Illiquidity Still Killing the Market
(March 8, 2009)
Dear Subscribers and Readers,
Amidst one of the greatest downturns in capitalism's history, endowments of American universities are down from 20% to 30% across the board in the last six months of 2008, with the smallest endowments fairing the worst. Even during the 1974 downturn, the average endowment only lost 11% for the year. While the wealthiest colleges (such as Harvard and Yale) are simply tightening their belts by halting construction of new buildings or through salary freezes, many of the nation's smaller colleges, in particular, historically black colleges, have been devastated. In times like this, we should all remember that the key to long-term wealth and happiness is through sustainable investments – investments through education, long-term scientific research, and investments in our children – and that we should all make sacrifices to get to this goal. As demonstrated by the bridge collapse in Minnesota, the near-collapse of the global financial system, the sad state of our physical infrastructure, the sad state of our general education system, and soaring health care costs, it is time to think of long-term solutions to these long-term problems. The ancient Chinese, the Romans, and the Egyptians were capable of constructing infrastructure that lasted for hundreds if not thousands of years – why can't we? To that end, the latest lifting of the stem cell restrictions imposed by the previous administration is a necessary step in the right direction. Aside from the direct benefits such as increased funding and resources into stem cell research, this executive order will legitimize science as part of our new national policy and encourage US students to study the sciences once again. Given soaring health care costs in recent years (and which are still projected to grow faster than GDP), it is time to find some innovative ways to cut down on future health care costs.
Let us now begin our commentary by reviewing our 8 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 5,545.06 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 5,236.06 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a loss of 623.06 points as of Friday at the close.
In our commentary two weekends ago, we discussed that while a strict interpretation of the “mechanical version” of the Dow Theory looked downright ominous, the valuation and technical conditions of the US stock market was far from that. Specifically, as I discussed in our original “primer” on the Dow Theory and in subsequent commentaries and posts on our discussion forum – the concept of valuations override virtually every other technical signal that emulates from the Dow Theory. Moreover, while the Dow Transports did decline below its recent bear market low, it was still trading significantly above its March 2003 low – suggesting that both global trade the influence of global Ricardian growth remained intact (even though it has been damaged by the pullback of the US consumer). Combined with many positive divergences in the stock market, as well as more unconventional central bank policies coming down the pipeline, we suggested that it was a good time to break with tradition and go for a swing trade on the long side, and initiate an additional 25% in our DJIA Timing System – thus bringing us to a 125% long position.
While this would bring us to a leveraged position, we believe that this position contains minimal risk at this point. Again, I want to emphasize: We have always been very conscious of risk and will continue to be. We believe we are minimizing our risk by: 1) limiting the additional long position to only 25%, such that a further 30% or even a 40% decline should not cause long-term damage to our performance, 2) limiting our holding period to only a few weeks – but maybe longer if the market exhibits strong breadth and volume on any snapback rally, and 3) implementing this position ahead of institutional investors who will no doubt rebalance into equities over the next two to three months.
From a valuation standpoint, the price-to-book ratio of the S&P 500 has again sunk to a new low. As shown on the following chart (courtesy of Ned Davis Research), the price-to-book ratio of the S&P 500 (using NDR's estimate of the S&P 500's 2008 book value, or $555.00 a share) has declined to a 25-year low of 1.23:
More importantly, the book value of the S&P 500 is overstated relative to its lows in the early 1980s, as neither technology or biotechnology R&D spending (the biotechnology industry was not born until the late 1980s) is capitalized and treated as an asset on the balance sheet. For example, Amgen and Genentech – two of the better performing stocks on the S&P 500 over the last 18 months, have P/B ratios of 2.42 and 5.49, respectively. Even Microsoft, a mature cash cow in the software industry, has P/B ratio of 3.94. Assuming (conservatively) that 15% of the S&P 500 are made up of such companies that did not exist in their current forms in the early 1980s, and assuming that the book value of such companies are understated by about 50%, the S&P 500's book value for 2008 is closer to around $638 a share. On a R&D-adjusted basis, the P/B ratio for the S&P 500 is approximately 1.07, or its lowest level since the beginning of the greatest bull market in history in late 1982. In addition, analysts are still projecting the S&P 500's earnings to be in the range of $35 to $50 a share this year, suggesting that the S&P 500's book value will continue to grow this year. Based on the price-to-book ratio of the S&P 500, the core earnings power of the S&P 500's components, and the range of liquidity schemes implemented by the Federal Reserve and Bank of England, there is no doubt that stocks now present the greatest buying opportunity of our generation.
Let us now discuss the gist of our commentary – that of the problem of illiquidity in the financial markets. Professor Francis Longstaff at UCLA Anderson (and head of Fixed Income Derivative Research at Salomon Brothers from 1995 to 1998) recently published an article discussing the concept of contagion and illiquidity premiums in the context of the current crisis as part of the March 2009 CFA Institute Conference Quarterly Proceedings. As a demonstration of the importance of his insights into financial crises (Professor Longstaff is currently developing a record of every single default that has occurred in the US since the Civil War), there were three other articles published in the March 2009 CFA Institute Conference The other three authors are Mohamed El-Erian (CEO and Co-CIO of PIMCO), Sean Egan (Egan-Jones Ratings Co.), and Michael Mauboussin (Chief Investment Strategist at Legg Mason Capital Management). Taking insights gained from his recent research and papers, Professor Longstaff asserted that based on the weekly return data for the various tranches of the ABX (asset-backed) index in 2006 to 2007, it was clear that while no relationship existed between the various credit tranches in 2006, that all changed in 2007 when the tranches started moving together. Clearly, contagion was evident – more interestingly, by utilizing data from the lower-rated tranches, one could predict two to three weeks in advance of the returns on the higher-rated tranches with an R-squared of approximately 50% (which is an impressive rate for these highly uncertain markets). This relationship was also evident in the stock and Treasury bond markets. Professor Longstaff concludes that contagion spread from the subprime market to other markets through two channels: the liquidity channel (where the shock in the subprime market affected the liquidity of the overall mortgage market and the stock market), and the risk premium channel (where the shock in the subprime market affected investors' overall appetite for risk). Of note is the two to three-week lead-time. After all, one should always be highly suspicious of any leading indicator of the stock market – especially one that has worked so well for such a sustained period of time. This suggests that stock market investors have experienced a “deer in the headlights” phenomenon. That is, far from “irrational pricing” on the part of the ABS market, it was actually providing a credible forecast for both the stock market and the US economy.
His final comments in the article discuss his recent study on what the appropriate discount may be for the lack of liquidity in financial markets. For example, other researchers have noted that a mere two-year restriction period could result in substantial discounts in the order of 30% to 40%. In a similar exercise, Professor Longstaff asserts that the discount of an asset subject to a two-year restriction period is equivalent to the value of a two-year look-back option (an option to receive the maximum price over the two-year period) on the same restricted asset. In other words, the value of this look-back option is a good estimate of what this discount should be. This option is also relatively easy to price, as it could be priced using the standard Black-Scholes option-pricing framework. For example, by using the current market volatility numbers, Professor Longstaff estimated that the discount premium on illiquid CDOs is about 40% of the present value of their future cash flows. In other words, investors are so frightened of being stuck with these instruments (or so desperate for cash) that they are willing to sell these securities at a 40% discount.
Professor Longstaff notes that the upcoming financial bailout packages could change this discount very quickly, as once investors perceive that they could unload these securities to the government (or the soon-to-be-announced Public-Private Investment Fund) at a short notice; the discount should quickly go away. My personal sense is that – given the reliability of the ABX as a leading indicator of the financial markets in the last 18 months, and given that so many of our financial institutions are still holding these in their balance sheets – both the stock and bond markets should quickly recover once liquidity returns to the asset-backed security markets. To that end, the TALF (the first phase of which be implemented on March 25th), and the soon-to-be announced Public-Private Investment Fund (PPIF) should trigger a stock and corporate bond market rally sometime in the next couple of weeks.
For those still holding financial stocks, any rally in illiquid securities would be hugely bullish, since so many financial institutions are still stuck with these on their balance sheets. This would also help immensely with the upcoming “stress test” to be conducted by the US Treasury (for banks with over $100 billion in assets). Morningstar recently conducted its own stress test in a very informative “preview” of the government's more complete version. While Morningstar's basic assumptions are relatively simple, it is still a useful exercise, as it provides us a glimpse of the potential recapitalization required for various banks. The following table summarizes Morningstar's stress test results:
With the latest decision by the US Treasury and other investors to convert their Citigroup preferred holdings into common equity, the issue of more dilution for Citigroup is off the table, for now (note that the above stress test utilizes December 31, 2008 data and thus does not include Citigroup's just-announced preferred swap for common equity). Subscribers should also note that the US Treasury has “ring-fenced” in more than $300 billion of Citigroup's assets, or as much as 22% of their most risky loans and securities. Similarly, the estimated capital shortfall at Bank of America is not inevitable either. As of December 31, 2008, Bank of America was still holding a significant chunk of restricted stock on China Construction Bank - which is not officially counted as tangible equity on its balance sheet. Combined with a significant portion of super senior MBS that the firm has written down but will most likely be paid over time, Bank of America is probably understating its common equity by around $8 to $9 billion. In addition, there are also other assets that Bank of America could sell, such as a $3 billion stake in First Republican Bank. Finally, even if the government decides Bank of America needs a capital infusion, Morningstar estimates that it would result in only a 12% dilution for shareholders, while Goldman Sachs estimates a 19% dilution. In other words, I do not believe we are anywhere close to bank nationalization. And with the most attractive valuations in over 25 years, the oversold condition in the stock market, the numerous positive divergences that we discussed in the last two weeks, and investors starting to take advantage of valuations in riskier asset classes, I believe we are now in the midst of the greatest buying opportunity of our generation. Moreover, many institutional investors (such as pension funds) are now seriously underweight their target equity allocation, and will most probably rebalance back into equities (from mostly fixed income) over the next few months. For now, we would maintain our 125% long position in our DJIA Timing System.
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 March 6, 2009, the Dow Industrials declined 435.99 points while the Dow Transports declined 304.08 points. Over the last four weeks, the Dow Industrials declined by a whopping 20% while the Dow Transports declined by 31%. With the latest decline in both Dow indices, both the Dow Industrials and the Dow Transports have made new bear market lows. While this is usually an ominous sign, I believe we are now close to a snap-back rally, given the cheapest valuations in over 25 years, the many positive divergences we have discussed, and the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system as the Fed and Treasury move in with the TALF and the soon-to-be-announced PPIF. While the Citigroup recapitalization was not fun for equity shareholders, my sense is that a similar conversion into other banks such as Bank of America or Wells Fargo is not on the table, for now. Should there be any further need for capital, I continue to expect the US Treasury to stand by the terms of its February 10th “Financial Stability” plan, and once further clarity is provided on the PPIF, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending). Because of this, we will maintain our 125% 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 declined from -18.0% to -22.9% for the week ending March 6, 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:
With the four-week moving average of our popular sentiment indicators declining to -22.9%, this reading has declined to a new low, and is now at its most oversold level since July 2002! Moreover, one of its components, the AAII Bears reading, spiked to a whopping 70% last week, which is a record high level since the survey began in 1987. Will the US Treasury preparing to provide more clarifications on the PPIF in the next couple of weeks, and coupled with the inevitable rebalancing into equities by institutional investors, my sense is that the market could embark on a rally very soon. Given the very attractive global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, we are now more bullish than at any time since late 2002/early 2003.
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 its most recent low on February 4th, the 20 DMA has bounced back up to a reading of 122.9. While the rising bullish sentiment in this indicator isn't confirming the bearish sentiment in our other sentiment indicators, it is nonetheless still trading at an oversold level (relative to readings over the last five years). As a result, the ISE Sentiment reading is also supportive for snapback rally in the stock market. Assuming that the US Treasury clarifies its PPIF plan over the next couple of weeks, equities should be bottoming at around current levels. As I have mentioned in a previous commentary, as long as one is under the age of 60 and is in a reasonable state of health, I believe US equities are a once-in-a-generation buy at current levels.
Conclusion: With the price-to-book ratio of the S&P 500 now trading at its lowest levels in 25 years, and with its R&D-adjusted price-to-book ratio trading at lows not seen since the late 1982 bottom, I believe US equities now represent a once-in-generation buying opportunity. As demonstrated by Professor Longstaff's recent studies on contagion and illiquidity discounts in the context of the current financial crisis, any relief in the illiquid security markets will bring a significant amount of risk capital back into the financial markets. Such a scenario would not only benefit the asset-backed markets, but the stock and bond markets as well (especially the balance sheets of major financial institutions). With the darkest sentiment in decades (I personally believe bank nationalization fears are overblown, as demonstrated by Morningstar's “stress test”), and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System the Tuesday before last. Make no mistake: We have always been very conscious of risk and will continue to be. We believe we are minimizing our risk by: 1) limiting the additional long position to only 25%, such that a further 30% or even a 40% decline should not cause long-term damage to our performance, 2) limiting our holding period to only a few weeks – but maybe longer if the market exhibits strong breadth and volume on any snapback rally, and 3) implementing this position ahead of institutional investors who will no doubt rebalance into equities over the next two to three months.
With the US Treasury set to provide further clarifications on its PPIF plan, subscribers should start thinking about what individual stocks to buy, and in what industries, etc. Within one's global equity portfolio, I highly recommend an overweighting of US and Chinese equities at the expense of international developed (mostly Western European and Japanese) equities for the next 12 months. However, subscribers should be very selective if buying individual stocks, given the ongoing deleveraging phase in the OECD economies. As I mentioned before, subscribers will also need to be very careful with buying “yesterday's winners,” as the stock market's “favorites” tend to change in a new bull market. For those with a long-term timeframe, the stock market still represents one of the best buying opportunities of our generation. At some point in the near future, I would also start to be constructive on certain financial stocks, including Wells Fargo, JP Morgan, Bank of America, Morgan Stanley, Goldman Sachs, and Lazard Ltd. Subscribers please stay tuned.
Henry To, CFA