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It’s a Paradigm Shift, All Right

(March 15, 2009)

Dear Subscribers and Readers,

Just like the executives and Wall Street analysts that walked away with millions of bonuses, options, and ill-gotten gains from the stock market in the late 1990s, many others have also done so immediately before or even during the current financial crisis.  This list is long – including many CEOs at our largest financial institutions, many mortgage brokers at Countrywide, Washington Mutual, and IndyMac Bank who pushed option-adjusted ARMS or subprime loans to naïve borrowers, and the financial engineers who created and pushed the toxic CDOs and CLOs to investors across the world.  Interestingly, even as the financial crisis raged on, it still took a long time for Wall Street to realize “the paradigm” has shifted.  TPG forked up $7 billion for an investment in Washington Mutual in April of last year – only to see it seized by the FDIC and sold to JP Morgan (wiping out both bond and equity shareholders) five months later.  Many traditional value mutual funds – including those that did very well during the 2000 to 2002 bear market – bought financials all the way down.  Similarly, former CEO of Merrill Lynch, John Thain, remodeled his office for $1.2 million even as it was clear that Merrill would surprise with larger-than-expected write-downs in the fourth quarter of last year.  But what has been the most damning is the most recent disclosure of AIG's bonuses to its Financial Products team (totaling $165 million) – that's right, the team that nearly brought down the global financial system.  In its haste to rush out its “Sunday Night Specials” late last year, the previous administration never took this issue into account.  Not only is this a slap in the face to all taxpayers, but it is also a slap in the face to all those in the financial industry that worked with integrity, and who are now paying the price for AIG's (and others') mistakes.

With this, it is obvious why most taxpayers are angry at the banks and demanding punishment.  I rarely use these commentaries as a forum for my non-market opinions, but this is one of those rare times where something just has to be said.  To those who are still working at AIG's Financial Products team and are receiving bonuses today: Either volunteer all your bonuses back to the federal government, or donate all of it (anonymously) to charity.  It is the right thing to do.  Morals aside, this is also the smart thing to do – as I assure you that doing this will not only help AIG rebuild its brand equity but also the brand equity of the entire US financial industry.  Do you seriously want to buy that Porsche while Main Street is lining up outside with sticks and pitchforks?  Do you want to give the federal government the mandate to seize AIG?  Do you want the FBI to be keeping track of your every move going forward?  Give the bonuses back.  It is the proper and the smart thing to do.

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 4,948.02 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 4,639.02 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 26.02 points as of Friday at the close.

Paradigm shifts are rare, of course.  For example, value managers have typically made money by betting against paradigm shifts (investors typically bid up growth stocks and sold the low-growth stocks, anticipating just that, similar to the technology/telecom bubble of the 1990s).  By buying stocks that nobody wants at low prices, value investors have done very well over the last 30 years (with the exception of last year, of course).  As a matter of fact, the Fama-French three-factor model is a living testament to how much buying value stocks have worked even going back to the late 1920s (unfortunately, information on stock prices start to get sketchy prior to 1926).  Many quantitative managers has value (typically P/B ratio) as their primary input factor to their models, although the more astute managers (such as Cliff Asness from AQR) have typically treated the P/B ratios of financial stocks with a grain of salt, given: 1) the fact that the book values of many financial institutions were difficult to pin down, and 2) the extreme leverage in many financial institutions, thus rendering the book value a useless gauge of value in a (even moderate) deleveraging scenario.

It is obvious that we have been witnessing a tremendous paradigm shift in the global financial system.  But as the folks at AIG and other financial institutions should realize, nothing is set in stone at this point.  Whether there will be less or more restrictions on leverage ratios, structures (such as bringing back the part of the Banking (Glass-Steagall) Act of 1933 that called for the separation of commercial and investment banks), and in regulation will partly depend on the actions of those still working in the financial industry.  For example, if a large hedge fund was to blow up tomorrow, then surely the Congress will expedite steps to begin regulating the hedge fund industry as soon as possible.  It is now up to the financial industry to build up their brand equity among the Congress and taxpayers just so the industry could continue to thrive over the next decade or so.

However, as I mentioned before, there are other paradigm changes that are lying in the undercurrents of our economy and thus are not as obvious.  For example, any company operating in an industry that depend on consumer discretionary spending will need to quickly reexamine its business model, as US consumers will no doubt try to rebuild their savings through the “old-fashioned” way over the coming months (i.e. by spending less than they earn instead of relying on the stock or housing markets to bail them out).  As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, it will take at least several years before US households' net worth reach their prior peak levels again, even should the US economy start recovering by the end of this year:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions)(1Q 1952 to 4Q 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 5.38 at the end of 2007, to merely 4.61 today... 5) Household net worth declined by a record $5.1 trillion during the fourth quarter - representing the greatest quarterly destruction of wealth in US modern history and on a year-over-year basis.. At the end of the fourth quarter, household net worth has declined by $12.9 trillion since its peak at the end of 2Q 2007! 6) The *dip* in net worth caused by the October 1987 stock market crash.

A side note: Interestingly, US households' liabilities only declined by $308.9 billion (from $14.55 trillion to $14.24 trillion) since its peak.  This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as US consumer credit has grown by a negligible amount in the final quarter of last year.  So why did US households' liabilities only dip by $308.9 billion from its peak?  The most likely answer is that the vast majority of US households are still paying their mortgages and their credit card debt, even as global financial institutions have been writing them down (following “mark to market” rules and the lead of the structured finance indices and others who have been forced to dump their holdings into a distressed market).  In a truly efficient world where US mortgage borrowers could buy back their mortgages, this will be the perfect time to do so.  Unfortunately, the world of securitization has rendered this an impossibility.

This paradigm shift of more depressed discretionary spending all across the board (not just consumers, but by financial institutions as well) will have an adverse effect on many industries for years, especially those that have over expanded or have relied on other secular trends over the last decade.  Following are some industries that are my prime candidates:

  • The casino industry: For years, the casino operators were immune to recessions.  Las Vegas was especially immune – as both gambling as a form of entertainment and as cheap air travel proliferated across the US (and other parts of the world) over the last 30 years.  Las Vegas also benefited from being the sole brand name in the global gambling industry – despite the local popularity of Macau and Atlantic City.  This multi-decade trend has now come to an end for the following reasons: 1) With a penetration rate of about 20% of the US leisure industry, Las Vegas as a tourist spot is now oversaturated; 2) The “wow factor” of ever-grander casinos is now gone.  Unless they can encase the entire Strip in fiberglass and cool it during the summer, Las Vegas will have a difficult time increasing its traffic in the coming years; 3) Las Vegas (and other US casinos) are now experiencing significant competition from other gambling establishments.  Singapore and Macau are the obvious ones.  What are less obvious are the build outs of various tribal casinos around the US that are much closer to their customer base; and 4) As US consumers cut back on discretionary spending, casino operators will not only need to compete with other operators for the smaller pot of spending, but with other forms of entertainment as well – such as the cruising (popular with baby boomers), the gaming, and the theme park industries.  My guess (and this is only a guess) is that Las Vegas housing prices will not reach their former peaks until at least 2025.

  • The casual dining industry: For years, chains such as Chili's, Olive Garden, Red Lobster, Outback Steakhouse, Cheesecake Factory, Pappasito's, Applebee's, and P.F. Chang's have benefited from the secular trend of ever-high consumer spending on the casual dining industry, as Americans spent an increasing amount of their household budgets on dining out.  Part of this has been the proliferation of dual-income households over the last 30 years, but another part has been the wealth effect and the optimism caused by a secular rise in asset prices and the relatively tame downside business cycles since 1982.  Even before the current financial crisis, the portion of American's budget spent on dining out was already hitting a peak.  To make things worse, the casual dining industry has also grown very aggressively in the last decade.  Goldman Sachs currently projects the casual dining industry to shrink by 8.5% this year, with most of the deleveraging coming from the independents, as opposed to the restaurant chains.  For subscribers who are thinking of franchising his/her own casual dining restaurant or starting one from scratch, I would delay making this decision by at least another year.

  • The luxury retail industry: This industry consists of global brand names such as Tiffany's, Coach, Louis Vuitton, Gucci, Swarovski, and Rolex.  Not only has this industry benefited from the giant growth in US wealth over the last 25 years, it has benefited from the even more impressive growth in global wealth since the trough in the Asian Crisis and Russian Crisis in 1998.  Even if the US stock market recovers to its peak in the next several years, the “willingness to spend” and discretionary spending power among Americans will take a longer time to recover.  Here, subscribers should note that while I am relatively bearish on US discretionary spending, I am not as bearish on foreign discretionary spending, especially Chinese and Indian discretionary spending.  Over the long run, I expect the vast majority of the growth in consumer discretionary (and luxury) spending to occur in these two countries.  Because of this, subscribers should buy luxury retailers that have strong global recognition should they want to “bottom fish” in this industry.

While such a paradigm shift may wreck havoc on certain industries or result in severe underperformance in certain “value portfolios,” that does not mean the stock market will languish for years to come.  As a matter of fact – as demonstrated by the strong rallies and follow-throughs last week – there is a good chance that US stocks will embark on a significant rally over the next few months.  As I mentioned before, assuming that global policy makers continue to be aggressive in supplying liquidity and fixing the global financial system, this could even turn into a new multi-year bull market.  While we can no longer depend on either the financial or the consumer discretionary sectors to fuel sustainable growth going forward, there are definitely sectors which could rise from the ashes of the bear market and help us solve the US and world's biggest problems, namely the healthcare and technology sectors.  In fact, the cutback in US consumer discretionary spending could even be interpreted as a long-term bullish development, as a higher domestic savings pool would mean higher investments into our scientific community, educational system, and physical infrastructure.  It is from these investments (and savings pool) that our next “consumer spending boom” will arise (and which Peter Lynch benefited from mightily in the 1980s).

In the meantime, it is still imperative for policymakers to “jump start” the asset-backed markets before global equities could embark on a sustainable rally.  As I discussed in last weekend's commentary, the “illiquidity discount” in the asset-backed markets – through the “contagion effect” and the resultant high rates of financing – has been killing both the stock market and the corporate bond market.  Both investment-grade and high yield CDS spreads actually hit another record high last week.  Even with the latest rally in stocks, CDS spreads are still very close to their record highs.  Moreover, the ABX indices (which have been the leading indicator of other risky assets over the last two years) hit a new low again next Friday.  The following chart (courtesy of shows the market price of the ABX.HE.AAA 06-1 index since early September of last year:

ABX.HE.AAA 06-1 index

As shown in the above chart, the ABX indices are still hitting new lows.  With the inevitable roll-out of the TALF – and with Tim Geithner set to provide more details of the Public-Private Investment Fund (PPIF) sometime this week – my sense is that the ABX indices will hit an important low (and CDS spreads will hit an important high).  But there is no time to lose.  Moreover, until the Obama administration finds a more forceful way to stabilize the housing market, there is always a danger of more deleveraging and a resumption of the bear market in risky assets further down the road.  For now, we remain 125% long 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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports(July 2006 to March 13, 2009) - For the week ending March 13th, the Dow Industrials rose 597.04 points, while the Dow Transports rose 224.90 points. With the latest rise in the two Dow indices still put them below recent resistance levels, there is no doubt about the strength of last week's rally, as both upside breadth and volume have been the most impressive since the bear market started in late 2007. More importantly, the Dow Transports managed to hold above its March 2003 low of 1,942 (if the March 2003 low did not hold, then chances are we will experience a far greater-than-expected global recession).  Moreover, both the US Treasury is set to announce the terms of the Public-Private Investment Fund this week Until the financial system is working again and until the US housing market stabilizes, the Obama administration will continue to find ways to revive the financial markets. 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. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending March 13, 2009, the Dow Industrials rose 597.04 points while the Dow Transports rose 224.90 points.  Last week's rise in the two popular Dow indices broke its four-week losing streak (the Dow Industrials declined 20% while the Dow Transports declined 31% during that four-week losing streak) – and while the two Dow indices are still below their most recent resistance levels, last week's rally was certainly nothing to sneeze at, as both upside breadth and upside volume were at their most impressive levels so far in this bear market.  More importantly, the Dow Transports managed to hold above its March 2003 lows – suggesting that the global economy is still holding up relatively well (even though our leading indicators suggest the world economy will shrink for the first time since World War II this year).  Given the cheapest valuations in over 25 years, the many positive divergences we have discussed, 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 with the TALF and the soon-to-be-announced PPIF, I expect the rally to develop some legs over the next several weeks to several months.  Should there be any further need for capital, 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 on the PPIF, I also 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 -22.9% to a historically oversold reading of –26.8% for the week ending March 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending March 13, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios declined from -22.9% to -26.8% - its most oversold level in this bear market so far (and the most oversold since July 2002!) Subscribers should note that this indicator is now at historically oversold levels - similar to other indicators we have been tracking. We will remain 125% long in our DJIA Timing System, and are now looking for a continuation of the rally over the next several weeks, although we should expect some consolidation in the market this week.

With the four-week moving average of our popular sentiment indicators declining to -26.8%, this reading has now declined to its most oversold level since July 2002 (in fact, it is just 0.1% above its July 2002 reading)!  Moreover, one of its components, the AAII Bears reading, spiked to a whopping 70% the week before last, which is the highest bearish reading since the survey began in 1987.  With the US Treasury preparing to provide more clarifications on the PPIF this week, and coupled with the inevitable rebalancing into equities by institutional investors, my sense is that the market could sustain its rally over the next several weeks to several months.  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 are now 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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since its most recent low on February 4th, the 20 DMA of the ISE Sentiment has bounced back to 130.9 . While the 20 DMA has now become overbought relative to its readings over the last two years, it is still oversold relative to its longer term readings. Moreover, the 20 DMA is now trading authoritatively above the 50 DMA - signaling that the market is now biased towards the upside. 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. Now that we have received some concrete details of the Fed's TALF, we should see a continuation of the rally over the next several weeks.

Since its most recent low on February 4th, the 20 DMA has bounced back up to a reading of 130.9.  While this sentiment indicator is now trading at a level that is overbought relative to its readings over the last two years, it is still somewhat oversold relative to its longer-term readings.  More importantly, the 20 DMA is now trading authoritatively above its 50 DMA – suggesting that both bullish sentiment and the stock market is now biased towards the upside.  As a result, the ISE Sentiment reading is also supportive for a sustainable rally in the stock market over the next several weeks to several months.  Assuming that the US Treasury clarifies its PPIF plan sometime this week, equities should have already bottomed last week.  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 a once-in-a-generation buy at current levels.

Conclusion: While there have certainly been paradigm shifts in the financial and many other industries (especially those that cater to the discretionary spending of US consumers), such paradigm shifts do not necessarily have to be long-term bearish for US stocks.  While we will certainly experience lower ROEs in the financial industry and more deleveraging across the consumer discretionary sector, having a larger pool of domestic savings is actually a long term plus for the economy – as this pool of savings could be invested in projects to help solve the US and the world's biggest problems (foreign money has generally been too risk-averse to invest in higher ROIC projects such as venture capital or IPOs).  As the US Treasury and the Fed continue to find ways to reliquify the asset-backed markets and our financial institutions (through the Fed's stress tests), I expect CDS spreads to narrow and for the structured finance indices to start their recovery.  Such a scenario would not only benefit the asset-backed markets, but the stock and bond markets as well (especially the balance sheets of major financial institutions).  With the darkest sentiment in decades and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System on February 24.  We will sell this additional 25% long position once the market rally starts to lose steam.

With the US Treasury set to provide further clarifications on its PPIF plan, subscribers should start thinking about what individual stocks to buy, and in what industries, etc.  Within one's global equity portfolio, I highly recommend an overweighting of US and Chinese equities at the expense of international developed (mostly Western European and Japanese) equities for the next 12 months.  However, subscribers should be very selective if buying individual stocks, given the ongoing deleveraging phase in various industries.  While I expect the financial institutions to do relatively well over the next 6 to 9 months, there is no doubt that the longer-term growth plays are within the technology and the biotechnology sectors.  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.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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