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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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An Instinct to Swarm

(March 30, 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 413.60 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 501.40 points as of last week at the close.

I will update our inception-to-date performance for the end of March in our next weekend commentary. 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 still collectively in the black. I continue to 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.

In a typical risk tolerance survey conducted by financial planners, one typical question tends to be:

Assuming you have a significant amount of savings invested in the stock market, how much of a decline in the stock market would cause you to make a change?

  1. More than 50%
  2. About 50%
  3. About 30%
  4. About 15%
  5. About 5%

From a profit maximization standpoint, and given the history of stock market returns, the general optimistic outlook on global capitalism and productivity gains of the companies within the S&P 500, and given that the vast majority of individual investors cannot reliably time the stock market, the logical answer should have been "buy more" on all levels (note that this is essentially "dollar cost averaging" with a slight twist, as only declines, and not rallies, are bought). However, as most financial planners would no doubt realize (the answer to the above question determines how much equities the client can tolerate in his/her portfolio), human nature does not work that way, in that we tend to extrapolate recent events into the indefinite future - or in the case of the recent events in the financial markets, we tend to swarm to cash (safety) during times of uncertainty - comforted by the fact that most the "experts" in the mainstream media are also doing the same thing. This instinct to swarm, as documented by scientists is common to many species in the animal kingdom - and is a variant of the trait and tendency of humans to "follow the leader." In extreme cases - these two tendencies of human nature, combined with other traits such as nationalism and racism, have led to rather unfortunate events such as genocide and mass killings. Expressed in the financial markets, these two tendencies - combined with the two extreme psychological tendency of fear and greed, tend to result in crashes and manias, respectively, both of which result in severe mispricing of risk and assets in the downside and upside, respectively.

Such "instinct to swarm" has now resulted in catastrophic scenarios being priced into the financial markets, such as:

  1. A historical 200 basis point spread between Agency (Freddie and Fannie) MBS and Treasuries. In the current environment, there is little doubt that the "implicit guarantee" of the U.S. government behind this $4.5 trillion market (the underlying collateral is based on houses with average loan-to-value ratio of around 60%) has turned into an "explicit guarantee." As I mentioned in our discussion forum, there is no way that the Federal Reserve or the U.S. government can justify walking away from this market given that they have previously bailed out LTCM, Bear Stearns, and have just effectively backstopped the entire U.S. financial system. Factor in 65 to 75 basis points to compensate for prepayment risks, and you effectively have a riskless (over the long-run) carry of 125 to 135 basis points (especially since the marginal buyer of agency MBS, Carlyle Capital, has been liquidated).

  2. Junk bond yield spreads of close to 900 basis points - in essence already factoring in a 1990 style recession with an 8% default rate. Despite the credit crunch since August/September of last year, the junk bond default rate so far has been only about 1%. Moody's is currently forecasting a 5% junk bond default rate over the next 12 months. Investment-grade corporate yield spreads are even more bizarre - as investors have already factored in a scenario much worse than the prices at their troughs in 1990 and 2002.

  3. The unprecedented inflows into money market funds over the last 12 months, despite an easing campaign that has taken the Fed Funds rate from 5.25% to 2.25% over the last six months. BlackRock alone experienced a $100 billion inflow into its money market funds over the last 12 months. Based on data from the Federal Reserve, total money market fund assets increased over 43% on a year-over-year basis - a truly unprecedented increase unless one goes back to the early 1980s when the product was first incepted.

Of course, the "efficient market hypothesis" crowd can always argue that the market is efficient and thus risks are adequately priced, etc. But if one talks to any money manager that is well-connected, one would find out that every manager would agree that there are a lot of bargains in the financial markets today - but that those same folks are taking a very cautious approach since no one want to stick their necks out and "be a hero" in the current liquidity-constrained environment (and especially since we are approaching the end of the quarter). Moreover, such an argument would mean that risks were priced correctly as well during the up cycle - which as we argued back in our June 7, 2007 commentary ("Mid-Week Liquidity Update: A Discussion of High Yields") and which is now so evident - were non-sensical.

The "instinct to swarm" and the "follow the leader" mentality of human beings also manifest in each of us the tendency to follow the "guru" that have gotten his or her calls correctly in the latest cycle. A current example is the popularity of CIBC sell-side analyst Meredith Whitney. She has now gained a well-deserved following in light of her calls late last year on the potential downside of Citigroup, as well as its need to raise more capital and cut its dividend. Last week, she remarked that she is still bearish on Citigroup and many of the banks (including Wachovia and Bank of America) - although she is still constructive on many of the broker/dealers (with the exception of Merrill Lynch). I have read both her November 2007 and her recent report. She has done a great deal of sound and historical analysis (especially with regards to her comparison of today's losses and potential downside relative to those in 1990) - but as always, you need to look behind the language and dig through the assumptions and disclaimers and make an informed decision of your own. For example, forecasting more write-offs going forward is definitely a sound methodology given the continued decline in the popular structured finance indices such as the ABX and the CMBX, but most informed individuals would know that these indices are relatively illiquid and are already pricing in a very pessimistic scenario relative to what is going on in the "real economy" today (e.g. at its peak, the CMBX indices were pricing in a CMBS default rate of more than 30 times the actual current rate). Moreover, she - just like other human beings - is not infallible. In particular, she had an "outperform" call on Lehman Brothers with a target price of $79 a share as recently as January - and only retracted her call after the stock's most recent slide. Finally, both Whitney and other sell-side analysts do not have detailed information on each bank's structured finance products holdings, other than what has been disclosed in public filings. In other words, all her calculations are "back of the envelope" calculations, so to speak. Her current "50% downside" call is a "worst-case scenario" call, and is no way reflective of the most probable scenario, especially now that every investment bank and other primary dealer would be looking for a depository institution to acquire over the next 12 months. In light of Bear Stearns' dramatic collapse, guaranteed direct access to the Fed's discount window is now much more glamorous and certainly one of the most prized possessions in the (leveraged) financial community today.

Speaking of the subject of liquidity, and turning to the domestic stock market, the amount of "cash on the sidelines" waiting to be invested has continued to increase at a dramatic rate (43% year-over-year) and is now at a record amount relative to U.S. market cap. This indicator - the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 - had been particularly useful as a gauge of how oversold the US stock market really is - as well as how sustainable a current rally may be. I first got the idea of constructing this chart from Ned Davis Research - who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to March 2008 (note that the March data is only extended into last Friday, obviously):

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to March 2008) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market which would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio rose to 28.02% on Friday, due to the latest decline in the S&P 500 and the ongoing rush into money market funds. More importantly, this ratio has now surpassed both the month-end February 2003 high and the previous record high set in month-end July 1982. This is hugely supportive for stock prices over both the short and the long-run. While this does not mean that this ratio cannot go higher, chances are now that the market will be much higher over the next several months.

As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 28.02% - an astronomically high level that broke all previous record highs - including the month-end February 2003 high and the month-end July 1982 highs. The October 1990 high - the last time the U.S. stock market gave us a once-in-a-decade buying opportunity - has now been "blown out of the water." Unless the S&P 500 rises by more than 2% on Monday, this record is most likely to hold. Moreover, subscribers should remember that the amount global capital that is sitting on the sidelines waiting to be invested is also now at record highs (such an amount of capital was virtually non-existent back in February 2003, let alone July 1982 or October 1990). While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now extremely high on a historical basis and should be supportive for stock prices not only for over the next few years, but over the next few months as well. My sense is that we have already seen the bottom - which means that we will continue to remain 100% long in our DJIA Timing System for the time being, unless the Administration or Congress backs away from their current "housing bailout" plans, which I am not currently expecting.

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