The Great Deleveraging

By: Henry To | Thu, Mar 27, 2008
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(March 23, 2008)

Dear Subscribers,

Before we begin our commentary, let us now review our 7 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.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 268.68 points as of last week at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 646.32 points as of last week at the close.

I will provide an update of our inception-to-date performance after the end of this month. Suffice it to say, our long-term track record remains good - especially relative to our benchmark, the Dow Industrials Industrial Average. Moreover, our last two signals - which collectively brought us from a neutral to a 100% long position in our DJIA Timing System, are again collectively in the black. I expect the Dow Industrials and other major market indices, such as the S&P 500, the Dow Transports, the Russell 3000, and the Russell 2000 indices to continue their ascent over the next several months.

Let us now get on with our commentary.

What a difference a week makes. This time last week, as the Bear Stearns acquisition was announced, many folks were staring at the edge of the abyss, as the value of many broker/dealers' shares were being openly questioned. After all, if Bear Stearns was valued at only $2 a share (or $240 million), how much could Lehman, Merrill, or Morgan Stanley be really worth, especially in a credit crunch environment? Even though the $2 a share offer was initially shocking, it wasn't a total surprise, as Bear Stearns really had little say in the price of the offer, given the Federal Reserve and the Administration's push to get some kind of deal put together last weekend (in hindsight, it turned out that the Fed instructed JP Morgan to not pay more than $2 a share, as the Fed did not want to give the impression that it had bailed out Bear Stearns). Soon after the market opened, however, this question became irrelevant, as the price of JP Morgan's shares tacked on more than 10% in a down market, which essentially meant that the Bear Stearns acquisition was adding value to the tune of over $100 a share on the Bear Stearns common. Moreover, with the Fed's 25 basis point cut of the discount rate, as well as its promise to "backstop" the 20 primary dealers by allowing them access to the discount window, the Fed had ended the liquidity crisis with a single stroke. While there will be tremors as the financial sector continues to deleverage (think Thornburg Mortgage and CIT Group), systematic risk had significantly declined with the implementation of the Fed's 6-month "liquidity put" for the 20 primary dealers.

Subscribers should remember that these "boom/bust" cycles are an inherent part of our capitalist society. For the most part, the social and political atmosphere of the United States ever since her founding has allowed the "animal spirits" in all of us to express themselves - whether it is in entrepreneurship, business, investment, speculation, adventure, or in sports. Such "animal spirits" will no doubt exaggerate themselves at various times - and it is such "exaggerations" that bring about our boom/bust cycles. Moreover, such expression of "animal spirits" is not only inherent but is necessary to further advance the capitalist society. As John Maynard Keynes expressed in Chapter 12, "The State of Long-Term Expectation" in his book "The General Theory of Employment , Interest, and Money" in 1936:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; - though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and use them, is put aside as a healthy man puts aside the expectation of death.

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man.

Hyman Minsky - a student of Joseph Schumpeter - took Keynes' thesis to its logical conclusion by laying out a typical roadmap of such boom/bust cycles in capitalistic societies - or what we would call the "Minsky framework" today (I highly recommend reading his books "John Maynard Keynes" and "Stabilizing an Unstable Economy" for more of his insights). More importantly, Minsky believed that capitalism in itself is inherently unstable - and that the Federal Reserve should come in as a lender of last resort and to set/slash interest rates in order to stabilize a financial crisis or a severe economic downturn. Fans of the Austrian economists (note that Joseph Schumpeter was never an advocate of Austrian economics) would no doubt disagree with this view. But it really does not matter. We have had a Federal Reserve since 1913 and there is no political will to dismantle it. Moreover, our Fed Chairman, Ben Bernanke, and the NY Fed's President Timothy Geithner (the second most powerful figure, and the Vice Chairman of the FOMC) have essentially embraced these beliefs - and most importantly, have acted according to their beliefs over the last ten weeks. This is a major reason why (along with historically oversold readings in both our technical and sentiment indicators) we started turning bullish during the second week of January - and ultimately going 100% long in our DJIA Timing System during the intraday lows of January 22nd.

Given the lengths that the Federal Reserve has gone to "back stop" our financial system, and given its series of rate cuts since January 22nd (200 basis points in the Fed Funds and 225 basis points in the discount rate over the last two months alone), the old adage "Don't fight the Fed" certainly applies here. Moreover, given the stock market's historically oversold status over the last couple of months (in terms of relative valuations, technicals, and sentiment) - and given the many positive divergences we are now witnessing (such as the strength in the Dow Transports over the last few weeks, the higher lows in the NYSE McClellan Summation Index, and the higher lows in new highs vs. new lows on both the NYSE and the NASDAQ), the other important old adage, "Don't fight the tape" also applies. If you are still a U.S. stock market bear at this point, you are doing both - and it has NEVER paid to simultaneously "fight the Fed" and to "fight the tape." Following is an example of a positive divergence (the chart courtesy of Decisionpoint.com) - as the number of 52-week lows for common stock issues on the NYSE during the recent decline did not get anywhere close to that during the late January decline:

NYSE Common Stock Only New Highs and New Lows - Positive divergence - as the number of new 52-week lows during the latest decline on the NYSE did not get anywhere close to that during the late January decline...

Given the many severe oversold conditions we have discussed over the last few weeks (not to mention very bullish insider buying, as well as the fact that domestic equity mutual funds are now due to see their 10th consecutive monthly outflow, surpassing the previous eight-month streak following the October 1987 crash), the record amount of investment-ready capital sitting on the sidelines, and very decent valuations, I am now bullish on the U.S. stock market for at least the next few months.

That being said, there is no doubt that a "new era" of finance is now upon us. While I am still bullish on the financial industry and its ability to create new risk-hedging/speculation products over the long-run, there is no doubt that some "shakeout" over the next 12 to 24 months is imminent. This is simply human nature - as financing had been too lax and too cheap over the last few years due to the "anything goes" environment and the widespread belief that securitization would dilute risk from the financial sector to the overall global economy. To some certain, that argument was valid, but unknowingly - especially to those who invested in Citigroup, Merrill Lynch, or Bear Stearns - the financial sector had also kept a significant portion of this "toxic waste" paper on their balance sheets. Now that the "animal spirits" of financial sector CEOs and Harvard MBA students are being slapped down by the market place - and now that the politicians are screaming for more regulations, the appetite for risk-taking in the financial sector is past us, and probability suggests that a significant part of this sector will deleverage going forward.

In an institutional conference call late last week, Bill Miller of the Legg Mason Value Trust Fund remarked that global debt had also been growing at twice the pace of global GDP over the last few years. As such, he expects a significant part of the world would also enter a deleveraging phase over the next couple of years. In my humble opinion, the marginal players - such as Bear Stearns, Carlyle Capital, Thornburg Mortgage, and the subprime mortgage originators - were the first casualties. While the demise of Bear Stearns marked the end of the first phase of the deleveraging process, I expect other players to start falling as general financing gets more difficult and expensive to obtain over time. Over the longer-run, such deleveraging would be healthy for our economy, as current account deficits and household debt growth would decline. In the meantime, any significant amount of deleveraging would be painful for certain players, as the asset-to-liability ratio of U.S. households (see chart below) is now at a historically low level of 5.02 (at the end 4Q2007), down from 5.12 at the end of the third quarter of 2007:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 4Q 2007) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.02 today... 5) Household net worth dipped by $530 billion during the fourth quarter - representing the first Q-o-Q drop since 3Q 2002. However, household net worth is still up by 3.4% ($1.9 trillion) on a year-over-year basis. 6) The *dip* in net worth caused by the October 1987 stock market crash.

Note that I mentioned "certain players" would be hurt by the deleveraging. Who would those be? In a nutshell, those would be companies whose business models relied on cheap financing - such as SIVs, a significant number of mortgage REITs, certain private mortgage lenders, certain private student loan lenders, much of the private equity industry, and a significant portion of hedge funds who were involved in either the currency or credit carry trades. Note that I am not expecting a significant blowup over the next 12 to 24 months, but I do expect a "slow but certain death" for many of these companies, as credit lines are pulled and as investors withdraw en masse from some of these sectors (such as hedge funds). With respect to hedge funds, I expect many of them to fail as hedge fund investors bail out as financing gets tight and as the various carry trades (Yen, Swiss, Rand, NZD, and Icelandic Krona crosses, etc) go out of fashion. Furthermore, many former hedge fund investors will learn that "true alpha" is really elusive in the first place, and thus will move back into the traditional "beta strategies" - such as buying, for the most part - the unlevered and the well-managed companies in the Russell 3000 or EM equities. The UK and Eastern Europe will also dramatically go out of style, as some of the overly-extended countries (countries that have a significant amount of foreign bank credit and a significant current account deficit) such as Latvia, Estonia,, Hungary, Lithuania, and Romania, go bust.

More follows for subscribers...

 


 

Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com 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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