The State of the Markets, Part 2

There are several ways I would like to go from here in my short-term plan for this blog.  One is to focus on the stress in credit markets.  Second is to post on the macroeconomics surrounding these changes.  Third is to point at the oddball stuff that I am seeing away from points one and two.  Last would be portfolio strategy at this point in time.  From a conversation with my friend Cody Willard today, where we went over many of these topics and more, what I believe every investor should do right now is look at every asset in his portfolio, and ask two questions:  What happens if this asset can’t get financing on attractive terms, and would this asset benefit from any reflationary moves by the global central banks.  That’s the direction that I am heading.  Tonight, I hope to go through stress in the credit markets, and maybe macroeconomics.  I haven’t been feeling so well, so I’ll see what I can do.

Let’s start with Rick Bookstaber, who recently started his own blog, after writing a well-regarded new book that I haven’t read yet.  He sees the risks with the quant funds: leverage, similar strategies, and the carrying capacity of the strategies.  Very similar to my ecological view of the markets.  Move over to the CASTrader blog, a nifty blog that I cited on my Kelly Criterion pieces.  He also subscribes to the Adaptive Markets Hypothesis, as I do.  He also makes a carrying capacity-type argument, that the quants got too big for the markets that they were trying to extract excess profits from.  Any strategy can be overdone.  Then go to Zero Beta.  The hidden variable that the quants perhaps ignored was leverage, which affects the ability of holders to control an asset under all conditions.  Leverage creates weak holders, or in the case of shorts, weak shorts.  Visit Paul Kedrosky next.  I sometimes talk about “fat tails,” and yes, looking at distributions of asset returns, they can seem to be fat tailed, but regime shifting is another way to look at it.  Assets shift between two modes:  Normal and Crisis.  In normal, the going concern aspect gets valued more highly.  In crisis, the liquidation aspect gets valued more highly.

Looking at this article, quant funds were precariously over-levered, and now are paying the price.  Goldman Sachs may understand that now, as its Global Alpha fund moves to a lower leverage posture.  This NYT article points out how fund strategy similarities helped exacerbate the crisis, as does this article in the Telegraph.

We have continuing admissions of trouble.  AQR, and this summary from FT AlphavilleTighter credit is inhibiting deals, which is to be expected.  Some mutual fund managers are underperforming, including a few that I like, for example Wally Weitz, and Ron Muhlenkamp.  Problems from our residential real estate markets will get bigger, until the level of unsold inventories begins a credible decline.

Is 1998 the right analogy for the markets?  FT Alphaville gets it right; the main difference is that the funding positions of the US and emerging Asia are swapped.  We need capital from the emerging markets now; in 1998, it was flipped. Is 1970 the right analogy?  I hope not.  ABCP in credit affected areas should be small enough that the overall commerical paper market should not be affected, and money markets should be okay.  But it troubles me to even wonder about this.  Finally, CDS counterparty risk — it is somewhat shadowy, so questions are unavoidable.  The question becomes how well the investment banks enforce their margin agreements.  My suspicion is that they will enforce them well, particularly in this environment.  But what that means (coming full circle) is that speculators on the wrong side of trades will get liquidated, adding to current market volatility.