this year. Per the WSJ, hedge fund redemption requests – after accelerating during the fourth quarter of last year – have continued to be high so far this year. This is more pronounced in the case of US hedge funds, where redemptions typically have longer notice periods (European funds bore the brunt of the redemptions last quarter). Fortunately, European hedge funds are already seeing a slowdown in redemptions. Given European hedge funds as a leading indicator of US hedge funds, my sense is that after this quarter is over, US hedge fund redemptions will no longer pressure the US or global financial markets. In fact – with many hedge funds having already raised enough cash to meet their March 31st redemption request – my sense is that hedge fund redemption pressure will dramatically ease over the next couple of weeks.
Given the increased fund flows into fixed income (credit funds), and given the immense amount of cash on the sidelines, there is a good chance that inflows into US equity funds will also start to increase sometime over the next few weeks, especially given the inevitable rebalancing into equities by institutional investors. As soon as the Federal Reserve starts to implement the US$1 trillion TALF, and as soon as the US Treasury provides some clarity on its bank recapitalization program (word is that Treasury's staff has simply been too busy), we should see a sustainable rally in the US stock market. In addition, the amount of cash held by equity mutual funds is now (as of the end of January) at an eight-year high, as shown by the following monthly chart:
With cash levels at equity mutual funds at its highest level since March 2001, mutual fund managers now: 1) have a substantial cash cushion to meet redemptions, and 2) are overweight cash – meaning that once the Federal Reserve and US Treasury start to move into the credit markets, many equity fund managers will need to invest their excess cash so they would not fall behind their peers or benchmarks. Again, I expect this to lead to a snap-back rally lasting for at least a few weeks, if not a few months.
Over in the UK, the Bank of England is expected to slash its policy rate again from 1.00% to either 0.50% or below this Thursday – and to move to a “quantitative easing” policy by purchasing UK commercial paper, corporate bonds, and UK gilts. The initial plan is for the Bank of England to spend around £5bn-£10bn a month on these purchases. If this, along with the US bailout plans, does not revive the UK financial markets, I expect the Bank of England to expand this facility, or to expand its purchases to include equities or even pools of residential real estate.
With the most attractive valuations in over two decades, the oversold condition in the stock market, the numerous positive divergences that we discussed last week, and investors starting to take advantage of valuations in riskier asset classes, I believe last week was a good time for a swing trade on the long side. Moreover, many institutional investors (such as pension funds) are now seriously underweight their target equity allocation, and will most probably rebalance back into equities (from mostly fixed income) over the next few months. For now, we would maintain our 125% long position in our DJIA Timing System.
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 27, 2009, the Dow Industrials declined 302.74 points while the Dow Transports declined 199.80 points. Over the last three weeks, the Dow Industrials declined by a whopping 15% while the Dow Transports declined by 22%. With the latest decline in both Dow indices, both the Dow Industrials and the Dow Transports have made new bear market lows. While this is usually an ominous sign, I believe we are now close to a snap-back rally, given the cheapest valuations in two decades, the many positive divergences we discussed last week, and the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system as the Fed and Treasury move in. While the Citigroup “rescue” was not “fun” for equity shareholders last Friday, we should note that Citigroup was the proactive party that approached the US Treasury for a bailout. In other words, the Feds did not initiate and certainly did not force Citigroup to accept the rescue package. While the threat of further shareholder dilution in the banking industry is certainly unsettling, it is by no means the inevitable conclusion. I continue to expect the US Treasury to stand by the terms of its February 10th “Financial Stability” plan, and once further clarity is provided (most likely in the next couple of weeks), I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending). Because of this, we will maintain our 125% long position 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 -16.2% to -18.0% for the week ending February 27, 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:
With the four-week moving average of our popular sentiment indicators sinking to -18.0%, this reading is now at its most oversold level since early December of last year. More importantly, this indicator is also at a historically oversold level, suggesting that the market could snap back higher at any time. Word is that the US Treasury will provide more clarifications on its bank recapitalization scheme over the next couple of weeks. Combined with the inevitable rebalancing into equities by institutional investors, my sense is that the market could embark on a rally real soon. Given the very attractive 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 now be more bullish than at any time since late 2002/early 2003.
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 to a level of 125.4. While the rising bullish sentiment in this indicator isn't confirming the bearish sentiment in our other sentiment indicators, it is nonetheless still trading at an oversold level (relative to readings over the last five years). As a result, the ISE Sentiment reading is also supportive for at least a short snapback rally in the stock market. Assuming that the US Treasury clarifies its bank recapitalization plan over the next couple of weeks, equities should be bottoming at around current levels. 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: Sustainable, and snapback rallies in the stock market are typically preceded by positive divergences within the technical condition of the stock market. With many investors now starting to take more risk in their portfolios – and with hedge fund redemptions starting to slow – I believe the conditions for a snapback rally are now in place. Combined with the most attractive valuations in two decades, the sheer amount of investable capital on the sidelines, the overly bearish sentiment, and the aggressive policies of the Obama administration to counter the financial crisis, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System last Tuesday. Make no mistake: We have always been very conscious of risk and will continue to be. We believe we are minimizing our risk by: 1) limiting the additional long position to only 25%, such that a further 30% or even a 40% decline should not cause long-term damage to our performance, 2) limiting our holding period to only a few weeks – but maybe longer if the market exhibits strong breadth and volume on any snapback rally, and 3) implementing this position ahead of institutional investors who will no doubt rebalance into equities over the next two to three months.
In the meantime, there is no doubt that US corporations and consumers are still in the midst of a “great deleveraging” phase – a phase, once it ends, will provide the survivors to enjoy outsized profit margins for years to come. 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. 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 further induce a significant amount 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. 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. Subscribers please stay tuned.
Henry To, CFA