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Henry To

Henry To

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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When Will the Deleveraging in the U.S. Equity Market End?

(January 8, 2009)

Dear Subscribers,

The "deleveraging" and the "purging" of excesses and money-losing projects continue in the real economy. Some recent highlights (or should I say, "low lights") include:

  • Apparel retailer Goody's fails to restructure its debt. It now plans to liquidate its entire chain of 282 stores, with fiscal 2007 revenues of over $900 million. The apparel retailers that will benefit (if only marginally) from the liquidation of Goody's are Wal-Mart, Target, TJ Max, and J.C. Penney, as only these four retailers had established operations in the areas where Goody's operated.

  • Macy's announces that it will close 10 of its underperforming stores (out of a total of 860 stores), as it continues its struggle to digest some of the underperforming stores stemming from the May Co. acquisition in 2005. For the first nine months of 2008, the company lost $30 million - and this loss is most likely to increase for the last three months of the year.

  • Borders Group continues to struggle with its turnaround plans - appointing a new CEO and CFO - and closing some underperforming stores over the last few weeks.

  • As expected, the delinquency rates within the U.S. commercial real estate market are slowly but surely rising - as vacancy rates in hotel and retail properties start to rise and as it became apparent that cash flow projections had been far too optimistic during the underwriting process over the last few years.

  • The American Bankruptcy Institute just announced that consumer bankruptcy filings increased to 1.06 million last year, up from 801,840 (i.e. up by nearly a third) in 2007.

  • For the first time in a long time, retailers are reporting a surge in piggy bank sales - suggesting that Americans are finally adopting a savings mentality - as opposed to relying on the appreciation of their stocks or their houses to "bail them out."

With U.S. and global economic indicators still on a downtrend, balance sheets across the U.S. will become more strained in the months ahead, as U.S. GDP continues to contract and as the U.S. employment rate continues to rise. While Obama's fiscal stimulus plan should cushion this deleveraging, it is to be noted that only $300 billion of the proposed $775 billion fiscal stimulus plan will be in the form of tax cuts. The majority of the stimulus will be spent over time and presumably on initiatives such as infrastructure, alternative energy, and education funding. While the latter will be beneficial for the U.S. economy in the long run, it will do little for it (or halt the deleveraging) in 2009.

Of course - we all know that the U.S. stock market is the leading indicator of the leading indicators. In many U.S. past recessions, the Dow Industrials has bottomed out well before the end of the recession. That is, even though the U.S. economy was still deleveraging - and unemployment was still rising - investors were already bidding up stocks in anticipation of the next boom, and rising profits. The September 1957 to March 1958 recession was one example, as the Dow Industrials entered a bear market in July 1957 but bottomed in October 1957 (tracing out a 19.3% decline) - just one month after the recession began, and over five months before the recession ended. The Dow Industrials also made a solid bear market bottom in early December 1974 - nearly four months before the end of the January 1974 to March 1975 recession. Finally - even with the Savings & Loans crisis raging behind the scenes - the Dow Industrials ended its bear market in October 1990, more than five months before the end of the July 1990 to March 1991 recession.

It is not surprising that the U.S. stock market is treated as one of the main leading indicators of the U.S. economy - given: 1) The action in the U.S. stock market - just like action in the real economy - reflects the hopes and dreams of every investor in the U.S. In the vast majority of cases, investors will bid up share prices if they see an economy recovery on the horizon, and 2) The U.S. stock market is the only "real time" leading indicator of the U.S economy. Many other indicators, such as money supply and jobless claims, are only published on a weekly or monthly basis. Just as businessmen act in the economy if they see a recovery, investors also start to leverage up with stocks if they see a solid bottom in the stock market. Not surprisingly, all the major bottoms in the U.S. stock market have also coincided with the end to deleveraging, or a bottom in total margin debt outstanding.

Let us now take a look at the following monthly chart showing the Wilshire 5000 vs. total amount of margin debt outstanding for the period January 1997 to November 2008:

Wilshire 5000 Vs. Margin Debt Outstanding (January 1997 to November 2008) - Total margin debt decreased $50.2 billion during November to $227.3 billion, from $277.6 billion at the end of October 2008. Margin debt outstanding has decreased by a whooping $118.4 billion in the two months ending November. This immense rate of margin debt liquidation is unprecedented. Even during the 2000 to 2002 bear market, margin debt outstanding never declined so quickly. From its peak in July 2007, the amount of margin debt outstanding has now declined by 45%, and is now at its lowest level since June 2005.

As mentioned on the above chart, the deleveraging within the U.S. stock market has been very severe since the peak in July 2007 - especially for the two-month period ending November 2008. Since its peak in July 2007, the amount of margin debt outstanding has declined by 45% - all in just 16 months! During the March 2000 to September 2002 deleveraging phase (the stock market bottomed on October 9, 2002), total margin debt outstanding declined by 55%. That deleveraging phase, however, took a "whooping" 30 months. There is no modern precedent for this. For example, even during the bear markets in the late 1960s and early 1970s, margin outstanding never declined so quickly, as can be seen in the following weekly chart:

Margin Debt (January 1966 to December 1974)

From its peak in June 1968 to the bottom in July 1970, margin debt outstanding declined by 44%. Even though the magnitude of that particular decline is on par with the current decline, subscribers should note that it took 25 months for the stock market/margin debt to deleverage by 44%. Similarly, from its peak in December 1972 to November 1974, margin debt declined by 51%. Subscribers who invested during the 1973 to 1974 bear market may have remembered it as one of the most ferocious bear markets ever - as pension funds, insurance companies, mutual funds, and retail investors all liquidated into a hugely unforgiving market - but even then, it still took 23 months for margin debt to decline by 51%.

The current deleveraging, both within the U.S. stock market and within the real economy, only has one comparison - i.e. the 1929 to 1932 bear market in stocks, which coincided with the greatest three-year decline in U.S. GDP. This is something I have mentioned before. Taken in this context, it is therefore not a surprise to see policy makers throwing everything they can to stem the liquidation in the financial markets - anything from lowering the cost of borrowing, to bank recapitalizations, outright asset purchases, and fiscal stimulus plans. Whether this will ultimately be successful will depend on the political will of both U.S. and global policy makers. The Federal Reserve, the ECB, the Bank of Japan, the Bank of England, and the People's Bank of China have the necessary means to stop this (the "printing press" would be the main arsenal in their war on deflation) - it just depends on whether they are willing to use what they have, and whether they are willing to work in concert with one another. For now, the answer is "yes," despite the ECB's reluctance to go along with some of the more radical ideas (note that I am still looking for the Chinese economy to grow by 6% to 8% in 2009 - but there is no doubt that the People's Bank of China will continue to act to stem any further declines/deleveraging in the Chinese economy). In the meantime, the 45% decline in total margin debt outstanding within the last 16 months is a record move no matter how you look at it - and suggests that the deleveraging within the U.S. stock market may be close to being over for now, assuming policymakers are committed to more easing in the near future.

Signing off,


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