It is probably a good thing that the masses don't follow/care/understand the fixed income market in any great numbers. If they did, perhaps it to would be infected by manic depressive response that is pervasive in other markets. Not to say the bond markets haven't been volatile, but after the initial illiquidity-driven shockwave, that markets' actions have followed a pattern that is rational. The variables in the fixed income markets have all been reassigned different weightings in the value calculation mix, but, in general, it is the response expected given what has happened. Credit risk, fear of loss, the value of liquidity have all pushed their way to the front of the line after a long hiatus (Some have said that since this author has removed himself from active participation in fixed income, the market collapsed. I would say that is just speculation and coincidence, albeit uncanny.). The same cannot be said about other markets.
I can hear it already, what about the auction rate market, what about the muni market. Here is the response. The auction rate market isn't a true bond market. It is a bond market disguised as a money market. Money markets have had their own problems, particularly with how to value credit risk. While they are comings to grips with it, money markets may never return to the manner in which they had previously operated. The muni market is, and has always been, a completely different ball of wax than the rest of fixed income. Buyers are motivated by how much they can avoid paying to governments rather than sound financial judgement. The market even made it easier for investors by trying to stamp a AAA imprimatur on every security, reducing the investment decision to one based on tax rates. When the credit risk leg was kicked out from under the muni chair, the market searched frantically for a floor. Given the wide variety of muni issues and issuers, widespread mispricings overcame the market. When absolute (non-tax adjusted) yields reached rational levels as compared to other fixed income investments, buyers emerged providing that floor. In munis, the game has changed for the better, in the long run, as the market and its investors will need to value securities on the same basis as other fixed income investments. No longer will an outside guarantee, regardless of who is providing it, be looked at in the same way as before. Better credits will come out ahead, as the market will reward them for fiscal discipline and sound management. The rest will need to adjust their priorities to reflect the new market reality. From my standpoint, the credit crisis of the past year will end up being positive for the muni market. The old way of doing business there will end. Entrenched constituencies won't like it, but that has been the case in every market change to date.
I have spent many postings addressing the commodities and futures markets. They are both far from rational these days. They can be likened to rush hour at Penn Station. As soon as the track for a train is posted, everyone rushes to the stairs, trying to squeeze through the doorway. Getting through the door early means getting a seat, a valuable commodity for those facing an hour train ride standing at the end of a long day. The futures market is like that doorway; everyone that passes through pushes up the value on the remaining train seats for those still waiting in the station. What the gate rushers seem to forget is that there are usually more seats than riders, some are only going a short distance and will get off, and there is another train leaving in a few minutes. Still, the rush is on. What the riders seem to forget is that sometimes the train breaks down, or is taken out of service, then the rush is to get off the train. What's worse then is that there will be two train loads on people trying to fit on one train. When the speculative bid is removed from the market, and that will happen, it will be like the people leaving that train, scrambling for any way home. Some will get on the next train, some will take a car, and some will go to the bar and wait for a later train. Either way, it will cost the riders/investors something. Nine years ago, oil was at $10/barrel. When the pundits say it can't go down, watch and see the rationality flow back to that market.
Finally, the equity market has been on a roller coaster ride during all this. What is strange to me, but not surprising, is that all of the experts that have been going out of their way to say the US is in a recession are dumbfounded when corporate earnings come in weaker than expected or negative. Why? Of course they are weaker. By their estimation, there is less economic activity so they should be weaker. The problem here is that the people making the estimates are the same ones that are surprised when the estimates are inaccurate. In this market, you have to be a long-term investor or a short-term trader (you can be both, if you can mentally and physically separate the two). The long-term investor doesn't care week-to-week or month-to-month action. The short-term trader is usually a technician, in and out at predetermined level over a very short period. The equity market, however, has been dominated, publicly at least, by the analysts, making a living forecasting quarter-to-quarter earnings. With the uncertainty around credit markets and economic activity, the old rules are less applicable. In the Sarbanes-Oxley world, no company wants to overstate anything. In a perverse twist, the quality of corporate earnings have declined as a result of that legislation. When I first started trading European corporate bonds, it was difficult to get a handle on a company's earnings as they were able to hold earnings in reserve against nothing specific, which they would then reverse during a bad reporting period. This is no different really. There is enough uncertainty surrounding valuations to get away with it. Given that expectations are so low anyway, does it really matter that earning come in a little lower? I guess you can't blame equity analysts too much; it is just garbage in, garbage out. However, the market's rationality and the analyst's raison d'etre will remain in question for some time to come.
Monday, April 14, 2008
Thursday, April 10, 2008
Get Real
The "I told you so" crowd is out in force, decrying right and left everything about the United States: its government; its economic system; its regulatory bodies; on and on et.al. I'm not looking for a backlash so I will refrain from naming names, but it is the usual US bashing cadre; you know who they are. Fortunately, the pilers on, the stock jockeys that were all over the Fed for not cutting rates to zero back in August, have stayed on the sidelines (In fact, those people are now engaged in a love affair with the Fed). This time it is inflation that is the bee in the bonnet.
Inflation is a problem. Certainly, it is much higher than the official statistics being reported. However, the United States and its economy are flexible and resilient. Competition, the availability of substitute goods, etc. all help out. Clearly, not everything is substitutable, but the US will manage. Other countries have fewer options, particularly poorer ones. At the margins, faced with the choice of filling your car with gas or eating, guess what wins out. Serious unrest is certain to occur, and then no one wins. The standard mantra coming out of "the crowd" that emerging market growth is driving prices higher is almost completely nonsense. There is no reasonable justification for the meteoric rise in the price of commodities. It is time for this inflationary burst to be exposed for what it is, a plain old bubble.
Commodity futures were initially established to allow cash market participants the ability to hedge themselves against adverse market moves. Later on, a price discovery function developed, again with the idea of supporting the cash market. In recent times, as futures markets participation became easier, more and more investors jumped in, considering the small investment (relative to the cash market, the investment is negligible) required. Derivative and related securities became available, increasing the number of players. Meanwhile, the markets size and liquidity hasn't to the same degree as the level of participation. Given the pain that commodity price moves have caused and will cause, why hasn't there been the hue and cry from the usual sources as to the root cause of the problem? The reason is that all the players involved in the market are benefiting, a classic bubble scenario.
First, "the crowd" keeps telling everyone these moves are demand driven. Either they are quite naive, or they are trying to manipulate the market. Given that "the crowd" are the largest speculative element out there, I would choose the latter. Second, demand in the largest market, the US, is declining. Some of the declines are greater than reported. For example, the oil component of gasoline is down more than the absolute numbers gasoline usage. Why? The use of ethanol in gasoline is steadily increasing. Ethanol is significantly cheaper than gasoline. This is why refiners keep producing gasoline, even though the widely reported "crack" spread is hovering around zero to negative (if it was negative, there would be little incentive to produce gasoline). Fewer houses being built means far fewer of the commodities used in their production are being consumed. I won't even go into agricultural commodities, where price rises have been dizzying. There isn't that much ethanol being produced to justify a quadruple increase in the price of wheat. Third, and most important, is that everyone in the market is making money. As a trader, it is not hard for me (or anyone) to make money in a one way market. Producers simply lift their hedges or don't put them on in the first place. Consumers go long the contracts, benefiting from the price rise. As supply of contracts from fewer actual hedgers goes down while demand for contracts are increasing, guess what to the contract price? Big speculators go along for the ride, pushing contracts even higher, and then go out to the real world and sell the worldwide demand idea. This is a trader's paradise: put forth little effort and capital, and ride a one way market.
It is time to get real. For example, if the real price of oil should be $110, then the US would be self-sufficient in oil, tapping all of the shale reserves out West at $75-$80/barrel. The government is stepping in everywhere else these days. It needs to expose what is going on publicly,and take the speculative bid out of commodities (significantly raise the margin requirements for not cash market participants). Otherwise, there will be a massive inflationary spiral, which hurt all or a bubble bursting deflationary scenario that, while wouldn't be such a bad thing for the US, would be disastrous for the rest of the world.
Inflation is a problem. Certainly, it is much higher than the official statistics being reported. However, the United States and its economy are flexible and resilient. Competition, the availability of substitute goods, etc. all help out. Clearly, not everything is substitutable, but the US will manage. Other countries have fewer options, particularly poorer ones. At the margins, faced with the choice of filling your car with gas or eating, guess what wins out. Serious unrest is certain to occur, and then no one wins. The standard mantra coming out of "the crowd" that emerging market growth is driving prices higher is almost completely nonsense. There is no reasonable justification for the meteoric rise in the price of commodities. It is time for this inflationary burst to be exposed for what it is, a plain old bubble.
Commodity futures were initially established to allow cash market participants the ability to hedge themselves against adverse market moves. Later on, a price discovery function developed, again with the idea of supporting the cash market. In recent times, as futures markets participation became easier, more and more investors jumped in, considering the small investment (relative to the cash market, the investment is negligible) required. Derivative and related securities became available, increasing the number of players. Meanwhile, the markets size and liquidity hasn't to the same degree as the level of participation. Given the pain that commodity price moves have caused and will cause, why hasn't there been the hue and cry from the usual sources as to the root cause of the problem? The reason is that all the players involved in the market are benefiting, a classic bubble scenario.
First, "the crowd" keeps telling everyone these moves are demand driven. Either they are quite naive, or they are trying to manipulate the market. Given that "the crowd" are the largest speculative element out there, I would choose the latter. Second, demand in the largest market, the US, is declining. Some of the declines are greater than reported. For example, the oil component of gasoline is down more than the absolute numbers gasoline usage. Why? The use of ethanol in gasoline is steadily increasing. Ethanol is significantly cheaper than gasoline. This is why refiners keep producing gasoline, even though the widely reported "crack" spread is hovering around zero to negative (if it was negative, there would be little incentive to produce gasoline). Fewer houses being built means far fewer of the commodities used in their production are being consumed. I won't even go into agricultural commodities, where price rises have been dizzying. There isn't that much ethanol being produced to justify a quadruple increase in the price of wheat. Third, and most important, is that everyone in the market is making money. As a trader, it is not hard for me (or anyone) to make money in a one way market. Producers simply lift their hedges or don't put them on in the first place. Consumers go long the contracts, benefiting from the price rise. As supply of contracts from fewer actual hedgers goes down while demand for contracts are increasing, guess what to the contract price? Big speculators go along for the ride, pushing contracts even higher, and then go out to the real world and sell the worldwide demand idea. This is a trader's paradise: put forth little effort and capital, and ride a one way market.
It is time to get real. For example, if the real price of oil should be $110, then the US would be self-sufficient in oil, tapping all of the shale reserves out West at $75-$80/barrel. The government is stepping in everywhere else these days. It needs to expose what is going on publicly,and take the speculative bid out of commodities (significantly raise the margin requirements for not cash market participants). Otherwise, there will be a massive inflationary spiral, which hurt all or a bubble bursting deflationary scenario that, while wouldn't be such a bad thing for the US, would be disastrous for the rest of the world.
Wednesday, April 2, 2008
Musical Chairs
A former colleague of mine from Lehman wrote on his website yesterday "The value of liquidity is still underappreciated." Those of you that are regular readers here know that this is a central theme of this blog. As the fixed income markets slog through the "great unwind", liquidity will remain at a premium for years (probably) to come. Fixed income traders know this, if they know what they are doing. The problem has been that many people have jumped or been allowed into this marketplace, backed by vast pools of highly levered capital, that really didn't know what they were doing. It isn't hard to make money in a one way market (ask anyone involved in NASDAQ in 1999). The liquidity issue still isn't focused on in the popular press primarily, I believe, because they don't understand it. Most of the media that claims to have some sort of financial background had exposure to the equity market. On the liquidity front, that market is a completely different ball of wax from the fixed income game. The easiest way to explain it to people is to liken the situation to a game of musical chairs.
This game of musical chairs, up until last summer, was one where there were 20 players and 50 chairs. The music never stopped and the only time you sat down was because you were tired. Sitting was never a problem, however, because there were many more chairs than players. Finally, someone read the rules and realized that the music was supposed to stop and chairs were to be removed. So, the market removed 40 of the chairs and stopped the music. Twenty people tried to sit down, and some not knowing any better, fell on the ground. Those who got chairs found out that some of them only had three legs. The music was turned back on but the people in the chairs were tired from all the walking, were afraid of losing their chair, and didn't get up. The music kept playing but still no one got up. The party organizer (aka the Fed) then stepped in and tried to get the players up and moving again by offering treats (lower rates). Some though about getting up, but quickly sat down again. Then, the organizer tried adding a few chairs back to the game, and that seemed to make the players feel better and start to want to play again.
In this game of musical chairs, the players are the investment/commercial banks, you know who the Fed is, the chairs are liquidity and the music represents transactions. However, the goal of this game isn't to have one player left at the end, but rather to keep the game going as long as possible. The music stops once in a while, and someone find themselves odd man out. That's OK, this is a normal function of the checks and balances of the system. On the flip side, there are new market entrants, in which case chairs are added to the game. The organizer watches over the game, sometimes controlling the music and sometimes not, making sure there are the appropriate balance of players and chairs so that the game functions normally.
That balance got out of whack in the past few years. Unfortunately, to bring it back to a harmonious state will cause some of the players to cry and throw tantrums. That is too bad, but perhaps they shouldn't have been playing in the first place.
This game of musical chairs, up until last summer, was one where there were 20 players and 50 chairs. The music never stopped and the only time you sat down was because you were tired. Sitting was never a problem, however, because there were many more chairs than players. Finally, someone read the rules and realized that the music was supposed to stop and chairs were to be removed. So, the market removed 40 of the chairs and stopped the music. Twenty people tried to sit down, and some not knowing any better, fell on the ground. Those who got chairs found out that some of them only had three legs. The music was turned back on but the people in the chairs were tired from all the walking, were afraid of losing their chair, and didn't get up. The music kept playing but still no one got up. The party organizer (aka the Fed) then stepped in and tried to get the players up and moving again by offering treats (lower rates). Some though about getting up, but quickly sat down again. Then, the organizer tried adding a few chairs back to the game, and that seemed to make the players feel better and start to want to play again.
In this game of musical chairs, the players are the investment/commercial banks, you know who the Fed is, the chairs are liquidity and the music represents transactions. However, the goal of this game isn't to have one player left at the end, but rather to keep the game going as long as possible. The music stops once in a while, and someone find themselves odd man out. That's OK, this is a normal function of the checks and balances of the system. On the flip side, there are new market entrants, in which case chairs are added to the game. The organizer watches over the game, sometimes controlling the music and sometimes not, making sure there are the appropriate balance of players and chairs so that the game functions normally.
That balance got out of whack in the past few years. Unfortunately, to bring it back to a harmonious state will cause some of the players to cry and throw tantrums. That is too bad, but perhaps they shouldn't have been playing in the first place.
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