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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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The End of "Market Fundamentalism"

(April 6, 2008)

Dear Subscribers,

Before we begin our commentary, I want to update our DJIA Timing System's performance to March 31, 2008, in addition to reviewing our 7 most recent signals. While our historical performance could be calculated by tallying up all our signals going back to the inception (August 18, 2004) of our system, such a task for subscribers would been very tedious. Moreover, even though it is obvious that we had done well in our timing system in the last year or so, it is more difficult to quantify our performance during 2006 and prior, given that there were significantly more buy and sell (including sell-short) signals during 2005 and 2006. So without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to March 31, 2008:

DJIA Timing System Performance Statistics

To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way. We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500), given that most of the American public and citizens around the world have historically recognized the DJIA as "the benchmark" for the American stock market. In addition, the Dow Industrials has a rich history and has been computed since 1896, while the S&P 500 was only created in 1957 (although it has been retroactively calculated back to 1926).

Looking at our most recent performance and performance since inception, it is clear that most of our outperformance was due to our positioning over the last year or so - when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and our subsequent shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956. Put another way, subscribers should remember that:

  1. It is the major movements that count. Active trading - for the most part - only enrich your brokers and is generally a waste of time - time that could otherwise be spent researching individual stocks or industries;

  2. Capital preservation during times of excesses is the key to outperforming the stock market over the long-run. That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth we have been witnessing and that is still projected for the foreseeable future. I am not going to change my mind on this until/unless I see 1) a major policy mistake from the Fed, 2) the potential emergence of an inflationary spiral, or 3) extreme overvaluations in the U.S. stock market. At this point, I do not see any threat to the stock market on all three counts (versus late last year, when valuations were overly high and when the Fed was reluctant to cut rates) - although I would definitely let you know as soon as I see anything on the horizon (similar to my calls from February to April 2000).

Also note that our (annualized daily) volatility levels are also substantially lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in extremely good Sharpe Ratio readings across all time periods. However, given my belief the stock market made a sustainable bottom during the late January to mid March period, subscribers should not expect any outperformance from our DJIA Timing System for the foreseeable future. We will update the performance of our DJIA Timing System at June 30, 2008, and subsequently move to a semi-annual reporting schedule thereafter.

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 20.58 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 894.42 points as of last week at the close.

Let us now get on with our commentary.

In his latest book "The New Paradigm for Financial Markets" (the e-book was released last Thursday, with the print edition not available until next month), George Soros chronicles the current credit crunch as well as argues that the period of stability since the early 1980s, based on the dominance of the United States as a global power and the U.S. Dollar as the world's reserve currency is now ending. In the short-run, he continues to see a period of relative financial and political instability. He does not attempt to make any concrete predictions, however - other than that at some point, he believes the Administration will jump in and attempt to arrest the decline in U.S. housing prices. Quoting Soros:

Eventually, the U.S. government will have to use taxpayers' money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent, thus reinforcing both the recession and flight from the dollar. The Bush administration and most economic forecasters do not understand that markets can be self-reinforcing on the downside as well as the upside. They are waiting for the housing market to find a bottom on its own, but it is further away than they think. The Bust administration resists using taxpayers' money because of its market fundamentalist ideology and its reluctance to yield power to Congress. It has left the conduct of policy largely to the Federal Reserve. This has put too much burden on institution designed to deal with liquidity, not solvency, problems. With the Bear Stearns rescue operation and the latest term security lending facility, the Fed has puts its own balance sheet at risk. I expect better of the next administration. Until then, I foresee many policy turns and changes in market direction since current policies are inadequate. It will be difficult to stay ahead of the curve.

Soros' new book is a must-read for those who have not read "The Alchemy of Finance" (a book that I have read five times, three times in print, and twice in audio format; the only other book which I had read more often was "Reminiscences of a Stock Operator"). His discussion on his concept of "radical fallibility" is worth the entire price of the book. I agree with Soros' take on where the Administration is heading over the next several months. While he does not attempt to make straight predictions in his book, the title of his book suggests that there would be a new "regime" going forward, not only globally but within the U.S. financial system as well. In our August 30, 2007 commentary, I remarked that the current credit crisis is analogous to the "Panic of 1907" in a very important way - a watershed panic that led to the creation of the Federal Reserve in 1913 (see the following 1999 Federal Reserve Bank of Atlanta's paper "Why Didn't the United States Establish a Central Bank until after the Panic of 1907?" for some background).

Quoting our August 30, 2007 commentary:

Finally, at this time, there is good reason to believe that both the major central banks and investment banks of the world still don't have a clear view of where all the subprime or leverage exposure is, even though all their risk books are, for the most part, consolidated. Remember, as of the end of June, the total amount of money controlled by hedge funds around the world amounted to a range of US$1.7 to US$2.0 trillion. Utilizing a leverage ratio and an annual turnover ratio of 4-to-1 (which is very conceivable since half of all trading on the U.S. stock exchanges and more than one-third of all bond trading are done by hedge funds), the amount of hedge fund "efficiency capital" rises to a whooping US$27 to US$36 trillion, or nearly three times U.S. GDP. How could the world's central banks make policy (or even more of a stretch, provide specific solutions) if they (and their contacts at Goldman, Morgan, etc.) have no idea what half of the financial system is doing? In the Fall of 1998, many folks in NYC know that the problem was LTCM - today, not only has the problem gotten bigger, but it has spread to many more, heterogeneous, participants as well. In this way, the current crisis is analogous to the "Panic of 1907," as during the "Panic of 1907," much of the crisis had initiated in and spread around the NYC trust companies, as opposed to the national and NYC banking system, who were members of the New York Clearing House. Indeed, the Panic of 1907 was one of the most serious liquidity squeezes in US history, mainly because of 1) the explosion in NYC trust companies and assets in the 10 to 12 years prior to 1907, 2) the fact that they were not members of the New York Clearing House, and thus no legal or regulatory responsibility to hold sufficient reserves in order to stave off a general run, and 3) members of the New York Clearing House, who were lenders of the last resort in 1907, were reluctant to "bail out" many of the trust companies since they had never disclosed their books. Moreover, while trust companies were relatively conservative at first, they gradually evolved into more speculative institutions as the owners of the trusts "discovered" that they were able to invest in more risky assets, such as real estate and stocks, unlike banks who were strictly prohibited from doing so. The hedge fund industry today is analogous to the trust companies in 1907.

In retrospect, not only was the hedge fund industry analogous to the trust companies in 1907, so was most of the investment banks that are not under the regulation of the Federal Reserve. However, with the Fed "backstopping" the 20 primary dealers with the NY Fed three weeks ago - essentially bailing out the entire U.S. financial system - the so-called "paradigm" has definitely changed. Just like small businesses paying "protection money," there would be great consequences going down the road for the broker/dealer community. The Fed has now put its people in all the major investment banks and are analyzing all credit instruments, getting the names of managers, analyzing liquidity, and so forth. Of course, we are not going back to the regulations we saw in the 1930s but there is no doubt the government will have a heavy hand in the financial sector at least over the next 5 to 7 years. For those who believe this would destroy New York City as the world's premier financial center, I would argue otherwise since the latest financial crisis had been global in nature, and thus there is no doubt that all the G-7 finance ministers and central bank governors would sign on to this "pact." It would be interesting to see how China and India respond but given their culture and and the way that they are handling things and directing policies in the financial markets today, my sense is that they would be relatively content with more coordinated, government intervention going forward, as long as they are "invited to play." Moreover, the heads of all major investment banks and money managers should also sign on to this deal, given: 1) the former (along with the majority of their paper wealth) had just been "saved" from a potential collapse, 2) they are essentially part of the "establishment" anyway, given that they move freely between the public and the private sectors and given their influence on policymakers around the world, and can essentially make money no matter what environment we are in. On the contrary, they should gain even more financial power (taken from the hedge funds and the "quants" that had thrived over the last 10 years) under the revamped system.

Speaking of the bank system, it is interesting to note that U.S. commercial banks have continued to lend freely over the last six months, despite the fact that we have been in a genuine credit crunch (as exemplified by the blowout of credit spreads and a general lack of access to credit over the last six months). Following is a monthly chart showing the year-over-year change in loans and leases under commercial bank credit from January 1948 to March 2008 (source: Federal Reserve):

Year-Over-Year Change in Loans and Leases Held Under Bank Credit (January 1948 to March 2008) - 1) List of Recessions: July 1953 to March, 1954, Sept 1957 to March 1958, January 1974 to March 1975, July 1981 to November 1982, July 1990 to March 1991, March 2001 to November 2001 2) Four of the last six recessions over the last 60 years were preceded by a significant plunge and a subsequent dive to the zero line in the growth of loans and leases held under commercial bank credit. So far, we have not see any evidence that commercial banks are shrinking their balance sheets and curtailing lending - but from the recent spike in credit spreads and write-downs, it is obvious that the *shadow banking system* has been actively shrinking its collective balance sheet.

Note that four of the last six recessions over the last 60 years were preceded by a significant plunge in the year-over-year growth in loans and leases under bank credit down to the zero line. The remaining two recessions were preceded by a decline in the year-over-year growth in the 5% range. Interestingly, as of March 2008, the year-over-year growth in loans and leases under bank credit sat at slightly over 12% - a number that is hardly recessionary or in "credit crunch" territory. There are three possible/probable explanations for this interesting phenomenon. Firstly, much of the lending over the last 5 years has been done through securitization or the "shadow banking system" (as coined by PIMCO's Paul McCulley) - the latter of which consists of hedge funds, mortgage brokers, sovereign wealth funds, institutional investors, and high net worth individuals who invested in subprime mortgages or commercial mortgage backed securities. As indicated in news headlines (and soon, in the balance sheets of investment banks) and in the general blowout of credit spreads, such lending has grinded to a near halt. Secondly, while the banks have restricted lending to U.S. households, this has not been the case with commercial and industrial loans. Part of the reason is that in general, the balance sheets of many Fortune 1000 corporations are still very sound. The other reason is that many corporations are now drawing down credit lines that were put in place before the current credit crisis - credit lines that they may not have gotten in this environment. Finally, many banks are now being forced to put their previously off-balance-sheet SIV obligations back onto the balance sheets - thus forcing their own balance sheets to expand even in this contractionary environment. This is a phenomenon that is definitely worth tracking going forward, as this author does not see a long and protracted recession in the U.S. unless this declines to the 0% to 5% range, despite the fact that lending and borrowing in the "shadow banking system" has grinded to a halt.

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