Market Not Close to Capitulation Just Yet

By: Henry To | Tue, Aug 14, 2007
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Note: For those would like to learn more about Modern Portfolio Theory and the latest trends in the financial markets, please read our latest book review of Peter Bernstein's latest work, entitled "Capital Markets Evolving."

Dear Subscribers,

Let us know begin our commentary by providing update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on August 12th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). Last week was an exciting week, if you will - as, for the first time since the trading day after September 11, 2001, most of the world's central banks had to make a point and inject a significant amount of liquidity into the financial markets. On Thursday, the ECB injected close to US$130 billion into the Euro Zone's financial system by lending unlimited funds to the European money market at 4% - after overnight rates spiked to 4.7% as many investors panicked and cashed in their money market holdings. On Friday, the ECB injected a further US$83 billion. The Federal Reserve, Bank of Japan, and the Reserve Bank of Australia all injected certain amounts of liquidity during the last two trading days, with the Federal Reserve intervening not once, twice, but three times on Friday by buying up a total of US$38 billion of mortgage-related securities in the open markets. As late as Friday morning, the Fed Funds rate had spiked up to 6%, or 75 basis points more than the Fed's intended target. If the world's central banks had not acted on Thursday and Friday, then there was a good chance that parts of the fixed income and most probably the equity markets would have broken down.

As I alluded to in our "ad hoc" commentary on Thursday evening, the latest hedge fund losses over the last few weeks did not just originate from the problems in the US subprime area, but also in the proliferation of quantitative market-neutral hedge funds and mutual funds over the last few years. As we have also discussed in recent commentaries and in our postings on the MarketThoughts discussion forum, the popularity of these strategies (including the 120/20 and 130/30 strategies now being offered in 401(k) plans), had reached a crescendo over the last six months. Given the declining "alpha opportunities" as a result of the increasing popularity of these strategies, many existing market-neutral funds had to increase their leverage in order to maintain adequate returns. Sooner or later, this "alpha bubble" was sure to burst - and as what we have witnessed over the last few weeks - especially over the last week - it did, indeed, burst. As a result of this and the increasing problems in the US subprime and alt-A markets, many hedge funds had to quickly unwind their positions - not just because these funds were overleveraged, but because of increasing volatility in the financial markets as well. And now, the $64 billion question for our subscribers: Are the US and global equity markets now a "buy?"

In our weekend commentary two weeks ago ("An Update of our Technical Indicators"), I stated that I did not believe we are entering a new bear market, unless one or more of the following occurs:

  1. The promise of significantly higher income and dividend taxes by whoever wins the next US Presidential election in 2008, along with a Congress willing to implement these higher taxation policies
  2. A trade policy mistake by Congress in dealing with China, along with a significant response from China
  3. If the Yen carry trade or Swiss carry trade unwinds in a violent way and ends, which we are not looking for at this time. In all likelihood, such an event will most probably collapse the Korean consumer as well as the major Eastern European economies (not including Russia)

I now want to add a fourth qualifier: If the current credit market woes spread to other asset-backed securities, such as those backed with auto loans, auto leases, and credit card debt, then we will most probably enter a new bear market. Subprime and near subprime mortgage debt aside, any deterioration in the just-mentioned asset-backed securities will have severe repercussions for the average U.S. consumer, including higher auto loan and credit card rates all across the board. At this point, the rise in spreads among junk bonds, emerging market bonds, mortgage securities, leveraged loan securities, and CMBS securities still have not spread into the auto loan and credit market markets - but if it does, then we will have to seriously rethink the possibility of a US recession in early 2008 (we will revisit this issue in a later commentary, if applicable).

For now, probability suggests that we're still in a cyclical bull market. However, it is naïve to think that the last few years of excesses - including excesses in the US housing market, the US buyout market, and the global hedge fund market - can be corrected in a mere three weeks (both the Dow Industrials and the Dow Transports made all-time highs as recently as July 19th). Make no mistake: This is also the first genuine financial crisis we have witnessed in the cyclical bull market that began in October 2002 - and thus unlike the unjustified "four-year low" and bird flu scares that we experienced during the summer last year, it is natural to expect more corrective action in the US and global equity stock markets over the next few weeks. To put this in perspective: The Hong Kong Hang Seng Index can decline another 7% to 8% from its Friday close and still be above its uptrend line that stretches back to October 2005.

Moreover, there are still indicators out there which still do not suggest "capitulation" - or at the very least, a short-term, a tradable bottom. Let us first take a look at the action of the Japanese Yen versus other popular "carry trade" currencies (these are the currencies that are popular with folks who borrow in Yen and choose to invest in other currencies, not including the New Zealand Dollar). As our past commentaries have implied, it is natural to first look at the Yen carry trade for signs of capitulation, given that: 1) Speculative forex positions are, no doubt, the most liquid positions that any hedge fund or bank can liquidate in a financial crisis, and thus, it makes sense to look at the action of the Yen as a leading indicator of market capitulation, 2) In terms of measuring the Yen carry trade on either the purchasing power parity basis or in terms of the amount of Yen borrowed by investors or sent out by Japanese investors, the Yen has been getting very overstretched, i.e. close to its Fall 1998 levels, 3) Japanese retail investors, who have been the "main culprits" behind the Yen carry trade over the last 12 months, have historically (and still are) lousy market-timers. Therefore, should the Yen dramatically increase, that would most likely mean that Japanese investors have capitulated and repatriated their money back home - signaling an imminent bottom in the global equity markets from a contrarian standpoint.

The chart below shows the Yen cross rate performance (vs. the Euro, the British Pound, the Australian Dollar, and the Canadian Dollar) from January 2, 2007 to the present:

As mentioned on the above chart, the most recent correction in the four popular Yen cross rates is still not severe enough as what we witnessed during the late February to mid March correction. More importantly, these cross rates have only corrected to levels last seen during early June - definitely nowhere close to "capitulation" levels and a far cry to what we witnessed in Fall 1998, when the Yen - at one point - rose over 10% in a space of 24 hours!

The lack of an oversold condition in the various Yen cross rates (i.e. Yen carry trade) can also be witnessed in the percentage deviation of the Euro-Yen cross rate from its 200-day moving average, as shown in the daily chart below (from February 1999 to the present):

As can be seen on the above chart - even with the latest correction in the Euro-Yen cross rate, it is still trading at 1.88% above its 200 DMA as of last Friday. As a minimum, this author would like to see this % deviation go back to the zero line (similar to what we achieved during the October 2005 and the early March 2007 bottoms) before we would think about initiating a long position in our DJIA Timing System.

Another speculation with plenty of liquidity is crude oil - a commodity that is used and prized all over the world - and one which we consume over 80 million barrels a day and has attracted a lot of long interest over the last few years. Since the latest liquidity/credit crunch began, oil has declined from a high of over $78 a barrel to $71.60 at the end of last week, as can be seen in the daily chart (showing the daily spot price of crude oil as well as its percentage deviation from its 200 DMA) below:

While the latest one-week correction of about $7 a barrel has been relatively steep, it actually isn't much of a correction in the grand scheme of things - especially when compared to the action of crude oil prices over the last 25 years. In the last global credit crunch (keep in mind, however, that this came after the Asian/Russian/LTCM crises), crude oil declined approximately 60% from peak to trough from December 1996 to December 1998. Notwithstanding fears of a active hurricane season, the WTI spot price of crude oil is still lingering at near all-time highs, and is still 13% above its 200 DMA. Before we can conclude that investors have capitulated, this author would like to see this percentage decline back to the zero line, or at the very least , a crude oil price of $68 (5% decline from current levels), or below.

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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