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Just Who is Next?

(October 26, 2008)

Dear Subscribers and Readers,

Two weeks ago, we posted our review of Benjamin Graham's “The Intelligent Investor” in our “Favorite Books” section.  Penned in 1949 (with subsequent revisions by Graham to 1973), this timeless work has been called “the best book on investing ever written” by Warren Buffett – and is especially relevant in today's challenging investment environment.  I highly urge all subscribers to read this “investing bible” if they haven't already done so.  For subscribers who are looking to dig deeper into individual security analysis and Benjamin Graham's all-round philosophy, I highly recommend buying the latest (just-released) edition of Security Analysis by Benjamin Graham and David Dodd.

Let us begin our commentary by reviewing our 7 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 3,793.05 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 3,484.05 points as of Friday at the close.

No doubt, the gyrations in the financial markets have been tough for nearly everyone.  I totally understand and sympathize with all our subscribers who have incurred losses (I have also incurred losses in my personal portfolio).  But remember, this too, shall pass.  As I mentioned in our recent commentaries, while I am not happy with our losses, I am confident that the US stock market will be significantly higher over the next 6 to 12 months – as the market's historic oversold conditions and undervaluation, combined with the proactive and shareholder-friendly stance of global central bankers and finance ministers – should boost investors' confidence sooner rather than later.  Such a stance will inevitably attract a significant amount of cash into recapitalizing the banks (and the equity markets) that has accumulated on the sidelines since the beginning of this year.

Given the fast-moving nature of the financial markets, I have for the most part delayed writing our weekend commentary until Sunday evening for the last 12 months.  As of Sunday evening, we learned that South Korea, in a continuation of its $130 billion “bailout package” last weekend, has cut its policy rate by 75 basis points in an emergency meeting of its central bank and the finance ministry.  Combined with a further decline in crude oil prices last week (the greatest contribution to its current account deficit), my sense is that the South Korean stock market is now in the midst of hammering in a substantial bottom (the MSCI Korea Index declined another 25% last week and was down 67% on a YTD basis in USD terms as of last Friday's close).

We also learned that General Motors has approached the US Treasury for at a loan of at least US$10 billion in its latest bid for Chrysler – as both companies will inevitably experience a liquidity crisis by early next year if nothing dramatic is done (note that this request is separate from a $25 billion loan that Congress has approved for the ‘Big Three” automakers earlier this month).  My best guess is that the combined entity will most likely get a loan as part of the $700 billion TARP program through its finance arms (GMAC and Chrysler Financial) – as the Treasury will most likely refrain from making a direct loan to an industrial company.  Hence, the first answer to our headline question: The combined entity of GM and Chrysler will need such a loan to survive beyond Spring of next year, as auto (and other consumer durables) sales will most likely continue to decline for the rest of the year and into 2009.

We have also previously asserted that the Bank of England and the European Central Bank (which collectively set policy rates for 380 million citizens, versus the Federal Reserve, which sets rates for 300 million citizens) has been very much behind the curve – and that policy rates need to be 150 to 200 basis points lower than current levels.  As I am writing this commentary, there is now tons of pressure on both central banks to call an emergency meeting and to cut rates early this week, as opposed to waiting until their scheduled meetings next Thursday.  As we all know, ten days is an eternity in this type of environment.  My sense is that both central banks will cut by 50 basis points this week, and perhaps cut again next Thursday if financial markets do not stabilize.  Unless both central banks show more of a commitment to ease policy rates, global financial and equity markets will not stabilize.  Moreover, Denmark was forced to hike its policy rate by 50 basis points in order to defend the Krone against the Euro.  Spain, on the other hand, is now soliciting funds from Middle Eastern Sovereign Wealth Funds to rescue its mortgage sector.  This is the second answer to our headline question: If the ECB does not ease soon, then Denmark and Spain could be the countries to go down next. 

Unlike the stock market swoon in mid January, mid March, and mid July, the current “crash” has been accompanied (or most likely, caused by) the great unwind in both the Yen and the US Dollar carry trade over the last few months.  The unwinding of the Yen carry trade, in particularly, has been brutal – as illustrated by the following chart showing the daily spot price of the Euro-Yen cross rate from January 1999 to the present:

Daily Spot Euro-Yen Cross Rate (January 1999 to Present) - Since late July, the Euro has declined 30% against the Yen!

As stated in the above chart, the Euro has literally crashed against the Yen – falling over 30% in the last few months!  Such a fall is unprecedented in the history of the Euro-Yen cross rate (going back to the inception of the Euro in January 1999).  Moreover, the Euro is now at its lowest level against the Yen since September 2002.  Unless the rise in the Yen is curbed, countries that have engaged in the Yen carry trade (such as South Korea) will continue to experience difficulties in the days ahead.

Fortunately – and most importantly – the G7 just made an unscheduled statement on the rise of the Japanese Yen, expressing concern about its recent “excessive gains.”  More importantly, while the G7 did not pledge concerted action to stem the Yen's rise, the Japanese has indicated that it will act, if needed.  Given that the Bank of Japan can in theory sell an unlimited amount of Yen to stem its ascent, there's no reason to question the effectiveness of this policy, assuming it is implemented.  A direct intervention in the currency markets by the Bank of Japan most probably provides the “best bang for the buck” at this point.

Shifting our attention to emerging markets, the IMF has just announced that it will provide a financing/bailout package to Hungary and the Ukraine.  Given the recent global deleveraging and the general stampede out of emerging markets in recent months, it is not surprising to see countries that have both a high current account deficit and significant borrowings in foreign currency-denominated loans experiencing difficulties.  As discussed in previous commentaries, Eastern Europe in general remains the most vulnerable.  The following table from the IMF's most recent Global Financial Stability Report illustrates the most vulnerable countries in the emerging markets sphere:

Macro and Financial Indicators in Selected Emerging Market Countries

Aside from Hungary and the Ukraine, there are many other countries (mostly within Eastern Europe) that could be tapping the IMF for financing packages if the global deleveraging does not ease soon.  As shown in the above table, it is not surprising to see Iceland being the first country to tap the IMF and other sovereign lenders.  Other countries with the most vulnerability are Bulgaria, Croatia, Estonia, Latvia, Lithuania, and Romania (we did not include Serbia since it has ample reserves to cover its short-term external debt).  For the most part (with the exception of Vietnam), Emerging Asia is still doing fine (given the lessons it learned during the 1997 Asian Crisis).  Despite a net external position of -17.5%, South Korea's position is still relatively sound, as it has enough foreign reserves to cover its external position.  Moreover, given the recent decline in crude oil prices, South Korea is now back to running current account surpluses – which will allow them to build their reserves going forward.

At this point, the “best bang for the buck” to stem further global deleveraging and unwinding would be for the Bank of Japan to directly intervene in the currency market to stem the rise of the Japanese Yen.  Another lever that global policy makers could pull would be for both the Bank of England and the European Central Bank to cut policy rates by 50 basis points early this week – and to follow up with another 50 basis point cut on November 6th (the date of their scheduled meetings).  With the Fed now projected to cut the Fed Funds rate by another 50 basis points (taking it to 1.00%) this Wednesday, there is no doubt that the Fed is doing everything in its power to stem the global deflationary/deleveraging tide.  As discussed in our commentary two weeks ago, the Federal Reserve has continued to increase the size of its balance sheets (i.e. printing money) like there is no tomorrow.  That is, the Federal Reserve is finally starting to run the “printing presses” – a dramatic turnaround from its relative restraint over the last 15 months, as demonstrated by the four-week spike in the growth of the St. Louis Adjusted Monetary Base (the only liquidity indicator that is directly controlled by the Fed).  As we have covered here before, the Fed has been draining liquidity (by selling Treasuries to the public) on the one hand, while swapping illiquid instruments in return for Treasuries with the various commercial and investment banks on the other.  With the latest panic in the global financial markets, the Federal Reserve has staged a dramatic turnaround, as signaled by the latest year-over-year growth in the US monetary base shown in the following chart:

US Monetary Base Suggests A Stronger Stock Market in the Next Few Months... - Primary liquidity conditions are now immensely bullish for stock prices - as the Fed is now printing money (through the increase in the US monetary base) like there is no tomorrow.

As shown in the above chart, the year-over-year change in the St. Louis Adjusted Monetary Base (four-week moving average) bottomed out at 0.69% in early May.  The year-over-year growth ticked up to 2.58% on September 10th, 6.65% on September 24th, and 14.70% on October 8th.  For the two weeks leading into October 22nd, however, the year-over-year growth in the St. Louis Adjusted Monetary Base exploded to 28.44% as the Federal Reserve sought to prevent a full-blown panic in the financial markets - a rate of growth that is nearly double that of late 1999 – when Alan Greenspan ran the printing presses in anticipation of the “Y2K-induced recession.”  Such a rate of increase is unprecedented – even taking into account the monetary base expansion during World War II!  Assuming that the Fed continues to be as accommodative, such a rate of growth in primary liquidity suggests not only a solid bottom in the US stock market, but a sustainable rally that could last well into Christmas, assuming the Bank of England and European Central Bank slash rates early this week.

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 April 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports(April 1, 2003 to October 24, 2008) - For the week ending October 24th, the Dow Industrials declined 473.27 points while the Dow Transports declined 244.29 points. Over the last five weeks, the Dow Transprots has declined a whooping 1,651.87 points, or 32.3%. At the most recent bottom, the Dow Industrials touched its lowest level since April 2003. While the Dow Transports exhibited a great deal of weakness in the last two weeks, it is still holding above its June 2005 levels . The unprecedented selling and volatility over the last three weeks was a result of a near-total breakdown of the modern financial system. With global policy makers now adopting a more shareholder-friendly *bailout approach,* there is a good chance that global equity markets have made a good solid bottom, for now. Given the more aggressive stance of global policy makers - as well as the immense amount of capitulation - I expect both the broad market and the Dow Industrials embark on substantial rally lasting into Christmas. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending October 24, 2008, the Dow Industrials declined 473.27 points while the Dow Transports declined 244.29 points.  Over the last five weeks, the Dow Transports has crashed by 1,651.87 points or 32.3%.  Despite this decline, the Dow Transports is still holding above its June 2005 levels – still outperforming the Dow Industrials on a relative basis (as the Dow Industrials is now at its lowest level since April 2003).  Given the immensely oversold condition in the markets – combined with the radical (and shareholder-friendly) policies that global policy makers have adopted to jump start the financial and equity markets – my sense is that the stock market has made a solid bottom as long as both the European Central Bank and the Bank of England slash rates by 50 basis points (or more) this week.  For now, we will remain 100% long 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 decreased from -20.1% to -21.5% for the week ending October 24, 2008.   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 October 17, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios declined slightly from -20.1% to -21.5%. Subscribers should note that this indicator is now at a historically oversold level (the ten-week MA, not shown, is at its most oversold level since late March 2003) , and is probably in the midst of reversing as well. Historically, this (a reversal from a very oversold sentiment level) has been one of the most reliable signal preceding a major rally.  While sentiment can indeed get darker, my sense is that the market have hammered out a capitulation bottom. For now, we will remain 100% long in our DJIA Timing System.

With the four-week moving average of our popular sentiment indicators decreasing to a historically oversold reading of -21.5% (note that the ten-week moving average, not shown, is now at its most oversold level since late March 2003), chances are that the stock market are now hammering in a bottom as long as the European Central Bank and the Bank of England commit to a more aggressive easing schedule.  Combined with the oversold conditions in the global stock market, depressed global valuations, the recent correction in commodity prices, the sheer amount of global investable capital sitting on the sidelines, unprecedented global bailout packages, these latest readings should be sufficient for a meaningfully rally in US and global equities potentially lasting into Christmastime.  For now, we will remain 100% long in our DJIA Timing System.

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) - After breaking out of its 3-month consolildation phase, the 20 DMA of the ISE Sentiment Index has stalled and reversed to the downside - breaking below its 50 DMA six weeks ago. Since then, it has stalled. Regardless, relative to levels over the last five years, both the 20 and the 50 DMAs are at very oversold levels, signaling that sentiment is much closer to a bottom than a top. Given the immense selling in the global stock market in the last three weeks - combined with unprecedented public policy action all over the world - my sense is that the stock market has hammered out a capitulation bottom and should rally into Christmastime.

Since the short-term peak in the 20 DMA of the ISE Sentiment Index in late August, it has again “sold off” to oversold territory – with readings not seen since April earlier this year.  As discussed in the last two weeks, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are at oversold levels that are synonymous with a tradable bottom in the stock market.  Combined with the extreme valuations and oversold levels in the equity markets, as well as unprecedented global bailout package, and assuming that the Bank of England and the European Central Bank commit to a more aggressive easing schedule; I believe the stock market is hammering out a bottom.

Conclusion: While the G7 countries are doing as much as they could to prevent or stem the global deleveraging of all risky assets, my sense is that they could do more.  Specifically, I believe the Bank of Japan could directly intervene in the currency markets to prevent a further unwind in the Yen carry trade, while both the European Central Bank and the Bank of England could commit to a more aggressive easing schedule in order to prevent outright deflation in Western Europe.  In addition, if GM or Chrysler cannot obtain a direct loan from either the Federal Reserve or the US Treasury, then chances are that they will both file for Chapter 11.  Given the immense obligations of these two entities (read: GMAC and Chrysler Financial), this is a scenario that is to be avoided at all costs.  Remember, this too shall pass.  Again, assuming that the European Central Bank and the Bank of England commit to a more aggressive easing schedule, I expect the stock market to bottom out early this week and for any upcoming rally to last at least until Christmastime.

Going forward, I continue to be constructive on US, Japanese, and Chinese equity prices in the longer-run, as the world starts to focus on sustainable, Schumpeterian Growth vs. Ricardian Growth over the next few years.  For now, we will stay with our 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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