The April 2009 Global Financial Stability Report
(April 26, 2009)
Dear Subscribers and Readers,
Let us 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 4,095.71 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 3,786.71 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a gain of 826.29 points as of Friday at the close.
The last major global pandemic – the Hong Kong Flu – killed approximately a million people around the world during a nine-month period lasting from July 1968 to March 1969. The virus originated in Hong Kong on July 13, 1968, with the local infection rate peaking in two weeks, lasting six weeks in total. At the peak, 15% of the local population (500,000) was infected, although the overall mortality rate was low. Later in the month, similar outbreaks were reported in Vietnam and Singapore. The virus entered California (via returning troops from the Vietnam War) in September 1968, with the infection rate peaking sometime in December. By the time the outbreak ended in March 1969, 33,800 Americans (those over 65 were the most susceptible) have died from the Hong Kong Flu.
The outbreak of the Hong Kong Flu is interesting for two reasons. During most pandemics, the infection rate typically peak much earlier, driven mostly by schoolchildren who catch the virus from others (and subsequently passing them on to their family members). The fact that the Hong Kong Flu arrived on our shores in September without a more rapid diffusion rate was baffling. Secondly, the number of deaths in the US was much lower than past pandemics, given improved medical care and that children were no longer attending school by the time the infection rate peaked (December 1968).
With the unprecedented amount of global air travel, and with children still in school, the infection rate for the Swine Flu could peak over the next two to four weeks, similar to the diffusion rate of the Hong Kong Flu in Asia during July 1968. With many governments taking precautions to prevent the Swine Flu from spreading (Mexico has already closed all its schools, museums, etc.), there is a strong likelihood that this could dissipate over the next couple of weeks. With the US school year ending in four weeks, we should experience a brief respite from the Swine Flu from June to August. For now, we don't believe this would turn to a global pandemic, but we will continue to track it closely over the next few weeks. The key is for the WHO, CDC, the Mexican, and other governments around the world to be vigilant during the summer – as the Swine Flu could easily return later this year once school starts in early September (note that both the 1918 Spanish Flu and the 1957 Asian Flu effectively began their outbreaks in September). Yesterday, we began to stock up on dry foods, canned foods, medicine, and drinking water – and I recommend our subscribers to do the same (now and just before school begins in late August). If you have kids, please remind them to wash their hands often, and avoid touching their eyes, nose, and mouth. The following diagram shows how Swine Flu could be transmitted and some of the symptoms associated with it:
Let us now get to the gist of our commentary. Last week, the IMF published its semi-annual Global Financial Stability Report. In the report, the IMF acknowledged that it had grossly underestimated the amount of global asset write-downs in its last report (published in late October 2008), and provided an update of projected write-downs given current bank lending conditions, projected GDP growth, current retail sales, projected housing prices, etc. (a full explanation of the IMF methodology can be found on page 68 to 69 of its October 2008 Global Financial Stability Report). Under the IMF's baseline case, US asset write-downs were estimated based on the following assumptions: 1) US GDP growth will bottom out during 3Q 2009 with a year-over-year decline of 3.3%, 2) lending conditions will continue to tighten until 2010, 3) US home prices will fall a further 18% from now till the end of 2010, 4) charge-offs on consumer loans to peak at 5.8%, and 5) charge-offs on commercial real estate loans to peak at 5.3%. Due to data limitations, European and Asian write-downs were estimated based on a combination current credit spreads and US credit loss profiles as a basis. The following table shows total estimated cumulative and future (up to the end of 2010) write-downs for the US, European, and Japanese financial sectors:
Quoting the IMF: Looking at the range of assets originated in the United States over the same cumulative period (2007–10) as in prior GFSRs, expected writedowns have risen to some $2.7 trillion, up from the $2.2
trillion estimated at our interim update in January 2009, and from the $1.4 trillion estimated in October 2008. The rise represents the credit deterioration that the worsening economic cycle is creating. Considering a much wider set of outstanding loans and securities to include European-originated loans and related securities as well as Japanese-originated assets (totaling some $58 trillion compared to earlier estimates based on $27 trillion of U.S. originated loans and securities) provides a broader, albeit more uncertain, assessment of potential writedowns of some $4.1 trillion. While banks are expected to bear about two-thirds of the writedowns, other financial institutions including pension funds and insurance companies also have significant credit exposures. Among other market participants, hedge funds have suffered losses related to both mark-to-market declines and forced asset liquidations due to redemptions.
About one-third of the estimated eventual write-downs have been recognized so far. Note, however, that the above IMF scenario isn't as bleak as one might think. For example, approximately $250 billion in the “US Other” category will be taken by the GSEs, while $306 billion of Citigroup's and $118 billion of Bank of America's riskiest assets have been “ring fenced” in by the government – meaning that any further losses over the next 18 to 24 months won't be totally debilitating. As mentioned in our prior commentaries, the most vulnerable region is actually the European financial sector. Not only has it been slow to recognize losses and credit impairments, many Western European banks (in particular Austrian banks) have significant exposure to Central and Eastern Europe – countries that were on the verge of collapse had it not been for IMF aid.
The following table from the IMF provides an illustration of banks' equity needs under a number of assumptions about the future environment for banking, including earnings streams and capital adequacy measures asserted by the market. With the market focusing solely on tangible equity, the IMF has chosen to do an analysis of capital adequacy based on that alone:
Note that even if US banks were to bring forward all its estimated write-downs over the next 21 months (to the end of 2010), Tier 1 ratio would still be at a respectable 6.7%. With the IMF estimating a core earnings power of $300 billion, US banks' tangible equity is projected to decrease by only $250 billion (of the projected $550 billion of future write-downs) over the same time period. In particular, given a core earnings power of $300 billion, the Tier 1 ratio of US banks would still remain at a respectable 8.4%, while tangible common equity would stand at 1.7% at the end of 2010. Assuming US banks target a tangible common equity ratio of 4%, the IMF estimates that US banks will need an additional $275 billion in capital. While this sounds like an unreachable goal, this could be achieved simply by converting 2.3% of Tier 1 capital to tangible common equity. In addition, the US Treasury's recent implementation of the Public-Private Investment Program (PPIP) should eventually allow banks to offload various troubled assets to investors with a government subsidy. This should go a long way towards reducing the size of banks' balance sheets and helping to increase the tangible common equity ratio of US banks.
Unfortunately, the financial situation in Europe is much bleaker. Even under the IMF's baseline scenario, the European banking sector still needs an additional $375 billion to replenish its tangible common equity position. This also does not take into account a “Black Swan” scenario emerging from Central and Eastern Europe. Furthermore – given the lack of Tier 1 capital – European banks cannot simply convert their Tier 1 capital into tangible common equity. Going forward, both the European Central Bank and the various sovereign governments in Europe (in particular, the Austrian government) will need to be bolder than they have ever been in terms of easing monetary policy (the European Central Bank should implement a “quantitative easing” policy at its next meeting on May 7th) and bank equity injections. For now, subscribers should continue to keep an eye on the economies of Central and Eastern Europe. Within the Euro Zone, subscribers should keep track of Austria (whose banks have the highest amount of Central and Eastern European exposure). Should global policymakers fail to address this over the next three to six months, we could very well see another down leg in the global financial markets – triggered by a banking crisis in the entire European region. In the meantime, we will remain vigilant – and 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 April 24, 2009, the Dow Industrials declined 55.04 points while the Dow Transports rose 42.89 points. While the Dow Industrials ended its six-week upside streak, the Dow Transports managed to hold on for a seventh consecutive up week. With investors now focusing on the Swine Flu and its important impact on global travel, the Dow Transports may take a hit this week. But given that the market has held up relatively well despite the short-term overbought conditions, probability still suggests that the rally has further to go. Assuming the diffusion rate of the Swine Flu peaks in the next couple of weeks, I expect the broad market indices to rally further in the next several months, given the amount of liquidity on the sidelines, the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system, and the ongoing efforts of global monetary authorities to reliquify the world's financial markets. Should there be any further need for capital after the results of the banks' “stress tests,” I expect the US Treasury to stand by the terms of its February 10th “Financial Stability” plan. Despite the bleak assessment of the IMF's Global Financial Stability Report, I expect a significant increase in bank lending and an eventual reopening of the securitization markets, especially with the Feds now providing support for the PPIP,. 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 increased from a reading of -8.7% to –7.1% for the week ending April 24, 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 MA reversing to the upside from a historically oversold level just six weeks ago, this is still a good time to buy equities, as historically, the best time to buy equities is when this sentiment indicator reverses from a very oversold level. Moreover, the current four-week MA reading of -7.1% is still far from an overbought reading. Given this development there is a very good chance the market will continue to rally. For now (although Europe still remains a basket case), the world's governments are still committed to reliquifying the global financial system, 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. We will remain 125% long in our DJIA Timing System, for now.
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 peak on March 24th, the 20 DMA has consolidated in the 131 to 137 range. While this sentiment indicator is at a level that is overbought relative to its readings over the last two years, its consolidation over the last four weeks has allowed it work off its short-term overbought conditions. With this indicator still far from historically overbought levels, the ISE Sentiment reading is still supportive for a rally in the stock market over the next several weeks to several months.
Conclusion: While the Swine Flu is a short-term worry (from both an investing and a mortal standpoint), probability suggests that its intensity should peak over the next two to four weeks. More importantly, the virus should dissipate once the school year is over as schools and other major public gathering places are typically the most conducive to spreading flu viruses. As for the “financial virus” which by now has engulfed the entire world, I continue to believe the global policy makers will eventually succeed in tackling it, even though European policy makers are still behind the curve. Obviously, we will continue to keep an eye on the results of the Treasury's “stress test” on May 4th, as well as any further write-downs in the global banking sector. With the ECRI Weekly Leading Indicator bottoming, and with credit spreads starting to narrow, I also do not anticipate the IMF's estimates to rise any further.
In terms of the general stock market, I continue to expect levered beta strategies to outperform for the rest of this year as global policy makers go “all out” to cushion or stop the deleveraging in the financial markets. Consequently, I expect financial stocks, consumer discretionary stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis for the next several months. Starting in 2010, however, this trend should shift, as consumers and corporations around the world start to rebuild their balance sheets. Whatever future growth we achieve will need to come mostly from Schumpeterian growth (I expect a new bull market in technology stocks), while true alpha would mostly be extracted from “exotic beta” strategies such as microcap stocks, foreign small cap stocks, private equity, and private real estate strategies. 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. 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 24th. We will sell this additional 25% long position once the market rally starts to lose steam. For those with a long-term timeframe, the stock market still represents a good buy. Subscribers please stay tuned.
Henry To, CFA