Is the European Banking System Out of the Woods?
(October 4, 2009)
Note: One major trend that we have been tracking (both in our commentaries and in our discussion forum) is the next productivity and innovation cycle – or specifically, where the next major economic “growth engine” will emerge. While the ongoing “emergence” of countries such as Brazil, China, and India will continue to drive global economic growth, others – such as technological innovation – will be key in driving US economic growth and growth in other developed countries. One such specific trend is the emergence and breakthroughs in the creation and usage of carbon nanotubes. Last week, Honda Motors announced a major increase in its success rate from 25-50% to 91% in the creation of metallic carbon nanotubes. Such a process – if commercialized – would have a greater societal and economic impact than the commercialization of the Bessemer process in producing steel in the late 19th century.
Dear Subscribers and Readers,
Before we begin our commentary on the European banking system, I want to update our DJIA Timing System's performance to September 30, 2009, and review our 9 most recent signals. Note that subscribers who want to independently calculate our historical performance could do so by tallying up all our signals going back to the inception (August 18, 2004) of our system (we have sent our subscribers real-time emails whenever there is a new signal). Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to September 30, 2009:
To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way. We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500 or the Russell 1000), since most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market. In addition, the Dow Industrials has a rich history going back to 1896, while the S&P 500 was created in 1957 (although it has been retroactively constructed back to 1926).
Looking at our performance since inception, it is clear that most of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and when we decided to shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we subsequently closed out on January 9, 2008). While we have stayed on the long side for the most part since mid January 2008, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance during that timeframe. Looking at the last nine months, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided over 3% in outperformance, although that resulted in slightly higher volatility (since we were 125% long).
Subscribers should keep in mind that our goal is to beat the Dow Industrials by a significant margin over a market cycle with lower volatility. While we are not totally happy with our performance over the last 12 months, subscribers should note that we are still ahead of the Dow Industrials by over 12% on an annualized basis over the last two years, or since the beginning of the credit crisis. In addition, on a cumulative basis, we are ahead of the Dow Industrials by more than 15% since the inception of our DJIA Timing System on August 18, 2004, returning 11.45% vs. -3.68% for the Dow Industrials (on a price-only basis). Our goal is to beat the stock market with less risk over the long run, and so far, we have done that. Today, we remain 100% long in our DJIA Timing System.
Subscribers should remember that:
- It is the major movements that count. Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries (note that our two stock picks, Best Buy and Carnival Cruises have beaten the S&P 500 by a very wide margin since they were recommended);
- Capital preservation during times of excesses is the key to outperforming the stock market over the long run. That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back in the next innovation cycle. I am not going to change my mind on this unless: 1) the Fed or the ECB makes a major policy mistake, 2) an inflationary spiral emerges, 3) the Obama administration makes a major policy mistake, such as protectionist policies or higher taxes, 4) extreme overvaluations in the U.S. stock market, or 5) a major regional war becomes a possibility, especially in the Middle East. At this point, I do not see much threat to the stock market on any of these five counts (versus late 2008, when valuations were overly high and when the Fed was reluctant to cut rates), although Iran remains on our watch list.
Also note that our (annualized daily) volatility levels continue to be lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods. For now, we believe that the stock market made a solid bottom in early March, and thus we will likely remain 100% long in our DJIA Timing System for the time being. Unless the Dow Industrials experiences another rip-roaring rally during the fourth quarter (in which case, we will shift to a more defensive position), there is a good chance we will remain 125% long in our DJIA Timing System again. We will again update the performance of our DJIA Timing System at December 31, 2009.
Let us begin 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 2,684.33 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 2,375.33 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.
Over the summer, we discussed the liquidity and solvency situation in the European financial system, with a particular focus on the potential write-downs stemming from the troubles in Eastern & Central European lending and further write-downs from the rise in global residential real estate defaults. Specifically, in our July 19, 2009 commentary (“Europe Stuck in a Quagmire”), we concluded that, based on the ECB's Financial Stability Review report, that European-based banks would need to raise a minimum of US$284 billion in additional capital to sooth investors' fears because of further write-downs and to encourage normal lending again. On the downside – since bank-by-bank estimates are hard to come by – the ECB estimates that European-based banks would need to raise a whopping US$580 billion. Even though a financial dislocation in Latvia and other Eastern European countries is now off the table (given the IMF's and EU's financial lifelines), these estimates still stand given the overall slowing global economy and the ongoing decline in loan quality.
Fast forward two-and-a-half months, the latest edition of the IMF's Global Financial Stability Report is still suggesting the need for further capital raises in the European banking system, despite an overall increase in bank's equity and corporate bond prices since mid July. Specifically – and as shown in the following table – the IMF estimates that eventual global bank write-downs will total US$2.8 trillion (unchanged from its April estimates). With cumulative write-downs through the first half of 2009 totaling US$1.3 trillion, the IMF estimates that global banks will take additional write-downs of US$1.5 trillion through the end of 2010. European banks (not including UK) still have the most write-downs that are not recognized. The IMF estimates that European-based banks would need to write down an additional US$500 billion to the end of 2010.
The following table breaks down the IMF's eventual loss estimates by geography and the types of assets. While US banks have and will suffer the most write-downs, they have also recognized approximately 60% of their potential write-downs, versus just 40% for UK and European banks.
The key, of course, is whether European banks can withstand such further write-downs based on the current strength of their balance sheets and their “core earnings power” from now till the end of 2010. Quoting the IMF:
For this 18-month period, expected writedowns outweigh forecast revenues, resulting in a drain on capital. Notwithstanding this drain, capital ratios exceed 6 percent Tier 1 capital-to-risk-weighted-assets (RWA) ratio in aggregate, owing to increased earnings and successful private capital-raising efforts, as well as government capital injections. We also illustrate the capital required to reach an 8 percent Tier 1 to RWA ratio and find this to be modest as well. Finally, two other metrics—10 percent Tier 1 capital to RWA, and 25 times levered (a tangible common equity/total asset ratio of 4 percent, as presented in the April 2009 GFSR)—are included since they represent measures that many market participants use to assess bank balance sheet health.
The main message is that banks in all regions have achieved a degree of stability in their capital positions, but that further deleveraging pressures lie ahead, and markets are favoring banks that have already built up their resilience in anticipation of those pressures. Banks with strong capital positions and stable funding profiles will be able to lend as credit demand revives, while those that are still rebuilding capital buffers and terming out their debt will miss that opportunity and will not be able to support the economic recovery. Even if banks raise private capital on the scale indicated in Table 1.3, they will also need to shed assets to achieve the capital adequacy levels indicated. Thus, policies will need to continue to resolve weaker bank balance sheets, protect against downside risks, and strengthen lending capacity. Figure 1.12 summarizes the capital needs under different capital metrics and highlights their scale in relation to the size of respective banking systems.
Table 1.3, courtesy of the IMF, is reproduced below:
With the recapitalization of the 19 largest US banks in April, the capital needs of US banks have declined dramatically in the last six months. Conversely, the IMF believes that European-based banks will need to raise at least US$310 billion (to achieve a tangible equity ratio of 4%) in order to satisfy the solvency requirements of market participants. Fortunately, as shown in the following table, credit spreads (especially those for European financials) have come down dramatically over the last six months (European financial spreads are now a pre-Lehman levels). Combined with the rise in financials' equity prices over the last six months, this suggests that the weighted cost of capital for European banks have come down significantly – which means that European banks can probably raise the necessary equity to increase their capital levels from now till the end of 2010 (especially given the amount of global cash sitting on the sidelines):
In addition, individual sovereign countries within the European banking system could also play the “Citigroup card” such as “ring-fencing” toxic assets (essentially socializing the banks' losses) – which the Federal Reserve implemented for Citigroup and Bank of America earlier this year. Not all losses would be spread evenly among European banks of course, but overall, I expect any upcoming write-downs to be “manageable” in the context of today's fund-raising environment. While European banks probably no longer pose a global systemic risk, I expect the upcoming equity raises by European banks to be very dilutive for current equity holders – and thus I look for both European and US bank shares to underperform over the next 12 months.
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 January 2007 to the present:
For the week ending October 2, 2009, the Dow Industrials declined 177.52 points while the Dow Transports declined 115.98 points. In retrospect, the weakness in the Dow Transports three weeks ago was a precursor of the weakness in the stock market over the last two weeks, as the Dow Transports has typically led both the Dow Industrials and the broader stock market since October 2002. With the stock market now short-term oversold, we should probably see a bounce this week. However, my sense is that the correction is still not done – at the very least; I expect the market to experience a long consolidation period that will last until the end of 2009. Moreover, given the ongoing weakness in the European banking system, we do not recommend any new stock purchases right now. For now, we will maintain our 100% 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 6.7% to 8.2% for the week ending October 2, 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 four-week moving average is still far from a historic overbought level, its “spike” from early March to the present suggests that individual investors have gotten too bullish, too quickly. That is, while there is still enough “fuel” for a longer-term rally, probability suggests that the stock market will need to correct or consolidate further before we can embark on a further rally. Moreover, while the “Bernanke Put” is still alive, the Federal Reserve has already indicated it will end its “credit easing” policy at the end of 1Q 2010 – thus constraining liquidity creation and support for the financial markets. For now, we will remain 100% long in our DJIA Timing System, but would not hesitate shifting to a more defensive position should the stock market enters into a substantial rally (on weak breadth and volume) over the next several weeks.
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:
For the week ending October 2nd, the 20 DMA decreased from 123.7 to 122.1, while the 50 DMA decreased to 122.9, which remains close to its eight-month low. Both the 20 DMA and the 50 DMA have been mired in a narrow trading range for the last few months, with no indications of an imminent “breakout” in either direction. My sense is that investor's sentiment, as signaled by the ISE Sentiment Index, is now in “no-man's land” – this indicates that many investors are now undecided in the market and suggests at least a long period of consolidation over the next few months. Given the short-term liquidity headwinds and the troubles in the European banking system, we believe the risk for the stock market is tilted towards the downside in the short-run, although the longer-term uptrend remains intact. For now, we will remain our 100% long position in our DJIA Timing System.
Conclusion: While we no longer believe European banks pose a global systemic risk, there is no denying that European banks will need to raise a substantial amount of capital in order to resume its “normal state” of lending going forward. As a result – while this is relatively bullish for the global economy (since this would jump start lending again) – this would be very dilutive for current equity holders – and thus I look for both European and US bank shares to underperform over the next 12 months. Risks are tilted towards the downside of course, since there is no guarantee that European banks can raise US$310 billion so quickly and so effortlessly. Should any sovereign governments in Europe forced to step in – such as to ring-fence certain toxic assets – I expect the penalty to be severe, given the lack of populist support to “bail out” banks without penalizing the bankers or the shareholders. In addition, the ongoing decline in US commercial real estate prices continues to pose a global systemic risk, and is something that we will continue to track for the foreseeable future.
As for the US stock market, we continue to believe that it will at least be mired in a consolidation period for the rest of this year. While short-term tops and corrections are notoriously difficult to time (and most importantly, are typically quick and shallow) during a cyclical bull market (this author believes that a new cyclical bull market began in early March of this year) – it is likely that we will shift to a more defensive position (50% long) in our DJIA Timing System should the stock experience a significant 4Q rally based on weak breadth and/or weak volume. Subscribers please stay tuned.
Henry To, CFA