Archive for August, 2007

Stock Market Action & The Fed

Wednesday, August 29th, 2007
Below is an email I received this morning from noted economist Bob Genetski. Yesterday’s big drop in the market caused a few heads to turn, but Bob’s explanation seems to make sense to me. This, coupled with the fact that the week before Labor Day is sparsely populated on Wall Street and you have lesser experienced traders over-reacting to news.

My stand on the equity market still holds: this is a dip that should be used to reposition portfolios into our favored sectors (which we’ve been doing).

Enjoy Bob’s note.


Yesterday’s stock market response to economic news, particularly the Minutes of the Fed’s Aug. 7th meeting was just plain goofy. Everyone knows, or should know, that the Fed screwed up at its Aug. 7th meeting. Credit markets responded to the screw up two days later. After the credit squeeze, the Fed reversed its decision of two days earlier and allowed the effective fed funds rate to decline by about 50 basis points. Publishing obsolete Minutes without some amended, updated comments apparently left the impression that the Fed remained oblivious to the current credit crunch. That just isn’t the case.

The decline in consumer confidence also should not have been surprising, given the developments with respect to credit problems and the stock market crash earlier this month.

As for the decline in housing prices, the latest Case-Shiller home price index shows prices in June down 4% from the peak reached in June of 2006. The futures market calls for an additional 4.5% decline to the middle of next year for a total decline of 8.5%. Previously, the total decline in the futures market had been forecast to be 7%. From the betting on futures markets, the deterioration in the credit situation for housing over the past month has added an additional 1.5% to the expected drop in home values from the peak. Given that the credit squeeze has been centered on the housing sector, the expectation that housing prices will fall by only an additional 1.5% represents a pretty modest change.

Bottom line–none of this information yesterday added to what we already knew. Perhaps all of it coming on the same day contributed to yesterday’s market’s sharp downward move.
I continue to believe that the stock market is overreacting to old news, that the Fed will continue to restore liquidity to the system and that stock prices will recover.

Robert Genetski

SubPrime Mess Explained

Friday, August 17th, 2007

Its been a busy two weeks given the melt down in the credit markets. The catalyst was the unwinding of the SubPrime Lending market, but it transitioned into a full blown credit crunch. I’ve been researching and analyzing what happened (many thanks to David Merkel and Doug Kass for their source materials and news reporting from their own blog posts ) in order to put things into a historical context and to look to the future for the impact on our portfolios. In doing this, the analysis below will hopefully give you some perspective on what is happening.

Greed drives normally sane investors to seek outsized returns that have no true investment basis, rather they are engineered from derivative securities. The demand for these derivative securities drives up the compensation for the investment professionals who can utilize the derivative securities in a manner to achieve (albeit for a short period of time) the outsized returns. The increased compensation morphs into unjustified rewards which drive investment professionals to accept unjustified levels of risk in search of more reward, for their clients and for themselves.

The current crisis in the financial markets stems from both of these situations. Hedge fund providers are paid huge fees to provide above average investment returns and for short periods of time, investors see these and invest ever-increasing amounts of money in these hedge funds. Here is a short step-by-step discussion of how the search for outsized returns and the incentive to provide them worked relative to the hedge funds that bought the subprime paper:

  • Hedge “fund-of-funds” demand smooth returns that are higher than what a moderate quality short-term fixed-income fund can deliver. Fund-of-fund managers are paid an annual management fee plus an large incentive fee if the return exceeds a target level
  • This leads to the creation of hedge funds that seek yield through arbitrage strategies.
  • And the creation of hedge funds that seek yield through buying risky debts, without the use of leverage.
  • And the creation of hedge funds that seek yield through buying less risky debts, using leverage.
  • And the creation of hedge funds that seek yield through buying risky debts, using leverage.

In the short run, yield-seeking strategies work. If a lot of players pursue them, they work extra-well for a time, as late entrants to the trade push up the returns for early entrants. Increasingly greater demand for scarce, illiquid securities with extra yield make current holdings of them more valuable, providing ever greater incentive for hedge fund managers to obtain more of them.

These illiquid securities have no discernible market so they are priced off computer models using pricing grids. The pressure of demand for more of these illiquid securities raises the value not only of the securities being bought, but also of those securities already owned. If more of these securities are being bought, the computer models price them ever higher.

The problem that we have now is that since there is no secondary market to sell them. When the funds try to liquidate them in private transactions in order to meet client redemption requests, they are being offered 20 cents on the dollar. The assets, if sold at that price, are not adequate to pay off the debt incurred by the fund during the leveraging process — let alone enough to fund the client redemption requests — and the fund folds (just as Bear Sterns folded three of their funds).

Over the years, there have been various crises in the financial markets related to leverage and derivative securities. It is not unlike a game of musical chairs when the music stops and all the players are searching for a safe place to land. Something shifts at the back of the chain of related events which forces every asset in the category to reprice. For example:

  • 1989-1994: After the real estate boom of the mid-1980s, many banks, savings & loans and insurance companies get loose in their lending standards and real estate investment, leading to a crisis when rent growth can’t keep up with financing terms; defaults ensue, killing off a great number of S&Ls, some major insurance companies and a passel of medium and small banks.

  • Late 1991-early 1993: The adjustable-rate mortgage market, fueled by demand from ARM funds, overbids for ARMs in an effort to provide a high floating rate yield. As the FOMC loosens monetary policy, higher than expected prepayments force losses onto the ARM funds

  • Late 1993-late 1994: The FOMC threatens to, and does, start raising interest rates, which throws the residential mortgage-backed market into crisis. Pre-payments on mortgage pools dropped and the computer models that predicted the returns on derivative instruments were found to be erroneous. Many holders who purchased mid-tranche bonds and who planned on a certain average life actually ended up holding the bonds significantly longer.

  • Mid-1998-mid-1999: Long Term Capital Management blows up, forcing all manner of exotic asset-backed securities (ABS), residential-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) into the market for bids. The bids back up, until the entire market reprices downward and the holders of other similar securities see the values of their holdings tumble. Funds that had significant leverage fold.
  • 1998-1999: Home equity ABS blow up, as defaults threaten to, and then do, emerge at levels far higher than anticipated. Almost no originators survive.
  • 1999-2001: Cruddy high-yield bonds reveal their true value as defaults threaten to, and then do, emerge.
  • 2002-2003: The manufactured-housing ABS market blows up, as originators don’t take initial losses but roll borrowers over into new loans that reduce payments and extend payment terms, technically keeping the loans current. The system collapses when the buildup of bad debts and repossessed homes becomes too great to roll over.

Of the existing large securitization markets, only the CMBS market so far has not faced a real crisis, partly due to the influence of the B-piece buyers cartel: six or so firms that buy the junk-rated debt of deals and enforce credit quality standards on the individual loans by kicking out poorly underwritten loans.

In each of these situations, there was a boom-bust cycle. The markets did not adjust slowly and evenly to changing conditions; the transitions between “boom” pricing and “bust” pricing were swift. This is the nature of markets, particularly when enough debt is employed to amplify the process – in the case of the Bear Sterns funds, they were levered 15-to-1. That situation mirrors what we are seeing today in the subprime market.

There is no conspiracy necessary to make the shift happen even though often the media or the government will make it seem like there was one – remember it was simply greed that caused it.

The bubble pops when the credit market dries up and financing is not available to carry the assets. The assets reprice downward and no longer adequately secure the value of the loans obtained in the leveraging process. After the bubble pops, it becomes a question of what the underlying assets can be liquidated for, allocating losses mercilessly according to the loan documents and bankruptcy priority. Nothing is left over for the investors who were searching for the outsized returns.

Today’s crises are in the areas of (a) nonprime lending, (b) leveraged buyouts and other high-yield debt, and (c) over-leverage in the collateralized debt obligations (CDO) market. These problems will get worked out, as all other crises have, handing losses to those who speculated unwisely. Those fund managers who financed properly or who acted opportunistically buying the high quality assets from the failing hedge funds end up prospering once the crisis has passed (the high quality assets have to be liquidated along with the illiquid assets in the unwinding process).

The next shoe to drop will be with the management of money market mutual funds. We are already starting to see a number of money market funds disclose that they invested in subprime paper in order to increase money fund yields. In their grasping for yield, many money market funds — including BlackRock , Charles Schwab and Fidelity — attempted to enhance their investment returns by purchasing low-quality debt instruments (collateralized debt obligations, continuous linked settlements, mortgage-backed securities, etc.).

Many of those money market funds — like the hedge funds that invest in them (particularly futures funds, which typically keep large cash positions) — have yet to mark to market, or if they have, in certain cases have halted redemptions. This is likely the first time that many investors will hear that their money market mutual funds can lose money or that they cannot access their funds when they need the money. Depending upon how widespread this becomes, and whether Schwab and Fidelity infuse their own capital to make their funds whole, it will likely impact a lot of unsuspecting investors.

As with past crises, we will get past it, but not before a lot of pain is felt by investors who were either not paying attention to what they bought or by investors who greedily bought investments for outsized returns without understanding that with reward always comes risk.

As the stock and bond market has been tumbling downward, we have been buying shares of the companies in sectors that will continue to have strong earnings: energy, metals, Ag, defense and infrastructure. These commodity and economically cyclical names have been sold off because of two situations: (1) certain investors (hedge funds and mutual funds) are being forced to sell good companies because the bad investments they hold – subprime bonds – cannot get a bid at a time when shareholder redemptions are requiring them to raise cash; (2) some investors believe that we are at the beginning of a global slowdown and the commodity and cyclical names will have reduced earnings.

Situation (1) above is a temporary phenomenon that gives us buying opportunities. Situation (2) above is a point worth debating. If these investors are right, then selling these companies is a better move than buying them.

At this time, there is no evidence that we will see a slowing of people moving into the middle class in China and India. All of the numbers continue to show that millions are moving each year out of poverty into the middle class as their job situations improve. This means that the demand for all of products in our preferred sectors will continue and the earnings for the companies in those sectors will continue to grow. Could the GDP growth slow in China and India from double digit levels to high single digits? Absolutely. But to think that this will derail this investment theme makes no sense. On a comparative basis, if the companies in these sectors continue to grow earnings at a greater pace than companies in other sectors, this is still the preferred investment.

At this time, we will continue to follow our strategy and opportunistically make purchases in these sectors for the long-term outperformance of our client’s portfolios.


Demographic Changes

Tuesday, August 7th, 2007

This week’s Economist magazine has an excellent article on demographic changes in the world. Japan, South Korea, Italy, and Russia are in the worst shape, with the rest of Europe not far behind. The US is in slightly better shape, but only because of the huge influx of Hispanics and Asians in this country.

China, India, South East Asia, and South America are all growing and moving millions into the middle class. This is a secular trend that will continue for years.

Demographic changes are the driving force behind all investment decisions, either directly or indirectly. The investment themes that focus on the positive demographic trends in the developing world (Ag, Energy, Metals, Infrastructure) have years to run. Yes, there will be short-term pullbacks based upon cyclical factors, but ultimately the direction in these specific industries is up.

More later!


NASDAQ 100 Breaks Trend Line

Monday, August 6th, 2007

Looking at the chart above (courtesy of Chris Schumacher at The Street.Com) the NASDAQ 100 have clearly broken down and are correcting. They have broken through their uptrend line and appear to be headed to support established earlier this year.

We should be seeing a turn around based upon the fundamentals and the seasonally strong time for tech stocks. However, investors are working out the subprime lending mess and the stocks that get sold first are generally the most aggressive ones, which tech fits into.

The strategy for a situation like this is to hold on for the ride, don’t commit new money unless there is something specific at a certain company the presents a compelling reason to buy. The subprime mess will likely work itself out one way or another. We just have to hope that it is a short-term problem and doesn’t turn into a long drawn out ordeal.


BKX in Bear Market

Thursday, August 2nd, 2007

The post earlier noted that the VIX was at a 5-year high, indicating that we likely would see higher stock prices in coming weeks. The indicator leads us to believe that now is a good time to buy stocks.

The graph above (courtesy of Richard Suttmeer at The Street) is of the BKX (Philadelphia Stock Exchange Bank Index) and it shows that the Financials have entered into a bear market. They are down 10.6% YTD and are at their lowest point in over 4 years.

Historically, the BKX has been a good predictor of the fate of the broader large cap market. It has generally preceeded the performance of the S&P 500 and DJIA up and down by 6 months or so. We have never had a bull market in the broader stock market averages without the banks leading the way. It has just never happened.

The reason that the BKX reading is so important is that it is a proxy for the health of the US financial system. The stock market cannot perform well if the fundamentals of our economy and currency have issues. The current problems with the subprime lending market are leaking over into the big banks and brokers. Is the BKX telling us that we are going to have a major lending institution go under?

I can well remember the pain that the fall of Long Term Capital Management (one of the first and most successful hedge funds – you can read about it on the net and the negative impact it had on the financial markets in the 90’s) had on the stock market.

Even though the 90’s were a decade or more ago, we still have financial institutions that will, in hindsight, do dumb things accepting more risk than they are compensated for. With trillions of dollars in derivatives exposure, JP Morgan has positioned itself as the arbiter of risk and risk management. The same mathematical models that the subprime lenders at Bear Stearns (who are on the verge of bankrupting their third subprime hedge fund in as many weeks) used are being used by the bankers that price the risk on derivative instruments. My best guess is that these models will not be as successful as everyone (particularly JP Morgan) hopes. The mathematical models show that the investment risk in the derivative instruments is spread out so widely that no one can get hurt. This risk can be interest rate risk, credit risk, currency fluctuation risk, default risk, or anything else that the mathematicians believe they can model.

Unfortunately, the subprime market’s mathematical models showed that the default risk on mortgages was spread out so widely that no institution could get hurt – tell that to LEND and AHM, a pair of mortgage brokers that have announced that they will go belly up.

Any dislocation in the derivatives market will make the minor problems from the subprime market look like a blip on the radar. The subprime market is billions of dollars – the derivatives market is exponentially larger. It is definitely something that could throw the stock market into a secular bear, but more importantly, it could damage the banking system, throw the US (and the world) economy into a protracted recession, and crush the dollar.

The previous paragraph paints a fairly draconian outcome that is possible, but currently not likely – the derivatives market is currently operating as predicted (but so was the subprime market…until it wasn’t). It is our job as fiduciaries and money managers to assess risk in client portfolios. At the very least, maybe BKX is telling us that there is more pain to be felt in this correction before we see the next major leg up in the bull market. Both the VIX and the BKX have strong track records as indicators. When we see two strong indicators flashing divergent signals it is strong evidence that you want to reduce exposure to the markets weakest sectors (financials) and increase exposure to the markets strongest sectors (those with real earnings growth and pricing power – Ag, energy, metals, infrastructure, machinery, and defense), and keep some cash on hand for some opportunistic buying presented by the volatility in the markets.

That is what we have been doing over the last couple of weeks and we will continue to do so. There are some great bargains out there in our favorite investment themes. We are rotating into them with the expectation that a year from now we should see 20% gains or more on these names (absent the currently unlikely draconian outcome discussed above). Not all of these investments will work out – that’s just the way it is – investing in individual companies can be frustrating as CEO’s and managers are human and can make bad decisions that negatively impact earnings on a microeconomic level – in spite of having marcoeconomic fundamentals on their side. However, as long as the preponderance of the companies operating in our investment themes manage their businesses soundly and the macroeconomic fundamentals push these sectors forward, our clients will be winners no matter what the major averages do.

More later!


VIX hits 5-year high

Thursday, August 2nd, 2007

The widely followed Volatility Index hit a 5-year high today as you can see in the graph above. The VIX is also known as the fear index, and the higher it goes the more likely you’ll see a very volatile market, yet ultimately higher stock market prices as weak investors are forced to sell at bargain prices to committed long-term investors.

Analyst Donald Luskin writes: “Peaks in the VIX are closely associated with market bottoms. That’s because climaxes of fear are times when everyone who’s ever going to sell has sold — and when all the sellers are out of the way, the buyers have the field all to themselves. Take a look at the peaks in the VIX — the crash of October 1987, the oil crisis before the Gulf War in 1990, the global financial crises of October 1997 and October 1998, and the panic following the terrorist attacks of September 2001. They were all terrific buying opportunities. And now we’ve got another one. On average since 1986 (when the VIX was first calculated), the market has returned 16.9% in the 12 months following VIX readings above 40 — that’s more than half-again better than the 11.3% average for all 12-month periods.

“What’s the VIX exactly? It’s a measure of the market volatility reflected in prices of Standard & Poor’s 100 index options traded on the Chicago Board Options Exchange. To understand the VIX, all you have to do is grasp what volatility means, and then see why volatility gets reflected in options prices.

“Volatility is just a statistical term to measure the tendency of the market to fluctuate — a lot or a little. Big fluctuations like we’ve had recently suggest fear, because they mean that investors are frantically changing their minds about what stocks are worth in the face of great uncertainty. Smaller fluctuations suggest that investors are confident that they know what stocks are worth.”

Donald Luskin wrote this back in 2002, the last time that the VIX was above current levels. Then, it was at 40 at the peak of the post 9-11 market correction. Since then, stocks have performed amazingly.

There is no reason to think that today isn’t a buying opportunity just as it was in 2002 and earlier this year when the market sold off. Long-term investors with the conviction of their belief in their investment strategy will see profits from trades made at this level.

More later!


Sub-Prime, Sub-Performance

Wednesday, August 1st, 2007

Well, we’ve had a busy few days.

The market has been down then up then down then up, but the trend is down. What’s causing this? The melt down in the credit markets.

It started as a problem with sub-prime loans, but now we see that a lot of prime loans are having problems because the lenders gave borrowers home equity loans to get them from 0% down to 80% down. The 80% down loan appeared to be a prime borrowing, but the borrower still owed 100% on the house. Ugly.

So, what is and is not working?

There are some strong sectors that you can now buy at prices lower than a couple of weeks ago: Ag, Infrastructure, Machinery, Defense, Energy, Metals. These are the sectors that have pricing power and they will be winners. Buying now when prices have pulled back is an opportunity.

Cycle out of the financials and into these sectors. There is value in these sectors; there is pain or at best malaise in the financials.

I’ve been buying quality defense stocks (Northrup Gurman, Lockheed), Ag stocks (Syngenta, Monsanto, Deere, BASF) and energy ( Weatherford) on the pullback. These are companies with strong earnings and strong prospects for better than average earnings growth.

More later!