The credit cycle is kind of like a Monty Python skit where the humor has reached a point of diminishing marginal returns. At that point, they might blow something up, and move onto the next skit. Credit cycles end with a bang, not a whimper. Take a spin down the last few cycles:
- 2000 — Nasdaq, dot-coms
- 1997-98 — Asia/Russia/LTCM
- 1994 — Mortgages/Mexico
- 1989 — Banks/Commercial Real Estate
- 1987 — Stock Market
- 1984 — Continental Illinois
- Early ’80s — LDC debt crisis
In each case, we had assets that were weakly financed.? When liquidity began to become scarce, the entities that were weakly financed faced sharply rising borrowing costs, and many defaulted.? The purpose of this piece is to muse about what entities in our world today are reliant on the presence of favorable financing, and would suffer if that financing ceased to exist.? Here’s my initial list.? Can you give me some more ideas?
- Too obvious: CCC-rated bond issuers.? We’ve had a lot of them issue debt over over the past three years.? Those that have not shored up their balance sheets and paid down debt will suffer if they need additional financing.
- Yield-seeking hedge funds.? When the credit cycle turns, yield becomes poison.? Those holding the equity of Collateralized Debt Obligations, and other levered forms of credit will have a rough time, particularly if their investors ask for their money back.
- Dodgy mortgages.? We’ve already seen the beginning with subprime mortgages, but there are more loans that will hit resets over the next twelve months.? The troubles with Alt-A lending will be more spread out, but it really hurts to have your financing rate jacked up at a time that the asset financed is experiencing weakness in price.
- Private equity over-borrowing.? Much of private equity relies on the idea that they can have an easy liquidity event five years from now.? What if interest rate are three percent higher then?? P/E and EV/EBITDA multiples will be lower, not higher, and then what do you do with all of the debt used to finance the purchase?
- Overly indebted cyclicals, and mergers that increase leverage.? Companies that presumed too much about the future get killed when the cycle turns.? The mergers and recapitalizations that looked so promising are horrid when the willingness to take risk drops.
- Mis-hedged investment banks.? This is a little more speculative, but in a credit crisis, investment banks without adequate liquidity are in the soup.? Lehman Brothers barely survived 1998; in a more severe crisis, who would get harmed?
- Sovereign nations with large current account deficits.? This is the most controversial category.? I am not talking about the main emerging markets here; I am talking about developed countries that lack discipline, like Iceland, New Zealand, and the United States.? The large emerging markets are in better shape than the derelict nations that they fund.? If the debt is in their own currency, the nation has more options than merely defaulting.? They can inflate, or create a two-tier currency system to give foreigners the short end of the stick.? (Think of Argentina, or South Africa back in the 80s.)
These are the weak entities that I can think of. ?There are more, I am sure, particularly as the demographic crises emerge over the next decade, but for now, if liquidity becomes scarce, these are the entities?that will suffer.
Well-Done!
As of December 2006, the current account trade deficit was about $(195,790) million, or more than 6% of GDP. How long will foreign entities continue to subsidize our unwillingness to engage in fiscal restraint?
If Saudi Arabia really wanted us out of Iraq–which they don’t–they could just stop purchasing our debt refinances. So much for Bush the fiscal conservative. His father probably cries himself to sleep knowing that Bill Clinto had better control over government spending than his Yale Cheerleader of a C- student son! [and this coming from a registered Republican!]
And, no– I do not buy into the argument that we can continue to run up huge deficits as long as we exponentially increase worker productivity.
Too bad most voters are more fixated on Paris Hilton & Britany Spears than presidential second-tier candidates; for Ron Paul is on to something–time to rethink the Gold Standard.
PS. Contrary to twenty-something, newbie analysts– who were still in grade school back in 1987–justifying the S&P can rise another 15% based on “historic P/E multiples, yada yada…this bull market is dead if treasury rates continue to rise: [‘risk-free’ ten-year note yields of 6% or stocks, you pick!]
Keep up the good work!
Best,
David J. Phillips, Publisher
http://www.10qdetective.blogspot.com
A KIPLINGER & BUSINESSWEEK ‘MUST-READ’ BLOG
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David,
Thanks ever so much for posting here. You’ll find what I write here to be eclectic, partially because my work has changed roughly every five years. I’ve added your blog to my reader; looks interesting.
It seems like Saudi Arabia wants to keep the Shia world off balance; the US may not grasp the way it is being used. Then again, the recycling of petrodollar claims on terms that are favorable to the US is a kindness that is hard to turn down. We need all the help we can get, though as I have commented before, the US will not be able to run a current account deficit nearly so wide when the demographic switch trips somewhere in the 2010s.
Drop by anytime; thanks for the visit.
PS — Would that Ron Paul had more support; he at least is saying something different. I always found it funny when the Fed Chairman would come to testify that he and Bernie Sanders would usually ask questions one after the other. What a political whipsaw.
Dave, great post.
(Longtime fan from RM) I understand your diversification and rebalancing strategies for both market/insurance portfolios, but can’t recall how/if your investment “rules” restrict you on the short side.
In other words, what are you considering as actionable? Put options on the I-banks? Shorting the debt itself? Going against the dollar?
Would you hedge to manage continued upside risk until market sentiment changes?
Count Wilbur Ross as a recent member of the smart money crowd to publicly nod his head in violent agreement with 1-7 (short interest records on NYSE indicating conviction levels?) …but on the flip side, there seems to be more than rumors surfacing (source: The economist) regarding foreign governments rediversifying into equities at a time when buybacks have already reduced float.
The complexity is intense …but in a perfect world, I’d love to hear your thoughts on the next-stage consequences for 1-7, and an order of what you consider the high-probability outcomes.
Here are my shorting rules:
1) Can’t talk about shorts that my employer has on. The borrow gets troublesome.
2) I rarely short. I need to find something on the order of accounting fraud in order to short to any significant degree.
3) I want bullish momentum broken before I short… RSI < 60.
I have gone against the dollar through the purchase of foreign debt… that trade has been a winner for me, though not over the last month, because of the market finally figuring out that the FOMC is on hold.
My rules also tell me to favor the bull side unless things are desperate. Even then, I tend to adjust through stock and industry selection, rather than exiting in entire, or shorting. I do best at “long only” and balanced fund management. That’s what my risk control disciplines are designed for.
There is still a lot of liquidity chasing assets. Though most central banks are tightening, they are also letting their money supplies, particularly broad money, expand aggressively. For the most part, they aren’t willing to revalue their currencies upward versus the US dollar, which would finally end the flow of dollar based liquidity.
PS — the investment banks are opaque here. Supposedly they are much better prepared today than they were in 1998 (ask them, they will tell you!), but they make a lot off of trading now, which is a low quality source of earnings.
Is the negative bias to shorting due to statistical probabilies you’ve worked out in the past, or you just don’t like to do it? (After a run like this, I don’t blame you.)
Is “opaque” really what is keeping GS at a 10 multiple? Is FIG so much more translucent?
p.s.
Right after I see it in the Economist, here it is again on Bloomberg:
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_pesek&sid=aPh8aKUVEjFI
$12T is alot of tide to raise all boats.
(As sovereign wealth funds are owned by the state – and the state ultimately has their hands on the rulebook – what keeps any/everything from becoming a rigged game? e.g. China owns $3B in Blackstone, so BX now has carte blanche in China? How do these funds plan on avoiding obvious conflicts? (or do they plan on doing so at all…?)
Just a quick follow up regarding shorting as a valid investment methodology. I’m interested from a behavioral perspective as to why as a pro, you have a substantially long-only bias.
I’m not a PhD, so I have no quant bona fides around, but it doesn’t take much by way of stats to see negative correlation is fading. International markets now trend in lockstep with Domestic, stocks trend with bonds, groups and sectors (particularly on multi std dev days) all move with a noticeably higher positive correlation than in years past.
Shorting, on the other hand, is negative correlation – assuming one can manage the short side of the investment portfolio in a way that not only provides protection, but does not create too much of a negative drag on long term performance. That’s the magic I’m looking for.
Shorting is a tactical discipline used in extraordinary circumstances where you have a distinct edge over the most of the best minds in the market. It can be done when you have an identifiable catalyst. It is also only really effective when few others are doing it on a given security, unless it is a structural short where the company will head into distress.
I also want to have it such that the company is not desirable as an acquisition target, and is constrained in its use of cash flow. (Can’t fight back.) These are hard hurdles to achieve; it is hard for a fund to generate alpha from both shorts and longs — the skills are different. Being short is not the opposite of being long, it is the opposite of being leveraged long. Once gross exposure crosses 100%, the possibility of total ruin goes positive, and risk control is a lot different.
Now, if you just want to remove exposure while maintaining your differential bets, then short an index ETF that represents your normal portfolio against your longs, until your beta gets low enough.
It is very difficult to get the betas of short and long portfolios to cancel out if one is aiming for alpha on both sides. Typically that embeds a lot of factor bets that are ill appreciated in a simple model. E.g., long value, short growth. Long insurance, short banks. Long large caps, short small. Pure outperformance and zero factor exposures is very hard to achieve.
It is simpler for me just to rotate sectors, and use my rebalancing, value and reshaping disciplines. After that, stick to high quality balance sheets and clean accounting. I take enough risk as it is on an unlevered basis; were I running my own hedge fund, I would simply short index futures against my positions. The outperformance from my long exposure has always been enough to carry me along. It’s what I am good at, and my unlevered performance over the last 6+ years would be acceptable to almost all investors.
Sorry for the long winded response. Yes, investment banks, business development companies, private equity shops, long-tail casualty insurers, etc., have opaque, low quality earnings, and don’t deserve to trade at premium multiples. 10x earnings is generous enough for this interest rate environment.
awesome response david. much appreciated.
In hindsight of this conversation, “shorting” in the traditional sense (ala Doug Kass) may not be the best description of what it is I’m doing. Until sentiment changes, my conviction does NOT lie on the short side.* With what you’ve advised above (short etf), I’ve found it chews up alot of capital to effectively lower beta. I’m experimenting with derivatives as an alternative, and I’ll research your thoughts regarding futures.
I am admittedly utilizing a much higher risk strategy with max leverage. However, I attempt to manage the extra risk with:
1.) extremely tight loss discipline
2.) pair trades (eg long gs/short bsc) in an attempt to create negative correlation for short term (short notice) dislocations
“It is very difficult to get the betas of short and long portfolios to cancel out if one is aiming for alpha on both sides.”
You’re not kidding. But it seems to be effective for protecting against short term dislocations as long as the alpha targets are asynchronous. I’ll give the longs a little more room in our current environment, but I won’t allow the shorts to run against me.* In times like today and last Tues-Thurs, I attempt to manage the short/long positions individually while trying to attain a market nuetral balance at the total portfolio level…
The challenge with shorting an ETF is that an outsize position is required to create meaninful protection.
* The $10k question (as always) is determining when the sentiment has truly changed, which brings us back full circle to the original 1-7 post.
Sorry for monopolizing your time, and thanks again for the feedback – Aleph has become one of my 10 must-read financial blogs, keep up the great work.