Yesterday, almost everything sold off. There are some folks who question the idea of "window dressing" at the end of a quarter, but if you watched the action today, there was little doubt that some games were being played.
We ran up on very light volume, and then almost exactly at the start of the last hour, the profit-taking kicked in. Traders who had enjoyed the artificial run-up, and who didn't care about mark-ups, wanted to put the profits on the books before the day ended. They did exactly that in an aggressive fashion and took us well off the intraday highs.
We still managed a pretty good point gain, and breadth was better than 2 to 1 positive, but sharp intraday reversals like we saw in the last hour are not bullish. It indicates that buying power is faltering and that recent buyers are looking for exits.
In the bigger scheme of things, the market needs some further consolidation. The mark-up this afternoon was not particularly healthy from a technical standpoint, and we'll be better off in the intermediate term if we consolidate, or even pull back, more.
Better trading is being seen, but time frames are still very short term. While there is a little momentum in places, there are also plenty of fast reversals due to flippers. Hopefully, we will continue to find some underlying support that allows good setups to continue to form.
Tuesday, March 31, 2009
Once Again: Worldwide, How Bad Are Things, Really?
Times can always be classified as bad: There will always be war, geopolitical tensions, famine. BUT, as bad as things are perceived to be worldwide, for the first time in history more than half the world is middle class - thanks to rapid growth in emerging countries. Obviously "middle class" is a matter of definition.
The middle class's share of the whole world's population rose from 1/3 to over 1/2 (57%) between 1990 and 2006, according to The Economist, hardly a publication that lavishes undue praise.
Over the next 2 or 3 decades, an expanding global middle class could/should boost economic growth and encourage something that at least looks like western-style democracy. It could also press for global public goods, such as tighter controls on pollution, etc.
The global recession WILL end. It seems entirely reasonable to expect the engine of middle-class formation to start humming again when growth picks up.
A major leap forward in continuing this trend would be the further empowerment of women worldwide, which of course is the absolute key to diminishing the forces of poverty. It can be done; it IS being done; let's hope it continues.
The middle class's share of the whole world's population rose from 1/3 to over 1/2 (57%) between 1990 and 2006, according to The Economist, hardly a publication that lavishes undue praise.
Over the next 2 or 3 decades, an expanding global middle class could/should boost economic growth and encourage something that at least looks like western-style democracy. It could also press for global public goods, such as tighter controls on pollution, etc.
The global recession WILL end. It seems entirely reasonable to expect the engine of middle-class formation to start humming again when growth picks up.
A major leap forward in continuing this trend would be the further empowerment of women worldwide, which of course is the absolute key to diminishing the forces of poverty. It can be done; it IS being done; let's hope it continues.
Some Reasons Why I'm Currently Bullish On The U.S. Stock Market
March was a good month. The good news is that few, if any, believe a sustainable market rise is on the horizon. Rather, the almost universal view is that the rally from the March low was a classical bear market rally.
I respectfully demur and take the variant view that the March low was of major significance, and as Kass on Real Money has stated, likely a generational low.
Why? Housing. Housing, which was at the epicenter of our economy's woes and, through a variety of recipes (of a derivative kind), nearly bankrupted the world's financial systems. The prevailing and consensus view is that home prices will decline another 10% to 20% and that a swollen inventory of unsold homes will weigh on the industry's stabilization/recovery through 2010.
Frankly, I disagree.
The health of the housing markets is dependent on six key factors:
1. the level of interest rates;
2. employment;
3. the economic situation and outlook;
4. demographics (population growth and household formations);
5. affordability; and
6. the relationship of the cost of home ownership to renting.
With public policy targeted at lowering mortgage rates and stabilizing the jobs market and economy (seen by late 2009 or early 2010), a better backdrop for housing is in sight, but what most observers are missing is the current massive improvement in affordability and a major tilt in favor of home ownership over renting.
As seen by the two metrics below, affordability has dramatically improved:
1. Median existing and new home prices divided by median incomes are now at levels last seen about 10 years ago.
2. Median home prices to disposable income (admittedly skewed by higher net worth individuals) is now at 40-year lows.
If the cost of owning a home is no different than renting a home, then the tax, psychic benefits of ownership, and so forth will result in an improving demand component for housing.
Such is the case today.
Setting the Case-Shiller Home Ownership Cost Index to the Owners Equivalent Rent in 2000 to 1.0 times yields the following conclusions:
* The cost of home ownership in March 2009 is only 13% higher than the cost of renting a home. This ratio compares to a 73% higher cost of home ownership vs. renting at housing's cyclical peak in 2006.
* If we take out the high ownership cost/rental cost cities of Miami, New York City and Washington, D.C., then the national cost of home ownership is now equivalent to renting.
No doubt, a vigorous recovery in housing awaits improving consumer confidence and stability in the employment and economic picture. These conditions are all dependent on the degree to which policies gain economic traction in the last half of 2009.
Nevertheless, the improvement in affordability and the benefit of home ownership over renting holds even more significance over the near term.
I am bullish on housing, and I am bullish on the U.S. stock market. This week is an important one - the market reaction to quarter-end; the ratification vote on Thursday for proposed changes in FAS 157; and the employment report on Friday will tell us volumes.
I respectfully demur and take the variant view that the March low was of major significance, and as Kass on Real Money has stated, likely a generational low.
Why? Housing. Housing, which was at the epicenter of our economy's woes and, through a variety of recipes (of a derivative kind), nearly bankrupted the world's financial systems. The prevailing and consensus view is that home prices will decline another 10% to 20% and that a swollen inventory of unsold homes will weigh on the industry's stabilization/recovery through 2010.
Frankly, I disagree.
The health of the housing markets is dependent on six key factors:
1. the level of interest rates;
2. employment;
3. the economic situation and outlook;
4. demographics (population growth and household formations);
5. affordability; and
6. the relationship of the cost of home ownership to renting.
With public policy targeted at lowering mortgage rates and stabilizing the jobs market and economy (seen by late 2009 or early 2010), a better backdrop for housing is in sight, but what most observers are missing is the current massive improvement in affordability and a major tilt in favor of home ownership over renting.
As seen by the two metrics below, affordability has dramatically improved:
1. Median existing and new home prices divided by median incomes are now at levels last seen about 10 years ago.
2. Median home prices to disposable income (admittedly skewed by higher net worth individuals) is now at 40-year lows.
If the cost of owning a home is no different than renting a home, then the tax, psychic benefits of ownership, and so forth will result in an improving demand component for housing.
Such is the case today.
Setting the Case-Shiller Home Ownership Cost Index to the Owners Equivalent Rent in 2000 to 1.0 times yields the following conclusions:
* The cost of home ownership in March 2009 is only 13% higher than the cost of renting a home. This ratio compares to a 73% higher cost of home ownership vs. renting at housing's cyclical peak in 2006.
* If we take out the high ownership cost/rental cost cities of Miami, New York City and Washington, D.C., then the national cost of home ownership is now equivalent to renting.
No doubt, a vigorous recovery in housing awaits improving consumer confidence and stability in the employment and economic picture. These conditions are all dependent on the degree to which policies gain economic traction in the last half of 2009.
Nevertheless, the improvement in affordability and the benefit of home ownership over renting holds even more significance over the near term.
I am bullish on housing, and I am bullish on the U.S. stock market. This week is an important one - the market reaction to quarter-end; the ratification vote on Thursday for proposed changes in FAS 157; and the employment report on Friday will tell us volumes.
From Bloomberg: Financial Rescue Approaches GDP As US Pledges About $13 Trillion
The following story is from Bloomberg; what catches my eye is that as bad as things are right now, and they are bad - the amount pledged by the feds is still just one year's economic activity - AND A DOWN YEAR AT THAT!
The U.S. government and the Federal Reserve have spent, lent or guaranteed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s.
New pledges from the Fed, the Treasury Department and the Federal Deposit Insurance Corp. include $1 trillion for the Public-Private Investment Program, designed to help investors buy distressed loans and other assets from U.S. banks. The money works out to $42,105 for every man, woman and child in the U.S. and 14 times the $899.8 billion of currency in circulation. The nation’s gross domestic product was $14.2 trillion in 2008.
President Barack Obama and Treasury Secretary Timothy Geithner met with the chief executives of the nation’s 12 biggest banks on March 27 at the White House to enlist their support to thaw a 20-month freeze in bank lending.
“The president and Treasury Secretary Geithner have said they will do what it takes,” Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein said after the meeting. “If it is enough, that will be great. If it is not enough, they will have to do more.”
Commitments include a $500 billion line of credit to the FDIC from the government’s coffers that will enable the agency to guarantee as much as $2 trillion worth of debt for participants in the Term Asset-Backed Lending Facility and the Public-Private Investment Program. FDIC Chairman Sheila Bair warned that the insurance fund to protect customer deposits at U.S. banks could dry up because of bank failures.
‘Within an Eyelash’
The combined commitment has increased by 73 percent since November, when Bloomberg first estimated the funding, loans and guarantees at $7.4 trillion.
“The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets,” said Dana Johnson, chief economist for Comerica Bank in Dallas.
“Everything the Fed, the FDIC and the Treasury do doesn’t always work out right but back in October we came within an eyelash of having a truly horrible collapse of our financial system, said Johnson, a former Fed senior economist. “They used their creativity to help the worst-case scenario from unfolding and I’m awfully glad they did it.”
The following table details how the Fed and the government have committed the money on behalf of American taxpayers over the past 20 months, according to data compiled by Bloomberg.
===========================================================
--- Amounts (Billions)---
Limit Current
===========================================================
Total $12,798.14 $4,169.71
-----------------------------------------------------------
Federal Reserve Total $7,765.64 $1,678.71
Primary Credit Discount $110.74 $61.31
Secondary Credit $0.19 $1.00
Primary dealer and others $147.00 $20.18
ABCP Liquidity $152.11 $6.85
AIG Credit $60.00 $43.19
Net Portfolio CP Funding $1,800.00 $241.31
Maiden Lane (Bear Stearns) $29.50 $28.82
Maiden Lane II (AIG) $22.50 $18.54
Maiden Lane III (AIG) $30.00 $24.04
Term Securities Lending $250.00 $88.55
Term Auction Facility $900.00 $468.59
Securities lending overnight $10.00 $4.41
Term Asset-Backed Loan Facility $900.00 $4.71
Currency Swaps/Other Assets $606.00 $377.87
MMIFF $540.00 $0.00
GSE Debt Purchases $600.00 $50.39
GSE Mortgage-Backed Securities $1,000.00 $236.16
Citigroup Bailout Fed Portion $220.40 $0.00
Bank of America Bailout $87.20 $0.00
Commitment to Buy Treasuries $300.00 $7.50
-----------------------------------------------------------
FDIC Total $2,038.50 $357.50
Public-Private Investment* $500.00 0.00
FDIC Liquidity Guarantees $1,400.00 $316.50
GE $126.00 $41.00
Citigroup Bailout FDIC $10.00 $0.00
Bank of America Bailout FDIC $2.50 $0.00
-----------------------------------------------------------
Treasury Total $2,694.00 $1,833.50
TARP $700.00 $599.50
Tax Break for Banks $29.00 $29.00
Stimulus Package (Bush) $168.00 $168.00
Stimulus II (Obama) $787.00 $787.00
Treasury Exchange Stabilization $50.00 $50.00
Student Loan Purchases $60.00 $0.00
Support for Fannie/Freddie $400.00 $200.00
Line of Credit for FDIC* $500.00 $0.00
-----------------------------------------------------------
HUD Total $300.00 $300.00
Hope for Homeowners FHA $300.00 $300.00
-----------------------------------------------------------
The FDIC’s commitment to guarantee lending under the
Legacy Loan Program and the Legacy Asset Program includes a $500
billion line of credit from the U.S. Treasury.
The U.S. government and the Federal Reserve have spent, lent or guaranteed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s.
New pledges from the Fed, the Treasury Department and the Federal Deposit Insurance Corp. include $1 trillion for the Public-Private Investment Program, designed to help investors buy distressed loans and other assets from U.S. banks. The money works out to $42,105 for every man, woman and child in the U.S. and 14 times the $899.8 billion of currency in circulation. The nation’s gross domestic product was $14.2 trillion in 2008.
President Barack Obama and Treasury Secretary Timothy Geithner met with the chief executives of the nation’s 12 biggest banks on March 27 at the White House to enlist their support to thaw a 20-month freeze in bank lending.
“The president and Treasury Secretary Geithner have said they will do what it takes,” Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein said after the meeting. “If it is enough, that will be great. If it is not enough, they will have to do more.”
Commitments include a $500 billion line of credit to the FDIC from the government’s coffers that will enable the agency to guarantee as much as $2 trillion worth of debt for participants in the Term Asset-Backed Lending Facility and the Public-Private Investment Program. FDIC Chairman Sheila Bair warned that the insurance fund to protect customer deposits at U.S. banks could dry up because of bank failures.
‘Within an Eyelash’
The combined commitment has increased by 73 percent since November, when Bloomberg first estimated the funding, loans and guarantees at $7.4 trillion.
“The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets,” said Dana Johnson, chief economist for Comerica Bank in Dallas.
“Everything the Fed, the FDIC and the Treasury do doesn’t always work out right but back in October we came within an eyelash of having a truly horrible collapse of our financial system, said Johnson, a former Fed senior economist. “They used their creativity to help the worst-case scenario from unfolding and I’m awfully glad they did it.”
The following table details how the Fed and the government have committed the money on behalf of American taxpayers over the past 20 months, according to data compiled by Bloomberg.
===========================================================
--- Amounts (Billions)---
Limit Current
===========================================================
Total $12,798.14 $4,169.71
-----------------------------------------------------------
Federal Reserve Total $7,765.64 $1,678.71
Primary Credit Discount $110.74 $61.31
Secondary Credit $0.19 $1.00
Primary dealer and others $147.00 $20.18
ABCP Liquidity $152.11 $6.85
AIG Credit $60.00 $43.19
Net Portfolio CP Funding $1,800.00 $241.31
Maiden Lane (Bear Stearns) $29.50 $28.82
Maiden Lane II (AIG) $22.50 $18.54
Maiden Lane III (AIG) $30.00 $24.04
Term Securities Lending $250.00 $88.55
Term Auction Facility $900.00 $468.59
Securities lending overnight $10.00 $4.41
Term Asset-Backed Loan Facility $900.00 $4.71
Currency Swaps/Other Assets $606.00 $377.87
MMIFF $540.00 $0.00
GSE Debt Purchases $600.00 $50.39
GSE Mortgage-Backed Securities $1,000.00 $236.16
Citigroup Bailout Fed Portion $220.40 $0.00
Bank of America Bailout $87.20 $0.00
Commitment to Buy Treasuries $300.00 $7.50
-----------------------------------------------------------
FDIC Total $2,038.50 $357.50
Public-Private Investment* $500.00 0.00
FDIC Liquidity Guarantees $1,400.00 $316.50
GE $126.00 $41.00
Citigroup Bailout FDIC $10.00 $0.00
Bank of America Bailout FDIC $2.50 $0.00
-----------------------------------------------------------
Treasury Total $2,694.00 $1,833.50
TARP $700.00 $599.50
Tax Break for Banks $29.00 $29.00
Stimulus Package (Bush) $168.00 $168.00
Stimulus II (Obama) $787.00 $787.00
Treasury Exchange Stabilization $50.00 $50.00
Student Loan Purchases $60.00 $0.00
Support for Fannie/Freddie $400.00 $200.00
Line of Credit for FDIC* $500.00 $0.00
-----------------------------------------------------------
HUD Total $300.00 $300.00
Hope for Homeowners FHA $300.00 $300.00
-----------------------------------------------------------
The FDIC’s commitment to guarantee lending under the
Legacy Loan Program and the Legacy Asset Program includes a $500
billion line of credit from the U.S. Treasury.
Is The Dollar's Relative Strength Real Or Illusionary?
With the U.S. dollar index trading in the low 70s through much of 2008, the Bush administration’s so called ‘strong dollar’ policy had become a running joke. But the weak U.S. dollar served an important function, lubricating the global economy, and was one of the main propellants of the rise in commodity and equity prices. It took the bursting of the housing and credit bubbles and the resulting flight to quality to make the U.S. strong dollar policy real.
Because people needed to raise cash immediately, they panicked and liquidated the only other asset they had: their investments. And for most people, 90% of that is stocks and bonds. Everyone now thinks it’s the end of the world financially and they are jamming money into cash assets, creating demand for dollars. But the fundamentals of the dollar are worse now than when it was making record lows. The immediate effect of that panic selling has been an undervalued stock market and a temporary and artificial demand for dollars.
But even if the U.S. dollar is fundamentally weak, all the other currencies may be weaker and there are many traders who are bullish on the U.S. dollar longer term.
The odds remain in favor of U.S. dollar strength, despite the fact that the fundamental picture remains, for the time being, pretty bleak for the U.S. When one takes into consideration how bad things look in other regions, like the euro zone, the UK and Japan , it’s not quite as bad. One has to keep that in perspective. The most important factor determining U.S. dollar strength is increasing risk aversion, which favors continuing dollar strength.
One top-down global-macro theme is global rebalancing. The global economy is readjusting from over production by the surplus-side countries, such as China, and over consumption from the deficit-side countries, such as the United States. The rebalancing process is probably hurting China and the surplus countries more than it’s hurting a country like the United States.
Conventional wisdom is that considering the immense increase in U.S. trade and budget deficits, China , Japan and other countries could lose their appetite for U.S. Treasuries, the sales of which are necessary to fund U.S. government operations and the expanding menu of bailouts and other interventions.
But the United States is not the only country bailing out financial institutions, offering stimulus packages and increasing debt issuance to pay for those efforts. Everything will be fine with these debt issues until it’s not fine and one of these Treasury auctions fails. We have had the last two 10-year German bund auctions fail; they did not attract as much demand as was on offer. On the other hand, struggling countries like Greece and Portugal have had successful 10-year auctions because of higher yields. There is a trillion to a trillion-and-a-half dollars in U.S. debt being offered this year at a minimum. That’s a lot and it should be watched very closely to make sure demand is there and at what price.
A high level of debt issuance has typically preceded inflationary periods or a devaluing of the currency, and considering President Barack Obama’s unprecedented $3.6 trillion budget, many people are concerned about hyperinflation in the medium and long term, as evidenced in the rapid rise in the price of gold and other safe haven investments. And then there is the doomsday scenario in which China could stop adding to, or dump, its U.S. Treasury holdings, crushing the U.S. economy.
The argument is that with the breakdown of export markets, China could elect to spend on its own infrastructure needs, developing domestic consumption and managing rising unemployment. That’s unlikely. Buying Treasuries has been the best investment they could have made. The dollar has gone up 25%. Treasuries have soared with risk aversion.
If the Chinese did sell, it would be a nightmare, but demand eventually would be replaced, because the U.S. savings rate has typically risen during times of economic dislocations to between 6% and 8% of gross domestic product. The savings rate in this country could approach 10% in the coming years. With U.S. GDP at roughly $13 trillion, that would eventually balance the $1.3 trillion in FX reserves in Asia . You won’t have massive over production in China and you won’t have massive over consumption in the U.S. You will have more balanced global growth.
Despite the seven-year bear market the world’s reserve currency is still the dollar. The penetration of dollar credit has actually increased. As the dollar starts to revalue, and it’s already started, we will be over 70% held in U.S. dollars; so the dollar’s status is not in jeopardy. Second, where else do you go? The pound is history, in this cycle at least. Further, the European monetary union could unwind due to widening bond spreads. Portugal, Italy, Greece and Spain, they are fiscal basket cases. A few years ago, the spread between Portugal and Germany was maybe 20 basis points. Now it’s 650 basis points.
Across the world, central banks have been cutting interest rates aggressively, and many have created bailout and stimulus plans. The notable exception is the European Central Bank (ECB), which has been reticent to lower interest rates. One reason is that the ECB is responsible only for managing inflation to below 2%. Promoting growth is the responsibility of 16 individual member nations. Talk about a structural recipe for disaster....
The euro experiment is one of the most significant financial events in financial history. It has, up to this point at least, accomplished something that people have tried to do for centuries, which is to unify them against the underlying reason people fight wars: money. But European banks had huge exposure to U.S. mortgage backed securities and now there is growing concern about exposure to emerging markets, where there has been $4.3 trillion of international bank lending, $3.7 trillion of which belongs to European banks compared with just $675 billion for U.S. banks.
Look at Austria . They have the largest commitment in terms of the banking sector. Those countries have borrowed heavily over the past decade. With the credit conditions we are seeing and the economic downturns in these economies, it’s going to be difficult to roll over some of that debt. The euro zone is entering a deeper downturn than what the United States has already experienced because of the lack of fiscal stimulus and flexibility in the labor force and credit system.
The emerging market is starving for cash. The IMF has said they don’t have enough money to keep them afloat if something else happens. One more hit to the equity side, which is still a major collateral value for these emerging markets, and you are going to see some defaults, namely Ukraine, Serbia, Hungary and Argentina. Ecuador has already defaulted on a bond tranche. That’s the soft underbelly of the euro. Not that the United States can talk, but from a relative basis, it wins by default.
The British pound was the first major currency to break against the dollar because it was most leveraged against the financial services. When the credit crunch hit, which was the game changer — no more derivatives production and more regulation — it hit them the hardest. And it’s an inordinate hit because most of the discretionary income comes out of London and their consumers had even more debt than in the United States.
From a growth perspective, the British pound may be in the most dire position. For a long time people thought London was the new financial capital of the world, but all that was built on a huge increase in leverage and all of these derivatives. With the collapse, job losses have been heavy and housing values have dropped significantly. Everything related to finance has fallen apart, and now exports, especially to the euro zone, have plummeted as well, which will hurt the trade balance and manufacturers.
During the flight to quality, the Japanese yen has maintained its value against the U.S. dollar better than most other currencies. This is due to Japan’s persistently low interest rates and declining yield differentials as other central banks lowered rates to stimulate their economies. Those moves also prompted the unwinding of the yen carry trade, in which people borrowed yen to invest where returns are higher.
The U.S. dollar and the Japanese yen have been trading hand in hand for a while, but ultimately we may see it lower, at around 90. We are at 94 right now. April will be a tumultuous time because of the number of earnings reports. That will be a good barometer for how financial institutions are faring. If we do see that those banks are still accumulating a lot of losses, that could lead to the Japanese yen crossing to trade lower.
The repatriation of Japanese assets has led to exporters now being over hedged, and that could end relatively soon. In addition to lower demand for consumer goods around the world, a stronger yen has made Japanese exports more expensive. As a result, Japan’s annualized fourth quarter GDP was a staggeringly negative 12%. Further yen buying from exporters is going to diminish. And as the global outlook begins to stabilize, asset managers, having just brought home all that money, are going to be looking for opportunities to send it back out.
Exports from Asia have fallen off by 30% to 40% and thousands of factories in China have closed. Their official urban unemployment rate is 4.8%; unofficially it’s 10%. They are still clinging to an official growth rate of 8% per year, but a more likely figure is under 5%.
Investment may flow into Europe faster than it will flow into the United States, in part because of the interest rate differential. Perversely, an economic recovery could be a triggering event for the U.S. dollar to reverse, as it would reduce demand for safe havens.
If the stock markets bottom, that might weaken the dollar. They don’t always go hand in hand. Despite bleak fundamentals, odds favor continuing dollar strength. A winner in a deep recession/depression has to have a modicum of demand base. And we still have the best consumer base in the world, even though it doesn’t have much to consume with right now. One has to have flexible monetary and fiscal policy. We sure have that, they change it every day! Something will stick and eventually we will get it right. You have to have a capital-funding source. And we have the deepest capital markets in the world. You still have to have flexibility on the labor side, and we have that. From all those standpoints, and it’s all relative, the U.S. wins that game.
Because people needed to raise cash immediately, they panicked and liquidated the only other asset they had: their investments. And for most people, 90% of that is stocks and bonds. Everyone now thinks it’s the end of the world financially and they are jamming money into cash assets, creating demand for dollars. But the fundamentals of the dollar are worse now than when it was making record lows. The immediate effect of that panic selling has been an undervalued stock market and a temporary and artificial demand for dollars.
But even if the U.S. dollar is fundamentally weak, all the other currencies may be weaker and there are many traders who are bullish on the U.S. dollar longer term.
The odds remain in favor of U.S. dollar strength, despite the fact that the fundamental picture remains, for the time being, pretty bleak for the U.S. When one takes into consideration how bad things look in other regions, like the euro zone, the UK and Japan , it’s not quite as bad. One has to keep that in perspective. The most important factor determining U.S. dollar strength is increasing risk aversion, which favors continuing dollar strength.
One top-down global-macro theme is global rebalancing. The global economy is readjusting from over production by the surplus-side countries, such as China, and over consumption from the deficit-side countries, such as the United States. The rebalancing process is probably hurting China and the surplus countries more than it’s hurting a country like the United States.
Conventional wisdom is that considering the immense increase in U.S. trade and budget deficits, China , Japan and other countries could lose their appetite for U.S. Treasuries, the sales of which are necessary to fund U.S. government operations and the expanding menu of bailouts and other interventions.
But the United States is not the only country bailing out financial institutions, offering stimulus packages and increasing debt issuance to pay for those efforts. Everything will be fine with these debt issues until it’s not fine and one of these Treasury auctions fails. We have had the last two 10-year German bund auctions fail; they did not attract as much demand as was on offer. On the other hand, struggling countries like Greece and Portugal have had successful 10-year auctions because of higher yields. There is a trillion to a trillion-and-a-half dollars in U.S. debt being offered this year at a minimum. That’s a lot and it should be watched very closely to make sure demand is there and at what price.
A high level of debt issuance has typically preceded inflationary periods or a devaluing of the currency, and considering President Barack Obama’s unprecedented $3.6 trillion budget, many people are concerned about hyperinflation in the medium and long term, as evidenced in the rapid rise in the price of gold and other safe haven investments. And then there is the doomsday scenario in which China could stop adding to, or dump, its U.S. Treasury holdings, crushing the U.S. economy.
The argument is that with the breakdown of export markets, China could elect to spend on its own infrastructure needs, developing domestic consumption and managing rising unemployment. That’s unlikely. Buying Treasuries has been the best investment they could have made. The dollar has gone up 25%. Treasuries have soared with risk aversion.
If the Chinese did sell, it would be a nightmare, but demand eventually would be replaced, because the U.S. savings rate has typically risen during times of economic dislocations to between 6% and 8% of gross domestic product. The savings rate in this country could approach 10% in the coming years. With U.S. GDP at roughly $13 trillion, that would eventually balance the $1.3 trillion in FX reserves in Asia . You won’t have massive over production in China and you won’t have massive over consumption in the U.S. You will have more balanced global growth.
Despite the seven-year bear market the world’s reserve currency is still the dollar. The penetration of dollar credit has actually increased. As the dollar starts to revalue, and it’s already started, we will be over 70% held in U.S. dollars; so the dollar’s status is not in jeopardy. Second, where else do you go? The pound is history, in this cycle at least. Further, the European monetary union could unwind due to widening bond spreads. Portugal, Italy, Greece and Spain, they are fiscal basket cases. A few years ago, the spread between Portugal and Germany was maybe 20 basis points. Now it’s 650 basis points.
Across the world, central banks have been cutting interest rates aggressively, and many have created bailout and stimulus plans. The notable exception is the European Central Bank (ECB), which has been reticent to lower interest rates. One reason is that the ECB is responsible only for managing inflation to below 2%. Promoting growth is the responsibility of 16 individual member nations. Talk about a structural recipe for disaster....
The euro experiment is one of the most significant financial events in financial history. It has, up to this point at least, accomplished something that people have tried to do for centuries, which is to unify them against the underlying reason people fight wars: money. But European banks had huge exposure to U.S. mortgage backed securities and now there is growing concern about exposure to emerging markets, where there has been $4.3 trillion of international bank lending, $3.7 trillion of which belongs to European banks compared with just $675 billion for U.S. banks.
Look at Austria . They have the largest commitment in terms of the banking sector. Those countries have borrowed heavily over the past decade. With the credit conditions we are seeing and the economic downturns in these economies, it’s going to be difficult to roll over some of that debt. The euro zone is entering a deeper downturn than what the United States has already experienced because of the lack of fiscal stimulus and flexibility in the labor force and credit system.
The emerging market is starving for cash. The IMF has said they don’t have enough money to keep them afloat if something else happens. One more hit to the equity side, which is still a major collateral value for these emerging markets, and you are going to see some defaults, namely Ukraine, Serbia, Hungary and Argentina. Ecuador has already defaulted on a bond tranche. That’s the soft underbelly of the euro. Not that the United States can talk, but from a relative basis, it wins by default.
The British pound was the first major currency to break against the dollar because it was most leveraged against the financial services. When the credit crunch hit, which was the game changer — no more derivatives production and more regulation — it hit them the hardest. And it’s an inordinate hit because most of the discretionary income comes out of London and their consumers had even more debt than in the United States.
From a growth perspective, the British pound may be in the most dire position. For a long time people thought London was the new financial capital of the world, but all that was built on a huge increase in leverage and all of these derivatives. With the collapse, job losses have been heavy and housing values have dropped significantly. Everything related to finance has fallen apart, and now exports, especially to the euro zone, have plummeted as well, which will hurt the trade balance and manufacturers.
During the flight to quality, the Japanese yen has maintained its value against the U.S. dollar better than most other currencies. This is due to Japan’s persistently low interest rates and declining yield differentials as other central banks lowered rates to stimulate their economies. Those moves also prompted the unwinding of the yen carry trade, in which people borrowed yen to invest where returns are higher.
The U.S. dollar and the Japanese yen have been trading hand in hand for a while, but ultimately we may see it lower, at around 90. We are at 94 right now. April will be a tumultuous time because of the number of earnings reports. That will be a good barometer for how financial institutions are faring. If we do see that those banks are still accumulating a lot of losses, that could lead to the Japanese yen crossing to trade lower.
The repatriation of Japanese assets has led to exporters now being over hedged, and that could end relatively soon. In addition to lower demand for consumer goods around the world, a stronger yen has made Japanese exports more expensive. As a result, Japan’s annualized fourth quarter GDP was a staggeringly negative 12%. Further yen buying from exporters is going to diminish. And as the global outlook begins to stabilize, asset managers, having just brought home all that money, are going to be looking for opportunities to send it back out.
Exports from Asia have fallen off by 30% to 40% and thousands of factories in China have closed. Their official urban unemployment rate is 4.8%; unofficially it’s 10%. They are still clinging to an official growth rate of 8% per year, but a more likely figure is under 5%.
Investment may flow into Europe faster than it will flow into the United States, in part because of the interest rate differential. Perversely, an economic recovery could be a triggering event for the U.S. dollar to reverse, as it would reduce demand for safe havens.
If the stock markets bottom, that might weaken the dollar. They don’t always go hand in hand. Despite bleak fundamentals, odds favor continuing dollar strength. A winner in a deep recession/depression has to have a modicum of demand base. And we still have the best consumer base in the world, even though it doesn’t have much to consume with right now. One has to have flexible monetary and fiscal policy. We sure have that, they change it every day! Something will stick and eventually we will get it right. You have to have a capital-funding source. And we have the deepest capital markets in the world. You still have to have flexibility on the labor side, and we have that. From all those standpoints, and it’s all relative, the U.S. wins that game.
Monday, March 30, 2009
Just A Few More Thoughts For Today
Some thoughts on today's news that our government is now telling automobile companies how to run their business.
It seems to me that the vast majority of folks are not at all concerned with the change in course we have just taken with respect to the relationship between private business enterprise and our federal government. In fact, some are just downright giddy about all the long-overdue changes that are finally taking place. They trust big government to wage the war against the excesses of capitalism and all the greedy bastards on Wall Street.
Over the past several years, the excesses of various industries, companies, business leaders and individuals have all coalesced into one big chaotic mess of too much leverage and too little sense of responsibility. But that's the nature of humanity. As imperfect beings, we tend to get caught up in our own greed, narcissism and ambition. Like it or not, that's just what people tend to do.
Here in America, our system of government was set up to create an orderly structure that balanced the benefit of individual freedom against the burden created by the simple fact that not everyone is nice or plays fair. When the government doesn't do enough...the "not-so-nice" (or "not-so-smart") people have too much leeway to fuck things up, and their excesses negatively impact everyone. Not good. But because our government is made up of imperfect individuals, there is always a danger that government will go too far. The danger of an overreaching government was addressed extensively in our founding documents (Constitution, Bill of Rights, etc.) The focus was on protecting and preserving individual liberty...and an omnipotent and wide reaching government run by imperfect individuals was seen as a threat to individual liberty.
Hopefully I'll just say this once. Our government has stepped over the line. Way over the line. It is both pitiful and frightening to witness the unprecedented expansion of government influence and power occur in an atmosphere of applause by seemingly intelligent and enlightened people. Many eagerly sidestep the basic question of whether the government is empowered to do what it is doing.
Those who just want to "give it a chance" (whatever "it" may be) reveal themselves to be poor students of history. Every time...every single time...a government has engaged in the kind of actions currently being undertaken by our administration, it has ended badly. Massive inflation (which may or may not happen this time), an exodus of capital, a decline in competitiveness, and an expansion of the State. Simply put, big government is bad for business. And what's bad for business is bad for all of us.
Yes, our government must play a role in regulating business to strike a reasonable balance between individual liberty and the need for an orderly society. But it is my firm belief that those who are not alarmed on a visceral level by what is happening now are simply not seeing the big picture.
If you don't understand the basic framework of our system of government, then you're focused solely on what's "right" or "wrong." But if you do truly understand the "balance of power" between the three federal branches, the states, and ultimately the individuals, then you likely realize that arriving at the "right solution" is always the goal. But if you take the wrong road to get there, then it is a Phyrric victory.
The "powers that be" in Washington D.C. are taking the wrong road...simply because no one can stop them and it is politically expedient to do so. History will show that this is a dangerous victory.
A salient question: Why are American Eagle .45 ACPs now $31/box when they were just $19 last month?
Answer: Not everyone is asleep at the wheel.
It seems to me that the vast majority of folks are not at all concerned with the change in course we have just taken with respect to the relationship between private business enterprise and our federal government. In fact, some are just downright giddy about all the long-overdue changes that are finally taking place. They trust big government to wage the war against the excesses of capitalism and all the greedy bastards on Wall Street.
Over the past several years, the excesses of various industries, companies, business leaders and individuals have all coalesced into one big chaotic mess of too much leverage and too little sense of responsibility. But that's the nature of humanity. As imperfect beings, we tend to get caught up in our own greed, narcissism and ambition. Like it or not, that's just what people tend to do.
Here in America, our system of government was set up to create an orderly structure that balanced the benefit of individual freedom against the burden created by the simple fact that not everyone is nice or plays fair. When the government doesn't do enough...the "not-so-nice" (or "not-so-smart") people have too much leeway to fuck things up, and their excesses negatively impact everyone. Not good. But because our government is made up of imperfect individuals, there is always a danger that government will go too far. The danger of an overreaching government was addressed extensively in our founding documents (Constitution, Bill of Rights, etc.) The focus was on protecting and preserving individual liberty...and an omnipotent and wide reaching government run by imperfect individuals was seen as a threat to individual liberty.
Hopefully I'll just say this once. Our government has stepped over the line. Way over the line. It is both pitiful and frightening to witness the unprecedented expansion of government influence and power occur in an atmosphere of applause by seemingly intelligent and enlightened people. Many eagerly sidestep the basic question of whether the government is empowered to do what it is doing.
Those who just want to "give it a chance" (whatever "it" may be) reveal themselves to be poor students of history. Every time...every single time...a government has engaged in the kind of actions currently being undertaken by our administration, it has ended badly. Massive inflation (which may or may not happen this time), an exodus of capital, a decline in competitiveness, and an expansion of the State. Simply put, big government is bad for business. And what's bad for business is bad for all of us.
Yes, our government must play a role in regulating business to strike a reasonable balance between individual liberty and the need for an orderly society. But it is my firm belief that those who are not alarmed on a visceral level by what is happening now are simply not seeing the big picture.
If you don't understand the basic framework of our system of government, then you're focused solely on what's "right" or "wrong." But if you do truly understand the "balance of power" between the three federal branches, the states, and ultimately the individuals, then you likely realize that arriving at the "right solution" is always the goal. But if you take the wrong road to get there, then it is a Phyrric victory.
The "powers that be" in Washington D.C. are taking the wrong road...simply because no one can stop them and it is politically expedient to do so. History will show that this is a dangerous victory.
A salient question: Why are American Eagle .45 ACPs now $31/box when they were just $19 last month?
Answer: Not everyone is asleep at the wheel.
Today Was Not Fun
Another late-day spike took some of the sting out of an ugly day but we still suffered a good bout of profit-taking. While volume was a bit light, breadth was very poor and regional banks were particularly poor.
In the bigger scheme of things, the pullback today is very healthy but bear-market pullbacks have a way of turning into reversals. It is probably a good sign that buyers are willing to step up in the final hour, but I suspect those are mostly short-term traders playing a reoccurring theme rather than big institutions building positions. Nonetheless, there are obviously some folks out there who are willing to jump in on dips.
So is our pullback over and is it now time to jump in? A two-day correction isn't all that much and although we did close just slightly under the 790 on the S&P 500, we aren't at any major technical support, for those that believe.
We also have to wonder how the end-of-quarter games might manifest themselves. Will they try to hold us up tomorrow just to unwind them again later? There is a lot of focus on quarterly performance right now, so we should be pushed around a bit tomorrow.
Overall the market action holds some promise, but it is up to the bulls to not let things fade too much. Confidence is still fragile and too deep of a pullback will erode it I'm afraid.
In the bigger scheme of things, the pullback today is very healthy but bear-market pullbacks have a way of turning into reversals. It is probably a good sign that buyers are willing to step up in the final hour, but I suspect those are mostly short-term traders playing a reoccurring theme rather than big institutions building positions. Nonetheless, there are obviously some folks out there who are willing to jump in on dips.
So is our pullback over and is it now time to jump in? A two-day correction isn't all that much and although we did close just slightly under the 790 on the S&P 500, we aren't at any major technical support, for those that believe.
We also have to wonder how the end-of-quarter games might manifest themselves. Will they try to hold us up tomorrow just to unwind them again later? There is a lot of focus on quarterly performance right now, so we should be pushed around a bit tomorrow.
Overall the market action holds some promise, but it is up to the bulls to not let things fade too much. Confidence is still fragile and too deep of a pullback will erode it I'm afraid.
More On Mark - To - Market = Slipping Away?
In doing more detailed research on the web today, I ran across some interesting tidbits that don't seem to be in the public domain yet.
In spite of the horrid action in financials today, it seems quite possible that the financial stocks see an improvement in earnings this quarter. The US Financial Accounting Standards Board (FASB) did indeed change the mark-to-market rules last week, which many (including your humble analyst) thought was needed. First, they suspended the mark-to-market rules for assets in distressed markets. Second, they widened the definition of “temporary” impairments of troubled assets, which will “allow banks to write up the value of some troubled assets if these have been hit by falling markets without (yet) suffering any significant credit losses.”
(www.gavekal.com)
And here's the important part. The board decided to make the new changes effective
immediately, prior to full board approval on April 2. Like I wrote earlier, one explanation for today's nasty sell-off could simply be last-minute jitters regarding the vote, as well as quarter-end machinations.
As the esteemed analyst Charles Gave noted, this will allow banks to write up their paper, and it happens before Treasury Secretary Tim Geithner starts putting taxpayer
money at risk. Expect to see a pop in valuations. It will be interesting to see
if Citi and B of A post profits this quarter.
(I should note that the International Accounting Standards Board sent out a scathing press release. I guess from that we should assume that European banks will not be so
fortunate as their US counterparts.) (More European stupidity, in my opinion)
In theory, as I understand it, the information will still be there, but the way it will be recorded will not be reflected in the profit and loss statement. I understand
that this is a very controversial proposal, and I expect many will disagree. The key is whether or not the information is available to investors and how the proposals are put into actual practice. If there is abuse, and regulators should be all over this, then the old rules must quickly go back into place.This could put some strength back into financials, at least until the commercial mortgage and
credit card problems start having to be written off. At the least, it could
make for another solid rise in the stock market until we start to get what I
expect to be very bad 1 and 2 quarter earnings.
In spite of the horrid action in financials today, it seems quite possible that the financial stocks see an improvement in earnings this quarter. The US Financial Accounting Standards Board (FASB) did indeed change the mark-to-market rules last week, which many (including your humble analyst) thought was needed. First, they suspended the mark-to-market rules for assets in distressed markets. Second, they widened the definition of “temporary” impairments of troubled assets, which will “allow banks to write up the value of some troubled assets if these have been hit by falling markets without (yet) suffering any significant credit losses.”
(www.gavekal.com)
And here's the important part. The board decided to make the new changes effective
immediately, prior to full board approval on April 2. Like I wrote earlier, one explanation for today's nasty sell-off could simply be last-minute jitters regarding the vote, as well as quarter-end machinations.
As the esteemed analyst Charles Gave noted, this will allow banks to write up their paper, and it happens before Treasury Secretary Tim Geithner starts putting taxpayer
money at risk. Expect to see a pop in valuations. It will be interesting to see
if Citi and B of A post profits this quarter.
(I should note that the International Accounting Standards Board sent out a scathing press release. I guess from that we should assume that European banks will not be so
fortunate as their US counterparts.) (More European stupidity, in my opinion)
In theory, as I understand it, the information will still be there, but the way it will be recorded will not be reflected in the profit and loss statement. I understand
that this is a very controversial proposal, and I expect many will disagree. The key is whether or not the information is available to investors and how the proposals are put into actual practice. If there is abuse, and regulators should be all over this, then the old rules must quickly go back into place.This could put some strength back into financials, at least until the commercial mortgage and
credit card problems start having to be written off. At the least, it could
make for another solid rise in the stock market until we start to get what I
expect to be very bad 1 and 2 quarter earnings.
In And Of Itself, Credit Is NOT A Bad Thing
I've been reading alot of things recently suggesting that financially strapped consumers would be better off without access to credit. This is a common and, frankly, dangerous fallacy in the century-old litany of complaints about consumer debt. The problem is not credit. It is poverty. If you don’t have money to get your car fixed or pay your doctor, even high-priced credit is very welcome. Many of the things I read highlight the plight of poor, or lower-income people. So let's talk about that. The forms of credit traditionally used by lower-income people—pawnshops, rent-to-own stores, and loans from friends and family—do not show up in aggregate statistics on consumers’ savings or debt.
Credit-card prices used to be “high and simple,” with everyone paying the same, regardless of credit risk. Now people who reliably pay their bills no longer cross-subsidize higher-risk customers—which arguably makes pricing fairer—and people who used to be too risky for standard pricing can get credit cards. But the fees and interest rates that many complain about are one result. They represent the real cost of making those loans. As we’ve recently learned from the mortgage market, underpriced credit can prove terribly expensive in the long run.
The best argument against consumer credit is that its easy availability tempts people into buying things they later regret, not that credit-card companies make profits by lending to risky borrowers who need their services. The latter complaint is just a 21st-century form of the ancient attack on money lending.
Credit-card prices used to be “high and simple,” with everyone paying the same, regardless of credit risk. Now people who reliably pay their bills no longer cross-subsidize higher-risk customers—which arguably makes pricing fairer—and people who used to be too risky for standard pricing can get credit cards. But the fees and interest rates that many complain about are one result. They represent the real cost of making those loans. As we’ve recently learned from the mortgage market, underpriced credit can prove terribly expensive in the long run.
The best argument against consumer credit is that its easy availability tempts people into buying things they later regret, not that credit-card companies make profits by lending to risky borrowers who need their services. The latter complaint is just a 21st-century form of the ancient attack on money lending.
My Big Call; Either Spectacularly Correct Or (Possibly) Devastatingly Wrong
I don't pretend that anyone besides me reads these scribblings. I use it to crystallize my thoughts; augment my memory (Englebart would be proud!); keep my mind as sharp as possible; plus, I find it entertaining. That stated, here's the thing. I agree with some I read that today's market sell-off is due in large part because of Geithner's warning that banks may need to raise even more capital. This kind of rhetoric has brought back the fears and uncertainty for U.S. financial institutions. I'm just not sure I buy that. I have doubts about the idea. Geithner has been on the wrong side of this issue along with FASB and the SEC for over two years now. On Thursday, possibly still reeling from the massive celebration of the 44 years that have passed since my birth, we finally will (probably - we'd better...) receive new regulation that will allow the banks to start to heal. Investors will have to endure three more days of uncertainty, but come April 2nd, these stocks, I think, will resume their uphill climb toward prices that I think will eventually reach historical norms. This past rally off of the bottom of 3/6 (I think it was 3/6....) had everything to do with hopes for new mark to market rules and the subsequent sell-off is being caused by last minute fears that FASB won't get the job done.
I almost hate to put this out there; for fear of looking mighty foolish later on; but I'm as confident as I can be (and you know yourself, Mr. B) that FASB has gotten the message - especially politically.....
I almost hate to put this out there; for fear of looking mighty foolish later on; but I'm as confident as I can be (and you know yourself, Mr. B) that FASB has gotten the message - especially politically.....
Bank Cash Is Surging Again
The idea that commercial banks are letting sit on their books unusually high cash balances is by now well established. Banks for months have built up large amounts of cash, fearing further losses and marks against their assets. Modifications to the ridiculous m2m rules would help.
Cash balances, which consist largely of vault cash and balances held at the Fed, began moving sharply higher after Lehman fell, which was when the Federal Reserve opened its spigot and injected massive amounts of liquidity into the banking system.
Commercial banks held $300 billion of cash when Lehman fell, the same amount they had held for several years leading up to that point, before a surge took the tally to over $1 trillion, peaking at $1.038 trillion in early January. Cash levels fell to about $800 billion a few weeks ago amid a contraction in the Fed's balance sheet but increased a record $147 billion to $976 billion in the latest week, which was the week ended March 18, new data from the Fed show.
Further increases are likely, owing to the Fed's securities purchase programs--banks hold about 20% of their assets in securities, and the Fed will certainly be buying securities from banks. Cash holdings will increase also because of the term asset-backed securities loan facility, or TALF, and the public-private investment program, or PPIP.
The Fed will eventually find the right number with respect to the amount of money needed to compel banks to lend, but it is a massive amount, given the holes in the credit systemwide. The cash balances remind us that when banks are less fearful of losses, a very large amount of credit can be created - the so-called "multiplier" effect. The money supply will grow much more rapidly when this happens.
Success in removing illiquid assets will help free up some of the cash, but it will take time. Still, keep watching the cash tally, because as it becomes more mountainous, bankers will begin to notice, and the trade-off they are making for safety will slowly give way to a preference for earning the net interest margin on the loans they could be making but aren't out of fear of losses against legacy loans and securities.
Cash balances, which consist largely of vault cash and balances held at the Fed, began moving sharply higher after Lehman fell, which was when the Federal Reserve opened its spigot and injected massive amounts of liquidity into the banking system.
Commercial banks held $300 billion of cash when Lehman fell, the same amount they had held for several years leading up to that point, before a surge took the tally to over $1 trillion, peaking at $1.038 trillion in early January. Cash levels fell to about $800 billion a few weeks ago amid a contraction in the Fed's balance sheet but increased a record $147 billion to $976 billion in the latest week, which was the week ended March 18, new data from the Fed show.
Further increases are likely, owing to the Fed's securities purchase programs--banks hold about 20% of their assets in securities, and the Fed will certainly be buying securities from banks. Cash holdings will increase also because of the term asset-backed securities loan facility, or TALF, and the public-private investment program, or PPIP.
The Fed will eventually find the right number with respect to the amount of money needed to compel banks to lend, but it is a massive amount, given the holes in the credit systemwide. The cash balances remind us that when banks are less fearful of losses, a very large amount of credit can be created - the so-called "multiplier" effect. The money supply will grow much more rapidly when this happens.
Success in removing illiquid assets will help free up some of the cash, but it will take time. Still, keep watching the cash tally, because as it becomes more mountainous, bankers will begin to notice, and the trade-off they are making for safety will slowly give way to a preference for earning the net interest margin on the loans they could be making but aren't out of fear of losses against legacy loans and securities.
Deflation Reigns Right Now; Inflation Comes Later
Economists of monetarist and Keynesian persuasions disagree about many things. However, they are currently united in their views on inflation. They see the risk of deflation as being far greater. This conventional wisdom is reflected in extremely low yields for government bonds in Europe and the US. Yet a resurgence of inflation may be closer than many believe.
Monetarists concede that central banks are printing money in vast amounts to stimulate their economies. This will not lead to inflation, they say. The newly minted cash is not being lent out but stored in bank vaults. The “money multiplier”, to use the technical term, has collapsed. It is no secret why this is happening. Households and businesses are over-stretched and fearful about the future. As a result, they are borrowing less and saving more. As long as such fears persist, according to monetarist logic, the Federal Reserve can carry on printing money with impunity.
The aim of the central bank’s policy of quantitative easing is to dispel the threat of deflation and get people to borrow and spend more. The “unconventional measures” being undertaken by central banks around the world are novel and unproven. If the authorities overreact to the threat of deflation and print more money than is necessary, inflation expectations might suddenly pick up. The continued hoarding of money depends on people believing that a fiat currency, such as the US dollar, will remain a store of value in future. If this confidence dissipates due to excessive measures by the Fed, then cash would be considered a hot potato. The velocity of circulation would rise and inflation surge.
Inflation expectations might also shift if the markets lose confidence in the state of the public finances. Washington is set to produce a deficit this year of at least $1.8 trillion. The cost of bailing out Wall Street runs to several thousand billion dollars more. Meanwhile, the Fed has promised to expand its balance sheet by more than $2 trillion. Governments that issue debt in their own currencies and control their monetary printing presses do not tend to go bust. Rather, the sovereign default takes place covertly through a depreciation of the currency.
If market participants come to suspect the US government faces insuperable financial burdens and that the Fed is losing its political independence, inflation expectations are liable to change rapidly. Clearly, this issue is a concern to China’s leaders who, having acquired an enormous mountain of Treasury bonds in their foreign exchange reserves, are aware that Americans might seek at some stage to inflate away their foreign obligations.
Keynesian economists do not focus on inflationary expectations or on the money supply. Instead, they point to the dramatic collapse of demand in the global economy as a sign that deflationary forces will be around for a long while. Goldman Sachs estimates the current “output gap” to be about 8 per cent of global GDP. Inflation will not pick up until this spare capacity has shrunk, according to Goldman.
This argument should be viewed warily. There are times when inflation and economic activity move in the opposite direction. For instance, periods of rising inflation and unemployment are relatively common during emerging market crises. The US witnessed something similar during the stagflation of the 1970s. Leading indicators suggest the US economy is set to decline sharply in the first quarter. The last time these indicators were so dire occurred in 1974. Yet there was no deflation in that year. Rather the inflation rate climbed to over 10 per cent.
The output gap "guess" has doubters; British economist Peter Warburton argues the expansion of global trade over the past couple of decades exerted downward pressure on inflation. During the boom years, the global supply chain was tuned to perfection, he says. The credit crisis, however, has fractured this supply chain; companies have gone bust, working capital has been hard to come by, and inventories have been run down. As a result, the productive capacity of the global economy has shrunk and the world has become more inflation prone. “An aggressive stimulus package to aggregate demand,” writes Mr Warburton, “which seeks to restore the status quo ante will encounter inflationary tendencies at lower levels of activity than before”.
The deflationary consequences of the credit crisis may persist for some time. However, an early revival of inflation is not off the cards. My best guess at this point is a revival of inflation expectations in about 6 to 12 months.
Monetarists concede that central banks are printing money in vast amounts to stimulate their economies. This will not lead to inflation, they say. The newly minted cash is not being lent out but stored in bank vaults. The “money multiplier”, to use the technical term, has collapsed. It is no secret why this is happening. Households and businesses are over-stretched and fearful about the future. As a result, they are borrowing less and saving more. As long as such fears persist, according to monetarist logic, the Federal Reserve can carry on printing money with impunity.
The aim of the central bank’s policy of quantitative easing is to dispel the threat of deflation and get people to borrow and spend more. The “unconventional measures” being undertaken by central banks around the world are novel and unproven. If the authorities overreact to the threat of deflation and print more money than is necessary, inflation expectations might suddenly pick up. The continued hoarding of money depends on people believing that a fiat currency, such as the US dollar, will remain a store of value in future. If this confidence dissipates due to excessive measures by the Fed, then cash would be considered a hot potato. The velocity of circulation would rise and inflation surge.
Inflation expectations might also shift if the markets lose confidence in the state of the public finances. Washington is set to produce a deficit this year of at least $1.8 trillion. The cost of bailing out Wall Street runs to several thousand billion dollars more. Meanwhile, the Fed has promised to expand its balance sheet by more than $2 trillion. Governments that issue debt in their own currencies and control their monetary printing presses do not tend to go bust. Rather, the sovereign default takes place covertly through a depreciation of the currency.
If market participants come to suspect the US government faces insuperable financial burdens and that the Fed is losing its political independence, inflation expectations are liable to change rapidly. Clearly, this issue is a concern to China’s leaders who, having acquired an enormous mountain of Treasury bonds in their foreign exchange reserves, are aware that Americans might seek at some stage to inflate away their foreign obligations.
Keynesian economists do not focus on inflationary expectations or on the money supply. Instead, they point to the dramatic collapse of demand in the global economy as a sign that deflationary forces will be around for a long while. Goldman Sachs estimates the current “output gap” to be about 8 per cent of global GDP. Inflation will not pick up until this spare capacity has shrunk, according to Goldman.
This argument should be viewed warily. There are times when inflation and economic activity move in the opposite direction. For instance, periods of rising inflation and unemployment are relatively common during emerging market crises. The US witnessed something similar during the stagflation of the 1970s. Leading indicators suggest the US economy is set to decline sharply in the first quarter. The last time these indicators were so dire occurred in 1974. Yet there was no deflation in that year. Rather the inflation rate climbed to over 10 per cent.
The output gap "guess" has doubters; British economist Peter Warburton argues the expansion of global trade over the past couple of decades exerted downward pressure on inflation. During the boom years, the global supply chain was tuned to perfection, he says. The credit crisis, however, has fractured this supply chain; companies have gone bust, working capital has been hard to come by, and inventories have been run down. As a result, the productive capacity of the global economy has shrunk and the world has become more inflation prone. “An aggressive stimulus package to aggregate demand,” writes Mr Warburton, “which seeks to restore the status quo ante will encounter inflationary tendencies at lower levels of activity than before”.
The deflationary consequences of the credit crisis may persist for some time. However, an early revival of inflation is not off the cards. My best guess at this point is a revival of inflation expectations in about 6 to 12 months.
Friday, March 27, 2009
Expect Choppiness Next Week
After a big spike up on Monday, we have been battling back and forth the rest of the week and haven't made any further progress. That isn't a negative. We need the market to rest as short-termers exit and stronger buyers emerge. Big institutional buyers generally prefer to buy pullbacks rather than chase strength, and they will provide underlying support if they really are going to start going to work and deploy new capital.
Not complaining, but this market has not been an easy one. We have been highly news-driven with new bailouts and banking schemes on an almost daily basis. To add to the complexity, the final hour of trading has consistently seen crazy volatility. It doesn't much matter what happens the rest of the day as the whipsaws in the last hour will undo any logic that may have existed.
Nonetheless, a bounce off the March low and some churning over the past four days is constructive action. Many feel we have held up artificially due to end-of-the-quarter window-dressing and performance-anxiety. Even if that is so, we can afford to give back a chunk of the recent advance without completely killing the potential for a further bear market advance.
With earnings season on the horizon and plenty of economic news next week, you can be sure we are going to see some more choppy action. The chartists out there are starting to see better chart formations, so according to them it's a good time to work on those watch lists.
Not complaining, but this market has not been an easy one. We have been highly news-driven with new bailouts and banking schemes on an almost daily basis. To add to the complexity, the final hour of trading has consistently seen crazy volatility. It doesn't much matter what happens the rest of the day as the whipsaws in the last hour will undo any logic that may have existed.
Nonetheless, a bounce off the March low and some churning over the past four days is constructive action. Many feel we have held up artificially due to end-of-the-quarter window-dressing and performance-anxiety. Even if that is so, we can afford to give back a chunk of the recent advance without completely killing the potential for a further bear market advance.
With earnings season on the horizon and plenty of economic news next week, you can be sure we are going to see some more choppy action. The chartists out there are starting to see better chart formations, so according to them it's a good time to work on those watch lists.
Fed's Balance Sheet Expands
The size of the Fed's balance sheet peaked in December at $2.253 trillion in the week ended Dec. 17, 2008, falling to as low as $1.83 trillion in the week ended Feb. 11 before creeping up again to about $1.90 trillion in recent weeks. Then, in the week ended March 18, the Fed expanded its balance sheet by about $170 billion to $2.041 trillion, its highest in about two months.
In the latest week, ended March 25, the Fed's balance sheet expanded again, by $9 billion to $2.050 trillion. It is interesting to note that equities peaked at around the time the Fed's balance sheet did and began recovering when the Fed's balance sheet expanded. Monetarists will feast on the pattern.
The increase in the size of the Fed's balance sheet is likely to continue in the weeks and months to come, probably to at least $3.5 trillion as a result of securities purchases and eventually to over $4 trillion because of the Term Asset-Backed Securities Lending Facility.
It could eventually expand to over $5 trillion if the Private-Public Investment Fund gets off the ground and is effective. The Fed has thus far purchased $236 billion of mortgage-backed securities, leaving $1 trillion to go to meet the Fed's announced target. The Fed has also purchased $50 billion of agency securities out of $200 billion announced. The Fed will also be purchasing up to $300 billion of Treasury securities. he importance of the upcoming expansion in the Fed's balance sheet will be many-fold:
1. Eventually the Fed will find the "magic number" with respect to the amount of bank reserves that would compel banks to lend enough to promote normal levels of economic activity. The Fed found the "magic number" for some of its facilities, in particular the Term Auction Facility, the Commercial Paper Funding Facility and the currency-swap facility.
2. The Fed will revive the asset-backed securities market, and money will be channeled to consumers and businesses, boosting aggregate demand. A trough will be put underneath a swath of prominent economic statistics. For example, a bottoming in car sales will significantly affect the factory-laden economic calendar, leading to a trough in data such as durable-goods orders, factory orders, regional purchasing managers' indices, the ISM index and industrial production.
3. The purchase of agency and agency mortgage-backed securities will lower mortgage rates and do so at a time when millions of homeowners are likely to refinance their mortgages via the Obama adminstration's $75 billion Making Homes Affordable program. This will reduce the level of foreclosures.
4. By encouraging mortgage refinancing, mortgage originations will increase, boosting bank revenue in this area.
5. The purchase of Treasury, agency and mortgage securities boosts bank balance sheets. Commercial banks held $2.67 trillion of securities in early March, accounting for 22% of assets. The sharp price appreciation in the securities the Fed is targeting boosted bank assets.
6. The removal of risky securities from bank balance sheets will reduce the need to hold reserves against losses, boosting the velocity of money and unleashing some of the close to $1 trillion that banks are holding in reserves.
In the latest week, the main force behind the expansion in Fed credit was the Fed's $10.47 billion purchase of mortgage-backed securities. Agency purchases were $3.3 billion. The Fed is moving deliberately, seeking the maximum impact possible on the mortgage realm. In reality, the Fed has unlimited firepower for asset purchases, because it has a printing press, or at least the modern-day version of it.
Targeted assets are worthy investments in the current environment. In Treasuries, focus on two-years through 10s and TIPS. If the Fed's efforts bear fruit (for example, if the TALF revives the asset-backed market and the PPIP removes assets from bank balance sheets), expect investors to move a layer out the risk spectrum.
In the latest week, ended March 25, the Fed's balance sheet expanded again, by $9 billion to $2.050 trillion. It is interesting to note that equities peaked at around the time the Fed's balance sheet did and began recovering when the Fed's balance sheet expanded. Monetarists will feast on the pattern.
The increase in the size of the Fed's balance sheet is likely to continue in the weeks and months to come, probably to at least $3.5 trillion as a result of securities purchases and eventually to over $4 trillion because of the Term Asset-Backed Securities Lending Facility.
It could eventually expand to over $5 trillion if the Private-Public Investment Fund gets off the ground and is effective. The Fed has thus far purchased $236 billion of mortgage-backed securities, leaving $1 trillion to go to meet the Fed's announced target. The Fed has also purchased $50 billion of agency securities out of $200 billion announced. The Fed will also be purchasing up to $300 billion of Treasury securities. he importance of the upcoming expansion in the Fed's balance sheet will be many-fold:
1. Eventually the Fed will find the "magic number" with respect to the amount of bank reserves that would compel banks to lend enough to promote normal levels of economic activity. The Fed found the "magic number" for some of its facilities, in particular the Term Auction Facility, the Commercial Paper Funding Facility and the currency-swap facility.
2. The Fed will revive the asset-backed securities market, and money will be channeled to consumers and businesses, boosting aggregate demand. A trough will be put underneath a swath of prominent economic statistics. For example, a bottoming in car sales will significantly affect the factory-laden economic calendar, leading to a trough in data such as durable-goods orders, factory orders, regional purchasing managers' indices, the ISM index and industrial production.
3. The purchase of agency and agency mortgage-backed securities will lower mortgage rates and do so at a time when millions of homeowners are likely to refinance their mortgages via the Obama adminstration's $75 billion Making Homes Affordable program. This will reduce the level of foreclosures.
4. By encouraging mortgage refinancing, mortgage originations will increase, boosting bank revenue in this area.
5. The purchase of Treasury, agency and mortgage securities boosts bank balance sheets. Commercial banks held $2.67 trillion of securities in early March, accounting for 22% of assets. The sharp price appreciation in the securities the Fed is targeting boosted bank assets.
6. The removal of risky securities from bank balance sheets will reduce the need to hold reserves against losses, boosting the velocity of money and unleashing some of the close to $1 trillion that banks are holding in reserves.
In the latest week, the main force behind the expansion in Fed credit was the Fed's $10.47 billion purchase of mortgage-backed securities. Agency purchases were $3.3 billion. The Fed is moving deliberately, seeking the maximum impact possible on the mortgage realm. In reality, the Fed has unlimited firepower for asset purchases, because it has a printing press, or at least the modern-day version of it.
Targeted assets are worthy investments in the current environment. In Treasuries, focus on two-years through 10s and TIPS. If the Fed's efforts bear fruit (for example, if the TALF revives the asset-backed market and the PPIP removes assets from bank balance sheets), expect investors to move a layer out the risk spectrum.
Thursday, March 26, 2009
More Late-Day Theatrics
As was the case yesterday, we saw a frenzy of buying kick in just as the final hour got under way. In the end, the indices were able to close at the best levels of the day and add an average of 2.8% on breadth that was 7:2 to the positive, furthering the oversold rally that began over two weeks ago. Industrials, consumer discretionary and materials were the big winners on the day, while energy was the only cyclical sector to show any real relative weakness. In the process, there were some interesting themes at play.
First was that the S&P 500 was able to move above the 825 level, which represents a breaking of the downtrend that’s been in place since October. That’s a major coup for the bulls who were able to push us higher despite the fact that the market remains oversold. Secondly, traders were actively seeking out pockets of momentum. Semiconductors and solars saw big gains, spurred by a good deal of chasing, and it’s been a long time since we’ve seen that kind of action. The financials have been the main beneficiary of this oversold rally, and it’s encouraging to see buying interest spread to other areas, especially those with high betas.
Of course, none of this makes it any easier for prudent investors looking for proper entry points. There’s no question that this market is extended to the upside and in desperate need of some consolidation, but like we’ve been saying, end-of-quarter pressures will likely have money managers looking for ways to add long-side exposure so they can show their clients they’ve been in on this move.
We’ll see how it goes. There have been some signs that the character of this market may be changing, and the hope is that it will continue as we closed out the quarter and head into earnings season.
First was that the S&P 500 was able to move above the 825 level, which represents a breaking of the downtrend that’s been in place since October. That’s a major coup for the bulls who were able to push us higher despite the fact that the market remains oversold. Secondly, traders were actively seeking out pockets of momentum. Semiconductors and solars saw big gains, spurred by a good deal of chasing, and it’s been a long time since we’ve seen that kind of action. The financials have been the main beneficiary of this oversold rally, and it’s encouraging to see buying interest spread to other areas, especially those with high betas.
Of course, none of this makes it any easier for prudent investors looking for proper entry points. There’s no question that this market is extended to the upside and in desperate need of some consolidation, but like we’ve been saying, end-of-quarter pressures will likely have money managers looking for ways to add long-side exposure so they can show their clients they’ve been in on this move.
We’ll see how it goes. There have been some signs that the character of this market may be changing, and the hope is that it will continue as we closed out the quarter and head into earnings season.
Banks, Bank Nationalization And CDOs
Everything's now at the margin. I think over the next several months house prices in certain areas of the country bottom and then you will get bids of 20 or 30 or 40 cents on the dollar for 2006 vintage collateralized debt obligations. You may then get a rally in 2005 vintage CDOs, because the homes are cheaper to maintain than the
rents, especially if people qualify for the new mortgage reduction program. A break in the spiral occurs as people begin to adjust between those bonds that have nothing but worthless junk in them -- and there are plenty of those that use mortgages that are often fraudulent made by all the bad actors in the game circa 2006. Those are never coming back, particularly those with second loans.
What people like Roubini and Krugman might be missing is the ability to build, through earnings and higher stock prices and forbearance, a perfect combination of lower loan charge-offs, more equity, and therefore increased bank solvency.
Or, in other words, those who think that things are not better off since the March bottom strike me as people who were as unrealistically bullish during the 2008 top. You have to adjust if the facts adjust and perhaps Roubini's doing that by saying that "some" banks will be nationalized. If he isn't, I think he will be wrong.
rents, especially if people qualify for the new mortgage reduction program. A break in the spiral occurs as people begin to adjust between those bonds that have nothing but worthless junk in them -- and there are plenty of those that use mortgages that are often fraudulent made by all the bad actors in the game circa 2006. Those are never coming back, particularly those with second loans.
What people like Roubini and Krugman might be missing is the ability to build, through earnings and higher stock prices and forbearance, a perfect combination of lower loan charge-offs, more equity, and therefore increased bank solvency.
Or, in other words, those who think that things are not better off since the March bottom strike me as people who were as unrealistically bullish during the 2008 top. You have to adjust if the facts adjust and perhaps Roubini's doing that by saying that "some" banks will be nationalized. If he isn't, I think he will be wrong.
Wednesday, March 25, 2009
What A Rollercoaster Ride Today, Especially In FAS
Well, the media’s definitely going to be scrambling to come up with some sort of reason to peg on the rollercoaster ride the market took us on today. After a frenzied start, an early afternoon sell-off took us well into negative territory, but a burst of short-covering took shape just as the final hour got under way, which in the end allowed the major indices to finish the day with solid gains.
Certainly, the news flow today will be picked apart, with the positive durable goods orders report, the rise in mortgage applications and the uptick in new home sales being used as explanations for the early rally, while the poor Treasury note auction will be blamed for the early afternoon drop. However, one look at important technical levels in the S&P 500 tells the tale. Stocks reversed after that index was unable to move past the descending resistance trendline that’s been in place since October, but the shorts ended up getting smoked just as it pulled back to its 50 day moving average.
In the end, though, it was a pretty productive day for the market. These wide intraday swings might be difficult to navigate and are exceedingly frustrating to those who are starting to look for opportunities to put their capital to work, but they are helping the market digest its recent gains. The wild pops give short-termers the chance to book some gains, while the swift dips allow stronger hands to buy weakness. In the process, though, it’s important for technical levels to hold, and we did get to see that today.
long FAS
Certainly, the news flow today will be picked apart, with the positive durable goods orders report, the rise in mortgage applications and the uptick in new home sales being used as explanations for the early rally, while the poor Treasury note auction will be blamed for the early afternoon drop. However, one look at important technical levels in the S&P 500 tells the tale. Stocks reversed after that index was unable to move past the descending resistance trendline that’s been in place since October, but the shorts ended up getting smoked just as it pulled back to its 50 day moving average.
In the end, though, it was a pretty productive day for the market. These wide intraday swings might be difficult to navigate and are exceedingly frustrating to those who are starting to look for opportunities to put their capital to work, but they are helping the market digest its recent gains. The wild pops give short-termers the chance to book some gains, while the swift dips allow stronger hands to buy weakness. In the process, though, it’s important for technical levels to hold, and we did get to see that today.
long FAS
Housing Is Rebounding
After looking at the new-home sales this morning, quite strong at 337,000, and knowing that the rates are going lower still, and that the national average price of a home is down 18%, you are looking at what might be the single greatest moment to buy a home in the last 10 years. (I sure wish home prices were in the CPI, because you would see the deflation.)
When the collateralized debt obligations were first built, there was a constant, and that was house price appreciation. When that peaked in 2006, the models all went haywire. These CDOs were not supposed to "go bad" until unemployment spiked, because the models never showed that housing could decline 18%, or 40%-50% in the hottest areas that probably had close to 50% of the CDOs from 2005 to 2007.
When you combine the 100% loan-to-value with the fraud, with the added 20% to value -- making 120% -- and if you used home-equity loans to close the deal (more fraud in some cases) without documentation, you know that many of the CDOs will never come back. Many are probably worth zero.
Let's do the math. We are dealing with a universe of 17 million homes sold between 2005 and 2007 first quarter -- the worst vintages -- of which all but 20% were securitized, so we are using a universe of 13.6 million homes in CDOs (80% securitized of total number).
Half of these were fixed. That's 6.8 million homes in CDOs that are fixed. The fixed default or defaulting rate is 10%. That's 680,000 defaults in CDOs.
Half are variable. You have a 30% default or defaulting rate on the variables, that's 2.04 million homes.
Now, you have 680,000 fixed that are bad in CDOs and 2.04 million variable that are bad in CDOs. Let's call it 3 million defaults or defaulting in CDOs.
The average home price during that period for California (using the highest for worst case) was $330,000. So let's use that. We have 3 million homes in default or defaulting at $330,000 a pop, which yields a total of almost $10 trillion in CDOs.
That's the true size of the problem.
The CDOs are all screwed up. They are diversified among all sorts of geographies, including lots of second-lien mortgages within them.
If you can get the "defaulting" part, not the default part, halted, you can see the magnitude of the problem diminishing.
That's what might be happening.
Any diminishing is great news and makes Geithner's job easier. Of course, you could easily argue that all of these are worth pennies on the dollar. But that presumes they are all stuffed with all defaulting loans, and that's a mistake.
I think that a 2005 vintage now be something worth owning, as you have lots of equity in those homes now.
I think that the 2006 vintage as it goes on gets worse, with the first quarter of 2007 being horrible.
When I see these housing sales numbers -- these are new, but they help burn off inventory -- I would be willing to gamble with federal money on some of the vintages, maybe as much as a third of them; the 2005s have real value.
That's at the crux of the issue.
Remember, there have been lots of write-downs and write-offs already. Some would say we have written off worldwide about $3 trillion.
Now you are getting somewhere. You have about $4 trillion in 2005 that might be worth a lot. You have $4 trillion in 2006 that could have real value. And then let's just write off $1 trillion in 2007.
With these housing sales numbers and the new low rates and the money to buy CDOs, you could argue that what happens is the problem becomes "manageable." And that's where we are getting: a manageable problem, because it can be capped at some price.
Lots of businesses are going from bad to worse. Unemployment is going from bad to worse.
But the housing problem is going from worse to better. We are going toward house price stabilization.
When the collateralized debt obligations were first built, there was a constant, and that was house price appreciation. When that peaked in 2006, the models all went haywire. These CDOs were not supposed to "go bad" until unemployment spiked, because the models never showed that housing could decline 18%, or 40%-50% in the hottest areas that probably had close to 50% of the CDOs from 2005 to 2007.
When you combine the 100% loan-to-value with the fraud, with the added 20% to value -- making 120% -- and if you used home-equity loans to close the deal (more fraud in some cases) without documentation, you know that many of the CDOs will never come back. Many are probably worth zero.
Let's do the math. We are dealing with a universe of 17 million homes sold between 2005 and 2007 first quarter -- the worst vintages -- of which all but 20% were securitized, so we are using a universe of 13.6 million homes in CDOs (80% securitized of total number).
Half of these were fixed. That's 6.8 million homes in CDOs that are fixed. The fixed default or defaulting rate is 10%. That's 680,000 defaults in CDOs.
Half are variable. You have a 30% default or defaulting rate on the variables, that's 2.04 million homes.
Now, you have 680,000 fixed that are bad in CDOs and 2.04 million variable that are bad in CDOs. Let's call it 3 million defaults or defaulting in CDOs.
The average home price during that period for California (using the highest for worst case) was $330,000. So let's use that. We have 3 million homes in default or defaulting at $330,000 a pop, which yields a total of almost $10 trillion in CDOs.
That's the true size of the problem.
The CDOs are all screwed up. They are diversified among all sorts of geographies, including lots of second-lien mortgages within them.
If you can get the "defaulting" part, not the default part, halted, you can see the magnitude of the problem diminishing.
That's what might be happening.
Any diminishing is great news and makes Geithner's job easier. Of course, you could easily argue that all of these are worth pennies on the dollar. But that presumes they are all stuffed with all defaulting loans, and that's a mistake.
I think that a 2005 vintage now be something worth owning, as you have lots of equity in those homes now.
I think that the 2006 vintage as it goes on gets worse, with the first quarter of 2007 being horrible.
When I see these housing sales numbers -- these are new, but they help burn off inventory -- I would be willing to gamble with federal money on some of the vintages, maybe as much as a third of them; the 2005s have real value.
That's at the crux of the issue.
Remember, there have been lots of write-downs and write-offs already. Some would say we have written off worldwide about $3 trillion.
Now you are getting somewhere. You have about $4 trillion in 2005 that might be worth a lot. You have $4 trillion in 2006 that could have real value. And then let's just write off $1 trillion in 2007.
With these housing sales numbers and the new low rates and the money to buy CDOs, you could argue that what happens is the problem becomes "manageable." And that's where we are getting: a manageable problem, because it can be capped at some price.
Lots of businesses are going from bad to worse. Unemployment is going from bad to worse.
But the housing problem is going from worse to better. We are going toward house price stabilization.
Why Is Almost Everyone Missing The Point On AIG?
Echoing Soros' editorial in the Journal yesterday, in all the uproar over AIG, the most important lesson has been ignored. AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. When these products are allowed to run amuck, CDS become toxic instruments: why are those with no real fiduciary interest allowed to bet in this rigged casino? Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps. It would also save the U.S. Treasury a lot of money by reducing the loss on AIG's outstanding positions without abrogating any contracts.
CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them so destructive is that such speculation can be self-validating.
The so-called efficient market hypothesis - possibly the prevailing view even now - was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But is this really true? I don't think financial markets deal with the current reality, but with the future -- a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. Soros calls this feedback mechanism "reflexivity."
With the help of this new stance, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.
The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.
The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.
Taking these three considerations together, it's clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG utterly failed to understand this.
Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are in many situations toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. Under this rule -- which would require international agreement and federal legislation -- the buying pressure on CDS would greatly diminish, and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.
CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them so destructive is that such speculation can be self-validating.
The so-called efficient market hypothesis - possibly the prevailing view even now - was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But is this really true? I don't think financial markets deal with the current reality, but with the future -- a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. Soros calls this feedback mechanism "reflexivity."
With the help of this new stance, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.
The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.
The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.
Taking these three considerations together, it's clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG utterly failed to understand this.
Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are in many situations toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. Under this rule -- which would require international agreement and federal legislation -- the buying pressure on CDS would greatly diminish, and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.
Tuesday, March 24, 2009
Regressed A Bit
Although the buyers who were feeling a bit left out after yesterday’s monster rally had an attractive intraday situation to work with, the early afternoon push by the troops proved to be a bit early, as the brief foray into positive territory by the Dow and S&P 500 opened the door for a fresh wave of profit-taking that lasted into the close. Still, despite the average losses of 1.97%, all in all it was a pretty constructive day for the market, which was able to digest some of yesterday’s gains on decreasing volume.
The mild selling we saw to close out last week set the stage for some big gains, and the question is if some consolidation here will allow the market to make additional progress in the days and weeks ahead. The market has been able to make some decent technical progress and the indices were able to hold above the resistance levels they broke past yesterday, but we’re still dealing with a protracted V-shaped bounce off of the lows from the 9th. We’ll see how it goes, but while the action over the past two weeks had been encouraging, it’s still way too early to be declaring the end of this bear market.
The mild selling we saw to close out last week set the stage for some big gains, and the question is if some consolidation here will allow the market to make additional progress in the days and weeks ahead. The market has been able to make some decent technical progress and the indices were able to hold above the resistance levels they broke past yesterday, but we’re still dealing with a protracted V-shaped bounce off of the lows from the 9th. We’ll see how it goes, but while the action over the past two weeks had been encouraging, it’s still way too early to be declaring the end of this bear market.
M2M
One of the main causes of the 2008 financial crisis and current recession was subprime mortgages, which are home loans to borrowers with low credit scores, little or no down payment and high levels of debt. These borrowers have a higher risk of defaulting on their loans and are usually charged higher interest rates.
Investment banks and financial firms converted many of these subprime mortgages into mortgage-backed securities (MBSs) that allow investors to collect the underlying mortgage payments and interest. Unfortunately, thousands of banks, thrifts, insurance companies and credit unions who were not involved in making loans invested in these MBSs, thinking their AAA rating indicated that they were safe investments.
In 2008, when the subprime mortgages in these pools began defaulting at a higher rate, the market for MBSs dried up. Yet, rigid mark-to-market accounting rules, enforced by regulators, forced the drastic write-down in the value of MBSs, even when investors were both willing and able to hold them until the market improved or to maturity, when the loans would be paid off, if necessary.
However, even though the MBSs have hardly been trading, most of the underlying mortgages are still generating income, making them worth more than their marked down prices. Thus, a cheap way of addressing the financial crisis and saving banks is to suspend these mark-to-market rules.
Mark-to-market accounting forces firms to revalue their assets to current market prices, such as a stock's price at the close of business. According to Milton Friedman, mark-to-market accounting was responsible for many banks failing during the Great Depression. In fact, President Roosevelt suspended it in 1938. The practice reappeared in the mid-1970s and was formally reintroduced in the early 1990s.
In 1994, the Financial Accounting Standards Board (FASB), the independent institution responsible for writing accounting rules for the Securities and Exchange Commission (SEC), issued the Statement of Financial Accounting Standards (FAS) 115, which applied to all financial firms. It split financial assets into three categories: those "held to maturity," those "held for sale" and those "held for trading." FAS 115 allowed firms to value assets "held to maturity" based on discounted cash flow, and it required them to value assets in the latter two categories using mark-to-market.
Although FAS 115 reinstated mark-to-market accounting principles, "how to mark these assets to market became a highly complex and controversial matter," says former White House counsel Peter J. Wallison. Therefore, in 2006, FASB issued Statement No. 157, which clarified how to measure fair market value and took effect on November 15, 2007. The statement requires firms to mark to market assets at the price quoted in a functioning market or at the price of other, comparable assets with a working market. Assets that are not traded in an active market can be valued by discounted cash flow.
The tragedy in marking to market comes not from the write-downs per se, but from the resulting decline - dollar for dollar - in regulatory capital.
As a general accounting rule, investments drop in value when their market price drops below their original purchase price, a situation called impairment. Impairments can be classified as "temporary" or "other than temporary," in which case they must be written off as worthless.
For example, if a bank buys an MBS with 1,000 underlying mortgages and a few of these mortgages become "other than temporarily impaired," the bank must write down the whole bond - not just the impaired mortgages. The write-downs would be much more modest if the same 1,000 mortgages were separated. For example, the Federal Home Loan Bank of Seattle has a portfolio of MBSs that are predicted to only lose $12 million in the long run. However, the MBSs were marked to market because they were classified as "other than temporarily impaired," causing the bank to report a $304 million loss.
Although the original mark down may not be justified, it can lead to a real loss of capital. This loss of capital may lead to higher capital requirements at a time when capital is becoming scarcer. A bank's worsened condition may also require it to pay higher Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums in order to preserve the deposit insurance fund. As this process is multiplied across the banking system, these premiums may be raised across the board.
Consequently, the banks have their capital requirements increased when they can least afford it. The FDIC, after keeping its premiums low during good times, has to raise them during bad times. This is procyclical because it makes an economic downturn worse, and can artificially reinforce an economic boom.
If the securities are labeled "securities for sale" rather than "securities held to maturity," it can cause hypothetical or potential losses to result in actual or real losses of capital. These labels could be changed easily, but current accounting rules don't allow it. Fixing that would be an easy interim step.
Mark-to-market had its critics early on. Federal Reserve Board Chairman Alan Greenspan wrote a 4-page, single-spaced letter to the SEC in November 1990, urging them not to apply mark-to-market to commercial banks because their business model is not that of a trader, but involves holding assets on their balance sheet. In 2002, Treasury Secretary Nicolas Brady wrote a similar letter to the SEC.
Earlier this year, Paul Volcker, speaking as chairman of the "Group of 30," a private nonprofit composed of senior representatives from the private and public sectors and academia, released their study of the financial crisis. Recommendation No. 12 on Fair Value Accounting says:
a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments in distressed markets.
Even the International Accounting Standards Board, the international equivalent of the FASB, allowed European banks to relabel their MBSs as "held to maturity" in 2008 to avoid marking them to market. As a result of this change, says Wallison, Deutsche Bank went from a projected loss to a profit, and its stock price increased by 18 percent.
The most serious example of doing the right thing at the wrong time is overly strict adherence to mark-to-market accounting rules. Fortunately, there is historical and international precedent for suspending and reworking these rules. Congress and the SEC should consider doing so until the economy recovers.
Investment banks and financial firms converted many of these subprime mortgages into mortgage-backed securities (MBSs) that allow investors to collect the underlying mortgage payments and interest. Unfortunately, thousands of banks, thrifts, insurance companies and credit unions who were not involved in making loans invested in these MBSs, thinking their AAA rating indicated that they were safe investments.
In 2008, when the subprime mortgages in these pools began defaulting at a higher rate, the market for MBSs dried up. Yet, rigid mark-to-market accounting rules, enforced by regulators, forced the drastic write-down in the value of MBSs, even when investors were both willing and able to hold them until the market improved or to maturity, when the loans would be paid off, if necessary.
However, even though the MBSs have hardly been trading, most of the underlying mortgages are still generating income, making them worth more than their marked down prices. Thus, a cheap way of addressing the financial crisis and saving banks is to suspend these mark-to-market rules.
Mark-to-market accounting forces firms to revalue their assets to current market prices, such as a stock's price at the close of business. According to Milton Friedman, mark-to-market accounting was responsible for many banks failing during the Great Depression. In fact, President Roosevelt suspended it in 1938. The practice reappeared in the mid-1970s and was formally reintroduced in the early 1990s.
In 1994, the Financial Accounting Standards Board (FASB), the independent institution responsible for writing accounting rules for the Securities and Exchange Commission (SEC), issued the Statement of Financial Accounting Standards (FAS) 115, which applied to all financial firms. It split financial assets into three categories: those "held to maturity," those "held for sale" and those "held for trading." FAS 115 allowed firms to value assets "held to maturity" based on discounted cash flow, and it required them to value assets in the latter two categories using mark-to-market.
Although FAS 115 reinstated mark-to-market accounting principles, "how to mark these assets to market became a highly complex and controversial matter," says former White House counsel Peter J. Wallison. Therefore, in 2006, FASB issued Statement No. 157, which clarified how to measure fair market value and took effect on November 15, 2007. The statement requires firms to mark to market assets at the price quoted in a functioning market or at the price of other, comparable assets with a working market. Assets that are not traded in an active market can be valued by discounted cash flow.
The tragedy in marking to market comes not from the write-downs per se, but from the resulting decline - dollar for dollar - in regulatory capital.
As a general accounting rule, investments drop in value when their market price drops below their original purchase price, a situation called impairment. Impairments can be classified as "temporary" or "other than temporary," in which case they must be written off as worthless.
For example, if a bank buys an MBS with 1,000 underlying mortgages and a few of these mortgages become "other than temporarily impaired," the bank must write down the whole bond - not just the impaired mortgages. The write-downs would be much more modest if the same 1,000 mortgages were separated. For example, the Federal Home Loan Bank of Seattle has a portfolio of MBSs that are predicted to only lose $12 million in the long run. However, the MBSs were marked to market because they were classified as "other than temporarily impaired," causing the bank to report a $304 million loss.
Although the original mark down may not be justified, it can lead to a real loss of capital. This loss of capital may lead to higher capital requirements at a time when capital is becoming scarcer. A bank's worsened condition may also require it to pay higher Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums in order to preserve the deposit insurance fund. As this process is multiplied across the banking system, these premiums may be raised across the board.
Consequently, the banks have their capital requirements increased when they can least afford it. The FDIC, after keeping its premiums low during good times, has to raise them during bad times. This is procyclical because it makes an economic downturn worse, and can artificially reinforce an economic boom.
If the securities are labeled "securities for sale" rather than "securities held to maturity," it can cause hypothetical or potential losses to result in actual or real losses of capital. These labels could be changed easily, but current accounting rules don't allow it. Fixing that would be an easy interim step.
Mark-to-market had its critics early on. Federal Reserve Board Chairman Alan Greenspan wrote a 4-page, single-spaced letter to the SEC in November 1990, urging them not to apply mark-to-market to commercial banks because their business model is not that of a trader, but involves holding assets on their balance sheet. In 2002, Treasury Secretary Nicolas Brady wrote a similar letter to the SEC.
Earlier this year, Paul Volcker, speaking as chairman of the "Group of 30," a private nonprofit composed of senior representatives from the private and public sectors and academia, released their study of the financial crisis. Recommendation No. 12 on Fair Value Accounting says:
a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments in distressed markets.
Even the International Accounting Standards Board, the international equivalent of the FASB, allowed European banks to relabel their MBSs as "held to maturity" in 2008 to avoid marking them to market. As a result of this change, says Wallison, Deutsche Bank went from a projected loss to a profit, and its stock price increased by 18 percent.
The most serious example of doing the right thing at the wrong time is overly strict adherence to mark-to-market accounting rules. Fortunately, there is historical and international precedent for suspending and reworking these rules. Congress and the SEC should consider doing so until the economy recovers.
Monday, March 23, 2009
A Furious "Melt-Up" Today; A Buying Panic Into Month End/Quarter End?
Furious rally today, as the major indices ripped higher. Specifically, no real profit-taking kicked in, so the market was squeezed higher. Technicians were watching S and P 800 closely, and that ceiling appeared to have been shattered. Despite this strong action, we still have yet to receive any insight into the resilience of the bulls. They’ve been able to take control of the action recently because of some positive surprises, but they have yet to be really tested. When they are, hopefully they’ll have the fortitude to step up and provide support. It’s encouraging to see so much green on the screens, but are they willing to start putting up some longer-term money?
Friday, March 20, 2009
Soggy Day
Although the troops tried to lift us off the lows of the session as the final hour got under way, their effort failed to pay off, as the indices stumbled into the final bell, closing with average loses of 1.83%. Of course, given the propensity of prices to get pegged close to their strike prices, especially on quadruple witching, it’s hard to read too much into the day’s action. That said, Friday wrapped up just the sort of two-day pullback we needed to see after such a vigorous, if not inevitable, rally off the lows from last Monday.
The big question is if the bulls have enough confidence to step up to the plate and manufacture some support levels in the days ahead. The good news is that the bulls finally have some ammunition. Economic data, while far from inspiring, has been a bit better than expected, and the Fed’s recent action have the potential to provide a boost to the economy in the short-term. You can be sure that we’ll have to deal with the longer-term implications down the road, but at least we’re seeing a real effort to stimulate the economy.
Again, we’ll have to see how things go. Hopefully, the bit of selling that we saw over the past two days will give the bulls an opportunity to put some real money to work, which in turn should help potential leaders emerge and allow for better chart set-ups. In the end, the ball is squarely in the bulls’ court, and they need to prove that they’ve regained some of their confidence.
The big question is if the bulls have enough confidence to step up to the plate and manufacture some support levels in the days ahead. The good news is that the bulls finally have some ammunition. Economic data, while far from inspiring, has been a bit better than expected, and the Fed’s recent action have the potential to provide a boost to the economy in the short-term. You can be sure that we’ll have to deal with the longer-term implications down the road, but at least we’re seeing a real effort to stimulate the economy.
Again, we’ll have to see how things go. Hopefully, the bit of selling that we saw over the past two days will give the bulls an opportunity to put some real money to work, which in turn should help potential leaders emerge and allow for better chart set-ups. In the end, the ball is squarely in the bulls’ court, and they need to prove that they’ve regained some of their confidence.
Thursday, March 19, 2009
Today = Profit-Taking + Options Expiration? Or Something More?
We had two primary themes today. First was the continuation of the "inflation" trade that began yesterday on the Fed's announcement it is buying Treasury debt. That lit a fire under gold, oil, coal, natural gas and various commodities. There was a little late fade in the energy plays, but precious metals finished strong.
The second theme we saw today was profit-taking in the groups that have lead the recent bounce, particularly banks, insurance companies and various financials. Retailers, semiconductors, pharmaceuticals and medical stocks also saw some pullbacks but it was the financials that put the most pressure on the major indices today.
The primary question on my mind now is whether the inflation trade can gain further momentum. I'm not sure it is particularly healthy for the overall market but leadership in energy and commodities tends to provide good trading opportunities.
Out of this big V-shaped move this market has seen over the past two weeks, we should start seeing rotation into the winners and losers. So much of the market action has been generated by news about the latest governmental proposal. If we are going to have a better market, individual stock-picking should start to matter much more than it has.
The second theme we saw today was profit-taking in the groups that have lead the recent bounce, particularly banks, insurance companies and various financials. Retailers, semiconductors, pharmaceuticals and medical stocks also saw some pullbacks but it was the financials that put the most pressure on the major indices today.
The primary question on my mind now is whether the inflation trade can gain further momentum. I'm not sure it is particularly healthy for the overall market but leadership in energy and commodities tends to provide good trading opportunities.
Out of this big V-shaped move this market has seen over the past two weeks, we should start seeing rotation into the winners and losers. So much of the market action has been generated by news about the latest governmental proposal. If we are going to have a better market, individual stock-picking should start to matter much more than it has.
Big Inventory Drop Shows Up In Philly Fed Survey
Results of the Philadelphia Fed's Business Outlook Survey were better than expected, although the results remained poor. The survey's index on general business conditions increased to -35.0 from -41.3 in February, which was 4 points better than expected. The index has been between -24.3 (January) and -41.3 (February) over the past six months. Readings below zero indicate that a majority of respondents rated conditions negatively.
A turnaround in factory activity will likely lag stabilization in demand, as factory inventories have increased sharply in recent months.
That said, cutbacks in industrial output have been severe and are now exceeding the decline in demand (the decline in business inventories exceeded the decline in business sales in January); that will reduce inventories faster and hasten stabilization in factory activity. To wit, note that the inventory component within today's release plummeted to a record low of -55.6 from -24.3 in February, breaking the previous low of -50.7 set in March 1975.
In addition to the inventory drawdown, the combination of the TALF, fiscal stimulus and the public-private investment fund (PPIF) will likely underpin demand and make the first quarter the worst for the economic recession.
A turnaround in factory activity will likely lag stabilization in demand, as factory inventories have increased sharply in recent months.
That said, cutbacks in industrial output have been severe and are now exceeding the decline in demand (the decline in business inventories exceeded the decline in business sales in January); that will reduce inventories faster and hasten stabilization in factory activity. To wit, note that the inventory component within today's release plummeted to a record low of -55.6 from -24.3 in February, breaking the previous low of -50.7 set in March 1975.
In addition to the inventory drawdown, the combination of the TALF, fiscal stimulus and the public-private investment fund (PPIF) will likely underpin demand and make the first quarter the worst for the economic recession.
Wednesday, March 18, 2009
Whipsaw Movements Today On Fed Actions
While it had been rumored that the Fed would venture into buying some Treasury debt, the market was apparently surprised to see it actually announce such a move today. As so often happens on Fed announcements, we had some big whipsaws in the indices and a lot of second-guessing of the strategy.
It didn't take long at all for market commentators to start to wonder about the repercussions of yet another big dose of liquidity. The collapse of the dollar and a big reversal in gold following the Fed news indicate there are substantial fears that inflation will ramp up. On the other hand, consumer and mortgage loan rates should be coming down and it's obvious that there is going to be a lot of additional cash sloshing around out there, which can boost confidence and perk up the economy.
While there is plenty of celebration about the big bounce this market has seen over the past week, it has not been easy to trade. We went straight down and then straight up without much backing and filling in either direction.
This has been a good jump for those who stuck with longs they rode down or for those who were willing to chase a bounce. If you have been underperforming this past week, don't worry about it. Sharp bear market spikes will always make prudent traders feel a bit left out. The great thing about the market is that if you stay with it, the opportunities will always come. Just keep plugging away.
It didn't take long at all for market commentators to start to wonder about the repercussions of yet another big dose of liquidity. The collapse of the dollar and a big reversal in gold following the Fed news indicate there are substantial fears that inflation will ramp up. On the other hand, consumer and mortgage loan rates should be coming down and it's obvious that there is going to be a lot of additional cash sloshing around out there, which can boost confidence and perk up the economy.
While there is plenty of celebration about the big bounce this market has seen over the past week, it has not been easy to trade. We went straight down and then straight up without much backing and filling in either direction.
This has been a good jump for those who stuck with longs they rode down or for those who were willing to chase a bounce. If you have been underperforming this past week, don't worry about it. Sharp bear market spikes will always make prudent traders feel a bit left out. The great thing about the market is that if you stay with it, the opportunities will always come. Just keep plugging away.
The Fed Pumps Up Its Balance Sheet
Many people, in previewing the FOMC meeting, were anticipating that an expansion of the Fed's various securities programs was a possibility and that it was likely to be favored over any purchase of Treasuries.
This is how events played out, although in hindsight it would have made sense to believe that in order to optimize its securities purchase program, the Fed might want to anchor these securities by purchasing Treasuries -- the anchor -- and so it did.
It is notable that the expansion of the Fed's securities purchase program was far larger than its foray into Treasuries. Again, this is a sign that the Fed wants to continue to emphasize its purchase of securities in the private credit markets most of all, while keeping an eye on the anchor -- Treasuries. This theme is likely to be the dominant policy theme for a while, with the Fed staying active in markets vital to unclogging the credit system, and making sure that the anchor stays firmly in place.
This is how events played out, although in hindsight it would have made sense to believe that in order to optimize its securities purchase program, the Fed might want to anchor these securities by purchasing Treasuries -- the anchor -- and so it did.
It is notable that the expansion of the Fed's securities purchase program was far larger than its foray into Treasuries. Again, this is a sign that the Fed wants to continue to emphasize its purchase of securities in the private credit markets most of all, while keeping an eye on the anchor -- Treasuries. This theme is likely to be the dominant policy theme for a while, with the Fed staying active in markets vital to unclogging the credit system, and making sure that the anchor stays firmly in place.
Tuesday, March 17, 2009
A Good Day To Be Long The Market
After just a slight dip on Monday, the buyers jumped back in and drove us straight back up all day today. There was obviously some anxiety about being left out of this market, and the inclination to quickly buy a dip was a good sign for the bulls. As I've been discussing, a trustable bear-market rally requires a good foundation, and the action today added brick to the bullish case.
Retail, oil and technology led the charge, and breadth was better than 2-to-1 positive. However the very light volume was troubling. We want to see the big money driving the market, but for example, many of the oils have been rallying on declining volume, which is a technical negative.
I read quite a few complaints today about the low volume, but obviously it is the price action that matters most. I suspect that many market players have some trust issues with this market and are very slow to commit. That has been the proper approach, but the late-day action today clearly demonstrated some scrambling for long exposure, and clearly some folks started to wonder if all those bottom-callers are finally going to get it right.
Retail, oil and technology led the charge, and breadth was better than 2-to-1 positive. However the very light volume was troubling. We want to see the big money driving the market, but for example, many of the oils have been rallying on declining volume, which is a technical negative.
I read quite a few complaints today about the low volume, but obviously it is the price action that matters most. I suspect that many market players have some trust issues with this market and are very slow to commit. That has been the proper approach, but the late-day action today clearly demonstrated some scrambling for long exposure, and clearly some folks started to wonder if all those bottom-callers are finally going to get it right.
Pre-Market Thoughts
Although they’re off their best levels from earlier this morning, the index futures are pointing to a higher start after having regained some ground on the heels of a much better than expected reading on housing starts, which came in at +583K (versus estimates of +450K), and building permits, which came in at +547K (versus estimates of +500K). The data also showed an upward revision to last months numbers, with housing starts rising to 477K from 466K and building permits from 531K from 521K. Possible signs of improvement in the housing market, coupled with recent positive news flow from the financials and expectations for some actual details regarding the Administration’s plans for dealing with the bad debt still on the balance sheets of financial institutions gives the bulls some more ammunition, but does that mean we can start celebrating the end of this bear market?
Given the constant cheerleading in the media, many casual market observers are under the impression that the best thing for the market is if prices go straight up. However, the truth of the matter is that it’s the pullbacks and dips that are the necessary ingredients for a healthier market, especially when they come as the market tries to begin the process of repairing the sort of technical damage we saw in the Feb-Mar slow-motion crash. The reason, of course, is that they provide opportunities for some real accumulation by the big money once short-term traders who were lucky enough to catch a rally start to book their profits.
Yesterday, many so-called market experts were starting to get downright giddy as the major indices entered the afternoon sporting solid gains, but the sellers took control of the action in the final two hours, starting what will hopefully turn into a healthy pause which allows that sort of strong accumulation. If there’s real underlying support, then the market will pass a critical early stage test, after which we should really start to see some better entry points.
While the sort of rally we saw last week makes for some decent quick trading, it certainly doesn’t mean that we’ve reached a point where we can start building more substantial positions. This market and the economy are both far from being out of the woods and there’s gads of overhead resistance in the vast majority of the stocks out there. If we are indeed in the early stages of a meaningful turn, then the buyers will show up and help to start building the sort of foundation from which this market can start repairing that technical damage.
The bottom line, then, is that, while I hope that better times are ahead, there simply is not enough proof that this market deserves our trust just yet.
Given the constant cheerleading in the media, many casual market observers are under the impression that the best thing for the market is if prices go straight up. However, the truth of the matter is that it’s the pullbacks and dips that are the necessary ingredients for a healthier market, especially when they come as the market tries to begin the process of repairing the sort of technical damage we saw in the Feb-Mar slow-motion crash. The reason, of course, is that they provide opportunities for some real accumulation by the big money once short-term traders who were lucky enough to catch a rally start to book their profits.
Yesterday, many so-called market experts were starting to get downright giddy as the major indices entered the afternoon sporting solid gains, but the sellers took control of the action in the final two hours, starting what will hopefully turn into a healthy pause which allows that sort of strong accumulation. If there’s real underlying support, then the market will pass a critical early stage test, after which we should really start to see some better entry points.
While the sort of rally we saw last week makes for some decent quick trading, it certainly doesn’t mean that we’ve reached a point where we can start building more substantial positions. This market and the economy are both far from being out of the woods and there’s gads of overhead resistance in the vast majority of the stocks out there. If we are indeed in the early stages of a meaningful turn, then the buyers will show up and help to start building the sort of foundation from which this market can start repairing that technical damage.
The bottom line, then, is that, while I hope that better times are ahead, there simply is not enough proof that this market deserves our trust just yet.
Monday, March 16, 2009
With The Pullbacks Come The Tests
The tendency over the past week has been for the buyers to come to life in the closing hour, but today it was the sellers who controlled the late action. Banks were becoming downright giddy at midday following a stream of upbeat comments from the Obama administration. The folks on CNBC were even becoming excited over the fact that Ben Bernanke had made comments about seeing some "green shoots" of promise in the economy. Did they really expect him to say that he saw nothing at all positive?
I have to admit that I'm not at all disappointed to see a pullback at this stage of the game, because the bulls need to be tested. We had a straight up V-shaped bounce out of an extremely gloomy environment. There are many who really want to believe that this 10% bounce is different from the many other such bounces we've had over the past year and half during this bear market. Maybe it really is different, but we really don't have any good evidence yet. Just because a number of things are off their lows of five days ago, that alone isn't convincing.
Whether or not this bounce turns into something more than just another opportunity for flippers and shorts depends on what happens on the pullbacks. If a healthier market is developing, then banks will find support, new leading groups will emerge, and charts will set up. A four-day-long straight-up bounce, regardless of its magnitude, is just a short-term trading opportunity and not the resumption of a bull market.
I'm certainly hopeful that the process of pulling back and finding support will finally give us the chance for at least a decent bear market rally. If the bulls have some real conviction the pullback today is going to be a step in the right direction. If the bulls really believe weakness is an opportunity to put cash to work, they will prove it.
I have to admit that I'm not at all disappointed to see a pullback at this stage of the game, because the bulls need to be tested. We had a straight up V-shaped bounce out of an extremely gloomy environment. There are many who really want to believe that this 10% bounce is different from the many other such bounces we've had over the past year and half during this bear market. Maybe it really is different, but we really don't have any good evidence yet. Just because a number of things are off their lows of five days ago, that alone isn't convincing.
Whether or not this bounce turns into something more than just another opportunity for flippers and shorts depends on what happens on the pullbacks. If a healthier market is developing, then banks will find support, new leading groups will emerge, and charts will set up. A four-day-long straight-up bounce, regardless of its magnitude, is just a short-term trading opportunity and not the resumption of a bull market.
I'm certainly hopeful that the process of pulling back and finding support will finally give us the chance for at least a decent bear market rally. If the bulls have some real conviction the pullback today is going to be a step in the right direction. If the bulls really believe weakness is an opportunity to put cash to work, they will prove it.
Friday, March 13, 2009
The Bulls' Test Is Coming
The bulls held up quite nicely today; the sellers and shorts were unable to make headway.
Oils were the laggard today on worries about the OPEC meeting this weekend, but retailers, semiconductors, biotech and pharmaceuticals picked up the slack. After bouncing off key support, we traded back to the highs, and the longs decided to stick with their positions in front of the weekend.
After a four-day rally this week, the bullish excitement has really jumped. There is now a big contingent of folks who are ready to embrace the idea that we are in for bear market rally that will last months. There are even those who are ready to declare the death of the ursine market...
I'm certainly rooting for a good uptrend, but the bulls have yet to be tested yet. We had one pullback today that found support right where it needed to, but Friday afternoons are probably not the time when the bears will look to make their case. If we see a gap up on Monday morning, that is when I expect to see a more severe test.
The big positive we have going for the upside right now is the possibility that we will see a bank bailout plan soon. We rode up this week mostly on news about mark-to-market, banks making money outside of their loan portfolios and people being tired of being too negative. The doom and gloom was knee-deep on Monday and we've now boomeranged back in the other direction. Expect some choppiness next week.
Oils were the laggard today on worries about the OPEC meeting this weekend, but retailers, semiconductors, biotech and pharmaceuticals picked up the slack. After bouncing off key support, we traded back to the highs, and the longs decided to stick with their positions in front of the weekend.
After a four-day rally this week, the bullish excitement has really jumped. There is now a big contingent of folks who are ready to embrace the idea that we are in for bear market rally that will last months. There are even those who are ready to declare the death of the ursine market...
I'm certainly rooting for a good uptrend, but the bulls have yet to be tested yet. We had one pullback today that found support right where it needed to, but Friday afternoons are probably not the time when the bears will look to make their case. If we see a gap up on Monday morning, that is when I expect to see a more severe test.
The big positive we have going for the upside right now is the possibility that we will see a bank bailout plan soon. We rode up this week mostly on news about mark-to-market, banks making money outside of their loan portfolios and people being tired of being too negative. The doom and gloom was knee-deep on Monday and we've now boomeranged back in the other direction. Expect some choppiness next week.
The Uptick Rule Wasn't Irrelevant; Put It Back!
Finally it appears that there is a major reconsideration under way of the rules that have come to favor short-sellers and quant traders. The rule wasn't irrelevant, and that the changes were less well-thought-out than many thought -- particularly those who believe that there is no reason whatsoever to get back to this.
Why does this matter so much? Because the issue is intertwined with the mark-to-market debate -- these two "rules" have destroyed more value than the whole subprime/Alt-A /bad CDO mortgages have combined.
The common stocks of banks have become the arbiters of the situation in the absence of the government taking control of the situation -- not the banks themselves. If they are the arbiters, the prosecutors -- runaway, rogue prosecutors -- are the abolition of the uptick rule and the concomitant approval of the ETFs that were meant for rapid trading in either direction, regardless of the destruction of capital and the amazing penalty that you get when you try to embrace equities and the capital-formation process. Change the rules.
Why does this matter so much? Because the issue is intertwined with the mark-to-market debate -- these two "rules" have destroyed more value than the whole subprime/Alt-A /bad CDO mortgages have combined.
The common stocks of banks have become the arbiters of the situation in the absence of the government taking control of the situation -- not the banks themselves. If they are the arbiters, the prosecutors -- runaway, rogue prosecutors -- are the abolition of the uptick rule and the concomitant approval of the ETFs that were meant for rapid trading in either direction, regardless of the destruction of capital and the amazing penalty that you get when you try to embrace equities and the capital-formation process. Change the rules.
Mark To Market Madness
Many performing assets must be marked as nonperforming under the current standards. Asinine, but true. How can performing loans be considered defaulted-on? What kind of true depiction of a company's business is that?
There is a deep and wide gulf of knowledge here. Goldman Sachs, a "merchant" of business, should utilize mark to market. It does not intend to hold assets for five or ten years, only the short run.
A commercial bank intends to hold on to assets for a minimum of five to ten years. If many assets go bad, it has to mark those assets down, but it has the ability to work them out over time if given the chance.
So it makes no sense to mark all assets down on the price of the ones that are foreclosed and sent packing. Call that "mark to desperation," or "mark to fire sale."
Similarly, if a bank owns some CDOs and they are performing for the most part, the agencies shouldn't take them down as if they are all underperforming, but that is happening, too.
If putting all of the commercial banks into receivorship is the goal - just keep doing what you are doing. Bank of America, Wells Fargo, JPMorgan -- they can't survive. They are all too alike.
If that's the goal, state it. Let's get started.
But I disagree with that goal and disagree with the depiction of their books of business as if they are Goldman Sachs.
That's just unintelligent, counterproductive, and truly inaccurate, to boot.
There is a deep and wide gulf of knowledge here. Goldman Sachs, a "merchant" of business, should utilize mark to market. It does not intend to hold assets for five or ten years, only the short run.
A commercial bank intends to hold on to assets for a minimum of five to ten years. If many assets go bad, it has to mark those assets down, but it has the ability to work them out over time if given the chance.
So it makes no sense to mark all assets down on the price of the ones that are foreclosed and sent packing. Call that "mark to desperation," or "mark to fire sale."
Similarly, if a bank owns some CDOs and they are performing for the most part, the agencies shouldn't take them down as if they are all underperforming, but that is happening, too.
If putting all of the commercial banks into receivorship is the goal - just keep doing what you are doing. Bank of America, Wells Fargo, JPMorgan -- they can't survive. They are all too alike.
If that's the goal, state it. Let's get started.
But I disagree with that goal and disagree with the depiction of their books of business as if they are Goldman Sachs.
That's just unintelligent, counterproductive, and truly inaccurate, to boot.
Thursday, March 12, 2009
You Mean Money Can Also Be MADE In The Stock Market?
If one wants to be negative, volume could have been heavier but breadth was excellent and it was a very good follow-through day for the bulls. Volume for the entire three-day bounce has been only average, but a lot of folks are feeling much better now that we have regained about 10% and are back around the lows we hit in November and February. For the year the S&P 500 is still down 17% and the Russell 2000 down 22.5% but you wouldn't know it from the upbeat mood that a couple strong days produce.
The question now is whether we can go further without some backing and filling. The ideal bullish scenario at this juncture is some consolidation of gains through light volume pullbacks. We need the buyers who feel left out to provide underlying support and to keep the selling pressure from pushing us straight back down.
Although the media would have you believe the bear market is now over, I'm pretty confident it isn't going to be that easy. What we have now is a bear market bounce where a bunch of stuff flew straight up in V-shaped fashion. That is good for a certain type of shorter-term trading, but it is still too premature for position trading. Position trades take a while to develop and we've only had three days of positive action with no chance of building bases of support yet.
A three-day rally does get folks excited, and if you timed it right and made some fast trades, you did well. But the real importance of this action is how it sets us up for the future. Is this the foundation of a real bear market rally that will go for weeks or even months?
That is what will really change the mood and deliver the big gains. We are going in the right direction and the news flows seems to be helping, so some optimism is justified.
The question now is whether we can go further without some backing and filling. The ideal bullish scenario at this juncture is some consolidation of gains through light volume pullbacks. We need the buyers who feel left out to provide underlying support and to keep the selling pressure from pushing us straight back down.
Although the media would have you believe the bear market is now over, I'm pretty confident it isn't going to be that easy. What we have now is a bear market bounce where a bunch of stuff flew straight up in V-shaped fashion. That is good for a certain type of shorter-term trading, but it is still too premature for position trading. Position trades take a while to develop and we've only had three days of positive action with no chance of building bases of support yet.
A three-day rally does get folks excited, and if you timed it right and made some fast trades, you did well. But the real importance of this action is how it sets us up for the future. Is this the foundation of a real bear market rally that will go for weeks or even months?
That is what will really change the mood and deliver the big gains. We are going in the right direction and the news flows seems to be helping, so some optimism is justified.
Wednesday, March 11, 2009
Bear Market Rally Sustained
After the big day on Tuesday, the most important thing technically that could happen today was that we didn't give back too much of yesterday's gains. It didn't matter whether there was strong follow-through as long as there was some underlying support.
We did have a little selling in the closing minutes, but overall it was a pretty good day for the bulls. Breadth was on the plus side with financials and technology leading. Oils saw pressure and gold bounced, which are negatives, but it was fairly contained.
Driving this move are the big-caps: GS, AMZN, POT and AAPL. My biggest worry about the market at this point is that we really don't have any leadership sectors. We see some action in big-cap technology and banks, but it is short-term money and not the sort of leadership that is likely to be sustained and take the broader market with it. I'd really like to see technology stocks or some other group step up and keep moving steadily, but it is still very early in the game for that to occur.
We had a good start to a decent bear market rally on Tuesday. Today didn't change things, but we have a lot of overhead resistance and bad news to overcome. The bulls have a slight advantage now, but they still have to prove they have some juice and can sustain some upside. It is going to take a lot of effort and the news flow is likely to remain challenging.
We did have a little selling in the closing minutes, but overall it was a pretty good day for the bulls. Breadth was on the plus side with financials and technology leading. Oils saw pressure and gold bounced, which are negatives, but it was fairly contained.
Driving this move are the big-caps: GS, AMZN, POT and AAPL. My biggest worry about the market at this point is that we really don't have any leadership sectors. We see some action in big-cap technology and banks, but it is short-term money and not the sort of leadership that is likely to be sustained and take the broader market with it. I'd really like to see technology stocks or some other group step up and keep moving steadily, but it is still very early in the game for that to occur.
We had a good start to a decent bear market rally on Tuesday. Today didn't change things, but we have a lot of overhead resistance and bad news to overcome. The bulls have a slight advantage now, but they still have to prove they have some juice and can sustain some upside. It is going to take a lot of effort and the news flow is likely to remain challenging.
Tuesday, March 10, 2009
Finally, A Nice Day
We finally had the highly anticipated oversold bounce and, as usual when we have these sudden spikes higher after a steady downtrend, there are celebrations and declarations of clear sailing ahead.
The catalysts for the move today were an internal memo at Citigroup (C - commentary - Cramer's Take) of profits for January and February, talk that the mark-to-market accounting rules may be tinkered with and announcements by a couple politicians that the uptick rule, making shorting more difficult, is close to being re-imposed.
It certainly was a positive day for the bulls, but it MAY be nothing more than a potentially good start to a bear market rally. We have seen these sorts of spikes numerous times over the past year and they have all fizzled out -- some faster than others.
The key now is to keep an open mind and see if this can develop into something more. Will real buyers be sucked into this, or will it just be the folks who change their mind every day who become overly excited and will be whipsawed and disappointed when we don't go straight back up?
So far what we have is an oversold bounce on good breadth and better-than-average volume. It certainly is good news and an improvement over recent action, but it doesn't warrant a major celebration (yet).
The catalysts for the move today were an internal memo at Citigroup (C - commentary - Cramer's Take) of profits for January and February, talk that the mark-to-market accounting rules may be tinkered with and announcements by a couple politicians that the uptick rule, making shorting more difficult, is close to being re-imposed.
It certainly was a positive day for the bulls, but it MAY be nothing more than a potentially good start to a bear market rally. We have seen these sorts of spikes numerous times over the past year and they have all fizzled out -- some faster than others.
The key now is to keep an open mind and see if this can develop into something more. Will real buyers be sucked into this, or will it just be the folks who change their mind every day who become overly excited and will be whipsawed and disappointed when we don't go straight back up?
So far what we have is an oversold bounce on good breadth and better-than-average volume. It certainly is good news and an improvement over recent action, but it doesn't warrant a major celebration (yet).
Don't Fight This Fed
As we ponder what to do in the short term with this spike in the market, I would like to note that it would be difficult to have imagined a speech and Q&A that could have had more bullish medium term implications than the one Big Ben delivered at the Council of Foreign Relations today. In truth, Big Ben reiterated several themes he has mentioned in other forums. But today’s speech reflects greater clarity and a holistic integration of the various issues. I recommend reading the entire text carefully and going over to youtube.com and looking at the Q&A. Here are some quick observations:
1. Mark-to-market and other regulations that exacerbate pro-cyclicality must be revised. This not only includes M2M but other government regulations and accounting rules regarding capital and loss recognition such as those detailed so well in “Unruly Accounting”. He was even clearer on this point in the Q&A than he was in the text. Big Ben is signaling clearly that these rule changes ARE GOING TO HAPPEN. It is not a matter of if, but when. Big Ben has to be careful not to step on toes because this is not within his authority or jurisdiction. But given those constraints, the handwriting that Big Ben has scribbled on the wall could hardly be clearer.
2. When? In the Q&A Big Ben said that normally such decisions require time and deliberation. But then he said, “Given what is going on in the world, we should look to identify the weak points to mark-to-market and work to make some improvements on a more expeditious basis.” In other words, policy makers realize that they need to move quickly on this. So expect movement on this front.
3. The Fed and the administration will not allow the big banks to fail. He actually placed that in a bold faced heading in the prepared remarks. Any more clarity needed?
4. The government does not want to dilute current common shareholders and will do all it can to accommodate them. The government plan is to use the stress test to determine how much capital the banks need in an “adverse scenario” that is worse than consensus forecasts. The government will then give the banks all the capital they need to cover projected losses in the form of preferred shares. The government will give banks plenty of time to repay the government so that common shareholders will not have to suffer dilution. ONLY if losses are larger than expected and banks are not able to raise capital on terms that are more favorable, will the preferred shares be converted to common. This is a HUGE buy signal for banks such as Bank of America (BAC).
Ben Bernanke is the only government official that is providing leadership in this crisis. From his post at the Fed, there is only so much that he is authorized to do – and he has been stretching the limits of Fed authority at that. But bold leadership is what is required right now and Big Ben seems to realize that the Obama team has got leadership “issues” and that somebody has to step up.
My recommendation: Don’t fight this Fed. Bernanke is putting himself on the line and is delineating a coherent agenda for dealing with this crisis. Big Ben clearly understands that fiscal stimulus and budget plans are virtually irrelevant. EVERYTHING depends on stabilizing financial institutions. Big Ben is telling us that the regulatory rule changes and the capital that banks need are coming and that it will be provided in a market-friendly way.
If you want a better signal than that, I think you will be buying 15% higher from here.
Long BAC Leaps
1. Mark-to-market and other regulations that exacerbate pro-cyclicality must be revised. This not only includes M2M but other government regulations and accounting rules regarding capital and loss recognition such as those detailed so well in “Unruly Accounting”. He was even clearer on this point in the Q&A than he was in the text. Big Ben is signaling clearly that these rule changes ARE GOING TO HAPPEN. It is not a matter of if, but when. Big Ben has to be careful not to step on toes because this is not within his authority or jurisdiction. But given those constraints, the handwriting that Big Ben has scribbled on the wall could hardly be clearer.
2. When? In the Q&A Big Ben said that normally such decisions require time and deliberation. But then he said, “Given what is going on in the world, we should look to identify the weak points to mark-to-market and work to make some improvements on a more expeditious basis.” In other words, policy makers realize that they need to move quickly on this. So expect movement on this front.
3. The Fed and the administration will not allow the big banks to fail. He actually placed that in a bold faced heading in the prepared remarks. Any more clarity needed?
4. The government does not want to dilute current common shareholders and will do all it can to accommodate them. The government plan is to use the stress test to determine how much capital the banks need in an “adverse scenario” that is worse than consensus forecasts. The government will then give the banks all the capital they need to cover projected losses in the form of preferred shares. The government will give banks plenty of time to repay the government so that common shareholders will not have to suffer dilution. ONLY if losses are larger than expected and banks are not able to raise capital on terms that are more favorable, will the preferred shares be converted to common. This is a HUGE buy signal for banks such as Bank of America (BAC).
Ben Bernanke is the only government official that is providing leadership in this crisis. From his post at the Fed, there is only so much that he is authorized to do – and he has been stretching the limits of Fed authority at that. But bold leadership is what is required right now and Big Ben seems to realize that the Obama team has got leadership “issues” and that somebody has to step up.
My recommendation: Don’t fight this Fed. Bernanke is putting himself on the line and is delineating a coherent agenda for dealing with this crisis. Big Ben clearly understands that fiscal stimulus and budget plans are virtually irrelevant. EVERYTHING depends on stabilizing financial institutions. Big Ben is telling us that the regulatory rule changes and the capital that banks need are coming and that it will be provided in a market-friendly way.
If you want a better signal than that, I think you will be buying 15% higher from here.
Long BAC Leaps
We Need The Plus-Tick Rule, Part I
The plus-tick rule should be reinstated. Short-selling, where regulated by the existence of such rules, is a valuable component of well-developed capital markets. It adds liquidity by adding offer-side depth and encourages critical thinking by allowing for a way to profit by being bearish.
Short-selling without a plus-tick rule, however, not only takes liquidity out of the market by diminishing bid-side depth, it actually promotes behavioral factors which tend to diminish critical thought.
The rule addresses fundamental investment return asymmetries caused by permanent emotional and structural biases in the market. Contrary to arguments made in support of its elimination, its continued existence is more critically important today than it was a generation ago. Technological advancements which have in many ways been very good for the market have also made return asymmetries even more lopsided.
Further, these technological advancements have significantly weakened protections against other destabilizing factors that diminish market integrity, such as inaccurate or improper information dissemination and the use of excessive leverage. The plus-tick rule is an indirect but very effective antidote for these as well.
The capital markets exist so that growing enterprises may access capital, pay for the privilege of getting it and allow investors to account for their own liquidity needs without necessarily limiting those of the enterprises accessing the capital. The current system, which is continually evolving, is the best yet discovered which harnesses the power of the profit motive in a positive way while restraining some of its destructive extremes. The evolution of the capital markets is a dialectic, a never-ending process of trial-and-error which careens between "not enough" and "too much" while passing "just right" and spending most of the time in that middle area.
To that point, it doesn't matter that the mistake of removing the rule was made: We now have dramatic evidence that bad things happened in its absence. I will make the case in Part 2 that there is even more to the story
Again, making the mistake of eliminating the rule is nothing, as long as we learn and reinstate it immediately.
Many of us watched firsthand the destruction caused by the practice known as portfolio insurance in 1987, when a structural bias enabled by emerging strategies and technologies caused a dislocation between futures and underlying prices which could have been profitably exploited by those in a position to do so until price levels reached zero. Then as now, it was difficult for the market participants and regulators to get a grasp on the effects of unintended consequences.
An obvious point with respect to the 1987 crash is that the rule was in existence at the time. Although the developing options market provided a way to avoid the rule that was far less ubiquitous a generation prior, I am not arguing that the rule is a panacea, or even that there won't be clever ways devised to get around it. Rather, it is a powerful tool that can be brought to bear upon a large part of the market, and that, along with other factors, helps maintain balance. Now as then, the answer lies in controlling extreme behavior.
Reinstating the rule will be relatively easy to accomplish, it addresses permanent as well as short-term problems, and it will help alleviate problems for which more direct remedies will take some time to implement. The reinstatement of the rule will in particular address imbalances that are unique to today's market, such as those outlined eloquently by Doug Kass, Eric Oberg and others. It will have more relative power today, even, than it might at another time.
This series of articles will have three parts.
The first will address the permanent and structural biases in the market for which the plus-tick rule provides the right counterbalance. There were actually a number of variations to the rule, the first and primary example of which was Rule 10a-1 under the Securities Exchange Act of 1934. I refer generically to the rule because the basic premise is shared across its variations.
The second part will discuss certain obscure but significant risks built into certain market practices such as basket trading and the use of leverage, and examine some of the unintended consequences of having eliminated the rule to the detriment of the original purpose of capital markets.
The third part will describe how the rule has been strengthened and weakened at different times over the past two decades, show how the market acted during those times, and describe the process whereby the rule was eliminated in July 2007.
Part 1
The plus-tick rule was conceived in 1934 to address the lack of balance between the effects of the active emotions fear and greed as they are applied in a marketplace where the majority of investors are owners of stocks. The rule requires that any person selling a stock short must do so only at the price which is the higher of the last two discrete transactions. This means the final trigger on a short-sale transaction must be pulled by a buyer eager enough to do so. This not only forces the seller into the passive role, but allows long sellers to make their sales ahead of short sellers. Today, in the absence of the rule, the short seller may initiate the transaction and compete with natural sellers.
In this way, the rule specifically addresses the effects of emotional behavior on market pricing. There are two primary and related reasons why the rule was applied to selling, rather than buying, stocks. First, although there are many exceptions to this general characteristic, stocks tend to go down faster than they go up. Second, many more stocks are owned than held as short positions, and that results in a permanent bias toward supply which may become available for sale.
Not only are existing investors motivated to sell a security or market that is either trending down or subject to sharp downside moves, new investors tend to stay away as well. Their risk appetite is diminished along with their confidence in any eventual return of, or on, their capital, so they keep that capital away from the market and from the enterprises that may need it.
News accounts last fall promoted the notion that because spreads are so thin now, the rule is irrelevant. This is a specious argument, as while the width of the spread may influence the relative willingness of a buyer to "step up" and take an offer or buy higher than the last sale which was initiated by a long seller, the actual transaction will not occur until the buyer has decided to complete it, proactively.
After all, there is asymmetry between the need to enter any investment position and the need to exit the same one. Going in, the choice is unforced. You can take the position or forget about the whole thing and go bowling. Once the position has been assumed, however, its disposal is a matter of timing only; the act of selling a long, or covering a short, is a foregone conclusion, with the only the future date and price unknown.
Further, any investment position must be monitored to some degree until it is gone. During periods of adverse price action, a person who has not yet taken any investment positions can usually just wait and see whether the price gets better. The person already in a position might also adopt such a stance, but with the very different awareness that when the price goes the wrong way, real money is being lost rather than opportunity. This awareness, evolved into fear, regret and other forms of anguish, can lead to poorly timed exit decisions. History has demonstrated that such negative emotions can be extremely infectious.
Across the whole market, more stocks are owned, or held long, for positive investment returns than are shorted for such profits. When overall market price action is adverse to owners of stocks, more of them are forced to sell than are forced to buy when the price action is adverse to those who are short. There are just more people in long positions to be forced out when things go against them than there are people in short positions who get forced to buy when stocks go up.
This return asymmetry has a detrimental effect beyond what happens to investor wealth. As the security at the bottom of the balance sheet, common stock represents not only permanent capital but also the most sensitive, continuously priced and ubiquitous indicator of a company's fortunes. A rapidly declining stock price can very quickly not just distract management but also begin to limit managers' ability to accomplish financial and strategic operating objectives, creating a vicious downward spiral of cause and effect which can easily threaten the company's existence as a going concern.
There are other less obvious issues and exacerbating influences on these negative effects. As stocks go down, especially into the single digits, a given absolute unit move -- say, a dollar -- in the price per share becomes a larger part of the value overall of the position. The absolute value percentage return for that one-unit move increases relative to that of the return for that unit move when the stock had a higher price per share. This is just math, but it matters because of its effect on the shares' liquidity.
Transaction costs and other market-impact costs are generally not only fixed or not highly correlated to the share price change but also are mostly fixed per share, rather than per transaction. As a proportion of a given position size, they actually increase as share prices decrease and the number of shares required for a given position size increases.
This tends to put upward pressure on market impact costs, attenuating liquidity and increasing volatility, therefore lowering the likelihood that the marginal long-term holder will continue to be willing to stay in the stock, and so adding to potential selling pressure. Share ownership becomes redistributed to more speculative or potentially "weaker" hands, and so on. Finally, share-price limit rules at many institutions and stock exchanges and margin-lending rules related to share prices create additional selling pressure, while reducing the number of potential new investors and available investment capital as those price limits are broached.
The plus-tick rule was a reasonable single-factor counterbalance to these effects. By forcing the short seller to sit on the offer and wait for execution, it adds liquidity to the system. Because under the rule, short sellers are forced to be passive, it holds back supply when bids are disappearing, so acting as a circuit breaker when market action, or the action in an individual stock, becomes so frenetic that there is no time for information to be well disseminated so that cooler heads may prevail.
Short-selling without a plus-tick rule, however, not only takes liquidity out of the market by diminishing bid-side depth, it actually promotes behavioral factors which tend to diminish critical thought.
The rule addresses fundamental investment return asymmetries caused by permanent emotional and structural biases in the market. Contrary to arguments made in support of its elimination, its continued existence is more critically important today than it was a generation ago. Technological advancements which have in many ways been very good for the market have also made return asymmetries even more lopsided.
Further, these technological advancements have significantly weakened protections against other destabilizing factors that diminish market integrity, such as inaccurate or improper information dissemination and the use of excessive leverage. The plus-tick rule is an indirect but very effective antidote for these as well.
The capital markets exist so that growing enterprises may access capital, pay for the privilege of getting it and allow investors to account for their own liquidity needs without necessarily limiting those of the enterprises accessing the capital. The current system, which is continually evolving, is the best yet discovered which harnesses the power of the profit motive in a positive way while restraining some of its destructive extremes. The evolution of the capital markets is a dialectic, a never-ending process of trial-and-error which careens between "not enough" and "too much" while passing "just right" and spending most of the time in that middle area.
To that point, it doesn't matter that the mistake of removing the rule was made: We now have dramatic evidence that bad things happened in its absence. I will make the case in Part 2 that there is even more to the story
Again, making the mistake of eliminating the rule is nothing, as long as we learn and reinstate it immediately.
Many of us watched firsthand the destruction caused by the practice known as portfolio insurance in 1987, when a structural bias enabled by emerging strategies and technologies caused a dislocation between futures and underlying prices which could have been profitably exploited by those in a position to do so until price levels reached zero. Then as now, it was difficult for the market participants and regulators to get a grasp on the effects of unintended consequences.
An obvious point with respect to the 1987 crash is that the rule was in existence at the time. Although the developing options market provided a way to avoid the rule that was far less ubiquitous a generation prior, I am not arguing that the rule is a panacea, or even that there won't be clever ways devised to get around it. Rather, it is a powerful tool that can be brought to bear upon a large part of the market, and that, along with other factors, helps maintain balance. Now as then, the answer lies in controlling extreme behavior.
Reinstating the rule will be relatively easy to accomplish, it addresses permanent as well as short-term problems, and it will help alleviate problems for which more direct remedies will take some time to implement. The reinstatement of the rule will in particular address imbalances that are unique to today's market, such as those outlined eloquently by Doug Kass, Eric Oberg and others. It will have more relative power today, even, than it might at another time.
This series of articles will have three parts.
The first will address the permanent and structural biases in the market for which the plus-tick rule provides the right counterbalance. There were actually a number of variations to the rule, the first and primary example of which was Rule 10a-1 under the Securities Exchange Act of 1934. I refer generically to the rule because the basic premise is shared across its variations.
The second part will discuss certain obscure but significant risks built into certain market practices such as basket trading and the use of leverage, and examine some of the unintended consequences of having eliminated the rule to the detriment of the original purpose of capital markets.
The third part will describe how the rule has been strengthened and weakened at different times over the past two decades, show how the market acted during those times, and describe the process whereby the rule was eliminated in July 2007.
Part 1
The plus-tick rule was conceived in 1934 to address the lack of balance between the effects of the active emotions fear and greed as they are applied in a marketplace where the majority of investors are owners of stocks. The rule requires that any person selling a stock short must do so only at the price which is the higher of the last two discrete transactions. This means the final trigger on a short-sale transaction must be pulled by a buyer eager enough to do so. This not only forces the seller into the passive role, but allows long sellers to make their sales ahead of short sellers. Today, in the absence of the rule, the short seller may initiate the transaction and compete with natural sellers.
In this way, the rule specifically addresses the effects of emotional behavior on market pricing. There are two primary and related reasons why the rule was applied to selling, rather than buying, stocks. First, although there are many exceptions to this general characteristic, stocks tend to go down faster than they go up. Second, many more stocks are owned than held as short positions, and that results in a permanent bias toward supply which may become available for sale.
Not only are existing investors motivated to sell a security or market that is either trending down or subject to sharp downside moves, new investors tend to stay away as well. Their risk appetite is diminished along with their confidence in any eventual return of, or on, their capital, so they keep that capital away from the market and from the enterprises that may need it.
News accounts last fall promoted the notion that because spreads are so thin now, the rule is irrelevant. This is a specious argument, as while the width of the spread may influence the relative willingness of a buyer to "step up" and take an offer or buy higher than the last sale which was initiated by a long seller, the actual transaction will not occur until the buyer has decided to complete it, proactively.
After all, there is asymmetry between the need to enter any investment position and the need to exit the same one. Going in, the choice is unforced. You can take the position or forget about the whole thing and go bowling. Once the position has been assumed, however, its disposal is a matter of timing only; the act of selling a long, or covering a short, is a foregone conclusion, with the only the future date and price unknown.
Further, any investment position must be monitored to some degree until it is gone. During periods of adverse price action, a person who has not yet taken any investment positions can usually just wait and see whether the price gets better. The person already in a position might also adopt such a stance, but with the very different awareness that when the price goes the wrong way, real money is being lost rather than opportunity. This awareness, evolved into fear, regret and other forms of anguish, can lead to poorly timed exit decisions. History has demonstrated that such negative emotions can be extremely infectious.
Across the whole market, more stocks are owned, or held long, for positive investment returns than are shorted for such profits. When overall market price action is adverse to owners of stocks, more of them are forced to sell than are forced to buy when the price action is adverse to those who are short. There are just more people in long positions to be forced out when things go against them than there are people in short positions who get forced to buy when stocks go up.
This return asymmetry has a detrimental effect beyond what happens to investor wealth. As the security at the bottom of the balance sheet, common stock represents not only permanent capital but also the most sensitive, continuously priced and ubiquitous indicator of a company's fortunes. A rapidly declining stock price can very quickly not just distract management but also begin to limit managers' ability to accomplish financial and strategic operating objectives, creating a vicious downward spiral of cause and effect which can easily threaten the company's existence as a going concern.
There are other less obvious issues and exacerbating influences on these negative effects. As stocks go down, especially into the single digits, a given absolute unit move -- say, a dollar -- in the price per share becomes a larger part of the value overall of the position. The absolute value percentage return for that one-unit move increases relative to that of the return for that unit move when the stock had a higher price per share. This is just math, but it matters because of its effect on the shares' liquidity.
Transaction costs and other market-impact costs are generally not only fixed or not highly correlated to the share price change but also are mostly fixed per share, rather than per transaction. As a proportion of a given position size, they actually increase as share prices decrease and the number of shares required for a given position size increases.
This tends to put upward pressure on market impact costs, attenuating liquidity and increasing volatility, therefore lowering the likelihood that the marginal long-term holder will continue to be willing to stay in the stock, and so adding to potential selling pressure. Share ownership becomes redistributed to more speculative or potentially "weaker" hands, and so on. Finally, share-price limit rules at many institutions and stock exchanges and margin-lending rules related to share prices create additional selling pressure, while reducing the number of potential new investors and available investment capital as those price limits are broached.
The plus-tick rule was a reasonable single-factor counterbalance to these effects. By forcing the short seller to sit on the offer and wait for execution, it adds liquidity to the system. Because under the rule, short sellers are forced to be passive, it holds back supply when bids are disappearing, so acting as a circuit breaker when market action, or the action in an individual stock, becomes so frenetic that there is no time for information to be well disseminated so that cooler heads may prevail.
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