|W.I.L. Home Page||Finance Digest Home|
|Sign Up||Offshore News Digest Home|
WHAT IS BEHIND THE GLOBAL STOCK MARKET SHAKE-OUT? CONNECTING THE DOTS
In a keynote speech on February 2nd, Bank of Italy chief Mario Draghi warned global stock market operators not to assume that present favorable conditions would last. “It is not realistic to expect that the current orderly market conditions will last forever, we do not know where the next crisis will come from, we must do everything to be prepared,” he said. “Market pricing does not currently incorporate the full range of potential risks. Financial market participants need to take into account in their risk analyses, the full implications of a possible reversal of the current benign conditions, including the possibility of less liquid markets,” he warned.
But Draghi is the “Boy who Cried Wolf”, and few hedge fund or stock traders heeded his warnings. Central banks, including Draghi’s ECB, are flooding the global money markets with liquidity, encouraging rampant speculation in financial markets. On January 29th, the ECB’s Klaus Liebscher admitted, “Liquidity levels continue to be enormously accommodative, driven by high borrowing due to low interest rates.” The Euro M3 money supply is exploding at a 9.8% annual clip, its fastest in 17-years!
Two of the biggest culprits behind the rampant speculation in global markets are the Bank of Japan (BoJ) and the Swiss National Bank (SNB), whose lending rates are so low, that an estimated $330 billion of “carry trades” in yen and Swiss francs are swirling around the global markets. Interestingly enough, the latest plunge in global stock markets came on the heels of a hike in the BoJ’s overnight loan rate to 0.50%, its highest in a decade, and renewed warnings by Swiss central bankers of a tighter monetary policy in the weeks ahead, and threats of a short squeeze on speculators betting against the Swiss franc.
Global jitters linked to downturn in U.S. housing market.
Since former Goldman Sachs CEO Henry Paulson took the helm at the U.S. Treasury last July, the Dow Jones Industrials Average had marched 2,100-points higher, almost without interruption, and without more than a single 2% correction along the way. That was a winning streak unparalleled since 1964. It seemed as if the U.S. Treasury and the Federal Reserve had gained complete mastery over the markets. But the higher the DJIA flies, the greater the amount of liquidity that is necessary to keep the stock market afloat, and prevent a boom from turning into a bust.
Then on February 15th, with the DJIA climbing to within a stone’s throw of the 13,000 level, Fed chief Ben Bernanke identified the depressed U.S. housing market as the biggest risk to the Fed’s goal of a soft landing. The “soft landing” scenario for the U.S. economy was jolted on February 16th with news that housing starts had plunged to the lowest level since 1997. The Fed’s 2-year rate hike campaign has toppled the US home building industry into a severe recession, and now a meltdown in the sub-prime U.S. home loan market threatens the stock market. Also, sales of new U.S. homes plunged 16.6% in January – the sharpest monthly decline in 13-years. Suddenly, the first major crisis facing the Bernanke Fed arrived without much advance warning – a rash of defaults on sub-prime home loans that if unchecked, can drive the U.S. economy into recession in 2007.
HSBC Holding, a major sub-prime lender in the U.S., shocked Wall Street by announcing that home-loan delinquencies have gotten so bad that it set aside $10.6 billion to cover potential losses. Defaults could spiral higher as lenders are slated to reset as much as $1.5 trillion in ARMs this year. The entire sub-prime industry is likely to tighten underwriting standards and throttle back on the highest-risk loans. So with the Dow Jones Industrials badly shaken to as low as 12,086 on Feb 27th, the Plunge Protection Team went into action to rescue the other important ATM machine. “There’s not much indication that sub-prime mortgage issues have spread into other mortgage markets,” Bernanke said on February 28th, triggering a 150-point rally in the DJIA futures market, and allowing buy-side Wall Street investment bankers to shrug off the housing bearish news.
How will China deal with the Shanghai bubble?
The epicenter of Asian contagion is located in China, and how Beijing decides to deal with the Shanghai bubble, can have a great impact on the outlook for the Chinese economy, global commodity markets, and exporters in the region from Australia, Hong Kong, Japan, and Korea. Will Beijing try to prick the bubble and set-off a steep correction, or carefully calibrate a series of tightening measures to take some steam out of the market and simply flatten it out? “There is a bubble growing. Investors should be concerned about the risks,” said Cheng Siwei, vice-chairman of China’s National People’s Congress on January 31st. “But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice.” Sometimes, markets can boomerang on central banks and torpedo the most carefully designed strategies.
The People’s Bank of China (PBoC) put its warnings into action on February 16th, when it lifted bank reserve ratios by 0.5% to 10%, coming only six weeks after the last hike, and at faster pace of tightening than expected. Chinese government officials are disturbed by signs of a speculative bubble in the stock market. Investors opened 50,000 retail brokerage accounts a day in December and mutual funds raised 389 billion yuan ($50 billion) last year, quadruple the 2005 amount. The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. If 2006 corporate results fail to meet strong expectations, Chinese investors could easily dump inflated stocks, and send the overall market into a tailspin.
Swiss National Bank takes aim at Swiss franc “carry traders”.
Swiss Market Index futures plunged about 175 points from their intra-day high on February 21st, following hawkish comments by Swiss National Bank (SNB) chief Jean Pierre Roth. “Inflation will accelerate in 2009. The current interest rate level is not high enough to ensure price stability in the medium term. If the weakness of the franc feeds inflation, an interest rate increase would be necessary” he warned. Roth also repeated SNB warnings against the risks attached to short-selling the Swiss franc. “The exchange rates on the markets develop out of line with economic fundamentals. Experience shows that such situations are fragile.”
Earlier in February, SNB member Thomas Jordan warned investors of the high risks in carry trades, because of a possible sudden and violent appreciation of the Swiss franc. The SNB lifted its target for the 3-month Swiss franc Libor rate to 2.00%, on December 15th. The next policy meeting is due on March 15th, when the SNB is almost certain to lift its Libor target to 2.25%, to match the ECB’s repo rate hike to 3.75% a week earlier. Two more rate hikes by the SNB to 2.50% might slow M3 to as little as 1-2% growth, which could trigger an unwinding of short positions in the Swiss franc, but put a lid on the high-flying Swiss Market Index.
India signals tighter money policy to control inflation.
“We will continue to take more steps to dampen inflation,” said Indian Finance Minister Palaniappan Chidambaram on February 27th. If true, the Reserve Bank of India still has a long road ahead to contain the M3 money supply, which grew at an annualized 21.3% last month, and bank loans expanded at 30% clip, much higher than the central bank’s target of 20%. India’s central bank has been raising official interest rates gradually for the past 2½ years, and lifting bank reserve ratios, to curb rapid credit expansion and accelerating inflation, but remains far behind the inflation curve.
The Bank of India’s tightening campaign has so far failed to slow the M3 money supply or bank lending. But since mid-December, India’s 3-month Libor rate has climbed 300 basis points to 10.25%, the tightest squeeze on Bombay’s money markets in many years. That could take some of the air out of the Bombay Sensex bubble, where 75% of capital inflows are funded with hot money from abroad.
Gold is a safe haven from the global stock market storm.
So far this year, the Dow Jones Industrials have lost 6.5% to an ounce of gold, much to the chagrin of central bankers. Gold rallied as high as $690/oz. on February 26th in Asia, before market contagion knocked it off its upward course. With a background of sub-prime loan debt bombs, explosive global money supply growth, and jitters over Iran’s nuclear weapons program, gold has emerged triumphant over the DJIA.
Strategists at 12 of the biggest Wall Street firms predicted in December that S&P 500 stocks would rally an average 7.8% this year. The unanimous bullish outlook on Wall Street last happened for 2001, when the S&P 500 dropped 13%. The growing complacency about the stock market is strange with slower earnings and economic growth on the horizon. The amount of money borrowed from brokerage firms to buy stock reached a record $285.6 billion last month, topping the prior high set at the peak of the so-called Internet bubble. Changes in the level of margin debt have mirrored those of U.S. stock indexes. After setting an all-time high of $278.5 billion in March 2000, margin debt dropped to less than half that amount by September 2002. For now, gold is seen as a safe haven for the global stock market storm.Link here.
What a difference a week makes. Not many trading sessions ago global equity markets were generally near record highs and credit spreads rested at record tightness. Global risk markets are now on much less sure footing. Of course, faltering markets evoke pronouncements of “economic fundamentals remain sound” that, for me, always recall the history of the 1929 experience.
Certainly, economic and asset market booms will engender faith in policies, policymakers and markets, not to mention a strain of fanaticism from the bullish camp. Persevering through a few bouts of financial tumult (and bearish prognostication) only forges a more emboldened bullish contingent. Larry Kudlow’s op-ed piece in the Wall Street Journal, “The Prosperity Boom”, captures the essence of today’s optimism. “The high-tech, productivity-driven U.S. economy is more durable and flexible than its liberal-left critics will ever admit. It is a private-sector free-enterprise economy, not a government-planned one. Innovation is strong and entrepreneurial spirits are high. The four prosperity killers, a paradigm coined by Arthur Laffer many years ago, all look dormant: inflation, taxes and regulatory burdens are low, while free trade keeps expanding.”
Yet there is a fundamental problem with the Kudlow, Art Laffer and bullish consensus view of the U.S. economic miracle: Finance is today hopelessly unsound. And the reality of this predicament is that if you lose your bearings and get your finance terribly wrong, well, other things (so-called “fundamentals”) end up not really mattering all that much. Credit bubbles (and attendant asset inflation) tend to turn conventional analysis on its head, with “good” policies deemed those that work to prolong the fateful boom. Self-reinforcing asset bubbles and policymaker complicity are virtually guaranteed – and pose a great systemic dilemma.
When it comes to so-called “prosperity killers”, a prolonged bout of rampant Credit and speculative excess has no equal. Promote “pro-growth” programs in the midst of terminal “blow-off” excesses and you are hankering for a real mess. And, as we appreciate, confusing moderate consumer price inflation for astute policymaking and stable finance is a hallmark of the disasters back in the late-1920s in the U.S. and late-1980s in Japan. These are not a political views, but analyses of credit, inflation, and speculation dynamics.
Not surprisingly, Mr. Kudlow and others are content already to target foreign scapegoats for our heightened financial and economic instability: “The Chinese have sent a Shanghai flu across the globe” with their higher bank reserve requirements, tighter interest rates, etc. Today’s economic policy fanatics have not met a Bubble they have not fallen for. This group also seems determined to keep their heads planted firmly in the sand, with analysis incredibly off the mark. In their (over-confident) minds, analyst warnings of the perils of poor lending, leveraged speculation, derivatives, current account deficits and bubbles have already been proven inept. All the same, the Chinese stock market was certainly not the “trigger” for heightened global market tumult. Instead, look directly to the realm of (U.S. gone global) “contemporary finance”. The consequences of massive liquidity excess, global performance-chasing financial flows, trend exacerbating hedging-related trading, and unavoidable (Ponzi Finance) instability will inevitably come home to roost. It started this week.
Bubble-generated “fundamentals” are really signals from a distorted financial system.
Those believing that they are examining sound economic “fundamentals” – e.g., robust earnings growth, low Treasury yields, narrow credit spreads, booming tax receipts, easily financed twin deficits – should ponder the possibility that they are actually observing distorted signals from a system embarked on an unsustainable financial path. At some point, financial crisis will force through a wrenching adjustment period. One can expect this process to be instigated and shaped by a radical change in the global liquidity backdrop and the flow of finance.
Last week saw a tenuous backdrop lurch (as we have witnessed previously) into a significant event for highly correlated global risk markets. I will make a few observations. First, we have clearly reached the point where global bubble excesses are so egregious and prevailing that overextended markets have basically lost their capacity for pullbacks that do not incite fears of attempted mass exits and dislocations. Second, the principal contagion mechanisms are the hedge funds, “brokerage” proprietary trading desks, rampant capricious speculative flows, and ballooning global derivatives markets. Third, and significantly, The confluence of several key developments quickly pushed the risk markets to a state of heightened tumult.
Subprime mortgage meltdown a major credit market development.
The breakneck meltdown of the subprime originators, Freddie Mac and others scurrying to exit the business, and the great uncertainty associated with tightened mortgage credit conditions comprised a major credit market development. The hasty rally in the yen was a second major market occurrence with negative ramifications for global leveraged speculation. At the same time, Treasury prices spiked higher on safe haven buying, the reversal of spread trades, and interest-rate hedging-related buying (unwind of previous hedges as well as MBS-related hedging). Top this off with a synchronized drop in global equities prices and selling in metals and other commodities, and you have a series of market gyrations that epitomizes the nightmare scenario for the leveraged speculating community.
Weaker U.S. economic data, and the prospect for worse, exacerbated the rally in Treasury bonds. For the leveraged players, the spark came from an especially dangerous confluence of subprime mortgage problems begetting self-reinforcing mortgage credit tightening – of yen strength inciting the self-reinforcing unraveling of yen “carry trade” speculations – and of safe haven and self-reinforcing derivative-related buying and spread trade unwinding in the Treasury market – altogether immediately emerging as a potentially highly destabilizing confluence of market developments. So, in short order, global risk markets were hit with self-reinforcing mortgage credit, yen “carry trade”, and Treasury “melt-up”. Almost across the board, credit spreads and risk premiums widened significantly. Not unexpectedly (considering the nature of global speculative financial flows), fears of a reversal in speculations, aggressive derivative-related trading, and de-leveraging quickly mounted. Global markets relishing in the perception of endless liquidity were abruptly walloped with the specter of a liquidity crisis. Chinese policymakers and equities had little to do with these dynamics.
I will not venture a guess as to how quickly things will unravel from here. And not having a clue as to the actual size of the yen carry trade, or the true scope of leveraged speculation, or the underlying nature and dynamic-hedging characteristics of a couple hundred $trillion of global derivatives, I am not going to tonight profess any great insight as to how close we moved this week toward the proverbial breaking point. While this week certainly brought the potential for a systemic Credit and liquidity crunch closer to reality, I am not yet ready to dismiss the likelihood that a significant decline in market yields will prove stimulating to some sectors – perhaps the key corporate debt and prime mortgage arenas.
For now, I will continue to assume an especially unbalanced and, at times, chaotic flow of finance throughout our highly unbalanced bubble economy. Interestingly, energy prices for the most part held their own this week and emerging debt markets showed little fear of waning liquidity. At this point, liquidity issues appear a greater concern within the Financial Sphere than they do for the Economic Sphere. Of course this is a very fluid situation. To what extent unfolding tightened conditions in subprime and, perhaps, certain other segments of the credit system interplay with looser financial conditions associated with declining market yields for much of the investment grade marketplace is a fundamental analytical issue.Link here (scroll down).
WHAT THE END OF EASY-MONEY INDUCED STUPOR WILL LOOK LIKE
It is impossible to tell when the world’s stock markets will finally wake up from their easy-money induced stupor, but one thing is clear. When they do so the initial break will look like last Tuesday. A modest event of no apparent global significance will cause a stock market drop that cascades around the world. Last Tuesday’s break may or may not have started the climacteric sell-off, but that sell-off cannot be long delayed.
More interesting than the unanswerable question of when precisely a crash will occur is that of which sectors will be worst affected, which relatively unscathed. Current market thinking appears to be that since the crash originated in China, that market is due for a significant downturn, and that emerging markets in general are overpriced and due for a fall. That view fails to reflect an intelligent appraisal of where the true economic vulnerabilities are.
Japan will benefit from an unwinding ...
Japan, first, is said to be economically feeble and in dire danger of falling back into devastating “deflation” if interest rates are increased one iota from their current 0.5%. That is more or less the opposite of the truth. Japan’s market is so liquid that it has for the past 2-3 years been used as the borrowing currency for the international “carry trade” engaged in by hedge funds, whereby a low interest rate currency is borrowed and the proceeds invested in a high interest rate currency. 20% of the proceeds of this simple-minded profit scheme can be skimmed off by the hedge fund managers while its profitability lasts. So attractive has this trade been that it is popularly supposed to have been responsible for the yen trading at levels far below its purchasing power parity, and for dollar bond yields being apparently permanently below the already skimpy returns on short term paper and close to zero in inflation-adjusted terms.
The Achilles’ heel of the carry trade is the yen exchange rate. If the yen strengthens too far against the dollar, the carry traders, who mark their positions to market, are forced to reveal a huge loss as their yen liabilities are worth more than their dollar assets. The whole thing is a vast game of “chicken”. While the yen continues weak and interest rates low, the carry trade continues attractive, but a sharp strengthening in the yen or – apparently less likely – a rise in yen interest rates would make carry traders’ profits collapse, and almost certainly cause a panic of position closing that itself would cause the yen to strengthen much further. That suggests Japan’s economic position is considerably sounder than it looks. The seeming contradiction between very low yen interest rates and apparently tightish Japanese liquidity is explained by the hedge funds’ nefarious activity in sucking all the liquidity out of the yen market and dumping it in the dollar one.
Looking at Japanese economic activity and price trends overall, it is clear that short term yen interest rates should be in the 2½%-3% range and long term rates somewhat higher. At current levels, Japanese savers are getting ripped off. Once the carry trade is ended, the BoJ will need to raise short term rates rapidly, to prevent a burst of inflationary speculation in Japan itself. Of course, the BoJ could have ended the carry trade any time it wanted, simply by raising short term rates, thus restoring the Japanese economy to its accustomed stability and abolishing the subsidy currently flowing from Japanese savers to international hedge funds, but one must not expect such wisdom from central bankers. In any case, once the carry trade has ended, Japan will be an island of stability, with moderate asset prices, continuing solid real growth, and expansion concentrated in the domestic rather than export economy as the yen strengthens to its proper value above $1=Yen 100.
... while the U.S. and the U.K. will be hurt.
Just as Japan will benefit from the unwinding of the carry trade and emerge unexpectedly strong, so the U.S. and big borrowers of dollars will become unexpectedly weak, with their economies and stock markets faring worse than people predict. Long term interest rates will rise, which Ben Bernanke will attempt to counteract by lowering short term rates. However he will find himself unable to do much because of an entirely unanticipated upsurge in inflation. His reassurances to the market that all is for the best in the best of all possible worlds, already utterly fatuous, will finally be seen as such by denizens of Wall Street – who will ensure, as they face bankruptcy or more likely 20-year jail sentences, that Bernanke will not survive their departure.
Needless to say the U.S. housing market, already suffering from its orgy of overbuying in 2001-05, will go into terminal collapse, probably taking Fannie Mae and Freddie Mac with it (oh, one hopes so!) and houses will thereafter be nice and affordable until about 2025. Outside the U.S., Britain, so proud of its position at the epicenter of the overblown speculations of world finance, will find its economy in collapse and London house prices dropping by more than half over the next 5 years. Only the Russian mafia, accustomed to stealing their money directly rather than through mere financial manipulation, will remain in London, more or less safe from Vladimir Putin, propping up the West End housing and luxury goods markets to a limited extent by their vulgar excess.
Western Europe will suffer less, but will feel some pain.
Western Europe will suffer less than Britain and the U.S., but will nevertheless feel the pinch as the world economy overall goes into a downturn. Needless to say, the EU’s reaction will be one of protectionism. The Smoot-Hawley tariff of 2008, causing a lengthy world depression and untold hardship, will emerge from Brussels not Washington. However the German and French strengths of high quality products sold at premium prices will remain. Their markets will suffer but in the long run they will emerge little weakened, smug in the knowledge that Anglo-Saxon capitalism was always bound to lead to ruin.
Emerging markets will bifurcate.
Emerging markets will bifurcate, depending on their financial and economic positions. Those relatively prosperous countries in Asia with rapidly growing productivity and little debt (or, in the case of Taiwan, a net asset position internationally) will do fine, benefiting from rising dollar and yen interest rates on their net asset positions and losing only modestly from increased protectionism – their relatively high value-added products will remain essential to a West that has hollowed out its manufacturing base. Most of these markets do not have excessively high P-E ratios so will survive nicely with only a modest market downturn.
But the major constituents of the EMBI+ emerging markets debt index, primarily Latin America and Russia, will find life very difficult. Finance will become more expensive and harder to come by, and the phone will no longer be ringing with offers from international buyers for their dodgier assets. With a world downturn, commodity prices will be weak. Since most of these countries have not established themselves properly in non-commodity exports their economic and financial positions will deteriorate rapidly. At that point, many of these countries will come to regret bitterly their insouciance about property rights, whether of Western investors or of their own middle class. Except for those few countries which have nurtured their domestic savings base and not overspent (one thinks of Colombia and to a lesser extent Chile) it will be too late.
The Middle East, too, will suffer from declining oil prices, and relapse into its customary status of angry penury, only occasionally interspersed with bouts of spectacularly wasteful consumption. That leaves India and China, which fall neatly into no category, being neither the Idle Apprentices of Russia and Latin America nor the Industrious Apprentices of Korea, Taiwan and Singapore. Although industrious, they will be hit harder by world economic downturn and protectionism, because their products are mostly commoditized and substitutable by domestic goods as tariff barriers rise.
Moreover, both countries have cash flow problems. In China, the $1 trillion of bad loans in the banking system is only covered up by the extraordinary willingness of U.S. investment banks and their clients to invest in dodgy Chinese banks they know nothing about. Without the enthusiasm of Wall Street the Chinese banks will quickly run out of money and undergo a very expensive forced recapitalization by the state, probably involving loss of most of the domestic Chinese savings base.
In India, the government has planned for 9% economic growth on average over the next 5 years, and has demonstrated by an 18% increase in spending in this week’s budget together with tax rises that it means to spend as much as possible of that growth itself. Of course, even without a world downturn that policy would be economically suicidal in the long run. With a downturn the suicide will arrive more quickly and more thoroughly. India will suffer a severe liquidity crisis in its domestic economy, resulting in a sharp and unexpected recession. Where it goes from there will depend on politics.
Was this week’s hiccup the beginning of the big downturn? Who knows! But that downturn cannot now be long delayed, so wise investors will prepare for it, rearranging their portfolios accordingly.Link here.
THE BERNANKE “TRAP” IS SPRINGING SHUT
Just over a year ago PrudentBear posted an article of mine entitled “The US economy and Markets may be heading for a Bernanke Trap”. In summary I wrote, “I think the US economy is already slowing significantly. Monetary policy is tighter than it appears. Mr Bernanke’s Fed will (partly inadvertently) tighten policy even further and initially be slow to react to the resulting downturn in the economy ... Later down the road Mr Bernanke may get to implement his wilder ideas on monetary policy. Interesting times lie ahead!”
Over the last year I have not felt impelled to put pen to paper on these issues. In Scottish law (uniquely, I think) a verdict of “not proven” is available to the courts in addition to guilty or not guilty. If I had written again Before now I could not write an “I told you so” article, but nor could I apologize for being wrong. By the second half of 2006 it seemed to me that underlying conditions in the U.S. economy were notably deteriorating, particularly in the housing market. The Fed had raised rates further and seemed unduly complacent about a developing slowdown. However, financial markets were not following the script and indeed were positively euphoric rather than merely complacent.
In recent days much has changed. The housing recession has been joined by manufacturing and shows signs of spreading to the consumer. The equity market has had its sharpest one day sell off for many months. Wall Street “spin” is that this will be a healthy correction, taking some of the froth off markets and of limited duration. I see things very differently. Although the size of economic imbalances is such that there must be even more uncertainty about the future than usual, I feel fairly confident about the following:
Many important questions seem much less clear to me. To what extent will the global economy prove resilient in the face of a U.S. economic downturn and associated financial instability? Will commodities be a victim of recession, or be protected by a weaker dollar and central bank easing? How effective will easier money be in protecting financial markets and the economy in the context of unprecedented debt levels? How aggressive will the Fed be in attempting to turn things around? In the longer term could the low consumer price inflation of the last decade or so be under threat?
It does seem clear though that the Bernanke trap – “easy money” Ben tightens too much – is closing fast. Although Mr. Bernanke did include caveats in his speeches and testimony, he allowed himself to be strongly associated with the “goldilocks” economic scenario. His credibility will never recover from the coming recession.Link here.
DEBT PYRAMID THREATENS TO TOPPLE MARKETS
It’s not the economy, stupid.
After Ben Bernanke’s February 28 testimony, one member of the House Budget Committee asked him whether the selloff in global stock markets a day earlier – and in particular the 416-point drop in the Dow – had changed the Fed’s thinking. “There is really no material change in our expectations for the U.S. economy since I last reported to Congress a couple weeks ago,” Bernanke responded. "If the housing sector begins to stabilize, and if some of the inventory corrections that are still going on in manufacturing begin to be completed, there is a reasonable possibility of strengthening of the economy sometime during the middle of the year.”
Absolutely true, as far as it goes. But it does not go very far. Yes, nothing that happened on Febuary 27 changes the U.S. or global economic picture. But this time it is not the economy, stupid. What is more important is what Bernanke did not say: that this time, the biggest potential danger is not from a slowdown in the U.S. or Chinese economies. It is from the pyramid of leverage in the debt markets created by traders and speculators using cheap money from around the globe, and in particular from Japan. The 2/27 selloff demonstrated how a panicked unwinding of that pyramid of debt could send financial markets into chaos.
Bernanke’s answer on 2/28 was reassuring to the markets in the short term, but I worry that all it does is extend the complacency about risk piled on risk in the debt markets that got us into this fix in the first place. Let me first run through the evidence from the market action on 2/27 that shows that the problem is in the financial markets and not in the economy:
But the evidence is not limited to the market’s plunge on February 27. The use of derivatives to insure against risk actually increases the amount of risk-taking behavior, which means that when something goes wrong, it will go wrong in a big way. On 2/28, the premiums on derivatives to insure against default in risky corporate junk bonds soared on the European markets. Four times the typical volume traded on 2/27-28, and premiums to insure junk bonds against loss for five years climbed by about $80,000 in just those two days. The prices of the actual junk bonds fell much less than the premiums rose. Investors were not selling the risky asset, just buying more insurance.
This works as long as there are deep pockets willing to take both sides of a bet. The subprime mortgage market is a good example right now. Banks with exposure to the risk that borrowers will default in larger-than-predicted numbers are buying derivative insurance to protect against losses. Hedge funds, other banks and some insurance companies have been selling that coverage because they think the banks are overestimating the dangers of default. That works to keep the subprime mortgage market liquid and functioning. But it does set up the possibility of a swift collapse of the subprime market if the bet starts to go against the sellers of insurance and either a big seller of insurance cannot honor its derivatives or enough sellers of derivative insurance pull out, suddenly persuading subprime lenders to stop all lending.
You do not have to look to the mind-numbingly complex world of derivatives to see evidence that the financial markets are too complacent about risk – and that it could be starting to catch up with the markets and us. The world is building up a long list of ticking financial bombs that are only kept from exploding by the continued supply of cheap money around the globe:
Interest rate increases by the the world’s major central banks have not significantly cut the global supply of money or raised its cost. Too much money continues to chase too few good opportunities.
I can point to this evidence and these big trends and say “danger ahead”, but I cannot tell you what catalyst will trigger a turn or on what schedule. India seems likely to hit its tough patch later this year. The Japanese yen carry trade could be unwinding now. The uncertain timing of this shift notwithstanding, I think you ought to be preparing for it now. The risk is high enough, and the reward of staying the current course low enough, that I think that getting cautious now is just prudent. No need to panic. No need to undo all your positions. I think there is still a good chance that the Shanghai selloff will turn into a bounce and then a limited, seasonal rally running into the spring.
I think my previous advice still stands, that If I could not find bargains, I would be perfectly comfortable selling into this rally whenever a stock hits my target price. I would certainly like to have some cash on hand as we head into the second half of the year. But this is the time to take action, especially if a rally gives you a chance to rearrange a portfolio without taking big losses.
Notice I have not said a word about the economy. Currently it is the least of my worries. I just wish Fed Chairman Bernanke would take some time off from reassuring investors about the economy and the short run and start flagging some of the growing longer-term risks from cheap money and complacency about risk. The Fed could even do something about the problem before it bites us all.Link here.
Goldman Sachs warns of “dead bodies” after market turmoil, as the unwinding of the yen carry trade will create victims.
The global currency storm of the past week is starting to infect the corporate bond markets and may prove harder to contain than last year’s May sell-off, Goldman Sachs has warned. Jim O’Neill, the bank’s chief global economist, said investment firms playing the “carry trade” had been caught on the wrong side of huge leveraged bets against the Japanese yen. “There has been an amazing amount of leverage on currency markets that has nothing to do with real economic activity. I think there are going to be dead bodies around when this is over,” he said. “The yen carry trade has reached 5% of Japan’s GDP. This is enormous and highly risky, as we are now seeing.”
“The unwind of the carry trade has had an impact across emerging markets,” said Kingsmill Bond, a strategist at Deutsche Bank. “The capital exporters in Asia and the Middle East have been relative safe havens: the worst hit are Latin America, South Africa, Turkey and eastern Europe.” The yen has rocketed in a move known as a “short-covering squeeze”, rising almost 6% against the euro and the dollar in a week. Many funds that borrowed at near-zero rates in Japan to chase higher yields abroad are able to close bets at a profit, but some may be forced to liquidate positions – starting a chain reaction through other asset markets, such as gold.
Mr. O’Neill said the danger was contagion to low-tier bonds, driving up the cost of borrowing for business. “Our concern is that the repricing of risk we are seeing could spread to the credit markets. This is potentially more difficult to deal with, and needs watching,” he said. The Itraxx Crossover index used to take the pulse of corporate bonds shows that spreads have widened 43 basis points in a week. Stephen King, chief economist for HSBC, said it would take two or three weeks to gauge the severity of this shake-out. “The world economy is fundamentally strong, but this reversal of one-way bets built up over years creates great uncertainty. The key worry is that this could reveal a weakness in the architecture of financial markets. We just do not know who is trying to liquidate positions,” he said.
Bernard Connolly, chief strategist for Banque AIG, said conditions now are more threatening than they were in the six-week sell-off last spring. “The carry trade was bound to end with a bang rather than a whimper but this doesn’t look to me like forced liquidation yet. However, the yen is going up against all currencies this time and not just the dollar, and stocks are looking more panicky.” Steve Pearson, currency strategist at HBOS, said global markets were waking up to the reality that perma-growth with low inflation was not on the cards.Link here.
HOW TO SURVIVE THE STOCK EXCHANGE’S NEXT PANIC ATTACK
Panic early! Avoid the crowds.
When the Dow loses 3.3% in one day, including a 500-point nosedive, people notice. But they do not always realize that the computer system that helps to keep trades moving actually contributed to the panic. That is what happened on Tuesday, February 27, at the New York Stock Exchange. Jim Zarroli of National Public Radio reported one of the most colorful quotes of the day on the topic. He interviewed the chief investment strategist of Standard & Poor’s about the Dow dropping 200 points in a matter of minutes around 3 p.m. “I was quite taken aback by the magnitude of the numbers reeling off – it was almost as if somebody was spinning an odometer illegally,” Sam Stovall said.
It turns out that besides a slow-moving computer that was not calculating the DJIA fast enough, other computers could not handle the onslaught of trades. Reports show that trades took double their normal amount of time and that many trades at the end of the day simply did not get executed. But that is not supposed to happen to the NYSE, ca. 2007. It is the best in the world! We’ve got computers! But happen it did. And it is not as though there have not been warnings. One year ago, the 2nd-largest stock exchange in the world, the Tokyo Stock Exchange, shut down all trading when its computer system faltered under the strain of handling the volume of trades.
Trading volume is what strained the NYSE’s system, too, with about 2.4 billion shares trading on February 27, the highest volume since last June. “The biggest thing [Tuesday] pointed out in my mind is that the systems are not adequately prepared to handle the trading volumes,” Pat Fay, head of listed trading at D.A. Davidson, told the Wall Street Journal.
For anyone who has contemplated a future stock market crash, there is only one soundtrack: the sound of computers crashing. Bob Prechter envisioned and wrote about these problems in his book Conquer the Crash, first published in 2002: “Trading stocks, options and futures could be extremely problematic during a stock market panic. Trading systems tend to break down when volume surges and the system’s operators become emotional. ... Do you think the experience will be ‘smoother’ [than during the 1929 and 1962 panics] because modern computers are involved? I don’t. In fact, today’s system – much improved, to be sure – is nevertheless a recipe for an even bigger mess during a panic. Investors will be so nervous that they will screw up their orders. Huge volume will clog website servers, disrupting orders entered on-line. Orders may go in, but confirmations may not come out. A trader might not know if his sale or purchase went through.”
Sound at all familiar? The WSJ also reported that one company that measures how well online trades are executed said that “most of the leading online trading sites took up to double the average length of time to complete online trades. It also estimated a 25% decline in the number of trades able to be successfully completed during [Tuesday’s] sell-off.”
It is a living nightmare not to be able to maneuver when the markets are wild, as they were on February 27 – and will be again someday. It is time to realize that the stock-trading system is subject to disruption from human emotion. If too many people get scared and want to sell, it does not matter how well the computer system works under ordinary circumstances. It will still be crushed by the stampede of sellers. Tuesday was a mild case. Thanks to bulls who haven’t sold, bigger panics lie ahead.
Here is some tried-and-true advice: Avoid getting into trading positions that will bankrupt you if computers shut down for an hour or two, or a day or two. If you plan to lighten your stock holdings, do it on calm days, before the next panic prevents you from acting as you wish.Link here.
DIVERSIFYING AGAINST THE INEVITABLE U.S. FISCAL CRUNCH
Wouldn’t you know it. Finally, every single investor in the U.S. gets around to doing what the academics have been telling them to do for years. Finally they get some foreign stocks in their Schwab accounts. Okay, a lot of foreign stocks. And just as they sit back in their Office Depot chairs with the adjustable lumbar support, all ready to enjoy some superior risk adjusted returns, equities across the globe get smacked. Most investors would have been better off taking their lumps right here at home, particularly instead of venturing into emerging markets.
But it was just a day. A 10% drop in Chinese stocks is hardly a hiccup compared to 140% returns over the prior year. The great thing about profit taking in China is that there are still so many profits to take. For some. For now.
But there is more to diversification than maintaining the proper allocation to Haiti. The U.S. government offers workers a choice of when they pay taxes on their tax deferred retirement accounts. The choice, as you might guess, is Now or Later. Currently, most people choose Later. And why not? Later is the almost always the best choice. Get that cavity filled Now or Later? Tell your kids you lost their college money playing a stock you heard about from a spam email Now or Later?
Americans who contribute to a traditional 401(k) plan have chosen Later. Money goes straight from their employer into the retirement plan with no taxes withheld. Dividends, interest and capital gains pile up tax free. When the money is withdrawn during retirement, taxes are paid on the distributions. But now there is a Now option in addition to Later. That is the Roth 401(k) where employees contribute after-tax dollars to a retirement plan. Like the Roth IRA, once the taxes are paid, that is it. There are no taxes on the distributions during retirement.
One of the major reasons to pay taxes Later rather than Now, aside from the sheer joy of stiffing Uncle Sam, is because you think your tax rate in retirement will be lower than your tax rate today. But what if a lower tax bracket Later is not a sure thing? What if tax rates down the road are as unpredictable as Britney Spear’s behavior? These charts, here and here, might make a person wonder if tax rates today have anywhere to go but up.
Those depressing graphics come courtesy of the comptroller general of the U.S., who for several months has been the lead act in his office’s “Fiscal Wake-Up Tour”. The tour involves Comptroller David Walker speaking to groups around country about why the “p” is silent in “comptroller” and warning about economic disaster if the government does not change its spending habits. The problem, according to Mr. Walker, is that despite today’s yawning budget gap, things are likely to get worse. That is because health and retirement benefit costs for aging boomers are going to skyrocket unless somebody shakes up the status quo. Already, spending on Medicare and Medicaid has doubled over the last decade as a share of federal spending, while discretionary spending shrank from 44% to 38%. Walker figures we could balance the budget in 2040 if we cut spending by 60% or doubled the federal tax take.
So no wonder companies are giving more people the option to choose paying taxes Now while the prices are low. And no wonder Mr. Walker is running around the country trying to get people’s attention. Are people listening? Who knows? The GAO could set an example for Congress and the White House by doing a budget education campaign on the cheap. All it takes is the right theme. Maybe something like ... “It takes a village. And it takes China. And Japan. And India. Let’s do something before they want their money back.”Link here.
VOLATILE SMALL-CAP STOCKS
It was Shanghai that started it all, dragging down the Asian markets with what would become a 9% drop. After Tuesday, it seemed like every market across the world was struggling to reclaim some of the gains it had lost. Hong Kong rebounded 95 points onm Friday. However, The Standard reported that investors are dropping small-cap stocks because many do not expect the market to rebound to previous highs anytime soon. Speculative shares were hit especially hard. The Standard reports that the losers were mostly smaller stocks. The mayhem spread to our markets as well ...
Last week was a wake-up call for Wall Street. The Dow recorded its worst performance in over four years and the NASDAQ fell 5.9%. The Russell 2000 posted a 2% loss Friday. Is this the beginning of a new, painful recession? I do not know. But I do know that is this is not the time to run from the markets, stripping every last cent from the smaller stocks you were so excited about only a few short days ago. When I wrote to Penny Stock Fortunes readers Thursday, I told them nothing has changed. All of our original reasons for choosing the stocks in the portfolio remain true. We are not invested in the broad market, but rather in a handful of individual companies in which we see promise. If we keep these thoughts in mind, we should be successful. And if recent bear markets have taught us anything, it is that we can find profitable small stocks when the overall market sours.
In 2002, the Dow lost 16.8% of its value. The NASDAQ, still reeling from the busting of the tech bubble, posted a 31% loss. The bear market continued through early 2003. The first asset class to recover? Small-caps. The Russell 2000 recovered faster and stronger than the DJIA or the S&P 500. This small-cap index is continuing its strength over the larger indexes to this day.
By far, the best way to prepare for recovery is by looking for beaten-down small stocks. These will be the picks that will lift your portfolio in the coming months. A market downturn like this can only be viewed as a buying opportunity. As we mentioned before, if the fundamentals and your reasons for purchasing a stock have not changed, there is no reason to panic and sell. Stocks will be on sale for the time being. We will be bargain shopping over the next several weeks. In the mean time, you will know where to look for the stocks that are the most likely to rebound from a lagging market.Link here.
NEW ENERGY PLAYS
Alternative energy has long been a pipe dream. But today investing in alternative energy makes sense. The necessary catalysts now are in place: sustainably high energy prices, worries about global warming and climate change, uneasiness over Mideastern oil. Wind power, solar cells, uranium and ethanol have their pros and cons. The trick for the investor is to stay firmly focused on valuation and quality – and not to get caught in the hype. These alternative energy providers will supplement the traditional sources, not replace them.
For wind power, Zoltek (ZOLT) is the low-cost producer of the carbon fiber that forms the backbone of turbine blades. The business has suffered through a series of manufacturing stumbles and is burdened by an adverse legal settlement with a former subsidiary. Still, management is shifting operations from Texas to Hungary, where costs are lower and the customers are closer. (Europe has more wind farms than the U.S.) The company, while in the red, has been expanding sales at 50% annually. EBITDA, estimated at $50 million this year, likely will double in 2008.
At long last, uranium is getting recognized for what it always has been – the cleanest, most efficient energy source available. For too many years the idea of building a new nuclear plant was anathema to much of the public, afraid of another Chernobyl. Now new reactors are on the drawing board, both here and abroad. They will take a decade to open. But already the price of uranium has risen from $56 per pound last year to $75. Canada’s Cameco (CCJ, 38), the world’s largest producer of uranium, suffered a collapse of Q4 earnings after a flood at its Cigar Lake uranium project in Saskatchewan. Most likely Cameco will open Cigar Lake in 2011 or 2012. Well before then investors will anticipate the resulting income stream and push up the stock price.
Then there is the wonder motor fuel, ethanol. The wonder is that the federal government is falling all over itself to boost subsidies and mandates for this energy source. Brazil’s sugarcane-based ethanol is better, but no one represents Rio in Congress, and so the Latin stuff is kept out by heavy tariffs. Let us not forget that the presidential race begins in Iowa. The big winner is Archer Daniels Midland (ADM, 34), the best known of the agricultural commodity processors. From a high of $45 last May, the stock has sold steadily down on misplaced notions that higher corn prices, largely resulting from increased ethanol demand, would crush the company’s margins. Not so. With a trailing P/E of 14, ADM is probably the most conservative way to invest in domestic ethanol.
Conservation is the greenest energy available. Jazzed-up electric meters are coming to market to encourage off-peak consumption. Already common are meters that enable the electric company to give you a discount when you run the washer and dryer at night. New meters can make finer distinctions over the hours of the day. The two largest metering companies are Itron (ITRI, 59) and Esco Technologies (ESE, 43). Neither is cheap (P/E’s of 36 and 41), but they stand ready to prosper mightily in the new energy age.
The coal industry’s boosters are ever fond of saying that the U.S. is the “Saudi Arabia of coal.” Nevertheless, the unpleasant reality remains that coal-fired plants are the single biggest source of the dreaded greenhouse gases that suddenly even George Bush professes to abhor. That is why I am leery about coal companies at the moment. Take another look at the sector in a few years, when the first glimmerings of success may be surfacing from the research on ways to dispose of carbon dioxide somewhere other than into the atmosphere. If clean coal becomes a reality, then early investors in coal would be well rewarded.Link here.
HOW TO BUY CLOSED-END TAX-EXEMPT BOND FUNDS
The ideas apply to investing in any closed-end fund.
You are in a high tax bracket and you are looking for yield. What investments are suitable? Two obvious choices are municipal bonds owned directly and muni bonds owned through an open-end fund like the Fidelity Municipal Income Fund. A third option is muni bonds owned through a closed-end fund. Closed-end muni funds have some advantages. They also have some disadvantages you should understand before putting in your buy order.
A closed-end fund has a fixed number of shares outstanding. The sponsor is under no obligation to redeem shares. So, when you want out, you have to find someone else willing to take the shares off your hands. The shares in the fund, that is, trade like shares of General Motors stock and, depending on supply and demand, can trade at a premium or discount to the value of the portfolio. Usually they trade at a modest discount.
Because the portfolio manager of a closed-end does not have to worry about redemptions, he can put 100% of the assets to work in long-term bonds. Indeed, closed-ends often invest more than 100%. They might buy $1.50 of long bonds for every dollar that fund shareholders have put in, borrowing the 50 cents in the form of floating-rate notes that pay tax-exempt interest. If short-term interest rates are lower than long-term rates, this leverage gooses the fund’s yield. But leverage cuts both ways. When interest rates rise and bond prices fall, the leveraged muni fund will suffer an exaggerated decline in its net asset value. Buy a leveraged closed-end bond fund if, and only if, you are confident that interest rates are going to go sideways or down.
What about that discount? Neuberger Berman California Intermediate Municipal Fund (AMEX: NBW, 4), for example, sells at a 3.6% discount to its net asset value. Does that enhance your return? Yes – if you are lucky enough to buy a closed-end when it is trading at a 10% discount and then sell when it is trading at a 5% discount, you will get an extra return above and beyond the return on the fund’s portfolio. But the discount could just as easily widen, depressing your return. Caution: Nowadays muni fund discounts are already narrow. The BlackRock New York Municipal 2018 Term Trust (NYSE: BLH, 16) trades at a 2.7% discount to net asset value. The fund will liquidate at full net asset value in 12 years. But that comes to all of 0.23% per year additional yield.
A big disadvantage of closed-ends is that they tend to be expensive to own. First you have trading costs (commission plus bid/ask spreads), which might come to 1% round-trip for that Neuberger Berman fund. If you own it for a decade these costs will leave you with a return ten basis points a year below that of an open-end fund with an identical portfolio. Then there is the annual expense burden. For the Neuberger Berman California fund this damage comes to 0.93%, or 48 basis points more than the Fidelity California Municipal Income Fund’s expenses. The BlackRock 2018 fund costs 1.03% a year.
One final point about tax-exempt bond funds might, depending on your circumstances and on the fund you are considering, tilt the balance in favor of a closed-end. That is the alternative minimum tax. If you pay AMT, as many middle- and upper-class investors do, then interest from some munis becomes taxable, and you want to avoid funds that hold too many of these bonds. The Neuberger Berman California closed-end has 14% of its portfolio subject to the AMT. The Vanguard California Long-Term Tax Exempt Fund? Only 2%.Link here.
THE eBAY OF LOANS
Prosper.com links individual lenders to individual borrowers. It strips out some middleman costs but not default risk.
They want money to buy a K-9 bomb-sniffing dog, to make a house down payment, to set up a videogame studio, to pay tuition. And Gregory Bequette is happy to lend to them personally through a Web site called Prosper.com, the eBay of small personal loans. Bequette has hitched a good chunk of his portfolio, $878,000, to others’ hopes, dreams and debts – and their ability to repay him. An accountant for the University of California system, Bequette has lent to 163 cyberborrowers at an average interest rate of 26.4%.
Year-old Prosper functions as an online way station where borrowers and lenders can arrange 3-year loans of up to $25,000, at rates 3 to 5 percentage points lower than what credit cards charge (see table). Its A-rated borrowers pay an average 8.8% yearly, versus 11.8% for a fixed-rate credit card and 13.8% for a variable-rate card. They could get even better rates, along with tax deductions, if they tapped home equity, but many Prosper borrowers do not own a home. Prosper’s believers explain the bargain this way: Their system strips out overhead costs. “If the credit card companies are making so much money, why don’t I cut out the middleman and get some of that myself?” Bequette asks.
Prosper.com provides credit checks of borrowers via Experian and posts their ratings (ranging from AA to HR, for “high risk”) with their profiles online. Bids are for interest rates, and the lowest ones win among sometimes dozens of bidders. Borrowers post a requested rate on their Web profiles, mostly in line with their credit rating. The winning bidders’ money, usually in small increments, is packaged into one loan. When lenders browse through the borrower profiles and place bids, it is often for a fraction of the total loan needed, with $50 the minimum. Lenders get the safety of diversity. The profiles allow lenders to see borrowers’ debt-to-income ratio, current and past delinquencies. Borrowers provide photos of themselves, their kids, their pets and – a requirement – what they want to use the money for. The guy who wishes to buy the bomb-sniffing dog says he has a federal contract to detect explosives in Iraq, where he will be paid $9,000 per month.
In its year of existence Prosper has had 0.5% of total loan amounts default and 6.5% fall behind on payments for a month, compared to 4.2% and 4.4% for card companies. Prosper lenders choose among three collection agencies to pursue delinquent borrowers. But serving as an unsecured lender is a risky business. Most of the loan applicants are clustered in the iffier end of the credit spectrum. While bad loans are minor now, just wait until an economic downturn comes along. Another problem for Prosper lenders is that the loans are not liquid. The company had hoped to set up a secondary market, but that fell through. Lenders are stuck for a loan’s whole three-year term. And there is no way to guarantee that the proceeds will be applied to the stated purpose. What if that nice lady wanting to open a beauty shop blows the cash at a Las Vegas craps table?
Prosper makes money by charging borrowers an upfront fee of 1% to 2% and lenders 0.5% to 1% of the annual loan balance. That means Prosper should take in around $1.8 million in revenue this year. The company has $35 million in loans outstanding but is adding new ones at a steady clip and should have at least $120 million by year-end.
Company founder Christian Larsen was chief executive of E-Loan until Popular Inc. bought it in 2005. The eBay model enticed him. So did the wide spread between what banks pay for savings accounts and certificates of deposit, and what they charge card borrowers. That would be a big draw for individual lenders, he figured. Adding to the appeal was that a company called Zopa.com had been doing this successfully in Britain since early 2005. Prosper hooked up its first lender and borrower in February 2006. It has been a quick bloom. Larsen, 46, has himself invested $120,000 in 240 loans. He prefers proven borrowers; his portfolio’s mean interest rate is 11.4%.
Nobody has yet defaulted on Bequette, 55, who began lending last July. But Bequette does have three accounts with payments overdue (a loan is considered in default if unpaid for more than 120 days). Bequette expects an overall default rate on his portfolio of 8% this year, leaving him a net of 15% after fees. Plus, he professes to feel a ping of altruism when he lends. To make his loans, Bequette pulled money out of mundane mutual funds. He was so enthused with his early yields that he took out a $270,000 home equity loan at 7.9% to plunge back into Prosper.
Prosper investor Craig McHugh finds himself convinced that the default rates will end up lower than expected: “Because these people are borrowing from individuals who chose to help them out rather than Big Brother, they will feel more obligated to pay back the loans.” A sanguine attitude, to be sure. But McHugh is no naif; he is president of Creative Labs, a $1.1 billion Silicon Valley outfit.
While most Prosper lenders are amateurs, some investment pros are dipping in. Jonathan Hoenig, 31, runs Capitalistpig Hedge Fund in Chicago and has more than $150,000 of its money in 1,300 Prosper loans at an average interest rate of 20%. “This is a way to run a credit card company,” he says. Hoenig will not bid on a loan where the borrower has more than three delinquencies. Nevertheless, he tilts toward the riskier end of the credit ratings because these have juicier yields. Why lend to AA credits at 9% with a projected default rate of 0.2% when you can lend to the Cs at 17% and a default rate of 3.3%?
Personal finance author Jerrold Mundis (50 loans, totaling $10,000) prefers the riskier credits, too. Mundis, whose book How to Get Out of Debt, Stay Out of Debt and Live Prosperously is in its 40th printing, feels that Prosper helps subprime borrowers stay within their means. Mundis has been burned, though, by one delinquent borrower. The deadbeat’s credit rating was AA. “That was my one nod to conservatism,” he sighs.Link here.
START WATCHING THIS STOCK THAT HAS DROPPED 27%
The temptation to buy a stock like Midway Games (MWY: NYSE) can sometimes be unbearable. Pure plays are always attractive. Small-cap pure plays are doubly so. Consider that Jim Cramer has been educating his legion of viewers on the sales and development cycles for video game stocks for years now. Individual investors are getting very savvy about these issues.
Also consider that we are in another big upgrade cycle for gaming consoles. The most glaring sign of the times in this industry has got to be Sony’s audacity to price Playstation 3 at $600 for the all-singing, all-dancing iteration. How are sales for that one? Well, company execs claim that it is a testament to their ability to supply their channels so that if you go to a retail outlet, you will find a PS3. Translation: Stores have plenty because they are too expensive to move.
But maybe Sony will eventually be proven right and the market can support a super high-end game console. After all, the demographics are certainly on their side. The Entertainment Software Association (ESA) says that 75% of heads of households play video games, and the average player is clearly in the adult age range at 30 years. 43% of players come from the 18-49 age group. Research also has found that 19% of video game players are 50 or over! No wonder video game stocks have garnered high levels of attention.
Last November we highlighted Midway, a once-prominent name in the business that has proven to be a stock to avoid. Midway Games had a stranglehold on the industry throughout the 1980s, when arcade games were big business. In the years following the move from arcades to the hyper-growth of home consoles, Midway took many of their top coin-operated titles and transferred modern versions to Playstation and Microsoft’s Xbox. Midway has been in the red since 2000 up through to today. This has been the greatest period in video game interest and sales, yet profitability still alludes them. If you read their filings, a huge revenue drop occurred from 1999 to 2000 when the company left the coin-operated arcade business. That was the last time they posted a profit.
If you followed our lead to avoid MWY shares, it was a good move. Since November 9, 2006 to now, the stock has dropped 27%. But is there a ray of hope for Midway? 4Q0 2006 revenue was $97 million – up 39% over sales in Q4 2005. The loss for the quarter was $0.02 per share, a marked improvement over the $0.42 loss the year before. Midway is securing some strong licenses for games, with one of their strong sellers being Happy Feet, based on the film.
The market does not seem to think MWY is about to turn the corner to profitability. This is going to be one to watch in the weeks ahead.Link here.
HOW (NOT) TO FIX THE SUBPRIME COLLAPSE
Ben Bernanke told politicians in Washington last week that the collapse of subprime mortgage companies had been “contained”. Perhaps Dr. Ben was just thinking of Fremont delaying its fourth-quarter results ... or New Century Financial (NEW) having to restate its earnings for the first nine months of last year. That little nugget of news knocked NEW’s stock 30% lower in one session last month. But it is not like Bernanke had to revise GDP 30% lower as a result, right? And maybe the Fed chairman was just thinking of out-and-out mortgage lenders going bankrupt, like Ownit or MLN, rather than pan-global investment banks such as Merrill Lynch spending $1.3 billion to keep First Franklin running ... or Credit Suisse funding the defunct ResMAE ... or Bear Stearns picking up Encore in what ML-Implode.com calls a “firesale”.
As always, however, the market is way ahead of the Fed. Stock in Merrill Lynch has dropped 15% from its top of January. Morgan Stanley has fallen almost 13%, as has Citigroup. Goldman Sachs is off nearly 10% for the last week alone – and not only because no one wants to own investment banks when investors take a bath on Chinese equity funds.
In the bond market too, Wall Street’s biggest and best are being marked down. The price of credit-default swaps, the insurance contracts used to protect investors against non-paying bonds, have leapt on their debt. Since the start of January, for example, the cost of CDS insurance on Goldman’s debt has risen by 52%. The bond market thinks Goldman’s debt just got riskier. In fact, “their own traders are valuing the three biggest securities firms as barely more creditworthy than junk bonds,” says Shannon D. Harrington for Bloomberg.
Why are the investment bankers so nervous about their own debt? Both Wall Street and the City of London earned record sums in the last 12 months. But at the top of the credit cycle – and with global asset values tumbling as the flood of easy money dries up thanks to rising rates in Japan, higher real rates in the U.S., and the threat of rising rates in Switzerland – the biggest security firms are starting to look awfully insecure. They just happened to make a lot of money selling mortgage-backed securities, too. Yet the risk of mortgage default only got shared, rather than passed along.
In the United Kingdom for instance, 125% mortgages lent at 7 times income for 50 years were made to house-hungry consumers now struggling to make interest-only payments each month. Then the City of London bundled that risk along with yet more subprime debt and sold it – wholesale – to pension and insurance funds. A high-risk investment for unwitting pension savers, and “negative equity” for the homeowner even without house prices needing to drop. Trouble is, the investment banks also kept back a little of these asset-backed insecurities for themselves, too. At Bear Stearns, says CreditSights in New York, MBS junk equals some 13% of the firm’s “tangible equity”. Lehman holds 11% of its worth in such bonds. Goldman, Merrill and Morgan will not say, but CreditSights reckons their exposure sits in the “low- to mid-teens”.
Containing the subprime collapse, in short, might take more than simply talking down the risk before a Treasury committee. And looking for research on how to fix the U.S. real estate market, Dr. Bernanke could do worse than ask his friend (and fellow academic) Mervyn King at the Bank of England to show him what happened the last time British house prices collapsed.
The wipe-out in residential real estate prices that hit the U.K. in late 1989 took 7 years to reach rock-bottom. Judged against inflation, it destroyed one third of the “wealth” built up by the preceding bubble. Even with real interest rates slashed to half their bubble-top levels, home-buyers in the class of 1989 had to wait 12 years to get even. But luckily for them, real interest rates have only continued to sink since then. No prizes for guessing that house prices have more than doubled in the last 5 years.
Back on Wall Street, and “these guys have made a lot of money securitizing mortgages over the years in a mortgage boom time,” notes Richard Hofmann, a bond analyst at CreditSights. For mortgage boom time, read “cheap money”. “The question now,” Hofman goes on, “is what is the exposure to credit risk and what are the potential revenue headwinds if they are not able to keep that securitization machine humming along.”
But keeping revenues “humming” with fresh issues of asset-backed securities (ABS) might prove the least of Wall Street’s worries. Put the thought of the latest insider-dealing arrests to one side. It is the pile of asset-backed insecurities that will cause sleepless nights in Manhattan. The trouble caused by junk-rated mortgage bonds is beginning to show up like angry red spots on a class of pre-schoolers.
“Every year new investment products are created which are unsuitable,” as Bedlam Asset Management says in its latest annual report, although “unsuitable” hardly says it for subprime-backed mortgage bonds. Something had to give as real estate prices shot higher and fresh meat for the mortgage grinder grew harder to come by. That something was credit quality, plus all semblance of responsible lending. “Professional investors group-blunder into funds whilst wholly ignorant of the underlying investments,” Bedlam goes on. But everyone who has ever bought a house understands the housing market – including Wall Street’s finest.
Cheap money makes real estate look cheap on the monthly repayments. The extra demand it unleashes then pushes the total price higher – and to keep the bubble inflating, new ways of making cheap money look cheaper have to be created. Now that the air is gushing out of the subprime market, there is only way Bernanke can plug his finger in the hole and stem the defaults. Just like he said back in 2002, cheap money dropped out of a helicopter can fix pretty much any problem in the financial economy ... short-term at least.
Creeping back down from 5.25%, Dr. Ben has got room for 17 baby-steps on the Fed funds rate before he hits the “emergency” low of 2003. Choosing that path would prove a disaster for the dollar, of course, as well as putting the U.S. real estate market onto the same cyclical merry-go-round that British homeowners have enjoyed/suffered since the ‘70s. It would also prove a good time to own gold.Link here.
An avalance of mortgage-based lawsuits is just starting to gather steam.
Lawsuits are busting out all over. For a typical example, consider the March 4 article in Arizona Republic, “Lawsuits Targeting Mortgage Schemes”: “Dozens of civil lawsuits alleging the gamut of mortgage fraud, from cash-back deals to lying about income on loan documents, have been filed against Valley firms and individuals during the past few months. ... Fraud experts and regulators say the lawsuits are only the beginning as the fallout from mortgage fraud starts to hit the Valley. ... ‘Banks are going to force mortgage brokers to buy back bad loans, and mortgage brokers do not have the money, so they are going to go under,’ said Richard Hagar, a national mortgage and real estate fraud expert with American Home Appraisals, based in the Seattle area. ‘This is the beginning of the wave of lawsuits, lost licenses, and criminal indictments in Arizona.’”
In June 2006, in “Litigation Nightmare & Heartbreak Hotel,” I proposed a 12-point list of lawsuit items:
Judging from Morgan’s lawsuit vs. Lennar, various recent class action lawsuits against prominent subprime lenders, and “dozens of civil lawsuits alleging the gamut of mortgage fraud, from cash-back deals to lying about income on loan documents” (the latter just in the state of Arizona alone), it is safe to say that a fresh wave of litigation has started.
Things appear to be just as Richard Hagar suggests: “This is the beginning of the wave of lawsuits, lost licenses, and criminal indictments.” The key word in that sentence is “beginning”. The avalanche has a long way to slide before we can even begin to think it is approaching the bottom of the hill.Link here.
Homeownership the fast path to poverty?
Now that the housing bubble is starting to deflate, many of the excesses of the mortgage industry are coming to light. Many of the mortgages that they issued at the peak of the bubble are going bad, especially in the sub-prime market. More 10% of the sub-prime hybrids issued in 2006 were already seriously delinquent just 11 months after issuance. Note that this is the period in which low teaser rates are in place. One can only imagine the share of these loans that will eventually go bad when the interest rate resets at a higher level.
There is a real structural problem with the mortgage industry that hopefully will be addressed in the wake of the collapse of the bubble, but there is a more fundamental policy question that needs to be asked. Politicians routinely hawk homeownership as an end in itself and have pushed policies that are designed to maximize homeownership. This has often meant promoting policies that provide large subsidies to homeowners, and implicitly neglecting renters.
This single-minded promotion of homeownership is now proving to have disastrous consequences for many moderate income families that bought homes at the peak of the bubble. Many of these families will end up losing their homes and whatever savings they had used to buy a home. Their credit record may be permanently damaged and possibly their aspirations as well.
For many people, in many circumstances, homeownership is a good idea. But it is not everywhere and always better for people to own than rent. With the unwinding of the housing bubble, and the millions of tales of families in distress that will be part of this picture. Reporters should go after the ownership-at-all-costs crowd. These people have a lot to answer for.Link here.
WHEN TOO MANY INVESTORS THINK ALIKE, NOBODY IS THINKING!
As a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing. ~~ William Stanley Jevons (1835-1882)
When I continually hear and read about “excess liquidity”, “sustainable record corporate profits”, “new highs”, “Goldilocks economy”, and that “central bankers today are smarter than in the past,” I wonder whether the 19th-century economist John Ramsay McCulloch was not on to something when he wrote, “In speculation, as in most other things, one individual derives confidence from another. Such a one purchases or sells, not because he has had any really accurate information as to the state of demand and supply, but because someone else has done so before him” (J. R. McCulloch, Principles of Political Economy, 2nd ed., London, 1830).
What McCulloch omitted to add is that speculators not only buy assets because someone else has done so in the past, but because they expect that in the future someone else will enter the market and purchase the asset from them at an even higher price, since “excessive liquidity” will surely push asset prices higher.
This is certainly the view of Stanley Gibbons (Guernsey) Ltd., one of the world’s largest stamp dealers, who recently sent me an email offering guaranteed return contracts on a basket of rarities stamps. According to Adrian Roose, a director of Stanley Gibbons, “The actual returns which will be achieved are expected to exceed the minimum returns based on the quality and rarity of items included within investment contracts and backed up by a 50 year history of long term price appreciation in the rare stamp market averaging 9.5% per annum.” (The returns, in British pounds, on the guaranteed contracts offered by Stanley Gibbons vary according to the duration of the contact as follows: 4% per annum for four years, 5% per annum for five years, and 6% per annum for 10 years.)
Readers should not assume that I have mentioned stamp guaranteed return contracts as an investment because I will receive a commission from Stanley Gibbons for any clients I introduce to them, or because I recommend stamps as an investment. I have not invested in stamps and do not intend to do so. The reason I have mentioned stamps as an investment is because they show clearly the depreciating value and erosion in the purchasing power of paper money over the last 50 years or so. Moreover, not since I started out in the glorious business of investments in 1970 have I seen so much conviction among investors that all asset prices will continue to increase in value based on “excessive liquidity” and “money printing”.
Let me explain. To date, I have experienced four investment manias of epic proportions. By “epic proportions” I mean investment bubbles that, when they burst, caused serious economic pains to either an important sector of the economy, a whole country or an entire region. Those four investment manias were the parabolic increase, between 1970 and 1980, in the prices of precious metals, oil, mining and energy-related equities, as well as the Kuwaiti stock market, whose market capitalization in 1980 exceeded that of Germany.
The second “big” investment mania surrounded Japanese equities and real estate, and Taiwanese equities, in the late 1980s. It culminated in Japanese stocks commanding a larger market value than the combined values of the U.S., British, and German stock markets. At the same time, the trading volume in Taiwan frequently exceeded the daily turnover on the New York Stock Exchange! Then, in the 1990s, we had several rolling investment manias in the emerging markets, which ended with the devastating Asian crisis of 1997, and the Russian crisis and LTCM in 1998. In the 4th and last great investment mania, the object of speculation was the TMT sector on a worldwide scale and we all know very well how that ended.
These four “epic” investment manias – I have omitted mini-manias such as the U.S. casino stock boom in 1978 ahead of the opening of the Atlantic City casinos; the 1978-80 Philippine oil frenzy, which collapsed when no meaningful oil deposits were discovered; the 1983 personal computer mania; the 198–87 U.S. stock market and leveraged buyout (LBO) boom; the 1993-94 Mexican investment euphoria; and the 1996–97 Hong Kong property market surge – all had one common feature. They were concentrated in just one or very few sectors of the economic or investment universe and were accompanied by a poor performance in some other asset classes. recious metals soared in the 1970s, but bonds collapsed. Equities and bonds rose in the 1980s, but commodities tumbled. In the 1990s, we had rolling bubbles in the emerging markets, but Japanese and Taiwanese equities were in bear markets while commodities continued to perform poorly.
Following all great investment booms, the leadership changed. The 1970s’ precious metal boom was followed by the boom in financial assets in the 1980s. The Japanese stock and real estate mania of the late 1980s and the emerging market boom of the early 1990s were followed by the parabolic rise of high-tech stocks in the late 1990s. Therefore, while it is possible that in a prolonged environment of “excess liquidity” all asset markets could continue to increase in nominal value, it is most unlikely that the leaders of the previous boom – the U.S. stock market and, specifically, the TMT sector – will be the leaders of the current asset inflation. So far the gross underperformance of U.S. equities and especially of the Nasdaq (still down by 50% from its 2000 high) compared to the emerging markets and commodities seems to confirm that the leadership has indeed changed.Link here.
ALPHAS, BETAS, SCAMPS AND SCALAWAGS
Probably the greatest disappointment to a modern man over the age of 50 comes when he looks in the mirror. We say that not as a man who has just had his vacation in a bathing suit, but as one who has spent the last couple of days reading the financial press. The two are alike in that every time you look, the picture seems to get worse.
A brief summary of the subprime industry’s business model: There is a market, lenders noticed, of people who cannot afford houses and do not qualify for the credit necessary to buy them. On the surface of it, lending money to these people does not seem like a business you would want to take up. But “subprime” borrowers could be decent fish, the sharks reasoned, as long as they could make the mortgage payments. The quants did the math. The strategists looked ahead. Even if the occasional client could not pay up, they had the rising housing market to lift the value of their collateral. And so, a new “go-go” financial industry got going. Pretty soon, its hustlers and entrepreneurs – like the whiz kids of the dotcoms who preceded them – were driving Ferraris and drinking Chateau Petrus.
The Orange County (California) Register: “For Kal Elsayed, a former executive at New Century Financial, a large lender based in Irvine, driving a red convertible Ferrari to work at a company that provided home loans to people with low incomes and weak credit might have appeared ostentatious, he now acknowledges. But, he says, that was nothing compared with the private jets that executives at other companies had.
“‘You just lost touch with reality after a while because that’s just how people were living,’ said Mr. Elsayed, 42, who spent nine years at New Century before leaving to start his own mortgage firm in 2005. ‘We made so much money you couldn’t believe it. And you didn’t have to do anything. You just had to show up.’”
It was this last line that caught our attention and triggered our disappointment. It reminded us how each generation of geniuses are later unmasked as frauds and fools. It reminded us too of what weak-minded simpletons we humans are. We are always falling for our own line of guff. Modern Homo Sapiens Economicus believes in capitalism. He believes in it as he once believed in the Holy Trinity or the Virgin birth – as dogma. And so, he takes up its tenets and excesses without question or arriere pensees. And, he makes as big a mess of it as his ancestors did of the Crusades.
This is as true of the masters of the universe as it is of the lumpen. Recall Henry Paulson’s soothing words: “Credit issues are there, but they are contained,” the U.S. Treasury Secretary said to reporters in Tokyo during a four-day tour of Asia. The U.S. financial sector is healthy and most institutions will not feel “a big impact.” But a big impact is just what institutions feel – after they have flapped their wings and taken to the air. Typically, they come down with a thud.
The geniuses packaged, bought and sold subprime debt right until they heard the crashing noises. They believed the credits were good as long as homeowners could make their payments. And they saw no reason why homeowners would not be able to make their payments as long as they had jobs. That was their line of guff, and they believed it. In a world of full employment, there was no reason for the mortgages to go bad. In theory. But theories arise as needed when there is a sale to be made.
The theory was that low interest rates were giving a whole new group of borrowers access to credit. The reality was that what made credit available to uncreditworthy borrowers was the kind of corruption that wishful thinking hides – but that mirrors, and history, reveal. “What drove the housing-led cycle was not as much the cost of credit,” notes Merrill Lynch’s David Rosenberg, “but rather the widespread availability of credit ... only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”
Now, despite 4.6% unemployment and 4.7% yield on 10-year Treasury notes, the subprime lending business is crashing and burning. From Orange County comes news that the aforementioned New Century Financial is trading below $5 a share, vs. its high of $66 in December of 2004. At today’s price, in theory, the Golden State lender must be the bargain of a century, with a dividend yield of 167%. But, again, the reality is different: The news report also tells us that the company may be forced into bankruptcy.
While the subprime lenders are being pulled from the wreckage, the superprime borrowers are still flying high. In theory, hedge funds charge extraordinary fees for extraordinary performance – 2% of capital and 20% of performance. For what? For helping investors get “alpha” – a rate of return above and beyond “beta”, which is what the general market produces. Warren Buffett, probably the greatest investor who ever lived, says the whole idea is “grotesque”. In last week’s letter to shareholders, he explains that you could invest in his “hedge fund”, otherwise known as Berkshire Hathaway, and pay no management fees at all. The compounded average annual gain of Berkshire Hathaway from 1965 to 2006 is 21.4%.
What does the average hedge fund get? Over the longer run, hedge funds show an annual return of about 7%. Mark Gilbert, summing up for Bloomberg News, concludes that hedge funds, “levy outsized fees on the pretense of generating tons of clever alpha, when they are really just seizing the beta available to anyone.” In other words, in practice, the hedge fund managers, like the dotcom entrepreneurs and the subprime lenders, are not really geniuses at all. They make their money just by showing up, just like everyone else. And they get the same rate of return. Or worse.
Many funds and hedge funds jumped into Japan after that market went up 40% in 2005. The following year, 2006, was disappointing. The Nikkei Dow rose barely 4%. How did the hedge funds do? As Merryn Somerset Webb reported last week, “far from proving their ability to make absolute returns in any market conditions, [hedge funds] did particularly badly; they all fell between 5% and 20% over the year.”
Subprime lenders did not hedge the risk inherent in lending to weak borrowers. Instead, they sought it out and leveraged it up. Hedge funds seem to have done the same thing – reaching out a little too far in order to grab a few extra points of yield. Now, we wonder who owns the $23 billion of New Century Financial debt, and who owns the rest of the debt in the subprime area? We wonder too, who owned the $2.5 trillion worth of equity value that disappeared last week? Surely, there is some more “big impact” lurking out there ... still waiting to hit someone.
We look in the mirror and hope it is not us.Link here.
VIVA RECKLESSNESS! LONG LIVE THE PROM QUEENS!
Today, the significant news is that the European Central Bank has raised its key-lending rate to 3.75%, warning of growing inflation. That puts exactly 325 basis points between the yen and the euro. A speculator can still borrow in yen, convert to euro, and lend the money out – pocketing 3.25% of gross margin yield. Using leverage unwisely he can leverage that return up to the point where he is almost sure to go broke. The yen carry trade lives on!
But we are not high rolling international speculators here. We are low rolling, stay-at-home plodders more interested in the return on the local Laundromat than on yen carries. Still, there are butterflies flapping their shiny little wings all over the world of finance. One of them is bound to send shirttails flying somewhere. And thus begins some rambling reflections fit for a quiet Friday morning.
If investors think they can make money by investing in euro they should look at the New Zealand dollar. The Kiwis raised their rates too – citing the same zeal to declare preemptive war on inflation. The gap between a short yen position and a long New Zealand dollar position is precisely 700 basis points. That looks like easy money to us ... as long as nothing goes wrong.
And nothing ever goes wrong ... until something goes wrong. We had our eye on the yen, because we saw it as something that probably would go wrong. At some point – perhaps last week – investors were bound to get a little nervous. When they got nervous, we reasoned, they would make haste to exit their risky speculations. Since they are overwhelmingly short on yen, they would necessarily have to buy it back in order to unwind their positions. This would force the yen to rise. And the yen has been going up. If it continues upward it will both signal the demise of the carry trade ... and bring it about.
The math is elementary. Let us say you have $1 million you want to put into this play. You leverage it up to borrow $10 million in yen. Then you invest the $10 million in NZ dollar bonds. If all goes well, in raw numbers, you make $700,000 in net yield – or 70% or your original investment. But what if it is the yen that goes up 7%? That is $700,000 more that you have to pay back.
Yes, dear reader, it is a wicked, treacherous world, although no one else seems to notice. We still fly our “Crash Alert” flag. And while the world lost $2.5 trillion in equity value last week (before recovering some of it), and while the yen rises ominously, we see few signs that investors have gotten the message. Most think that today’s gush of liquidity will gush on forever and that today’s investment sweethearts – stocks, bonds, art, property – will remain prom queens forever. Eternally young. Forever beautiful. Oh, dear reader, if only it worked that way!
And here we let you in on a little secret. Don’t tell anyone, but stocks are going to sag and fall. Especially those cute little Asian beauties. Bonds too. And art? Today’s belles will be yesterday’s news – rejected, ignored, neglected – like the prom queen’s mom! Even housing will fade and fall out of fashion. It is already happening. Quietly, prices are being cut, while mortgages go bad. It may not yet be the end, or even the beginning of the end, but it is surely the end of the beginning for America’s housing boom.
Our old friend Marc Faber says he has lived through four MAJOR financial booms in his lifetime. There was the boom in commodities and precious metals in the ‘70s. Then the boom in Japanese assets in the ‘80s. Then the mania in emerging markets in the 1990-98 period. And finally, the bubble in tech and telecoms in the 1990-2000 era. During each one of these booms, people thought the good times would last forever, “because there was so much new money coming in.” Today, that is just what people say about China, art, and London property – and stocks and bonds, generally.
But each bubble popped, and its brightest stars – its alpha companies, go-go market leaders, prom queens, and its celebrity kings – all quickly vacated the headlines. When they reappeared in the news, it was in the fine print ... that is, in the notices for workout, refinance and chapter 11.Link here.
|Previous||Finance Digest Home||Next|
|Back to top|