Will the European Delivery be a Dud?
(May 3, 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 3,959.59 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 3,650.59 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 962.41 points as of Friday at the close.
As we have covered over the last 12 months and in recent commentaries (see our February 1, 2009 commentary “A Dislocation in Europe?” and last weekend's commentary “The April 2009 Global Financial Stability Report”), we believe that Central and Eastern Europe – with its historical funding gaps, overvalued currencies, and dramatically slowing economies – remain the most economically vulnerable region in the world today. With many banks in Western Europe (especially Austrian banks, calculated in proportion to its GDP) exposed to the region, any dislocation in Central and Eastern Europe could result in an irreversible bust unless the national governments or the IMF step in through bank recapitalizations or direct lending to the most vulnerable countries in Central and Eastern Europe. Specifically, Romania (20 billion Euros), Hungary (totaling $25.1 billion from the IMF, the World Bank, and the European Union), Latvia (7.5 billion Euros), and Belarus (1.8 billion Euros) have already received IMF aid, while Poland, Serbia, and the Ukraine are expected to receive IMF aid in a matter of days.
As we commented on the latest IMF's findings into the US and European banking sector last week:
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.
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.
With the “stress test” results of the 19 largest US banks to be finalized and released this Thursday – and with the government “forcing” some of these banks to raise more equity as a cushion to future anticipated losses (preliminary reports suggest that both Citigroup and Bank of America will be required to raise $10 billion each in common equity), the US financial sector seems to be on a decent footing for now. While the situation in Central and Eastern Europe has been buffeted by recent aid (and promises of aid) from the IMF, the World Bank, and the European Union (no doubt Germany and France want the Chinese, Japanese, and the US to do the heavy lifting here), the region will undoubtedly need to adjust further over the next 12 to 18 months given the immense current account deficits and the various asset bubbles it experienced during the late 2002 to early 2007 period. Goldman Sachs estimates the funding gap (the region's projected capital shortfall this year plus the accumulated current account deficits) to be about 10% of the region's GDP, or about 100 billion Euros. For this to be a “benign” adjustment (i.e. for it not to be a systemic event), global policy makers have essentially three options:
1) Ramp up official aid (through the IMF, World Bank, and the European Union) in the months ahead allowing the region's businesses and consumers to roll over their debt and to eventually “grow their way out” of the problem. This should be combined with an “engineered” depreciation of the local currencies – allowing Central and Eastern European households to continue paying their foreign-denominated debts and to export their way to future economic growth. My sense is that this is the scenario that European policymakers are hoping would work.
2) Unfortunately – with the entire developed world (especially the US) shrinking their current account deficits through less imports – it will be very difficult for Central and Eastern European countries to export their way out of their current bind (unless the Asian tigers back in 1997 to 1998). If official aid fails to prevent local bank runs or a run from the local currencies, then more dramatic measures will be taken. In such a scenario, the IMF – in coordination with other central banks – would need to accelerate its funding to local central banks, with the funds to be used to prop up local financial institutions. Since this is only a short-term solution, it would need to be accompanied by other measures, such as more aggressive interest rate cuts by the European Central Bank or a quantitative easing policy where the ECB would buy government bonds of lower-credit countries like Spain, Italy, or Greece or even AAA-rated corporate bonds in the region (similar to what the Bank of England has been doing). Such a measure would not only help cushion the slowing European economy, but also provide much-needed liquidity (along with a lower Euro) to the entire region.
3) If none of these measures succeed (or if they are not implemented in time), then there will be no choice but for European policymakers to recapitalize the Western European banks (through equity injections or nationalization) that will inevitably take a major hit from a financial collapse of the Central and Eastern European region. This will spell disaster for both debt and equity shareholders of financial institutions around the world.
Note that option 3 is truly an “Armageddon scenario.” Before that happens, both European and global policymakers will have tons of options to help cushion Central and Eastern Europe. The recent IMF aid to the region is a crucial first step – and should go a long way to “slowing the bleeding” in the region at least until the end of the summer. This is one reason why the European Central Bank has been so slow to act – not just in cutting interest rates but in implementing a “quantitative easing” policy as well. The other reason is this: For both moral hazard and efficient capital allocation purposes, the ECB simply does not want to “subsidize” the Spanish, Greek, and Italian governments by buying their (Euro-denominated) debt. As a result, I expect the ECB to buy AAA-rated corporate bonds instead should it move to a “quantitative easing” policy later this year. As for its upcoming May 7th monetary policy decision, I expect the ECB to deliver a “dud” by cutting its policy rate by a mere 25 basis points with no promise to shift to a quantitative easing policy anytime soon.
In addition, with the successful launch of the US$120 billion crisis fund by the 10-country ASEAN under the “Chiang Mai Initiative” over the weekend, there is no question that global liquidity will be sufficient for now. Not only will this ensure increased (or at least stabilize) bank lending and trade over the next few months, this should also stabilize Asian consumption. Finally – and on a more American-centric basis – primary liquidity conditions in the US have remained extremely accommodative. Not only has the Federal Reserve continued to purchase Treasuries and agency debt/mortgage-backed securities, it has also been pumping up the US monetary base, as shown on the following chart:
Note that the stock market decline during February and the early part of March was preceded by a slowdown in the growth of the US monetary base. Since then, however, the growth of the US monetary base has accelerated to a new height. Combined with the creation of the US$120 billion “crisis fund” by the ASEAN, this should help pave for a further rally in the stock market over the next several weeks to several months. While the lack of further easing in Europe is a concern, we believe that European policymakers could postpone the “hard decisions” until the end of the summer. 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:
For the week ending May 1, 2009, the Dow Industrials rose 136.12 points while the Dow Transports rose 14.63 points. The Dow Transports has now risen eight weeks in a row. This is encouraging for the stock market, as the Dow Transports has been a leading indicator of the broader market during the last bull market and bear market (and especially with the H1N1/Swine flu scare curtailing travel last week). With the swine flu infection rate now peaking, and with liquidity continuing to improve, probability suggests that the rally has further to go. Moreover, preliminary results of the “stress tests” of the 19 major US banks suggest that both Citigroup and Bank of America would need (at most) $10 billion each in new common equity. 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 in late April, Europe should continue to hold together at least for the next several months, given recent and promised IMF aid and the increase in US and Asian liquidity. 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 decreased from a reading of -7.1% to –7.3% for the week ending May 1, 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 seven 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 -7.3% 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 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 127 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 five 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 Europe remains a basket case in general, recent and the promise of more of IMF aid for Central and Eastern Europe should be sufficient to stabilize the region for at least the next several months. Failing that, there are still many unconventional policies that global and European public policy makers could take before the region turns into a systemic threat. As a result, I don't believe the European Central Bank would announce any unconventional or “quantitative easing” policy at its May 7th monetary policy meeting. Rather, I expect the ECB to cut its policy rate by 25 basis points, with a promise to ease further should liquidity conditions or economic growth continue to decline over the summer. With the ASEAN countries working together to create a US$120 billion crisis fund to stabilize South-East Asia, and with the US monetary base making new highs, global liquidity should be conducive for a further rally in the stock market over the next several months.
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, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis for the next several months. On a country-specific basis, I expect Taiwan to outperform as the Greater China region continue to liberalize and encourage cross-border fund flows and as the market has turned very favorable for semiconductor and technology stocks. 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