Ten Things Not To Worry About

There are many that cover the markets that try to get you to worry about things that aren’t real problems.  Here’s a sampling for the evening:

1) Changes in accounting standards, or ineffective/opaque accounting standards.  Take Goldman Sachs and level 3 assets as an example.  The accounting standard is fine, so long as you understand it.  In general, the higher the level of level 3 assets, the more opaque the valuation of assets is, and a valuation haircut gets assigned to the stock.  This is proper, because it happens to all companies with high or cloudy accrual figures.  It makes it hard to estimate free cash flow.

Should we move from US GAAP to IFRS, it should not affect the valuations of stocks on average, though it will make it a little harder to do financial analysis.  What does not change is free cash flow, which is not subject to accounting rules.  The money that can be withdrawn from a business without harming its current prospects (free cash flow) is the key metric for understanding business value.

2) Counterparty risk.  In derivatives, for every loser, there is a winner.  So long as the appropriate margin levels are maintained at the main brokerages, and the main brokers don’t experience conditions that dramatically change their credit quality, counterparty risk is not a problem.  (Or maybe, I should say, worry about the brokers, not the other counterparties.)

3)  Investors moving to cash.  Money rarely leaves the market.  When funds raise cash (and here), others buy their shares at a discount.  Typically, they are stronger holders than those that sold.  I wouldn’t be too bullish over stories of investors moving to cash, but I certainly would not be bearish.

4)  Rating agency downgrades, unless they trigger a debt covenant.  For the most part, market spreads and yields are set independently of debt ratings.  Sophisticated investors dominate the market, not the rating agencies.  As an example, suppose the US were downgraded to Aa1/AA+/AA+.  After a week, I doubt yields would change much at all, because the fundamental view of the US would not be changed by a change in its rating.

5) High credit spreads.  Those are a reason to be optimistic, because it means pain has been taken already.  Spreads can’t get higher than a certain level, or companies start delevering, because it is profitable to do so.  So when you see spreads near record highs, that is a buying signal, at least for the debt.

6) Retailers in trouble.  Some retailers are always in trouble during hard economic times.  It’s a tough business model, so expect some defaults; it is normal and healthy for the economy as a whole.

7) Collapse of a large portion of the auction rate securities market.   Most borrowers will refinance.  In the interim, speculators are driving down the rates that get paid.

8) Downgrades of the major financial guarantors.  The market has priced it in, and perhaps we just run off MBIA and Ambac.

9) Tranche warfare in CDOs.  Read your prospectus with care, but when the seniors grab hold of a deal after and event of default, that is a step toward normalizing the market, though the mezzanine holders may ineffectively object as they end up getting nothing.

10) The ABX indexes, etc.  I’ve written about this before, but the various synthetic indexes — ABX, CMBX, LCDX, etc., are very hard to arbitrage against the cash market bonds that they represent.  The indexes should not be used for pricing as a result.  Whenever the synthetic market gets too much bigger than the cash market, it becomes a bettors market, and becomes incapable of delivering pricing signals to the underlying cash markets.

There are enough real things to worry about.  Perhaps I will write about those tomorrow.