Liquidity Providers Will Get Rewarded
(November 9, 2008)
Dear Subscribers and Readers,
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 3,228.19 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 2,919.19 points as of Friday at the close.
The weekly streak of new (and substantial) policy announcements from the world's major central banks and governments has not been broken. On Thursday morning, the Bank of England slashed its policy rate by a higher-than-expected 150 basis points, as we discussed in our latest mid-week commentary. As we discussed before, prior to the global coordinated emergency rate cuts on October 8th, I had estimated that both the Bank of England and the European Central Bank were about 150 to 200 basis points behind the curve, given the rapidly diminishing inflationary forces and the slowing global economy. As long as the Bank of England continues to commit to an easing policy, the Bank of England is no longer behind the curve. Somewhat disappointedly, the European Central Bank only followed up with a 50 basis point cut – a disappointment paving the way for a 443.48-point down day in the Dow Industrials and a hugely oversold NYSE ARMS reading of 4.06. Meanwhile, the Swiss National Bank followed with an unexpected 25 basis point cut (their policy rate is tied to 3-month LIBOR) from 2.5% to 2.0%. This should bring further relief to the overall European financial system, as many companies and citizens in Europe (particularly Eastern Europe) have been heavily involved in the Swiss Franc carry trade over the last five to six years.
Fortunately, policymakers in Asia haven't been “asleep at the switch” either. Last Friday, the Bank of Korea again cut its policy rate (from 4.25% to 4.00%) – its third rate cut in a month. The Taiwanese central bank followed up with an unexpected 25 basis point cut earlier today – its fourth cut in just eight weeks (previous rate cuts occurred on September 26th, October 9th, and October 30th). But the 800-pound gorilla in the room has to be the Chinese. Just hours ago, the Chinese government announced a massive US$586 billion (4 trillion yuan), two-year fiscal stimulus program to combat its (and the global) slowing economy. Over the next two years, the Chinese government is expected to take “10 major steps” to enhance its transportation and power infrastructure (especially in rural areas), health and education system, the environment, building more affordable housing, and supporting the development of high-tech and services industries. I expect the People's Bank of China to continue to ease into Christmas.
With the unprecedented easing and the many unconventional policies coming from central banks and finance ministries over the last 12 months, we are now possibly seeing a thaw in the commercial paper and asset-backed markets (witness the bounce in the amount of financial and asset-backed commercial paper outstanding over the last two weeks). More significantly, the G-20 and other countries (as well as the IMF and the World Bank) have continued to commit to an aggressive policy to ease the current malaise in the credit markets and to combat the slowing global economy. As we discussed in last weekend's commentary, there are still other tools at the Fed's (and other central banks') disposal should current policies fail to reignite credit availability or borrowing among US and global consumers.
But as subscribers have emailed me last week, what if, just what if, we are wrong? As the events over the last five weeks demonstrated, things do go wrong – especially in a market that is still in the midst of deleveraging and panic. At the end of the day, the global financial market and economy is simply composed of human beings. Each of our actions – whether they are driven by a rational decision to preserve our own balance sheets or an irrational decision to stuff cash into our mattresses (I highly discouraged going this route) – will ultimately have an impact on the global economy. For example, the populist calls to “punish the bankers” and to force Lehman Brothers into bankruptcy on September 15th began a daisy chain of further deleveraging – causing various money market funds to incur significant losses and ultimately freezing the commercial paper market and discouraging global bank lending. The initial rejection of the $700 billion “Troubled Assets Relief Program” on September 29th not only resulted in one of the biggest down days ever in the Dow Industrials, but also a lost of confidence among our leaders, politicians, and the American population to “do things at all costs” to revive the American economy – resulting in an eventual 26% loss in the Dow Industrials from the September 26th close to the most recent bottom on October 27th. Make no mistake: Hank Paulson and our politicians were simply giving us what we wanted.
Fortunately (for the bulls), unlike the Japanese, Americans shaping our policies (baby boomers, the X-gens, and the Y-gens who have seen nothing but inflation – and the latter credit cards as opposed to cold, hard cash) will not tolerate or allow a Japanese 1990s-style deflationary bust. Immediately after the 777.68-point decline in the Dow Industrials on September 29th, sentiment immediately shifted in favor of the TARP. From a populist standpoint, the government's $125 billion recapitalization of the nine largest banks in the US also went surprisingly well. We have also not heard a single objection to the possible appointment of current NY Fed Governor Timothy Geithner as US Treasury Secretary under the Obama administration – even though Geithner is regarded as one of the most dovish Fed governors in Federal Reserve history. And this just in: The US government is now set to revise its $85 billion lifeline to AIG – giving them far more generous terms, benefit AIG's shareholders in a major way. More significantly, this will encourage US investors to come back into the equity and debt markets and to help recapitalize the US financial system.
In other words, US citizens have now given the “green light” to the Federal Reserve and the Treasury Secretary to “inflate at all costs” to rejuvenate the world's largest economy. Already we're talking about a second, if not a third round of fiscal stimulus. A strategy that epitomizes the willingness to “inflate at all costs” is the recent expansion of the Federal Reserve's balance sheet. Over the last two months, the Federal Reserve has been “printing money” like there is no tomorrow, which as we have discussed, represents a dramatic turnaround from its relative restraint in the 15 months leading into mid September (curiously the exact date of the Lehman bankruptcy), as demonstrated by the latest spike in the growth of the St. Louis Adjusted Monetary Base (the only liquidity indicator that is directly controlled by the Fed) over the last six weeks. 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:
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, 14.70% on October 8th, and an unprecedented year-over-year growth rate of 28.44% on October 22nd. For the two weeks leading into November 6th, however, the year-over-year growth in the St. Louis Adjusted Monetary Base exploded again – to 43.12% as the Federal Reserve sought to not only prevent further panic in the financial markets, but to actually re-inflate the markets. Such a rate of growth is nearly triple that of late 1999 – when Alan Greenspan ran the printing presses in anticipation of the “Y2K-induced recession.” Again, 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.
More importantly, however, the rest of the G-20 countries remain committed to tackling this financial/credit crisis head-on for the foreseeable future. As a result, despite the fact that the Federal Reserve cannot continue to “backstop” every country out there, there are other countries willing to pick up the slack. For example, the G-20 countries have signaled their support for more IMF funding as long as the agency revises its “hard-handed” lending terms to countries that are in trouble. As discussed before, China has just announced a two-year fiscal stimulus program totaling US$586 billion – a sum that is equivalent to approximately 20% of its GDP!
From the standpoint of US equity investors – and as documented by Eugene Fama & Kenneth French – subscribers should note that there is significant evidence of serial negative autocorrelation in US stocks over a three to five-year horizon. In other words, the “reversion to the mean” phenomenon is in play. Among various asset classes, we also see this tendency, as can be easily seen from a table showing annual returns for US stocks, international stocks, government bonds, corporate bonds, cash (short-term US Treasury bills), commodities, and TIPS over a long-term horizon. Given that US stocks have arguably been one of the worst-performing (on a relative basis) asset classes over the last five years, there is a good chance that we could see US stocks outperform over the next five years – as long as the global economy does not sink into a deflationary spiral.
But Henry, what do you think of dangers of inflation assuming global public policy makers are successful in reigniting the world economy? Could we see a return of the high inflation/high interest rate era of the late 1970s to early 1980s?
As I said, anything is possible. But first, we have to take heed of the information that is currently in front of us. In light of the recent dramatic decline in commodity prices and the ECRI Future Inflation Gauge, the chances for a global or US resurgence in inflation is almost nil at this point. This is also being confirmed by the benign reaction in long-term bond yields in the vast majority of developed countries – despite inevitability of more future issuance of government debt. More importantly, as discussed in a NY Fed study that we cited earlier this year, money stock (such as the traditional M-2 and M-3 indicators) is only useful as a measure of liquidity in a financial system that is dominated by traditional deposit-funded banks. The NY Fed study asserts that in today's world of securitization, policymakers and analysts alike should instead pay heed to the growth rate of aggregated balance sheets of leveraged financial institutions, or outstanding repurchase agreements (this is why the Fed stopped publishing M-3 numbers, with the exception of one critical component: institutional money market funds). With the securitization markets still stuck in a “quagmire” – and with more global regulations to come to curb leverage across the financial system – it is still too early to be discussing the potential for higher inflationary pressures going forward.
But Henry, I insist the danger is still there. Could you provide further comfort?
First of all, the fact that there is more government debt outstanding (i.e. more fiscal spending) does not necessarily result in higher interest rates or higher inflation. For example, during the late 1940s and early 1950s – when US government debt as a percentage of GDP was much higher than today's levels – interest rates were lower than today's levels as the Federal Reserve enacted a policy of committing to a ceiling of 2.5% for long-term Treasuries. Such a policy lasted for a whole decade – which the Fed enforced at various times by buying both Treasury bills and Treasury bonds on the open market. Of course, such a policy can only work if the Fed's long-term policy of fighting inflation looks credible to the financial markets. During the 1970s, this completely broke apart. As discussed by a recent paper by Alan Meltzer on the “Origins of the Great Inflation” of the 1970s, one of the reasons why the country was mired in a stagflationary period during the late 1970s was that the Federal Reserve, under the “leadership” of Arthur Burns and William Miller, constantly “flip-flopped” between fighting inflation and promoting economic and monetary growth. That is, the Federal Reserve never had a coherent policy during that time and lacked credibility. Moreover, many of the decisions were “ad hoc” and were never based on sound analyses. Given the Fed's communications and credibility to the markets so far, it is thus non-sensical for us to worry about the 1970s stagflationary environment to be returning at this point. Finally, as I discussed in our June 22, 2008 (“Oil and the Stock Market”), over the long run, the ability of a society to hold down consumer price inflation rests on three things: 1) productivity growth, 2) labor force flexibility, and 3) monetary, fiscal, and financial system regulatory policy. As long as the capitalist engine is not disrupted, the scientific innovators, entrepreneurs, and venture capitalists will ultimately come up with not only appropriate solutions to solve our energy and raw materials needs, but also promote long-term productivity growth and hold down consumer price inflation as well. Fortunately, as we have previously discussed, years of research into better battery and plug-in hybrid technology, and alternative fuel sources are starting to bear fruit. This so-called Schumpeterian growth continues to accelerate in the supercomputing, the biotechnology, and now the nanotechnology sectors as well. While the last bull market in risky assets were mainly driven by Ricardian growth, the next five to ten years of global economy growth will most probably be driven by Schumpeterian Growth – starting with sectors where we need it the most, i.e. the energy and the healthcare sectors. Given that the United States has held the dominant position in promoting Schumpeterian Growth for the last 100 years, I continue to believe that relative strength will reverse back to US equities – and that the US will be able to hold down consumer price inflation as we step up or keep pace with historical productivity growth for the next five to ten years.
Obviously, as the recent troubles at GM, Las Vegas Sands, Circuit City, Office Depot, and Yahoo can attest to, it doesn't make sense to be blindly buying stocks in a world that is still in the midst of deleveraging. For sure, the survivors (such as Best Buy, Bed Bath & Beyond, etc.) of their respective industries will reap great rewards as the market sees a potential recovery – but in the meantime, assuming one is buying individual stocks, I highly recommend you to look long and hard at the target company's leverage ratios and operating efficiency vs. its peers. In particular, each industry will have its own set of rules and competitive forces – forces that are ever-changing in the current deleveraging environment and the threat of higher government regulations in the future. To that end, I highly recommend our subscribers to read Michael Porter's article entitled “Understanding Industry Structure” as well as the S&P's industry reports (which can probably be downloaded from your local library's website). For asset allocators, I would simply advocate purchasing the S&P 500 index funds on dips.
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:
For the week ending November 7, 2008, the Dow Industrials declined 381.20 points while the Dow Transports declined 219.81 points. While the Dow Industrials exhibited relative strength over the Dow Transports in last week's decline, subscribers should note that the Dow Transports has continued to exhibit relative strength over the last four weeks and ever since this current credit crisis began. With the announcement of the US$586 billion fiscal stimulus by the Chinese this weekend, transportation stocks should continue to outperform. Given that the Dow Transports has lead the broader markets since October 2002, and given that the G-20 countries have committed to more global easing going forward, my sense is that the stock market has made a tradable bottom. 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 -20.7% to -14.3% for the week ending November 7, 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:
With the four-week moving average of our popular sentiment indicators reversing from a historically oversold reading of -21.5% (note that the ten-week moving average, not shown, has also now reversed to the upside), chances are that the stock market has hammered in a bottom as long as the G-20 countries remain committed to easing monetary and fiscal policies as well as funding the IMF. Combined with the 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:
Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early October, the 20 DMA has reversed to the upside and has just broken above the 50 DMA. Moreover, as discussed in the last three weeks, both the 20 DMA and the 50 DMA of the ISE Sentiment Index are still 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 G-20 countries commit to more easing policies going forward, I believe the stock market has hammered out a tradable bottom.
Conclusion: The hits keep on coming, as global public policy makers continue to adopt innovative and aggressive policies to fight the global deleveraging – with the Bank of England cutting by an unprecedented 150 basis points last Thursday and with the Chinese government just announcing a US$586 billion fiscal stimulus to be implemented over the next two years. Finally, word is that the US government will announce a new $150 billion bailout deal for AIG on Monday – a deal which will be significantly more generous to existing shareholders. Going forward, I expect more easing from the Federal Reserve, the People's Bank of China, the Bank of England, the European Central Bank, the Reserve Bank of India, the Reserve Bank of Australia, the Bank of Canada, and the Brazilian Central Bank, among others. I also expect to see a rescue of GM by the US government over the next few weeks – and for the stock market to continue to rally into 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. Over the intermediate term, I am still bullish on gold miners – specifically, the GDX. Given the announcement of the Chinese fiscal stimulus, I am also expecting a short-term bounce in commodities for the next four to six weeks. For now, we will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA