The Nature of a Crowded Trade

Let me start off with two Columnist Conversation posts that talk about crowded trades:

David Merkel
When Is a Trade Crowded?
8/9/2006 9:35 AM EDT

At the end of every day, every asset is owned by somebody. If you want to count in the shenanigans that occur as a result of shorting (naked or legal), those are a series of side bets that do not change the total number of shares/bonds outstanding. (I.e., if legally, shares get borrowed. Naked shorting creates a liability at the brokerage for the shares that should have been borrowed.)

So how can a trade be crowded? It comes down to the character of investors in the given stock or bond. A trade will be crowded if those owning the asset have a short time horizon that they are looking to make money over.

My example of the day is the run-up in financial stocks while waiting for the Federal Open Market Committee to pause. Financial stocks ordinarily don’t do well when the FOMC tightens, but from the time of the first tightening until now, they have returned 10%-11% annualized. There still are a lot of people betting that things will get a lot bettr for depositary institutions now that the FOMC is (in the eyes of some) done tightening.

Even if the FOMC is done tightening, as Bill Gross thinks (Who cares that he has been wrong since tightening number 5?), the yield curve needs to steepen by about 75 basis points from twos to tens before the lending margins of banks are no longer under pressure from the shape of the yield curve.

Maybe once we get our first loosening, I’ll be more constructive on lending institutions, but as for now, I am steering clear. There are too many parties that believe that the FOMC is done and too many trying to profit from the rebound that “has to happen” in lending-based financials when the FOMC is “done.”

Position: None.

David Merkel
Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

The concept of a crowded trade is simple.  Trades are crowded when those that hold the assets in question have short time horizons.  This can happen for a variety of reasons:

  • The trade could have negative carry, i.e. you have to pay to keep the trade going (e.g., shorting a high-dividend stock).
  • The investors holding the assets are predominantly momentum-driven.
  • The investors bought the assets using borrowed money. (or, sold short…)
  • There is an event expected to take place that will provide liquidity (e.g., a buyout); woe betide if it doesn’t happen.

Now, some will look at crude oil and other hydrocarbons and say that the trade is crowded.  Though I am now finally underweight the energy sector for the first time in seven years, I’m not sure it is a crowded trade.  The financing of the sector is pretty strong, and valuations are reasonable, discounting an oil price of around $80 or so.

What I do think is a crowded trade is residential housing, and commercial property as well.  A little over three years ago I wrote a piece called, Real Estate’s Top Looms. It had all the marks of a crowded trade:

  • Lots of leverage, with much of it short-dated (Option ARMs, 2/28, etc.)
  • Momentum buyers (and the get rich quick books)
  • Negative carry for investors (capital gains must happen in order for the purchase to work)
  • Much reliance on the “greater fool” that would buy the property from the new owner.
  • A high proportion of investors to owner-occupiers

It is still a crowded trade today.  There are excess homes.  Investors still face negative carry.  Buying power of prospective buyers is reduced because of higher lending standards.  Then, there’s dark supply.

Dark supply are the homes that will come onto the market if it looks like prices have stabilized.  There are owners who want to sell, but they don’t want to take a large loss, or, they can’t afford to, because they would go bankrupt.  So, they feed the mortgage for now, and wait for the day when the market will have life again.

I experienced things like this in the corporate bond market in 2001-2003.  Whenever a bond would fall sharply and not die, the recovery would be fitful, because there would be market players who were burned, wanted out, but could only justify a certain level of loss.  Dealers would tell me when I expressed interest in some of the damaged names that there would be supply a short bit above the price where I could buy today, so, I should be careful.  I had a longer time horizon, so I would often buy, and watch the struggle as fundamentals improved, but prices went up more slowly due to selling pressure.

Oh, here’s another area of dark supply:  Real estate owned by the GSEs.  They can probably be a bit more patient than commercial banks, but as prices begin to firm, they will start to unload properties.

I have been reading estimates of the size and duration of further declines in residential housing prices.  My view is that we have another 10% down, and that in two years, we should be at the bottom.  How long it takes to burn through the dark supply is another matter, and one that I don’t have a good guess for.

When investors can make a good return off of buying and renting (but there aren’t many of them), and many people have reconciled themselves to the losses they have incurred, then the trade will no longer be crowded, and we will have a normal residential real estate market once again.

For those that want to read some of my older articles on market structure, have a look at these five articles at RealMoney:

The Fundamentals of Market Tops
Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

The latter four were a series, but not labelled as such.