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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…

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Whats Next for Financials?

July 6, 2008

Dear Subscribers,

Let us begin our commentary with a review of our 10 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;

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

9th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 943.46 points as of Friday at the close.

10th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 634.46 points as of Friday at the close.

We will update (and "clean up" our above text) our DJIA Timing System's performance as of the end of the 2nd quarter for our readers in next weekend's commentary, and then subsequently move to a semi-annual update schedule. Please refer to our subscribers' area for our March 31st update. As of Friday at the close, our DJIA Timing System is still beating our benchmark, the Dow Jones Industrials Average, on all timeframes since the inception of our system.

As I mentioned in our mid-week commentary, this commentary is going to be brief, as Thursday's trading session was relatively uneventful, and as we had to prepare for our two-day trip to Catalina Island tomorrow morning.

A recent study released by Keefe, Bruyette & Woods suggests that US banks (excluding investment banks) would need to raise another $30 billion in "coming years" as the "multiplier effects" of the recent subprime problems spread across the US economy. Bank of America is at the top of the list. In a "worst case scenario," KBW estimates that Bank of America would need to raise $10 billion in capital, as it struggles to digests its recent acquisition of Countrywide Financial.

A July 4th article on Bloomberg featured Goldman's latest estimates of total capital raisings required by European banks. According to Goldman, approximately US$95 to US$140 billion would be needed by all European banks over the coming years in order to raise their Tier 1 capital ratio to 9%. Goldman estimates that the upper range of US$140 billion would be needed if we experience a scenario reminiscent of the early 1990s credit crisis/global recession.

Over the next few days, look for more reporting on Merrill Lynch, as rumors continue to swirl regarding an inevitable divesture of its holdings in Bloomberg (Merrill is reportedly asking $5 billion) and part of its $12 billion holding in BlackRock in order to cover more projected write-downs in its earnings report in the middle of this month. Total write-downs for the second quarter for Merrill estimated to be from $3 billion to $6 billion.

Meanwhile, Deutsche Bank has now emerged as the sole bidder for Citigroup's retail banking operations in Germany, as Citigroup continues to deleverage and shore up its capital base in anticipation of further write-downs for the second quarter. Such a sale is estimated to fetch US$6.3 to US$7.9 billion. Second quarter write-downs for Citigroup is estimated to range from "as little" as US$5 billion, to as much as US$12.2 billion (this final estimate is courtesy of Meredith Whitney from Oppenheimer).

Assuming both Merrill's and Citigroup's sales of go through over the next couple of weeks (right before the announcement of their second quarter earnings), chances are that both will have little need to raise more capital in the immediate future. However, given Goldman's latest assessment of the health (or lack thereof) of the European financial system, and given the slowing global economy and tightening monetary policies around the world, there is no doubt that both the US and global financial system continues to remain under stress. For example, on a year-to-date basis, the S&P 500 financials index is down about 30%. During the second quarter alone, the S&P 500 financials index declined nearly 20%, despite the barrage of rate cuts an the creation of the Primary Dealer Credit Facility by the Federal Reserve in light of the collapse and subsequent takeover of Bear Stearns. This "elevated stress" in our financial system can be witnessed in the stubborningly high levels of the "TED Spread," as shown in the following chart:

5-Day Simple Moving Average of the TED Spread (January 1998 to Present) - The TED spread hit a 20-year high in mid December - making a lower high in mid March - and has since declined back to the 1.2% level on the back of the recent easing and liquidity injections by the Fed. Despite the 225 bps ease by the Fed since the beginning of this year, the 5-day MA of the TED spread remains at a relatively high level of 1.18% - suggesting that the bank liquidity conditions are still relatively tight. There is no doubt the Fed would like to see this back below the 1.0% level, which is where it has been over the long-run. Unfortunately, the recent spike in headline inflation is preventing the Fed to ease any further - but by the same token, the continued stress in the US banking system also suggests that the Fed won't be hiking anytime soon.

Despite the 225 basis point easing by the Fed since the beginning of this year, and over $320 billion in global capital easing since August of last year, the 5-day moving average of the TED spread still remains at an elevated level of 1.18%. While this spread is down from the >2% rate in mid December of last year, there is no doubt that liquidity conditions still remain tight among many banks across the globe. Unfortunately, the recent spike in headline inflation is preventing the Fed and other major central banks from easing any further. That in turn means any immediate relief will need to come from more capital raises - as many banks are not projected to retain profitability anytime soon.

Fortunately - as covered in our prior commentaries - unlike past downturns in the US banking/economic cycle, there is now an unprecedented amount of capital sitting on the balance sheets of private equity funds, sovereign wealth funds, distressed debt funds, and "vulture investors" intended to scoop up much of these assets of ownership in financial institutions once some of the smoke in the US housing sector and US economy starts to clear out. Moreover, private equity funds have shown substantial interest in putting more capital to work in many US financial institutions once the Fed clarifies some of its ownership rules surrounding bank holding companies, while Japanese financial institutions (which for most part emerged unscathed from the subprime crisis) are now also expressing an interest in recapitalizing many global financial institutions - with an eye to expanding their global reach over the next three to five years. For those financial institutions who do not want to tap "strategic investors" such as private equity or Japanese financial institutions for more capital, they can always raise more funds from the secondary market, as both institutional and retail investors have for the most part kept buying financial ETFs and financial mutual funds over the last few weeks, even as the share prices of many companies in financial sector continued to decline.

This author expects relative strength to rotate back to US, Japanese, Taiwanese, Hong Kong, and South Korean equities over the next few months - especially as global pension funds and sovereign wealth funds "rebalance" their portfolios over the next few weeks in response to the recent run-up in commodity prices and the decline in equity prices (having institutional investors buying commodity futures is a double-edged sword). With respect to US equities, I continue to like the technology and healthcare sectors in general (I also like the biotech industry for those who want to buy a specific industry fund). I also expect both the financial and consumer discretionary sectors to outperform the S&P 500, as these two sectors are now severely oversold (while both sectors are still in the midst of deleveraging, the "pendulum" has definitely swung too far into the bearish side). To put this in perspective, let us take a look at our Overbought/Oversold Model for the various S&P 500 sectors (this model is constructed using the same methodology as utilized by our Global Overbought/Oversold Model, which is discussed in our December 6, 2007 commentary).:

S&P 500 Sectors Overbought/Oversold Model as of June 30, 2008

Using this methodology, the financials sector is now at its most oversold level going back to the beginning of 1998 (this model uses historical data going back to 1998), with the exception of its three-month moving average (its most oversold level on a three-month basis came in August 1998). Meanwhile, the consumer discretionary sector also remains oversold in all timeframes, while industrials have also suffered given the recent global economic slowdown (although I predict more general weakness in industrials for the next few months). Not surprisingly, I expect both the energy and the materials sectors to underperform the S&P 500 over the next few months.

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