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November 10, 2007

The Various Bear Markets
by Henry To

(November 4, 2007)

Dear Subscribers,

Note: Please participate in our latest poll. The question is: What is the probability of a US recession in the near future? Comments are also welcome, as always.

Let us begin our commentary by first providing an update on our four 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 October 4, 2007 at 13,956, giving us a gain of 360.90 points as of Friday at the close.

In this weekend's commentary, I am going to highlight the various major bear markets in the US today and give a sense to when we will buy into some of these asset classes. Hopefully, this will prepare our subscribers for the buying opportunities once they arrive. We will then end this commentary with our usual discussions on the US stock market and the sentiment indicators that we track on a weekly basis.

One of the major bear markets in the world today is, no doubt, the bear market in global financial stocks (e.g. Citigroup made a fresh four-year low and Merrill Lynch made a fresh 2 ½ year low last Friday), as well as the structured finance market and the private equity industry. Since these topics have already been discussed extensively by both MarketThoughts.com and the mainstream media, we will refrain from speaking about these in this commentary. Rather, I want to begin this commentary with the topic of US REITS.

We first discussed the overstretched valuations in US REITs in our February 1st commentary (coincidentally, 7 days before the ultimate peak in US REITs). In that commentary ("REIT Market Overheating?"), I concluded that "... given the rich valuations in the REIT market today, subscribers should be very cautious - as it probably will not take much for anything to act as a catalyst for a major peak in the REIT market." To give readers a sense of how overvalued US REITs were,: At the end of January 2007, the spread between REIT dividend yields and the 10-year Treasury yield was at approximately negative 1.4%, compared to an average 0.5% positive spread during the 1990 to 1997 period and the 1.4% positive spread during the 1998 to 2006 period. Moreover, the spread between REITs and 10-year Treasuries have never traded at such a negative spread before. During the last US REIT bull market that peaked in mid 1997 (REITS would decline 18.8% in 1998 and 6.5% in 1999), the spread declined to "only" negative 80 basis points. By all historical measures, US REITs were priced at their richest in history at the end of January 2007, just 8 days before the ultimate peak.

According to the FTSE NAREIT All REIT index, US REITS were down 2.4% at the end of October on a year-to-date basis, after outperforming the S&P 500 for six consecutive years from 2000 to 2006. By contrast, the S&P 500 was up 10.9% on a YTD basis, for a return differential of a huge 13.3%! There is no doubt that US REITs are currently in a bear market after peaking in early February of this year. The $64 billion question is, as always, when would REITs present a good buying opportunity?

Let us start with the dividend yield on the FTSE NAREIT Equity REIT Index. As of the end of October, equity REITs yielded 4.17%, just 12 basis points below the 10-year Treasury yield at the close on Friday, and up from a yield of 3.40% at the end of January. However, the spread of negative 12 basis points is slightly "misleading," as 10-year yields have declined substantially since the end of January, from 4.83% to 4.29% at the close on Friday. Common sense would dictate a higher "yield cushion," given that REITs are now officially in a bear market. Over the last 24 months, 10-year yields have traded in a 102 basis point range of 4.28% to 5.30%. Assuming that subscribers are happy with a yield that is comparable to 10-year Treasuries (such a scenario would involve betting on higher rental growth and higher real estate prices going forward), I believe subscribers should at least settle for a 5.00% yield. Moreover, given that the rental market in New York and San Francisco continues to be weak, an optimistic projection would be for a 10% growth in rental income over the next two years. To get to a 5% yield point, and assuming a 10% growth in general rental income, the FTSE NAREIT All REIT Index would need to decline a further 10% over the next two years in order to meet our buying point.

Note that our above scenario represents out most optimistic projections. Firstly, it does not assume that the US economy will slide into a recession, as a recession typically has widespread repercussions in the REIT market, such as declining rents, lack of access to borrowing, and higher borrowing costs for "lesser-quality" REITs. Secondly, as I have mentioned before (and as shown in the following chart courtesy of the monthly NAREIT REITWatch publication), the spread between equity REIT yields and ten-year Treasury yields has historically traded at some kind of spread. During the early to mid 1990s, the average yield spread was 50 basis points. From 1998 to 2006, the average yield spread rose to 140 basis points, as a result of 1) investors shifting money from REITs into technology stocks from 1998 to 2000, and 2) as investors pulled back from taking general risk during the 2001 to early 2003 period.

Given that REITs are now currently in a bear market, it would not surprise me if REITs again trade at a spread of 150 basis points to 10-year Treasury yields sometime the next few years, especially if the US enters a recession. Even if the US does not experience a recession going forward, it is still reasonable to assume that REIT investors would like to see some kind of spread before investing in REITs again. To that end, I believe a 50 basis point spread is reasonable, and actually, relatively conservative. Assuming a 10-year Treasury yield of 5% sometime over the next two years, a two-year rental growth rate of 10%, and a 50 basis point spread between REIT and ten-year yields would result in a 16% to 18% decline in the FTSE NAREIT All REIT Index over the next couple of years, as opposed to the 10% "optimistic" scenario that I had outlined previously. My guess is that this is the most likely scenario, and should provide a good risk-adjusted return for long-term investors. For more conservative investors or older retirees, I would simply demand a higher spread before buying. If it never goes there, then so be it. To that end, I believe a 100 basis point spread is reasonable, which would imply a 25% decline from current levels over the next couple of years assuming my relatively optimistic assumptions hold true. If rental income growth slows further going forward, or if 10-year yields spike to 6%, then all bets are off.

I now want to discuss another bear market that we have been experiencing - the bear market of the U.S Dollar Index. We last discussed the U.S. Dollar Index in our September 16, 2007 commentary ("Tactical Trade on the U.S. Dollar?"). In that commentary, I stated:

Over the last two and a half years, we have - off and on - gotten bullish in the U.S. Dollar Index (see our May 1, 2005 and November 12, 2006 commentaries). While the official calls that we made in our commentaries were, for the most part, correct and tradable on the long side in the short-run - in retrospect, the "bullish dollar" call was far too early and had not pan out over the longer-run. At this point, however, we still stand by our original thesis - that over the longer-run, while most Asian currencies should out perform the U.S. Dollar (not only because of higher economic growth in Asia ex. Japan, but also because of the differences from a purchasing power parity standpoint), things are not so clear in either the UK or Euroland. I have discussed our many reasons before, but among them are: 1) deteriorating demographics, combined with the lack of a coherent immigration policy of young and enthusiastic talent with good education, 2) lack of structural reforms, 3) housing bust in Spain, along with the fact that both the UK and France's economic boom over the last few years have, in no small part, been helped by rising housing equity in both countries, 4) the fact that much of Euroland (especially Germany) is the marginal manufacturer in the world - and therefore, at the first sign of an economic slowdown, European exports will come to a screeching halt, and 5) a hugely overvalued currency from a power purchasing parity standpoint, as exemplified by the wave of UK tourists doing their Christmas shopping at Macy's during 2006.

I continue to stand by this thesis. Moreover, we are now starting to see some strains on the UK economy, given that UK economic growth has been so leveraged to the growth of the financial sector and the boom in the UK housing market over the last five years. There is no doubt that the Bank of England will need to lower rates possibly as soon as February of next year in order to combat lower economic growth and high credit costs. But more importantly, I believe the current fallout in the credit markets will have a bigger impact on the UK economy as opposed to the US economy, especially given that the UK housing boom has been much more violent than the US housing boom in recent years.

In our September 16, 2007 commentary, I also stated that over the short-term, I was still not willing to go long the US Dollar Index just yet (a view that has had luckily worked out in our favor). One major reason was the growth in foreign reserves held in the custody of the Federal Reserve had continued to increase substantially increase over the last six months, signaling that there was still "too much U.S. Dollars" in the system. For readers who have not been with us for long, we first discussed the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index in our May 1, 2005 commentary. In that commentary, I stated:

Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.

Since our May 1, 2005 commentary, this inverse relationship has more or less has held. More importantly for us, the growth in foreign reserves has slowed down over the last six weeks, as evident by the following monthly chart showing the annual change in the U.S. Dollar Index. vs. the annual change in the rate of growth (second derivative) in foreign reserves:

Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that aside from the decline in the growth of foreign reserves, the U.S. Dollar Index has been decreasing significantly as well - meaning that the divergence between the rate of growth in foreign reserves and the decline of the U.S. Dollar Index is now getting rather "long in the tooth." Assuming that foreign reserve growth continue to slow down in the weeks ahead, there is a good chance that the above chart will flash a "buy" on the U.S. Dollar Index sometime in the next several weeks. We will update our readers once we get to a good buying point.

More follows for subscribers...

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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