There’s no order to this post, so enjoy my reflections on broader trends that are affecting the markets.
Corn-based ethanol is costly, and a mistake for our government to subsidize it, when we could buy sugar-based ethanol from Brazil. I’m no environmentalist, but even I can see the advantages of eliminating sugar subsidies and quotas here in the US. The only people hurt are some rich farmers that bribe Washington to keep the subsidies. With a little encouragement from the US, Brazil could adopt more environmentally friendly harvesting techniques, while not kicking up costs that much. Such a deal, better economics, and better for the environment.
Stories like this always make me skeptical. Remember cold fusion? Maye there is a real innovation here that produces more energy than it consumes on net. I wouldn’t bet on it, though.
Since the creation of the Earth, farming has been the dominant occupation of man, until now. More people are employed outside of farming, than inside it. This is not big news, except to confirm that what happened to the developed world 80 years ago is happening to the world as a whole now.
ETFs are not open end mutual funds, where there is one price struck per day for liquidity. For small ETFs, the bid-ask spread can be quite wide on small funds. This shouldn’t be too surprising; the same is true of any small stock. If there is demand for an ETF concept, more units will get created as people bid for them, and the bid-ask spread will narrow.
Rationality in markets is misunderstood. You can bring bright people to manage money, and they will still in aggregate become prey to the speculative aspects of the markets. Some will resist it, but most won’t. It is not a question of intelligence, but of discipline.
Give Hersh Shefrin some credit. I think that behavioral finance is a much richer explanation of the markets than modern portfolio theory. MPT exists because it is easily mathematically tractable, which allow professors to publish, and not because it is a correct description of reality.
It’s tough to be an orphan company. Much as I like investing in companies that have no analyst coverage, if they are cheap enough, when a company loses analyst coverage, the stock price typically declines, and often, the company disappears within a few years. Perhaps the lack of analyst coverage is a proxy for the demand for a company to be public, rather than private.
Here’s a good article on why the market crashed in October of 1987. My quick summary for why it happened was that bonds were more attractive relative to stocks, and dynamic hedging left the market unstable, as many player were willing to sell on big down days.
Will junk defaults triple from 2007 to 2008? Seems reasonable to me; given all of the CCC and single-B issuance over the last few years, the companies that have recently issued bonds seem weak to me.
For the last six years, I’ve had a reasonably good call on Federal Reserve policy.? That partly stems from having been an institutional fixed income investor in one way shape or form for fifteen years.? This dates back to my days at Provident Mutual where the company at that point in time left hedging decisions in the hands of the line of business actuaries.? In 1994, I sold GICs (Guaranteed Investment Contracts) like mad after the first Fed tightening, and ran unhedged.? Smooth move at the time, but that was too much power to grant me.? In hindsight, I was a novice then, and it could have gone badly wrong.
But at the present time, my view on the FOMC is cloudy.? It’s cloudy for a few reasons:
Bernanke is new, and we really don’t know his reaction function.
He has granted more autonomy to the Board of Governors to speak their minds, unlike Greenspan.
There are more inflation hawks with voting rights at present than over the past two years.
Using the discount window adds another dimension to the puzzle.? Unless the gap between the discount window and Fed funds is narrowed further, I don’t see it becoming a major factor, unless they further liberalize collateral requirements, and who may use the window.
Now, Bernanke has committed to act to avoid damage to the economy from conditions in the credit markets.? To me, this is important, not because I think the Fed can help the dead and dying — they can’t.? They can help the walking wounded, and overstimulate the healthy.? In the former cases, credit spreads dominate, in the latter credit spreads are still low.? From my angle, the Fed will slowly be forced to recognize that problems developed from speculation in residential real estate, CDOs, overdone arbitrage strategies and private equity are either a) too big to solve through monetary policy, without causing a lot of inflation, or b) they will try to “solve” the problem anyway, and hope that inflation doesn’t rise too much.
There’s no panacea here, and personally, I am not expecting anything too great out of the US equity markets if the Fed starts loosening.? After all, during the tightening cycle, the market rallied, including financials.? That was weird.? Weird things come in bunches; “Don’t fight the Fed” didn’t work last time.? Will it work this time?? Many are assuming that Fed policy will make the markets go because it has done so in the past.? When too many think so, it may not work.
Treasury and Swap rates have fallen enough that we are finally getting mortgage refinancing/hedging activity. 10-year swap spreads are 12 basis points below where they peaked a month ago, and 10-year swap rates, which serve as a proxy for prime 30-year mortgage rates, are 35 basis points below their 18-month moving average. The 10-year swap rate has come down 90 bps since the peak three months ago. Remember the panic then over higher rates? I wish I had put on more then, but I didn’t panic, and my bond positions did well.At present the discount window action is doing little; I struggled to find any mention of it last night. But M2 is showing some life, and my M3 proxy as well… quietly, banks in the Federal Reserve System are expanding their balance sheets, making up for the loss of commercial paper (and mebbe absorbing some collapsing conduits…). But the monetary base is stuck in the mud, and Fed funds averages 5% since the crisis began. Lotsa talk, but not much action.
I would let the long bonds ride here, because mortgage hedging sometimes takes on a life of its own. That doesn’t mean that systemic risk has gone away, but some of it is being hidden by mortgage hedging; interest rate swaps have many uses. You can still see the systemic risk in the TED spread (over 160 bp), and other option implied volatility measures.
For more fun, look at the TIPS market, where inflation protected bonds are outrunning nominal bonds. The longest TIPS is up more than 2% today. Wow. Also, the carry trade currencies (yen/swiss franc) have been running as well.
So, fear is alive and well, and so are prime mortgage bonds. What a fascinating day to watch the bond market in action.
Position: none, my prior bond positions are with the firm that I no longer work for…
Not that I am calling for a recession in 2007, but when a hawk like William Poole says that the odds of a recession are rising, it tells me that the Fed is looking for a reason to cut rates.? With the jobs report on Friday (which I think is over-analyzed relative to its true value), the FOMC may have more reason to cut.? If nothing else, it gives them political cover to cut.
Now, there are bigger issues here, and it is possible to be too shortsighted about current policy.? Efforts to solve the immediate problem can complicate future problems.? Even the actions of the ECB, in doing nothing at their recent meeting, sends a signal that the credit markets are more important than inflation.
Financial crises will always happen, and if we use monetary policy and bank regulation to try to avoid them in entire, we only set ourselves up for larger crises in the future.? (Ask Japan how much it likes low interest rates — they are really stimulative.)? Financial crises eventually end when bad debts are liquidated, or when financing is adequate to make it through.? In this case, the Fed will have a hard time fighting the large increase in debt to GDP.? (Also here.)? Bad loans have been made.? Regulation can deal with future loans to some limited degree, but monetary policy is at best a crude tool to deal with past mistakes.
It is outside the Fed’s mandate from Congress to deal with asset bubbles unless they affect inflation or full employment of labor.? Yet the Fed gets criticism for that.? Maybe Congress should get the criticism.? As it is, most of the current problems are manifesting on the short end of the yield curve, and among non-regulated lenders.? There are some assets that Asset backed commercial paper conduits should never have financed, as the SEC is now probing.? No surprise, though; the BIS saw this coming, after a fashion, and much more clearly than US regulators.? In any case, the problems in short-term lending are difficult to deal with.? Clearly, credit losses need to be taken by lenders who made bad loans; I don’t think that Fed policy can do much about that.
The deeper problem is that financial systems that rely on short-term lending are inherently unstable.? From the end of Alan Abelson’s column this week:
But, Stephanie [Pomboy] sighs, the current credit bust is not confined to real-estate lending. In truth, there are interest rate “resets” galore across the entire economy. Borrowing short has become a raging epidemic. Floating-rate paper now accounts for 54% of total debt issuance, up from 26% as recently as 2002. That means a startling $540 billion in corporate bonds will need to be rolled over next year.
The serial abusers in this realm are — who else? — financial enterprises, who need to replace a tidy $428 billion in debt next year, a third more than this year. In 2008, too, some $160 billion worth of leverage loans mature.
To top off this orgy of borrowing short, there’s the $87 trillion interest-rate swaps market. Essentially, she explains, here’s where long-term fixed-rate obligations are converted into floating-rate short-term notes. Swaps, Stephanie reports, accounted for more than half the growth in the $145 trillion derivatives market in the past two years.
What she foresees is a kind of financial Armageddon as the credit crunch deepens and widens. “Scarcely will they finish putting the subprime situation under house arrest” before policymakers will be forced to address similar problems in “credit-card debt, commercial-real-estate loans, CLOs…and beyond.”
As the credit engine sputters, the repair crew will be forced to “print and spend.” That, she says, is what gold has figured out. And what equities, we might add, are only beginning to learn.
Now, ignore the derivatives to a degree, because for every long there is a short.? So long as the counterparty risk management of the investment banks works, there should be no reason to worry.? (I wonder about this, but know that the investment banks are trying to manage this.)? The increasing prevalence of floating rate finance should make the system more sensitive to Fed policy, but even more to LIBOR in the Eurodollar-markets, which the Fed can’t directly affect.? That doesn’t mean that they won’t try, though, and to me, it indicates that he Fed will cut rates significantly through 2008, assuming that inflation or a rapidly falling dollar doesn’t intervene.
We live in interesting times.? I think that there is an inflation bias here, and that investors should prepare for it.
When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.
Onto longer-dated topics:
Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.
I have enough for two more pieces on longer dated data.? It will have to come later.
Sometimes I think that the Keynesian and Austrian Schools of economic thought can be merged into a consistent synthesis that would disagree about the goals of policy, but largely agree on how economies work.? One of the men that would help promote such an idea would be Hyman Minsky.
One of the beauties of capitalist economies is that they are dynamically unstable.? Businessmen as a whole for a variety of reasons tend to over- and underestimate the desirability of doing business as a group.? There at least two reasons for this.? First, there is trend-following, because success by one businessman causes others to try it, until it is overdone, then a large number of businessmen drop out, setting the stage for the next cycle.? Second there are shocks correlated across the system, whether it is monetary policy (too high/low for too long), tariffs, tax changes, wars, technological shifts, etc.
This instability is actually a plus for the system, because each period of failure creates the seeds for the next round of success, as vulture investors pick over the assets of failed firms and redeploy them to longer lasting practical uses.? The decks have to be cleared of bad ideas every now and then, or else the marginal efficiency of capital declines, along with overall interest rates.
But central banks prolong cycles by bailing out marginal ideas and not letting them purge, also creating a culture where risk is not respected, because the central bank will ride to the rescue.? Today, we are at such a “Minsky Moment,” where we rescue the marginal, and overleverage some currently healthy segments of the economy, while housing-related and high-yield related items die a lingering death.? We will likely set up the seeds of the next bubble in the next year, while we reconcile only the most egregious of business ideas.? (Amazing how many real estate agents and mortgage loan brokers there are, huh?? Same for investment bankers… time to redirect these bright people to solving operational business problems, and away from financing issues.)
Now, maybe this time we run into the brick wall, where inflation rises amid weak business conditions, as it did in the 70s.? At that point, the economy will take the pain.? Bernanke will keep the economy from a 30s experience, but possibly at the price of a 70s experience.? After all, which would you rather have, depression or stagflation??? Both are unpopular words, and I hate dragging them out, but if the price of avoid Depression is Stagflation, the present FOMC will take that cost.
