The Fed’s 1Q 2009 Flow of Funds Update
(June 14, 2009)
Dear Subscribers and Readers,
Before we provide an update of our DJIA Timing System, I want to ask our subscribers a question: Why do financial professionals get paid? The commercial bank model involves borrowing on the short end and lending on the long end of the yield curve, while most asset managers charge their investors a proportion of the funds that they manage (typically 30 to 60 basis points for a US large cap equity fund and about twice that for a US small cap equity or an emerging market mutual fund). This is how they get paid, but why do they get paid? As compensation, what kind of value-added services do financial professionals provide to society, and which factors are the main drivers of their fees and compensation?
Ever since the dawn of the modern day banker in 13th century Florence, financial professionals have been compensated (either directly or indirectly) through the provision of three essential services: 1) Act as an intermediary to those who want to defer (e.g. save for retirement) or bring forward consumption (e.g. borrowing money to buy a house); 2) Provide liquidity to the financial markets, sovereign states, or predominantly in the last 200 years, corporations and venture capital firms (e.g. investment bankers getting paid for an IPO of a corporation); and 3) Act as a kind of market-maker, who in turn makes the market more efficient and assist in price discovery and transparency. Aside from the NYSE specialists back in the old days, Jim Simons' flagship Medallion Fund comes close to emulating this model, which is one reason why this hedge fund has been so successful over the last two decades.
The above framework provides a clear picture of why financial professionals get paid, and more importantly for investors and financial professionals, the magnitude of modern-day fees and compensation packages. In addition, financial companies typically don't specialize in just one service. Financiers have historically branched out to other areas, such as adding value to their investments through operational advice or sitting on the companies' boards. The Morgan bank was famous for doing this, especially in the railroad industry in the late 19th century. Today, small to middle market private equity firms are instrumental in not only providing capital, but also operational advice and other services to the companies within their investment portfolios.
In general, financiers' rewards are inversely correlated with the magnitude of liquidity and efficiency of the markets in which they operate. The traditional/quintessential investment banker – that of the gentleman banker bringing a company's issue to the market for the first time – still enjoys some of the highest compensation in the industry, primarily because he or she operates in a very illiquid and “clubby” market. In addition, companies issuing stock for the first time (with the notable exception of the Google IPO) typically seeks out the firms with the greatest franchise value, as these firms are typically able to maximize the success of an issue. Studies have found that no amount of competition could dent the fee structure of the “bulge bracket” investment banks, despite Google's success with its “Dutch IPO' model in 2004.
Based on this inverse relationship between compensation and market liquidity/efficiency, it is thus no surprise that some of the greatest fortunes or transactions were made during times of great illiquidity and inefficiency. John Pierpont Morgan, for example, was able to snatch the Tennessee Iron & Coal Company for a absurdly low price to complement its steel holdings in the midst of the Panic of 1907. Not only did Morgan have the funds to purchase T&I, he also had enough funds at his disposal (most of which were not his) to reliquify the US financial market. In retrospect, Morgan could've easily multiplied his fortune if he had wanted to. Nearly 70 years later, Warren Buffett provided much-needed liquidity to GEICO in the midst of a record loss and shareholder revolt in 1976, as the company struggled to stay solvent in an era of highly inflationary medical costs and a general lack of cheap capital. This investment by Buffett, along with his investment in American Express during the aftermath of the 1963 “Salad Oil Scandal” and in Freddie Mac in the early 1980s, would disproportionally drive investment returns at Berkshire Hathaway for years to come.
Based on this liquidity/efficiency framework – and coupled with my above examples – it becomes clearer on where the investment industry is heading in terms of where the best investments lie and how financial professionals would be compensated. We now also understand why US mutual fund managers were rewarded so handsomely during the 1980s and 1990s (for most of that time period, the US equity market was still relatively inefficient), and why this “gravy train” will never come back, even in the next secular bull market in equities. Stretching this analogy still further, it is highly doubtful that the “traditional 2 and 20” hedge fund fee structure will survive going forward, as by definition, only a small handful of hedge funds could take advantage of market illiquidity and/or inefficiency to reap outsized rewards. In other words, the traditional hedge fund industry – whether it is in convertible arbitrage, merger arbitrage, fixed income relative value, or global macro – was never meant to be a mainstream industry in the first place. Even with a diminished asset base of just US$1.3 trillion, there is simply not enough opportunities for most hedge funds to justify their “2 and 20” fee structure. Finally, recent papers have shown that many traditional hedge fund strategies (such as the LIBOR-swap spread strategy favored by Long Term Capital Management in the mid 1990s), contrary to initial beliefs, simply did not generate any market alpha over the long run, especially on an after-fees basis. With many low-fee hedge fund replication strategies now being created and marketed to institutional investors – and with institutions such as CalPERS and CalSTRS now revising their hedge fund fee agreements – there is no doubt that the “hedge fund gravy train” has come and gone, and will most likely never come back (except for a small handful of hedge funds).
Let us now continue our commentary by reviewing our 9 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 3,372.74 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 3,063.74 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.
In last weekend's commentary, we mentioned:
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.
On Monday morning, we sent an email in real-time informing our subscribers that we were shifting our 125% long position in our DJIA Timing System to a 100% long position. Since then, systemic risk has continued to increase. As discussed in our mid-week commentary, the Federal Reserve has dramatically slowed their asset purchases, while the European Union is still “sitting on its hands” with regards to the potential Latvia devaluation. Geopolitical tension also increased, as the allegations of widespread fraud in the Iranian election and as the saber rattling in North Korea became front-page topics over the weekend. While we still believe the intermediate trend of the stock market remains to the upside, there is no denying that there is substantial downside risk in the short-run. As a result, we decided that cutting our long position to a 100% long position in our DJIA Timing System is the best way to reduce risk in our portfolio, while maintaining the possibility of more upside for the rest of this year.
Let us now get on with the “gist” of your commentary. One of the main themes that we will continue to track is the concept of the overleveraged US consumer, as well as the “new journey” of the US consumer as he or she actively deleverage and rebuild his/her balance sheet going forward. In our March 15, 2009 commentary (“It's a Paradigm Shift, All Right”), we discussed the fact that US households' asset-to-liability ratio (using the Fed's Flow of Funds data as of 4Q 2008) hit a new post WWII low, and that it will take at least several years before US consumers can rebuild their balance sheets. As of 1Q 2009, US households' balance sheets have deteriorated further (although there is no doubt that they have recovered quite a bit since then). As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, US households' net worth have a very long hill to climb before it will take at least several years before it can reach its prior peak levels again, even should the US economy (and housing prices) start its recovery this summer:
During the first quarter of this year, the asset-to-liability ratio of US households declined from 4.63 to 4.56 – setting another record low. In addition, US household net worth declined US$1.3 trillion in the first quarter, and a whooping US$13.9 trillion from its peak at the end of 2Q 2007! Interestingly, US households' liabilities only declined by $420.6 billion (from $14.56 trillion to $14.14 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 minimal amount over the last six months. So why did US households' liabilities only dip by $420.6 billion from its peak? The most likely answer is that the vast majority of US households are still paying their mortgages, even as global financial institutions have been writing them down (following “mark to market” rules and the lead of the structured finance indices). 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 made this an impossibility.
Given the rise in asset prices since March 31st, we should see a dramatic improvement in the asset-to-liability ratio of US households as of 2Q 2009 (this data will be released in mid September). Coinciding with the active deleveraging in US households' balance sheets, I estimate this ratio to rise back above 5.0 as of 2Q 2009. Even at a ratio of 5.0, however, it will take at least several years for this ratio to regain its level of 6.0 during the “pre housing bubble days.”
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 12, 2009, the Dow Industrials rose 36.13 points while the Dow Transports rose 11.44 points. With the two Dow indices having risen by 34% and 57%, respectively, from their early March lows, and with systemic risks having increased substantially in the last couple of weeks, we decided to reduce our risk exposure by paring back our 125% long position to a 100% long position in our DJIA Timing System as the probability of a short term correction had increased dramatically. For now, more active subscribers should continue to keep track of the amount of liquidity creation by the world's central banks, as well as the situation in the Latvia economy.
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 -0.3% to 0.6% for the week ending June 12, 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 paring back our 125% long position in our DJIA Timing System was the right move. For now, we will remain 100% long in our DJIA Timing System, and will most likely not ever shift back to a 125% long position again unless the Dow Industrials break the 7,000 level and approach the early March lows.
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:
Except for the brief spike two weeks ago, the 20 DMA has been consolidating in the 127 to 137 range for the last three months. While this consolidation has allowed this indicator to work off its short-term overbought conditions, there are still some short-term but significant obstacles that the market needs to deal with. Moreover, 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: As the global financial system continues its reforms – and as many parts of the global financial system become more “efficient” and transparent – many business models and investment strategies among financial participants will need to undergo a fundamental review. The hedge fund industry, in particular, will need to continue to evolve. Specifically, hedge funds will need to sought out less mainstream strategies, including those in the emerging markets (in particular, Asia, which has the cleanest balance sheets in the world), or failing that, lower their fee structures. As I alluded to last week, for those who are currently working in the financial industry, I highly suggest taking a step back and a hard look on your future prospects – 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 it to undergo a correction in the short-run, as global central banks start to think about reining in their liquidity facilities 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. 2010 will be trickier, as there is no doubt that consumers and corporations around the world will continue 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. While this is still too early to say, I expect the next US bull market to be driven by technology and biotechnology stocks (with the Asian consumer also being a big part of it). Subscribers please stay tuned.
Henry To, CFA