Victims of Their Own Successes
(June 7, 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 3,408.87 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 3,099.87 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 1,513.13 points as of Friday at the close.
With the Dow Industrials having risen 34% and the Dow Transports 56% since the multi-year March 8th bottom, and with the world's major central banks now holding off on liquidity creation, it is now time to par back our 125% long position in our DJIA Timing System for risk management purposes. Specifically, the size of the Federal Reserve's balance sheet has stagnated at the US$2.1 trillion level, while the Bank of England and the European Central Bank did not commit to expanding their “quantitative easing” policies during their monetary policy meetings last Thursday. Most ominously, there is now strong evidence suggesting that Latvia will devalue its currency in the coming days. Such devaluations forced by the markets tend to be disruptive in nature (no matter how much one is prepared for it). More importantly, a Latvia devaluation (unlike the Icelandic crisis late last year) could result in a “contagion effect” across many countries in Central and Eastern Europe, similar to the Thai Baht devaluation's effect on South East Asia on July 1, 1997. Again, in order to reduce risk in our DJIA Timing System, we will look to par back our 125% long position into a 100% long position and take profits of 1,513.13 Dow positions on our 25% long position (initiated on February 24th) - perhaps as soon as Monday.
Let us now get on with the “gist” of your commentary. In our weekend commentary two weeks ago (“A Day of Reflection”), we covered what we believe are some of the most important (both investment and social) trends over the next five to ten years. These trends include the realms of general finance reform, the hedge fund industry, the most popular asset classes, and the rise of the Asian consumer. In this commentary, I will attempt to expand on these points – as well as discuss other trends that will be important from an investment, career, and social standpoint. We have a lot to cover, so let's start right away.
The US Consumer
The topics of the “tapped out” US consumer has been virtually “beaten to death” in our commentaries and our discussion forum, but the impact of the “tapped out” consumer on many industries and companies cannot be overstated. As shown in the following chart, the 1Q 2009 savings rate rose to 4.2% of disposable personal income. In April, the US savings rate rose to a 14-year high of 5.7%. In short, I expect the official US savings rate (as flawed as that measurement is) to settle into a 6% to 10% range over the next few years. While this will lead to a decrease in short-term consumption, a higher US savings rate would allow us to invest more in our children, infrastructure, and the sciences going forward. It will also help keep interest rates relatively low – as the increase in the domestic pool of savings should offset any decrease in Treasuries and other asset purchases from China, etc.
Big bear markets happen for a reason. While the “black swan” risk of a collapse in our financial system is now off the table, the October 2007 to March 2009 bear market no doubt suggests that the forward outlook for many companies and industries are indeed very dire. In particular, many industries and companies have been the “victims of their own successes” – a phenomenon that I will now explain in the context of the “tapped out consumer.”
One industry that we have been bearish on is the US casino operator industry (in particular casinos on the Las Vegas Strip), which includes names such as Las Vegas Sands and MGM. As we discussed in our March 15, 2009 commentary (“It's a Paradigm Shift, All Right”), 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 we 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 online gaming, and the theme park industries.
What is less obvious is that the US casino operator industry (in particular the large ones on the Strip) is a victim of its own success. In a now-famous Harvard Business Review article published in 2003, the CEO of Harrah's Entertainment, Gary Loveman, discussed how Harrah's has been able to boost the most loyal clientele in the industry, resulting in 16 straight quarters of same-store revenue growth and the most profitable casinos in the industry through customer-data mining and innovative marketing strategies. A summary of the article is as follows: “Harrah's Entertainment CEO and former Harvard Business School Professor Gary Loveman explains how his company has trumped its competitors by mining customer data, running experiments using customer information, and using the findings to develop and implement marketing strategies that keep customers coming back for more. Harrah's identified its best customers--who were not typical high rollers--and taught them to respond to the casino's marketing efforts in a way that added to their individual value. The company's customer preference data were collected through its Total Rewards incentive program; in addition, it used decision-science-based analytical tools and database marketing. This deep data mining has succeeded because Harrah's has simultaneously maintained its focus on satisfying its customers. Loveman outlines the specific strategies and employee-performance measures that Harrah's uses to nurture customer loyalty across its 26 casinos.”
Similar customer data-mining and marketing strategies were adopted by other casino operators – not just on the Strip but also by Atlantic City and some tribal casinos as well. Unfortunately – especially with the advent of computer tracking technology, the use of modern-day quantitative marketing strategies, and the immense hiring of marketing MBAs in recent years – casino operators were too successful, resulting in a severe oversaturation of the domestic gaming market. This “victim of its own success” phenomenon was clear across many US industries, including the casual dining, auto, consumer electronics, specialty retail, mortgage, and the home improvement industries. Such a spending binge was further fueled by the structural decrease in borrowing rates (accompanied by an increase in credit availability) from 1980 to 2006. Who could've thought that Alfred Sloan's innovative strategy of annual model changes (a strategy designed to increase aspirational spending to get folks to buy more cars) – combined with late 20th century financial innovation – would ultimately lead to the crash of the domestic auto industry, and the demise of GM and Chrysler?
As has been evident for many years, the US auto industry (especially the relationship between the companies and the unions) was in need for a fundamental reboot. That it took a “liberal” like Obama to ultimately break the UAW isn't a surprise (much like Nixon's 1972 visit to China). What is less obvious – from both an investing and social standpoint – is that a “fundamental reboot” of the spending behavior of US consumers would also mean dramatic changes in the various industries as described above. In general, one does not want to be investing or working in the US retail, mortgage, restaurant, auto, and casino industries, as these industries have already reached saturation point and should experience below-GDP growth (or an outright shrinkage) in the next decade or two. Moreover, many of these industries are also saturated on the “supply side” with skilled workers and MBAs who will be competing ferociously as their industries shrink going forward. For the MBAs that are just graduating – take heed! For those with an international background or international experience, I would highly suggest migrating to Asia in order to take advantage of the next consumer-spending boom, as we briefly discussed in our weekend commentary two weeks ago. Working in a growing industry that isn't “top heavy” from a labor standpoint is the best career move anyone could make. Conversely, working in a declining industry that is “top-heavy” with workers with many years of experience could result in a lifetime of agony – unless one could find a special niche in said industries.
Saving for Retirement?
Most people forget that Wall Street and commercial banks exist to serve two overriding purposes – the first is to provide capital to entrepreneurs, corporations, and sovereign nations, and the second is to provide savings vehicles for individuals who want to defer current consumption – such as saving for a house, automobile, or for retirement. Investment management, venture capital, and investment and commercial banking are supposed to be niche industries, and going forward, given the size of these industries, there is no doubt that profit margins will continue to decline. More importantly, Americans (from the lower-to-middle class up to the high net worth individual) have shown that they are not disciplined enough to save for themselves – either in spending less than they earn or in picking the right investments. High net worth individuals are particularly vulnerable to the latest investment fad or fraudulent schemes (the vast majority of hedge fund withdrawals during the last 18 months came from high net worth individuals).
As we discussed in our April 30, 2009 commentary (“Can the Baby Boomers Ever Retire?”) – especially with the latest crash in financial assets – most baby boomers will not be able to retire by the time they turn 65. While a “prolonged saving scenario” (such as working until age 70) will help improve the state of baby boomers' finances, approximately half of all baby boomers will need to continue to work well after age 70, unless the US experiences another structural bull market in financial assets soon. With the US private savings industry having effectively been demonized (first with the bursting of the technology bubble, and now with the housing bubble and structured finance), and with US private defined benefits plans still shutting down daily, I believe the federal government will take a more active role in the US savings market going forward. Whether the US follows the “Singapore model” of a national mandatory retirement scheme or an increase in social security taxes is still up in the air, but it will get done.
Coincident with this, I expect the Obama administration to replace Treasury Secretary Geithner at least a year before the next Presidential election. While Geithner has (so far) played a major role in alleviating the current financial crisis, the Obama administration will need someone who can represent a more financially-disciplined United States while appearing “credible” to global investors. Geithner's reputation as the most dovish NY Fed Governor (even though he speaks Mandarin) – combined with his many proposals for government guarantees of private-sector debt thus far – will directly come into conflict with the more financially-disciplined image that the Obama administration will seek to project in the coming years. As Wall Street loses more of its political/lobbying power, I also expect the next Treasury Secretary to come from outside of Wall Street, and with a good background for dealing with Chinese businesses and politicians.
As we've discussed previously, I continue to expect some kind of breakthrough in the alternative energy space sometime in the next 3 to 5 years. I expect either cellulosic ethanol or solar power to reach “grid parity” in the sunniest parts of the US (i.e. parts of California, Nevada, and Texas), assuming natural gas and coal prices stay relatively high. Prior to this breakthrough (or in preparation for this breakthrough), I expect tons of investments to be made in our existing energy grid. Center Point Energy, which serves 2.2 million customers in metropolitan Houston, already has plans to spend $1 billion over the next 5 years on a smart grid upgrade. Not only will a “smart grid” be able to track usage and equipment failures on a real-time basis, it will also allow customers to sell energy (e.g. energy from a co-gen or from his/her own solar panels) back to the grid at a market-based price. An upgrade of the nation's power grid will also be needed if we are to tap more alternative energy resources or pave the way for a mass adoption of plug-in hybrids by the automobile industry.
Until the nation adopts some kind of “smart” energy grid, there is no chance we could ever wean ourselves off foreign oil.
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 June 5, 2009, the Dow Industrials rose 262.80 points while the Dow Transports rose 147.53 points. With the two Dow indices having risen by 34% and 56%, respectively, from their March 8th lows, the market is now very overbought in the short run. While the Dow indices have held up well, and while the strength of the rally since the March lows has been strong, we are nonetheless concerned in the short-run given the relative lack of liquidity creation in the world's major central banks over the last few weeks. Moreover, there is a strong chance that Latvia will devalue its currency in the coming days – potentially setting off a “contagion” effect in other Central and Eastern European countries. While we are still bullish on US equities over the next several months, we should also reduce our risk exposure. Because of this, we will par back our 125% long position (to a 100% long position) in our DJIA Timing System in the coming days (perhaps as early as Monday).
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 -1.3% to –0.3% for the week ending June 5, 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:
While the 4-week MA is still relatively oversold on a historical basis, it has also increased very quickly since the early March lows – suggesting that we may be due for a short-term correction, especially given the recent lack of liquidity creation by the world's major central banks and the impending devaluation by Latvia. While I believe the world's central banks are still committed to reflating the global financial system and economy for the foreseeable future, evidence suggests that we should par back our 125% long position in our DJIA Timing System as soon as feasible. For now, we will remain 125% long in our DJIA Timing System, but will look to shift back to a 100% long position sometime this week – perhaps as soon as Monday.
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:
From its most recent peak on March 24th to late May the 20 DMA has been consolidating in the 127 to 137 range – which has allowed this indicator to work off its short-term overbought conditions. More importantly, as of two Fridays ago, the 20 DMA has finally “broken out” to the upside of its recent range, rising to close at 140.01. While this indicator is still far from historically overbought levels, it is now bumping up against recent “resistance” – suggesting that we could in for a correction in the short-run.
Conclusion: Big bear markets happen for a reason. Aside from the potential collapse of our global financial system (said “tail risk” which is now off the table), the bear market during the early March lows was also discounting a fundamental “reboot” of many US domestic industries – specifically those related to the US consumer and the US financial sector. For those who have investments or who are currently working in the industries I mention, I highly suggest taking a step back and a hard look on the future prospects of your industry – in particular, whether you have a niche or are nimble enough to navigate the significant changes these industries will experience in the next 5 to 10 years.
In terms of the global equity markets, I expect the upside to be relatively limited in the short-run, as global central banks are now in a “wait and see” mode and as the inevitable Latvia devaluation may usher in higher risk premiums in the Central and Eastern European countries. That said, I still expect the global equity markets to rise for the rest of this year. Consequently, I expect financial stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis in 2009. 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 and biotechnology 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 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 in order to manage for risk – perhaps as soon as this week or even Monday. Subscribers please stay tuned.
Henry To, CFA