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Systemic Risks Still Tilted to the Upside

(June 18, 2009)

Dear Subscribers and Readers,

While every leading indicator that I track (e.g. OECD leading indicators, the Conference Board Leading Indicator, the ECRI, the stock market, etc.) is predicting a bottom in the US/global economy sometime this summer, this does not mean that the US economy will automatically revert to its historically 3% real growth rate by the end of this year or even by next year.  As we have mentioned before – the “twin headwinds” of deleveraging and lack of technological innovation (at least in the short-run) – will impede GDP growth for at least the next several years.  Even the UCLA Anderson Forecast – which has been one of the more optimistic economic forecasters heading into this crisis – is looking for only 2% GDP growth for the next several years.  A real GDP growth of only 2% would lead to an “L-shaped” economic recovery in terms of the unemployment rate.  Combined with the structural changes now going on in many industries (such as auto, specialty retail, casino operators, financial, etc.) we are now looking for unemployment to peak at over 10% sometime early next year and for it to stay at 9% to 10.5% for the rest of 2010.

With deleveraging still in full swing with the consumer sector of the developed world, there is still a higher-than-average amount of potential systemic sources of risks.  Combined with the precarious balance sheets of many Western European (including the UK) banks, as well as a struggling commercial real estate market, global policy makers will need to continue to be accommodative from both a monetary policy and a fiscal policy standpoint.  In our mid-week commentary last week, we mentioned that both US and Japanese liquidity were not growing as much as we could like, as the pace of the Fed's purchases of Treasuries and agency securities have slowed down dramatically in the three weeks leading into last week, while the Japanese monetary base growth declined from 8.2% in April to 7.9% in May.  These confirmed our suspicions that the Federal Reserve, along with the world's major central banks, had been easing their accommodative stance.  I also asserted that unless crude oil prices decline to the $60 to $65 area in the next week or so, there is a good chance that the world's major central banks will remain on hold in their next meetings (the European Central Bank has already indicated as such, and therefore should remain on hold in their next policy meeting in early July).

Interestingly, one major central bank that has maintained its pace of asset purchases (known as “Quantitative Easing”) is the Bank of England.  For the week ending June 11th, the Bank of England purchased 6.4 billion pounds of UK Gilts and other highly-rated securities, down from 7.0 billion pounds for the week ending June 4th.  Since the Bank of England's QE policy began in early March, the Bank has purchased a total of over 86 billion pounds of UK Gilts, commercial paper, and corporate bonds (with 83.4 billion pounds in UK Gilt purchases).  The following weekly chart (showing the weekly as well as the cumulative asset purchases made by the Bank of England since early March) illustrates how consistent these weekly purchases have been:

Central Bank Reserves Supplied Via Asset Purchases by the Bank of England (in Sterling millions)

The Bank's QE program currently has a limit of 125 billion pounds, and this could be raised to as high as 150 billion pounds if needed.  While there are signs that the UK economy is also bottoming, chances are that the Bank's QE policy played a very minor role in the recovery, as it could not have worked without a similar accommodative stance from the Federal Reserve and the rest of the world.  In fact, the Bank's asset purchases pale in comparison to the Fed's asset purchases (US$560 billion since early March), despite the fact that the Bank has bought more than 86 billion pounds (or about US$140 billion) of securities since early March.  While the Bank of England's asset purchases do help on the margin, my sense is that systemic risks will continue to rise during the summer unless the Fed ramp up their asset purchases again (e.g. we need to see lower mortgage rates before we could call a solid bottom in US housing prices).

While the recent relative lack of liquidity creation is a concern, both the amount of cash sitting on the sidelines and the Fed's latest Flow of Funds information suggest that equities could quickly rally again since global policy makers become more accommodative (and assuming energy prices remain relatively low).  After rising to a record high of 54.66% at the end of February, the amount of money market funds relative to the S&P 500's market capitalization has declined to 44.35%.  This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge of how oversold the US stock market really is – as well as how sustainable a current rally may be.  I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006.  Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to June 2009:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap(January 1981 to March 2009) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market which would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Since the ratio spiked to an all-time high of 54.66% at the end of February, it has declined to 44.35% - but is still much higher than the highs set in the bottom of the previous bear markets in October 2002 (27.66%) and month-end July 1982 (27.95%). Moreover, the amount of money market fund assets has remained steady. This ratio is supportive for stocks for the rest of 2009, but in the meantime, a further correction is certainly possible.

While a ratio of 44.35% marks a significant decline from its peak of 54.66%, such a ratio is still indicative of a very oversold market from a long-term perspective.  Should the Fed become more aggressive in their asset purchases going forward, then this ratio would definitely be supportive for stocks for the rest of 2009.

In the meantime, there is ample evidence that households have been capitulating in terms of their exposure to equities.  The following annual chart (with the last bullet point taking into account 1Q 2009 data) shows the percentage of total asset holdings by households and nonprofit organizations that are held (directly and indirectly) in equities (this chart is courtesy of the Federal Reserve's Flow of Funds data).  As of the end of 1Q 2009, equity holdings as a percentage of both financial and total assets held by households and nonprofit organizations declined to their lowest levels since the end of 1991:

Equities as a Percentage of Total Household and Nonprofit Organizations (1955 to 1Q 2009) - Equity holdings as a percentage of both financial and total assets by households and nonprofit organizations recently hit their lowest levels since the end of 1991!

Both percentages have declined by approximately 50% from their peak at the end of 1999 – suggesting widespread capitulation of stocks as a long-term asset class among households and nonprofit organizations.  As the US savings rate continues to grow going forward, and as the US housing market starts to put in a bottom by the end of this year or early 2010, there should be more support for equities as an asset class by households and nonprofit organizations from a diversification and asset allocation standpoint.  For now, I continue to believe the current correction has more room to run.  However – given the amount of cash sitting on the sidelines and the “widespread capitulation” by US households – I believe equity prices at the end of this year will be higher than where they are now, unless the Federal Reserve or the European Central Bank makes a significant policy mistake.

Signing off,

Henry To, CFA

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