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April 17, 2008

The Great Deleveraging - Part II
by Henry To

(April 13, 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 304.58 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 610.42 points as of last week at the close.

As of the close last Friday, our two latest buy signals in our DJIA Timing System are collectively in the green. Readers who are interested in the historical performance (as of March 31, 2008) of our DJIA Timing System can refer to our comments from last week (The End of "Market Fundamentalism"). Excluding dividends, our DJIA Timing System returned 13.76% over the last 12 months, beating the Dow Industrials return of -0.74%, and with lower volatility. Again, our next update would be for the period ending June 30, 2008 - with a move to a semi-annual update schedule thereafter.

Let us now expand on our prior discussions on the upcoming "deleveraging phase." We first raised this issue in our March 23, 2008 commentary ("The Great Deleveraging"). In that commentary, I stated:

"... 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."

I also stated that the demise of Bear Stearns - along with Carlyle Capital and the near-demise of Thornburg Mortgage - represented the end of the first phase of the deleveraging. Since then, other players who have depended on cheap financing to sustain their business models have continued to fall - with the airlines being the "poster child" of the latest deleveraging phase (this includes Hong Kong to London carrier Oasis Airlines). Again, I expect most of the players/businesses who have traditionally relied on cheap and ample financing to fail or to take a significant hit going forward - this not only includes businesses, but certain hedge funds, private equity funds, and even certain sovereign countries (Iceland may only be the first casualty in a line of about two or three more countries, especially given the recent record high food prices).

While the "first phase" of the deleveraging is now over, there is no way to tell when the "second phase" will start. Sure, many banks have bulked up their balance sheets lately by raising capital (Wachovia is the latest financial institution to do so) - but there is no doubt that lending and risk-taking would be significantly dampened, at least in the commercial and investment banking industries over the next 12 to 24 months. Given the tremendous amount of global capital sitting on the sidelines, however, I expect this deleveraging to be relatively benign compared to pass deleveraging cycles, but this would not preclude the necessary "washing out" phase of the marginal consumer (i.e. the overleveraged and overextended subprime borrower) or the marginal business. Going forward, whatever lending or leveraging up that will occur over the next 12 to 24 months would be carefully scrutinized. For example, the majority of the lending in the U.S. mortgage sector would be done via "government-sponsored" institutions such as the FHA, Freddie Mac, and Fannie Mae. As we move towards the summer purchase season, I expect close to 90% of all U.S. mortgages would be originated with the help of these institutions. Another sector that could see some significant lending over the next 12 to 24 months may be the credit card sector, given that credit card charge-off rates have held up well (traditionally, the credit card sector was a good leading indicator of other default rates and of a U.S. recession) and as U.S. consumers become more desperate for credit. In this sector, I expect the share prices of Discover Financial (disclosure, I am long Discover Financial in my personal portfolio) and American Express to do very well, given their decent valuations and given the fact that many mutual fund managers who have to maintain a benchmark weighting to the financial sector would probably be buying these stocks, as opposed to investment banks or even commercial banks.

In a recent hedge fund summit organized by Reuters, the consensus "around the table" is that there will be a giant shakeout in the hedge fund industry over the next few years. More specifically, the major industry players, consultants, and investors all expect the number of hedge funds to shrink "a few thousand" from around 10,000 today. Normally, this author (as most subscribers would expect) would treat this "consensus" as a contrarian indicator, but there are now many strong and irreversible forces that are now going against the "marginal hedge fund," such as:

1. The unprecedented rise in margin requirements instituted by all major prime brokers in recent months. This would not only force various fixed income or "credit" hedge funds to continue to deleverage, but would also depress hedge fund profit margins as cheap and ample financing is now being severely curtailed. Following is a table courtesy of the latest IMF Financial Stability Report summarizing the change in margin requirements for various instruments over the last 12 to 16 months (note that initial margin requirements for U.S. Treasuries have gone up more than ten times!):

   

2. From an investment consultant or investor's perspective, the call is now to find a better way to screen better-performing funds going forward. One way to do this would be to seek out certain fund of funds vehicles. Another way would be to develop tighter screens, such as (typically) a screen that requires more assets under management and a longer track record. The word is that all the major hedge fund investors would not even consider a fund unless it has over $1 billion under management as well as at least a five-year track record. This would further exacerbate the "cash crunch" of the smaller and more marginal out funds.

3. The calls to regulate the hedge fund industry have trickled in over the last couple of years but they have now reached a crescendo - even among those who have previously rejected regulation, such as the Federal Reserve. A more stringent regulatory environment would obviously result in a much higher cost of doing business in the hedge fund industry, thus changing the economics of some of the smaller hedge funds or resulting in further consolidation.

Aside from a general shakeout in the hedge fund industry, I also expect the majority of "quant" hedge funds to disappear. Even though margin requirements for equities have not risen significantly, many quant hedge funds (and this includes 130/30 mutual funds) have simply not performed as expected, even excluding their underperformance from the "quant fund crisis" during those fateful six-sigma days in August/September of last year. This is not surprising, as many of these funds are practically using the same underlying data, the same investment strategies, and the same risk management models. There will still be some funds that could overperform (such as Jim Simons' Renaissance Technologies) but the vast majority of the quant hedge fund industry is now saturated. Until the inevitable shakeout occurs, I expect this sector to continue to underperform. For those subscribers who were thinking of getting that Masters degree in financial engineering (such a degree usually only takes 12 months on top of your Bachelors degree), I would advice you to hold off - until after the inevitable shakeout occurs, or preferably once we start seeing signs of the next boom in structured finance (a la Robert Shiller's "The New Financial Order"), the latter of which may not arrive until at least three to five years from now.

The G-7 Meeting

The latest meeting of the G-7 finance ministers and central bankers concluded in Washington DC over the weekend. Participants (which included heads of major Western banks) discussed and debated the latest recommendations from the Financial Stability Forum. Not surprisingly, the group agreed that the following three major recommendations were the most urgent: 1) The urgent need for the financial sector to raise more capital, 2) The urgent need for greater transparency in banks' balance sheets, accompanied by a shift away from mark-to-market accounting during times of financial stress (such as what we have been experiencing over the last six months), and 3) The need to enhance the regulatory framework, coupled with a new "global standard" for capital requirements of structured credit and off-balance sheet activities. However, from the market's perspective, the two most invaluable "take-aways" were 1) the cooperative spirit of the meeting - not only between the world's finance ministers and central bankers but between them and the heads of the major commercial and investment banks as well, and 2) its firmer stance on the recent decline of the U.S. Dollar against the major trading currencies in the world.

While I anticipate the U.S. Dollar to do well in the short-run given this latest statement from the G-7, I don't believe the U.S. Dollar Index could sustain a multi-month appreciation against the Euro unless at least one of the following three conditions are satisfied: 1) The European Central Bank becomes more dovish, once it is clear that the Euro Zone is slowing down as much as the United States, or 2) There is a more concerted effort of supporting the U.S. Dollar through an outright intervention by the world's major central banks, including, at the very least, the Federal Reserve and the European Central Bank, and 3) The market takes the decline of the U.S. Dollar to its logical conclusion, i.e. downright capitulation. Even though almost everyone and his neighbors are now bearish on the U.S. Dollar (see the latest McDonalds "one dollar menu" ad), I don't believe we have achieved capitulation yet. One indicator that is arguing against capitulation in the U.S. Dollar Index at this stage is the Goldman Sachs Sentiment Index on the U.S. Dollar against the Euro:

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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