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The Deleveraging in the US Financial Sector

(May 10, 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 3,597.35 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 3,288.35 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 1,324.65 points as of Friday at the close.

In last weekend's commentary, we asserted that the European Central Bank would “deliver a dud” by cutting its policy rate by only 25 basis points last Thursday, with “no promise to shift to a quantitative easing policy anytime soon.”  So much for that prediction.  While the ECB's rate cut was only 25 basis points, further rate cuts were not ruled out (in direct opposition to Bundesbank President, Axel Weber).  More significantly, the ECB also announced a 60 billion Euro (US$80.4 billion) plan to purchase covered bonds (securities issued and partially held by banks and backed by mortgages and public loans), which effectively shifts the ECB to a quantitative easing (i.e. money printing) policy.

But the big news last week was the release of the results of the US Treasury's stress tests of the 19 largest US banks – those being (ranked in terms of excess/deficit capital as a percentage of market cap by the stress test): MetLife, Capital One, State Street, JP Morgan, Bank of New York Mellon, American Express, BB&T Corp, US Bancorp, PNC Financial, Morgan Stanley, Wells Fargo, Citigroup, SunTrust Banks, Fifth Third Bancorp, Bank of America, KeyCorp, and Regions Financial (we were not able to rank two other banks, Goldman Sachs and GMAC, given limited information).  Out of the 19 banks, 10 banks are deemed to require additional capital, ranging from PNC Financial (3% of market cap, or $600 million) to Regions Financial (69% of market cap, or $2.5 billion).  On an absolute basis, the four banks (not surprisingly) that had the greatest need for capital were Bank of America ($33.9 billion), Wells Fargo ($13.7 billion), GMAC LLC ($11.5 billion), and Citigroup ($5.5 billion).  By the end of Friday, Wells Fargo had already raised $8.6 billion in common stock, while Morgan Stanley raised $4 billion in common stock and $4 billion in senior notes.  In addition, Citigroup announced that it plans to exchange an additional $5.5 billion of preferred securities into common stock, while Bank of America announced plans to sell 1.25 billion shares of new common stock and new debt that won't be guaranteed by the FDIC.

Of the $74.6 billion required by the stress test, approximately $20 billion have already been taken care of.  Moreover, the banks have 28 days to announce capital raising plans and until November 9th to implement them.  In the meantime, banks will be allowed to raise less than the $74.6 billion if earnings in the next six months surpass that of the US Treasury's forecasts.  Given the rally in bank stocks last Friday, the vast majority of the 19 banks – with the exception of GMAC LLC – should be able to raise equity without the government's aid.  Extending the stress test into the entire US banking sector, Goldman Sachs projects a $100 billion overall need for capital ($80 billion now given last Friday's completed equity offerings).  While there may be pockets of small bank failures in parts of Florida or California, the systemic risk posed by the US banking sector is off the table, for now, especially since the global economy is now showing signs of stabilizing.  Looking closer to our shores, the quarter-over-quarter growth in real GDP should turn positive in the third quarter.  Specifically, by the end of June, this recession would have lasted 18 months, which is the longest recession since the end of WWII.  While the length or severity of a recession is not an indication (by itself) that the deleveraging in the US economy is over, it is definitely due for a breather.  I am not predicting a return to 3% real GDP growth by any means, but I think we could squeak by with 1% to 2% annualized growth in 3Q GDP, especially considering:

  1. Residential real estate investment growth will should no longer be a drag on GDP as it has been in the last two years, simply because it has already declined by so much (i.e. the Q-o-Q comparison will be relatively generous).  On top of that, the record low mortgage rates and the easing in the banking sector should raise home affordability and mortgage loan availability during the peak of the buying season this summer.

  2. The amount of inventory liquidation from October of last year to the end of April has been unprecedented.  With demand now starting to tick up (e.g. Toyota is increasing production of a few selected models), inventory replenishment will provide a tailwind for 3Q real GDP growth.

  3. Credit spreads have come down significantly, providing another tailwind in upcoming credit growth and thus for Q-o-Q growth in 3Q GDP.  As the banks continued to raise capital over the next six months, credit availability will continue to ease – thus further reinforcing the tepid recovery the US economy is now experiencing.

Again, I do not expect US GDP growth to recover to the 3% area for a sustained period anytime soon.  As US consumers continue to rebuild their balance sheets, US consumer spending will need to readjust further to the downside.  As the US cannot reliably export “her way out” of an economic slowdown, this adjustment will most likely manifest itself in 1.5% to 2.0% real GDP growth, spread out over the next several years.  However, assuming that Central and Eastern Europe does not experience a financial collapse (which we do not expect at this time, as discussed in our last weekend's commentary), we also do not expect a deflationary depression.  I expect investor sentiment to factor in a more benign scenario (i.e. to turn more bullish) as the summer in the Northern Hemisphere progresses.  As a result, I continue to expect the stock market to grind higher over the next several months, especially given the more dovish policies now being implemented by the European Central Bank.  For now, we remain 125% long in our DJIA Timing System.

For those that work in the US banking sector, the latest mandatory capital requirements by the US Treasury is a blessing in disguise.  While this will dilute existing shareholders of the 10 banks mandated to raise capital, this also means the “forced deleveraging” of the US banking sector is over for now.  The additional $74.6 billion in capital will generate an additional lending capacity of nearly $750 billion, assuming a 10-to-1 leverage ratio.  As the lending capacity of the US banking expands, there will be less need to cut costs and to lay off employees.  According to Challenger, layoffs in the financial sector totaled 260,000 employees during 2008, out of a total of 1.22 million layoffs in the entire US economy.  This represented the third largest annual industry layoffs on record, behind the 318,000 layoffs and 269,000 layoffs in the telecommunications sector in 2001 and 2002, respectively.  More importantly, at the end of 2008, the proportion of the US labor force in the finance and insurance industry has shrunk to a 14-year low, as shown in the following chart (courtesy of the BEA, with estimates provided by Challenger):

Proportion of US Employment in the Finance and Insurance Industry (1987 to 2008 (projected)) - 1) Over the last 20 years, the proportion of the US labor force in the finance and insurance industry has actually remained very steady - even during the peak of the credit bubble in 2006! 2) More importantly, the size of the US labor force in the finance and insurance industry - at 4.1% of the total US labor force - is now at its lowest level since 1995!

With the recent capitalization of the US banking sector and the stabilization of the global economy, the above chart suggests that employment in the finance and insurance industry (barring a few industries such as hedge funds, leveraged loans, and credit cards) should remain steady for the rest of this year (the last time this declined to below 4.1% was 1979!).  That is, while I don't foresee a significant uptick in employment in the finance and insurance sector in the near future (most employers are still too shell-shocked to hire anyone), the outlook remains bright for those looking for (more stable) jobs in the industry over the long run.  True, the 2009 graduation class has been sacrificed.  The reputation and glamour of the financial sector has also dissipated.  But this is precisely the time to get in for students who want a career in the financial sector in the long run (there will also be less competition for jobs).  That said, don't look for a resumption of the “anything goes” era anytime soon – that period is over and won't come back for at least a generation.  The following chart – showing the contribution to US GDP by the finance and insurance industry – illustrates why:

Contribution to US GDP by the Finance and Insurance Industry (1987 to 2008) - Over the last 20 years, the contribution to GDP from the finance and insurance industry increased by almost 50% from 5.8% in 1987 to 8.1% in 2006. Since the peak, this has declined back to 7.5% of GDP, but it's still at a historically high level!

Even though employment in the US finance and insurance industry remained steady over the last 20 years, its proportional contribution to GDP has increased by nearly 50% during that period!  This could be explained by many trends the global economy has experienced over the last 20 years, such as the proliferation of the high-margin hedge fund and private equity industry, the expansion of the general asset management industry (it takes as many portfolio managers to manage $1 billion as $10 billion), and the creation of the securitization business.  With the impending regulation of the hedge fund and private equity industry, and with the debilitating hit to the securitization industry, I expect margins to come down significantly over the next several years.  That is, while I expect employment in the finance and insurance industry to remain steady over the next several years, many of the ultra high-paying jobs and highly profitable products will disappear.  Going forward, this will be a good thing for the long-term health of the US economy, as our “best and brightest” migrate to the sciences and engineering fields as opposed to going to Wall Street instead.

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 May 8, 2009) - For the week ending May 8th, the Dow Industrials rose 362.24 points, while the Dow Transports rose 198.78 points. The Dow Transports managed to hold on for an 9th consecutive up week, with both Dow indices managing to break out recent resistance levels and making a new four-month high. So far, the strength of this rally has been strong, as both upside breadth and volume have been the most impressive since the bear market started in late 2007. In addition, the relative strength of the Dow Transports is very encouraging, as the Dow Transports has been a leading indicator of the broader market in both the last bull market and the latest bear market. In the short-run, we are now definitely due for a correction, but the intermediate term uptrend remains intact. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending May 8, 2009, the Dow Industrials rose 362.24 points while the Dow Transports rose 198.78 points.  Amazingly, the Dow Transports has now risen nine weeks in a row.  While the market is now due for a short-term correction, this is encouraging nonetheless, as the Dow Transports has been a leading indicator of the broader market ever since the bottom of the last bear market in October 2002 (and especially with the H1N1/Swine flu scare curtailing travel a couple of weeks ago).  With the swine flu now appearing less dangerous than it did a couple of weeks ago, and with liquidity continuing to improve (especially given the successful recapitalization of the US banking sector and the more dovish stance of the European Central Bank), probability suggests that the rally has further to go.  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, a more dovish ECB, 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 increased from a reading of -7.3% to –4.1% for the week ending May 8, 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 May 8, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -7.3% to -4.1%. Meanwhile, its ten-week MA (not shown) has also reversed from a historcal oversold reading of -18.9% six weeks ago (lowest since August 2002!) to -12.3% - suggesting that sentiment has reversed from its very bearish readings and is now on a sustained uptrend. Subscribers should note that any reversal from historically oversold readings is usually a precursor to a significant rally. We will remain 125% long in our DJIA Timing System, and are now looking for a continuation of the rally over the next several months.

With the four-week MA reversing to the upside from a historically oversold level just eight weeks ago, probability suggests that both the rally and bullish sentiment still has further to run.  Moreover, the current four-week MA reading of -4.1% is still far from an overbought reading, while the 10-week MA has just reversed from a historically over reading six weeks ago.  For now, the world's governments are still committed to reliquifying the global financial system, and coupled with the inevitable institutional rebalancing into equities, probability suggests the market could sustain its rally over the next several months.  For now, we will remain 125% long in our DJIA Timing System, and we do not anticipate shifting back to a 100% long position until this sentiment indicator rises into overbought territory.

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 peak on March 24th, the 20 DMA has been consolidating in the 127- to 137 range - indicating that this sentiment indicator is working off its short-term overbought conditions. While the 20 DMA has become overbought relative to its readings over the last two years, it is still oversold relative to its longer term readings. Moreover, the 50 DMA has now caught up to the 20 DMA - suggesting that this sentiment indicator has now worked off its ST overbought conditions. I believe we should see a continuation of the rally over the next several months, especially now that the European Central Bank has moved to a more dovish monetary policy.

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 six weeks has allowed it work off its short-term overbought condition.  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 months.

Conclusion: With the successful recapitalization of the 19 largest US banks (the rest of the banking system is estimated to only need a manageable $25 billion in additional capital, as weighted by banking assets), and with the European Central Bank turning more dovish than most analysts had expected, the threat of a systemic meltdown (i.e. the tail risk) has been reduced yet further.  At the same time, the Bank of England announced last Thursday that it would increase its mandate to purchase assets (by utilizing central bank reserves, i.e. print money) by an additional 50 billion pounds.  In the meantime, the flood of more IMF aid for Central and Eastern Europe should be sufficient to stabilize the region for at least the next several months.  Furthermore, the ASEAN countries are now working together to create a US$120 billion crisis fund to stabilize South-East Asia.  All in all, this tremendous increase in global liquidity should be conducive for a further rally in the stock market over the next several months.

While I expect employment levels in the US finance and insurance sector to stabilize, probability suggests that both net revenues and income should continue to decline in the next several years, as the overall leverage in the US financial sector declines and as certain business lines shrink or disappear (such as the leveraged loans and securitization businesses).  By the spring of 2010, the finance and insurance sector should be hiring the new graduation class again, but in the future, a career in finance will no longer be as glamorous as it used to be (although it will still be relatively lucrative). 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.  Starting in 2010, however, this trend should shift, as consumers and corporations around the world start to rebuild their balance sheets.  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.    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.  With the US Treasury and Fed having now recapitalized the US banking system, I expect CDS spreads to narrow and for the structured finance indices to recover.  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.

Signing off,

Henry To, CFA

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