I’m swamped with putting the finishing touches on my talk for the Society of Actuaries, so this post will be brief.? When it’s done, I’ll be posting it here for all of my readers.? When the transcript gets published, I’ll post that as well, but that takes a while.
A few observations, some of them obvious, because we’re at an interesting juncture in the markets now:
The equity markets are near new highs.? Who’da thunk it?
Equity implied volatilities have returned to a semi-normal state, and corporate credit spreads have tightened, but lagged.
Fixed income implied volatilities look high.
Fed policy, if LIBOR, narrow money, or the monetary base is the measure, hasn’t worked that well.
Fed policy, if the stock market or total bank liabilities is the measure (credit expansion), has worked pretty well.
The dollar has bounced, but I would expect it to retrace the losses.
We’re experiencing a small period of macroeconomic quiet amid the start of earnings season.? Earnings season should be good overall, with weakness in housing-related areas, and strength in export-related areas.
Banks should be able to end the logjam in the LBO debt markets.? The cost is feasible.
Residential real estate prices are still weakening, and provide most of the drag on the US banking system and economy.
Inflation is rising with many of our trading partners; the US may begin absorbing some of it.
Our trading partners are going to have to choose between controlling their interest rates, and following US policy, or letting their exchange rates rise further.
In this environment, I am trimming my equity portfolio slowly as positions hit the upper end of their trading bands.? 20% of the portfolio is within 5% of the upper rebalance point.? Almost nothing is within 10% of my lower rebalance point, so I’m not likely to add anytime soon.
1) In an open economy, you can control your exchange rate or your interest rates, but not both.? The first time I learned that was late 1986, when the Dollar crashed, then the bond market crashed (May 1987), then the stock market crashed(October 1987).? This article from Morgan Stanley goes over the same idea.? Pay attention to the investment? implications at the end, though Hong Kong may have already rallied enough.
For a more bearish view, many Asian economies are facing the choice of slowing their economies, or importing inflation from the US. My sense is that we are in an uptrend for inflation globally.? Few central banks are truly pursuing sound currencies.
2)? Europe is no monolith here.? Managing the ECB is some trick, because money is political, and there is monetary union without political union.? The Swiss Central Bank continues to tighten, while the Bank of England effectively loosens, because of the recent panic there, involving Northern Rock.
3) One of my favorite observations about technical analysis is that slow moves tend to persist, while fast moves tend to mean-revert.? Well, the US dollar is having a grinding, slow adjustment downward. ? To me, that is just another indicator that the decline will persist.
4) Will the Saudis drop the dollar peg?? Maybe.? Given the current inflation rate there, I would suspect that they, and other Persian Gulf nations, will move to a currency basket approach that has a high US Dollar weighting.? That will allow themselves the flexibility to make further adjustments that allows them to arrest inflation.? That will lead to further declines in the dollar against other currencies.
5) What makes a currency attractive?? GDP growth and high real (inflation-adjusted) interest rates.? The US has neither of those now.
6) An old dear friend of mine, Roy Hallowell, had two merciful rules: a) We all make mistakes.? We ALL make mistakes. b) Most of them are like the rest of them.? Such is Goldman Sachs Global Alpha.? They played too much on the carry trade and got burned, among other bad trades.
8)? Given the fall in the implied volatility of the yen, the yen carry trade is coming back.? The carry trade works best when implied volatilities are low, because the cost of protection against adverse moves is modest.? But, if low interest currencies persist in tightening, the carry trade could be a bad bet.? My thought : Japan is not tightening anytime soon, and? the carry trade continues there.? Switzerland goes the other way.
The Chinese banking system still can’t stand on its own.? It’s not as bad as it was, but it still needs more of a capital cushion to be more certain of survival.
They have punished over 3000 government officials for illegal land transfers.? And we complain about eminent domain.? On the bright side, perhaps the Chinese government finally realizes that property rights are necessary to a healthy economy.
1) Fed chatter has gotten a little quieter, so maybe it is time for an update.? Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy.? This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.
2) For another example, Look at the discount window.? That has faded as a factor over the past two weeks.? You have to dig into Dow Jones Newswires just to hear about this.? The discount window is back to being a non-entity.
3) Review his book.? Cite his article.? Though I think the FOMC will loosen more, I agree that it should not be loosening.? The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works.? (Maybe I should review James Grant’s The Trouble With Prosperity?)
4)? I may not vote for him, but I like Ron Paul.? He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke.? I favor a sound dollar, and risk in our system.? It keeps us honest.? Without that, risk taking gets out of control.
5) Now, onto the chattering Fed Governors.? Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation.? He argues that much of the speculation occurred while the FOMC was tightening.? Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.
Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy.? If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.
But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.”? They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing.? This maximizes surprise, which adds punch to policy moves.
6)? Consider foreign central banks for a moment.? I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem.? Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem?? Tough decision, but I would take the growth slowdown.
8) Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means.? Now, money market funds are better off than they were one month ago, but all of the issues are not through yet.? Some money market funds contain commercial paper financing subprime CDOs.? Now, the odds are that the big fund sponsors would never let the ir funds break the buck.? They would eat the loss.? That’s not a certainty though so be aware.
9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs — pages 32-33].? Some suggest that this is the “too big to fail list,” though by now, it is quite dated.? On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.
10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”? My way of saying it is that trying to control a system changes the system.? The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.
About a month ago, when the financial markets were more skittish, I saw a series of four articles on more interest in distressed debt investing (One, Two, Three, Four).? In this market, it didn’t surprise me much because we have too many smart people with too much money to invest.? It reminds me a bit of a RealMoney CC post that I made a year and a half ago:
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
We are still on the side of the demographic wave where net saving/investing is taking place, and that forces pension plan sponsors to find high-return areas to place additional monies.? Away from that, the current account deficit has to be recycled, and they aren’t buying US goods and services in size yet.? That’s why there will be vultures aplenty, outside of lower quality mortgages.? Even the debt market for new LBO debt is slowly perking up.? The banks pinned with the loan commitments may be able to get away with mere 5% losses.? Away from that, investment grade and junk grade corporate bonds are looking better as well.
Now, don’t take this as an “all clear.”? There are still significant problems to be digested, particularly in the residential real estate and mortgage markets.? CDOs still offer a bevy of credit issues.? There will be continued difficulties, and I don’t expect big returns.? But with so many willing to take risk at this point, I can’t see a big drop-off until they get whacked by worsening credit conditions.
Well, look at the DJIA and Nasdaq Composite.? New 52-week highs.? I am still bearish on our credit markets, tepidly bullish on equities, particularly inflation-sensitive sectors (and insurance), and bearish on Real Estate and Real Estate finance.? This is a hard combo to hold together, but in some ways, I suspect that surplus capital that was making its way to the credit markets is now making its way to the equity markets.
I’m eclectic, what can I say?? I’m always trying to blend signals from the long-, intermediate-, and short-term, with greater emphasis to the longer cycle elements.? I’m not a trader.
Now, just a few notes to catch up on reader questions:
Why FSR and not VR or IPCR then?
I forgot about VR, and will have to consider it in the future.? I like IPCR, but it has run some recently, and their aggregate maximum loss discipline will limit their returns vs those companies that use probable maximum loss.
I think your post is very useful but that it raises some critical issues about successfully forecasting future inflation/real rates. Your study period includes a period where 3 major versions of CPI existing. There is the pre-Reagan CPI, the pre-Boskin CPI and the current. John Williams at shadow statistics calculates all three. The curren pre-Reagan CPI is running over 10% so ?real rates? based on that would be negative 6-7%! The pre-Boskin is I think 5-6% which would still produce negative real rates?.and the Fed is cutting rates!
I wish anyone luck trying to forecast 10 year hence real rates or inflation given this mix. My personal opinion is that due to fiat currencies they are likely to be much higher unless central banks allow a deflationary credit contraction to take force without trying to inflate. History suggests that they all try to inflate!
One thing that is different about my blog is that I will do different sorts of posts.? I’m hard to categorize. ? This comment makes some very good points, most of which I agree with.? I believe inflation is understated in the US, and I think that the idea is growing in the populace, while Ph.D. economists stay in lockstep with the guild, and deny it.? My main article on the topic, for those with access to RealMoney, can be found here.
Also, my main point was not to get people to try to forecast inflation and real interest rates.? It was to point out how changes in inflation and real interest rates disproportionately hurt equity investors compared to bond investors.? That said, it takes a large move in inflation rates to wipe out the ordinary advantage of equities.
Hi, how do you think i-bank incentive fees will effect EPS over the next year?
I worked for a technical trend following CTA in the 90?s that had a severe drawdown of -55% over the course of a year. It started with one bad day and the company was never even remotly profitable again and the owners closed it down 3 years later.
I think that people don?t understand that in order to make incentive fees the hedge funds have to make new highs, just being flat doesn?t cut it. Unless they are constantly making new highs, the hedge fund business is the same model as the mutual fund biz but with much higher overhead.
Alternatively they shut their existing funds down and open new ones to reset the mark but its hard to replace the truely large capital pools.
Interested in your thoughts.
That’s an interesting question.? With respect to compensation from internal hedge funds, there will be some loss of EPS.? That said, investment banks have more true technical information than most hedge funds, and will benefit from trading against funds that are in bad situations.
In general, most hedge funds that lose 25% of capital go out of business.? At 50%, almost all of them do.
That’s all for the evening.? Let’s see if the S&P 500 hits a new high on Tuesday.
With the US Dollar Index taking out an all time low previously set in 1992, I thought I would take this moment to discuss my thoughts about where the dollar is going, and what we might see along the way. If the dollar gets much lower against the major currencies of our world, I would expect to see some currency intervention to try to raise the value of the US dollar.
There are rules to effective currency interventions. There may be more than four, but here are the four that I know.
Do the intervention on a day when the economic releases favor a stronger US Dollar.
Do the intervention when traders are overconfident, and pressing their bearish dollar bets too aggressively. Catch them leaning the wrong way.
Don’t do it alone. You will fail. You must get the central banks of most of your major trading partners to go along to create an impression of unanimity.
Do it BIG. This is not a time to hold back; either do it BIG, or don’t do it at all. You want the currency traders to wish they had never taken up the profession.
You want to have at least three of these in play for an effective intervention. You want to create a genuine panic that feeds on itself, leading everyone to readjust their positions on the US Dollar, pushing it up, and winning the psychological battle against a lower US Dollar.
Easy, right? Well, no. In the short run, interventions work if done properly. They don’t solve the macroeconomic problems underlying the weak Dollar, though, and so toward the end of the shock move upward in the Dollar, I would be inclined to buy more foreign bond exposure. Why?
During the intervention, the participating central banks suck in US Dollars, and pump out their local currencies. In the case of the Fed, they sell foreign currencies and buy US Dollars. Most of these central banks have all of the US Dollar assets that they want already, and they understand the fundamental situation regarding the US Dollar. So, like OPEC in their ineffective days, where they would announce production cuts, and then everyone cheats, in this case, the Central Banks do the intervention, but then quietly recycle the US Dollar assets that they never really wanted to hold.
That leads to a slow retest of the levels that the intervention happened at, and eventually, breaking through the level, at which point, the Central Banks can try again, or give up.? Eventually the response is a “give up,” after which, the US Dollar slowly overshoots and then finds a new temporary equilibrium level, and the rest of the world adjusts to it.
I’m leaving out a lot here.? The internal political pressures to keep the Dollar from falling.? The effects on export industries.? The slowly growing willingness to buy US Goods and services.? Rising interest rates in the US.? Rising inflation abroad.? And more.
The investment implication is this, though.? Until an intervention happens, the path of the US Dollar is down.? After it happens, the path of the US Dollar is down, until a new equilibrium is found.? Economies are bigger than governments, and in the long run, governments can’t affect exchange rates.
Just stay on your toes, and be ready to buy non-Dollar assets after the coming currency intervention.
Implied volatilities have fallen below long-run averages for equity indexes.
The equity market is within spitting distance of a new high.
The Fed is loosening (will they do more?)
The discount window is largely vacant.
Away from real estate, and real estate finance, things seem pretty chipper.
The yield curve is normalizing.
Inflation as measured by the government is low.
Long term interest rates are low, for investment grade borrowers.
Commercial paper problems are gone.
LBO debt difficulties will be solved soon, through a combination of losses to the banks, and canceled deals.
Or maybe not:
Inflation is rising globally.
The dollar is weak.
US inflation should start to rise as a result.
Housing prices are weak and getting weaker.? Default and delinquency statistics are rising.
The CDO [Collateralized Debt Obligation] problems are still not solved.
Defaults should begin to increase significantly on single-B and CCC-rated corporate debts in 2008.
The TED [Treasury-Eurodollar] spread is still in a panic-type range.
I’m seeing more of my stocks get closer to the upper end of my rebalancing range.? I will begin reducing exposure if the market run persists.? I’m not crazy about the market here, but I am not making any aggressive moves.
There are still significant areas of concern that have not unwound yet — residential housing exposure will increase as housing prices fall further, including lawsuits which will eventually prove not meritorious, and CDO exposure.
It is my firm belief that their hedges hold in minor moves, but not major moves.? VAR modeling is fine for when the winds are calm, but not when they are gale force.? At gale force the Extreme Value Theory models kick in, and they are untested at present.? Berkshire Hathaway’s experience in unwinding GenRe’s swap book was telling; few things were marked conservatively.? That is probably true industrywide, partly because auditors are incapable of audit the swap books in all of their complexity, or they’d be working for the investment banks themselves.
New accounting regulations make earnings quality more opaque, and less comparable across time periods and companies.? This should result in lower multiples, akin to big commercial insurers.
That’s all.? Personally I think the investment banks will be a buy sometime in 2008, but I am waiting to see how the current leverage unwind affects them.
Though I don’t agree with all of his theories, John Hussman did an excellent job describing how little the recent Fed loosening has done for monetary policy. There still has not been a permanent injection of liquidity since May 3rd. The monetary base is flat. The real changes in monetary policy have come through additional leverage at the banks. That comes through explicit policy waivers, policy changes (e.g., permitted collateral at the discount window, removal of stigma), and the “wink, wink, naughty boy” returning to bank exams.
That reflects in the monetary aggregates. M2 and MZM both have moved up smartly since the beginning of the temporary loosening, as have total bank liabilities, which is a good proxy for M3. That said, because LIBOR is high relative to Fed funds, it is less good of a proxy, because banks are less willing to lend unsecured to each other in the Eurodollar markets.
Think of it this way, US Dollar LIBOR has only incorporated 16 basis points of the 50 basis point rate cut, measured from the equilibrium level that existed previous to the latest crisis in 2007. During the rate rise, they moved pretty much in lock-step.
So, things are a little better on the liquidity front in the short-run, but not much better. If the banks begin to become more conservative, just for survival reasons (i.e., more leverage is permitted, but they don’t want to use it), the small effects of regulatory easing will be erased.
Position: none, but while I wrote this, my youngest boy (10) came up to me, and asked me to explain what the stock market was like during 9/11, and during the Great Depression. It is very rewarding to be with my family during the day.
After this, Dr. Jeff Miller of A Dash of Insight pinged me asking me to clarify a little.? My response went like this:
You’re right, I need to be plainer about where I agree with him, and disagree with him, and I’ll probably put that into a post tonight at my blog.? Oddly, his models, from what I can gather, work off of some sort of cash flow yield for valuation, and even have a “don’t fight the Fed” component to them, in addition to momentum.? The reason this is weird, is that from those simple measures, he should be far more bullish, but he is not.? My suspicion is that he assumes that profit margins will mean revert, which they will, but maybe that will happen a lot more slowly than many anticipate.
As for his theory on the Fed, he is off.? The Fed has real impact on the economy through its effect on short term rates, admittedly with a lag, and they can’t fix inverted situations, no matter how low rates go (like Japan).? They affect bank leverage quite a bit, and though not cost-less, it has a real impact on the economy, with less of a lag, unless they go too far.
In essence, Hussman got the data right, and part of the interpretation, but missed increased leverage at the banks, which so long as it is sustainable, will stimulate economic activity.? He also missed that “Don’t fight the Fed” generally works.? I understand his valuation arguments, but he needs to get more sophisticated, and look at relative valuations of stocks to bonds.? Stocks are quite attractive on a relative basis, at least for now.
Monetary policy and its effects are complex, and non-nuanced explanations do a disservice to readers, particularly when the investment prescription is too simplistic.? At present, the Fed has done little to increase the money supply directly, but has encouraged the banks to lend more.? If the banks can tolerate that, then good.? If not, then watch out, because the banks are integral to our credit-based economy.
There is a misunderstanding about contrarianism, that somehow if a lot of people think something, it must be wrong, so take the other side of the trade.? We can make an exception here for some financial journalists, because they are often late to catch onto a story, and thus, the magazine cover indicator often works.
My point here is that intelligent contrarianism does not work off of what market players think, but how much they have invested relative to their investment policy limits, and the capital that they have available to carry the trade.? When there are many investors that have gone maximum long on a given company, that is a situation to either avoid or short, because unless new longs show up, the current longs have no more buying power — it is a crowded trade.
I saw this with housing in 2005, as I wrote a piece on residential real estate that proved prescient.? It drew a lot of controversy, but my point was plain.? Where would additional buying power come from?? In September of 2005, I concluded that we were at the inflection point.? One of my theories about inflection points is that there is no good numerical signal of an inflection point, but qualitative chatter undergoes a shift at the inflection points.? In that case, I had a series of googlebots trawling the web for real estate related chatter.? The tone shifted in September/October of 2005, but it was largely missed by the media and the markets.
Though I have nothing written on the web on the Internet Bubble, the qualitative chatter change that happened in March of 2000 was commentary from a variety of companies that had relied on vendor financing were turned down by their vendors.? That was new, and it indicated a scarcity of cash.? My rule of thumb on bubbles is that they are primarily financing phenomena; bubbles pop when cash flow proves insufficient to finance them.
Now, with both the residential real estate and internet bubbles, there were a bunch of naysayers prior to the bubbles.? Most were way too early.? Keynes observed something to the effect that markets can remain irrational longer than an investor can remain solvent.? Risk control is a key here, as well as cash flow analysis. When does the financing fall apart?? What will the inflection point, with all of its fog, look like?? Where is the weak spot in the financing chain?
Those naysayers were an inadequate reason to take a contrarian position; many of them didn’t have a dog in the fight, aside from intellectual bragging rights.? Rather, the contrarian position was to ask what side had overcommitted relative to their ability to carry the positions, and the ability of others to get financing to buy them out.
Where I differ with many permabears is that I am usually unwilling to extend my logic to second order effects.? Just because one area of the economy is falling apart, doesn’t mean that a related area will of necessity get blasted.? There are dampening effects to almost any economic phenomena, such that you don’t get cascading effects where failure in one area leads to failure in others, leading to a failure of the system as a whole.? The exception is of course the great depression, and that was a situation where the whole economy was overlevered.? We’re not there today, yet…
Okay, one semi-practical application, and then this article ends.? I get a certain amount of pushback for being bearish on the US Dollar.? I’ve been bearish on the US Dollar since mid-2002, when I saw that our monetary and fiscal policy were shifting to aggressive levels of debasement stimulus.? Today I heard someone dismiss further US dollar weakness because “everyone knows that.”? Well, if everyone knows that, tell it to the foreign investors who are stuffed to the gills with US dollar claims (bonds), such that their economies are beginning to suffer higher inflation.? I see a continued crowded trade here, and I am waiting to see where the pain points are, such that foreign central banks begin to intervene to prop up the dollar.? It hasn’t happened yet, and we are within 20 basis points of taking out the all time low in the dollar index, set back in 1992.
