Merrill effort to "lance the boil" shouldn't be surprising. If they survive, and they will, the question is in what form, this will be seen as the bottom for Merrill re: this crisis. As any good trader does when a position is foisted upon him/her, the position is evaluated and quickly as possible, dumped. Perhaps if Mr. Thain inherited the CDO position at 22, he might have been more inclined to keep it. Perhaps not. As the new guy in town, Mr. Thain has had a free shot to do whatever he wants, but that window only stays open for so long. Merrill isn't Goldman Sachs and if he didn't know it before, he knows it now. They shouldn't try to be, either. Fortunately for Merrill and Thain, the company has a lot of assets it has accumulated over the years that it can offload to others. Even at depressed prices, these assets are at much higher levels than what Merrill paid for them; look at its stake in Bloomberg for example. When the CDO position increases in value over time, and it will because Lone Star isn't paying $6.7 billion looking for a tax writeoff, Thain can either say: 1) Oops, I made a mistake. Here is my resignation.; 2) We are taking Merrill in a new direction and CDOs are no longer part of our core business. It was necessary to get them off the books so that we can focus on returning to our roots. I think choice 2 is more likely, of course, as it is what Merrill does best.
Next up is the Treasury weighing in on speculation in the commodity markets. Their verdict, along with a raft of other so-called experts, is that speculation is non-factor in the run up in commodity prices. It is hard to believe, to say the least. The value of every commodity, save potatoes and wine (good news for me on both counts) has shot skyward. This, according to the aforementioned raft, is solely due to supply and demand factors. Now I sat through all the microeconomics courses and understand that the cost at the margin determines the price at the physical commodity (otherwise, oil would be $10/barrel as it costs the Saudis $2 to pump it out of the ground), but there is more going on here than the physical commodity market. I agree completely that it is supply and demand driving prices, but it is the supply of futures contracts, not commodities, that is the problem.
The pundit world says that the futures market in its present form is necessary for hedging , price discovery, speculation, etc. Up to a point that is true. However, when the futures market usurps the cash market as the primary driver of value, then it has gone too far and changes need to be made (The same could be said about the fixed income market, where derivatives have dwarfed the cash market, exacerbating the problem there). Not to sound paranoid, but it is in the best interests of the participants to perpetuate this fantasy regarding prices. The reason is that everybody wins and losers are the non-professionals and commodity consumers (most people in the world). The thought is that there is an open ended supply of futures, so prices will be constrained by the physical commodity level. The problem occurs when a bunch of new participants get involved, funds, hedge funds, ETFs, etc., that have no stake in the physical commodity price. Right now, money has been pouring into this space at a torrid pace, causing a one-way movement. Couple that with easing of market entry and low margin requirements and you are left with situation that currently exists in that market. Changes, especially in relation to margin requirements, need to be made.
Tuesday, July 29, 2008
Wednesday, July 16, 2008
It's Too Late To Privatize...
To change things up a bit, I'll start with the conclusion. Fannie Mae and Freddie Mac should have went the way of Sallie Mae years ago. Alas, it is too late to do that now. First and foremost, let's forget about what might have been. That's in the past and shouldn't be dwelt upon. That leaves two other options. The first is to leave them as a they are now, some kind of public-private hybrid. However, that model is what created the problem. This isn't the UK or a Commonwealth country. We don't have Crown Corporations. If it wasn't for the Treasury and Fed, FNM and FRE common equity would be worthless. They should be worthless. If the common equity went to zero, there would be very little hue or cry about stockholder bailouts or moral hazard. The government would just take over the debts and wind down the two organizations to the size they should be. Note to common stockholders: this is what is going to happen so you might as well bail out of FNM and FRE now.
It didn't have to be that way. Fannie and later Freddie were set up to make sure that there was enough liquidity in the mortgage market so that it would function smoothly. Somewhere along the way, they became more like the investment banks that were profiting so handsomely off Fannie and Freddie securities. They even became publicly traded corporations to make them look like investment banks. Congress, with one notable exception, went along with this charade, fuelled by the political contributions that these two entities pumped into the legislators. This is not to say that the functioning of Fannie and Freddie were not without critics. The commercial banks complained vehemently to anyone that would listen that Fannie and Freddie were engaged in unfair competition given their, implied or otherwise, government backing. The Wall Street Journal has written a steady stream of editorials questioning their practices and their raison d'etre.
As a bond trader for the past 20+ years, we always listened to the party line about implied government obligation, the Treasury credit line, etc. of the agencies. But, it was always assumed that when push came to shove, the government would step with explicit backing. That push came Monday. The government should just take the next step , at this point, and take Fannie and Freddie completely.
What gets lost in the hype of this situation is that, in all likelihood, the government will come out ahead on this whole deal, it probably won't cost anything, and have the ancillary benefit of stabilizing the market. The only problem is the matter of the stockholders. Get over it. Take your lump and move on.
The final point is that, no matter what happens, Fannie and Freddie can't go back to what they were doing. They need to return to their roots, become more Ginnie Mae-like (granted, Ginnie Mae's mandate is much more restrictive, but you haven't heard of any significant problems surrounding them).
It didn't have to be that way. Fannie and later Freddie were set up to make sure that there was enough liquidity in the mortgage market so that it would function smoothly. Somewhere along the way, they became more like the investment banks that were profiting so handsomely off Fannie and Freddie securities. They even became publicly traded corporations to make them look like investment banks. Congress, with one notable exception, went along with this charade, fuelled by the political contributions that these two entities pumped into the legislators. This is not to say that the functioning of Fannie and Freddie were not without critics. The commercial banks complained vehemently to anyone that would listen that Fannie and Freddie were engaged in unfair competition given their, implied or otherwise, government backing. The Wall Street Journal has written a steady stream of editorials questioning their practices and their raison d'etre.
As a bond trader for the past 20+ years, we always listened to the party line about implied government obligation, the Treasury credit line, etc. of the agencies. But, it was always assumed that when push came to shove, the government would step with explicit backing. That push came Monday. The government should just take the next step , at this point, and take Fannie and Freddie completely.
What gets lost in the hype of this situation is that, in all likelihood, the government will come out ahead on this whole deal, it probably won't cost anything, and have the ancillary benefit of stabilizing the market. The only problem is the matter of the stockholders. Get over it. Take your lump and move on.
The final point is that, no matter what happens, Fannie and Freddie can't go back to what they were doing. They need to return to their roots, become more Ginnie Mae-like (granted, Ginnie Mae's mandate is much more restrictive, but you haven't heard of any significant problems surrounding them).
Thursday, July 3, 2008
An Independence Day Wish
In my last post, the final point was to state that Fed needs to move higher, and quickly. Today, as the ECB has pushed up rates 25bps and the US economy lost another 60,000+ jobs, it is even move imperative. While this seems counterintuitive (certainly to the Fed it is), a further at the reasons for slower economic growth make higher rates necessary. A wise corporate bond trader told me many times over that it is all about perception, and perception becomes the reality eventually. That is where we are now. Fuelled by an overactive media (A note to the media: When you start interviewing each other, meaning "reporters" interviewing other "reporters", and passing them off as experts, the line has been crossed. CNBC/NBC are notorious for this practice, but they are all starting to do it.) individual and market psychology has changed to the point where doom and gloom have become a self-fulfilling prophecy.
The most fundamental reason for lowering interest rates is to create conditions that will stimulate economic growth. If it wasn't apparent last year that economic growth didn't need to be stimulated in any meaningful way, it should be now. This blog argued vehemently that interest rates should not have been lowered last year. The problems last year were a response to excesses in various markets (housing, credit, etc.), all interrelated to some degree. In the credit markets, the appropriate response would have been to put in place measures to increase liquidity. In fairness, that did happen, along with the sledgehammer of a lower Fed Funds rate. Housing was even easier. It was and is one of the few markets with too much supply. Prices and supply needed to come down. The market is in the process of doing that. Yes, it is painful, but it is the best way to bring the situation back to equilibrium. It can be argued, and is here, that if the Fed Funds rate hadn't been lowered, banks and other players funded by banks would have more incentive to restructure loans as they would not have had the Fed prop of paying out virtually zero on deposits.
Which brings me back to why rates need to be higher. All of those deposits earning nothing, in a normal stimulative phase, would start to be plowed into other markets in search of higher returns. That isn't happening because the negative psychologies of fear and loss have taken hold. The only funds flow that is occurring is out of losing markets into ones that are overheated, commodities for example. (For the last time, probably not though, the rules on commodity futures trading need to be brought in line with that of equities. I realize this isn't the Fed's bailiwick, but you would think that Ben Bernanke, student of economic history that he is, doesn't talk about the parallels between the Crash of '29, helped by overly liberal margin use in equities, and the current situation in commodities.) Despite rising inflation, investors are willing to accept zero return in exchange for safety. The cycle won't change until the inflationary bias is removed from the equation.
That brings me to my Independence Day wish. This problem can solved in reasonably short order if this country would put aside its differences, look at solutions objectively, be willing to work together and, most importantly, realize that there will have to be some sacrifice to get there. First and second, raise rates and change futures margin requirements. This will ease the pressure in the commodity and currency markets. Third, develop a comprehensive energy policy, one that increases near-term supplies AND focuses on long-term sustainable alternatives. (yes, this can be done) If there needs to be some kind of sliding scale carbon tax to encourage and foster this, then so be it. Fourth, provide certainty to the tax situation in this country. Perhaps if they would stop calling them the Bush tax cuts, Congress might be more inclined to make them permanent. Why this is still being debated is unbelievable!
The last fifteen years has been marked by a Congress doing whatever it can to bide time until a change in the Presidency. We can no longer afford that type of obstructionism/inaction. Whomever gets elected needs our support to do the right thing for the USA. That person also needs to put the needs of this country first.
The most fundamental reason for lowering interest rates is to create conditions that will stimulate economic growth. If it wasn't apparent last year that economic growth didn't need to be stimulated in any meaningful way, it should be now. This blog argued vehemently that interest rates should not have been lowered last year. The problems last year were a response to excesses in various markets (housing, credit, etc.), all interrelated to some degree. In the credit markets, the appropriate response would have been to put in place measures to increase liquidity. In fairness, that did happen, along with the sledgehammer of a lower Fed Funds rate. Housing was even easier. It was and is one of the few markets with too much supply. Prices and supply needed to come down. The market is in the process of doing that. Yes, it is painful, but it is the best way to bring the situation back to equilibrium. It can be argued, and is here, that if the Fed Funds rate hadn't been lowered, banks and other players funded by banks would have more incentive to restructure loans as they would not have had the Fed prop of paying out virtually zero on deposits.
Which brings me back to why rates need to be higher. All of those deposits earning nothing, in a normal stimulative phase, would start to be plowed into other markets in search of higher returns. That isn't happening because the negative psychologies of fear and loss have taken hold. The only funds flow that is occurring is out of losing markets into ones that are overheated, commodities for example. (For the last time, probably not though, the rules on commodity futures trading need to be brought in line with that of equities. I realize this isn't the Fed's bailiwick, but you would think that Ben Bernanke, student of economic history that he is, doesn't talk about the parallels between the Crash of '29, helped by overly liberal margin use in equities, and the current situation in commodities.) Despite rising inflation, investors are willing to accept zero return in exchange for safety. The cycle won't change until the inflationary bias is removed from the equation.
That brings me to my Independence Day wish. This problem can solved in reasonably short order if this country would put aside its differences, look at solutions objectively, be willing to work together and, most importantly, realize that there will have to be some sacrifice to get there. First and second, raise rates and change futures margin requirements. This will ease the pressure in the commodity and currency markets. Third, develop a comprehensive energy policy, one that increases near-term supplies AND focuses on long-term sustainable alternatives. (yes, this can be done) If there needs to be some kind of sliding scale carbon tax to encourage and foster this, then so be it. Fourth, provide certainty to the tax situation in this country. Perhaps if they would stop calling them the Bush tax cuts, Congress might be more inclined to make them permanent. Why this is still being debated is unbelievable!
The last fifteen years has been marked by a Congress doing whatever it can to bide time until a change in the Presidency. We can no longer afford that type of obstructionism/inaction. Whomever gets elected needs our support to do the right thing for the USA. That person also needs to put the needs of this country first.
Wednesday, June 18, 2008
Just Some Random Thoughts...
Sorry for the long break, but I've been busy trying to put a few things together. Reading the paper this morning, I have come up with some random thoughts, which I would like to put forth at this time. Very little is directly fixed income related, but, as I engage in new endeavors, I am seeking to broaden my horizons.
First, I don't think I need to go into the details of the extreme level of irony that is conjured up by the raft of Missouri politicians clamoring for anti-trust protection for Anheuser-Busch, a company that holds roughly 50% of the domestic beer market. As much as I'd rather not see A-B sold off to the Brazilians (it is also ironic that the popular press, not the financial press, keep referring to InBev, as a Belgian company even though senior management all came from AmBev and are Brazilians), anti-trust isn't the way to go. Here's a thought: How about coming up with a plan where A-B would be better off on its own and convincing the stockholders that they should side with current management. It maybe too late for that, but that would be the free market way to handle it. Hiding behind anti-trust means they can't compete effectively. That speaks volumes with regard to A-B as a company.
Next we have Barack Obama criticizing John McCain on changing his mind on offshore drilling. The reason Sen. Obama given is weak, but at least it was different from the tried and true objection of the potential environmental disaster potential of offshore drilling. I think that no one would want to see an environmental problem, but some comfort should be taken in the fact that during Hurricane Katrina, certainly a significant event, no real environmental damage occurred. Sen. Obama stated that offshore drilling won't help lower prices for five years, so it should be allowed. For a guy that is holding himself out as an agent for change in America, that is an odd stance. At $10/barrel, it was easy to say don't drill offshore (or in ANWR, or in the Rocky Mountains, where the largest reserves of oil in the world is trapped in shale) because it didn't make economic sense. The Cubans have already sold drilling rights to the Chinese 60 miles off Key West. The technology is much better than it was almost 30 years ago when most drilling on the Continental Shelf was banned. Just announcing the opening of the shelf to drilling will take some of the speculative bid out of the oil market, the real cause of the spike in oil prices. However, the decision to drill shouldn't be made in a vacuum (which it will, for now). It needs to be part of a comprehensive national energy policy, one that focuses the nation on a day when we are not utterly dependent on foreign oil. If that means a sliding-scale carbon tax, then so be it.
Finally, the Fed needs to raise rates now. For those of you that are regular readers of this blog, you would recall that I was opposed to the easing in the first place. The tangible benefits, of which there really haven't been any, have been far outweighed by the detriments, most notably being a significant contributor to global inflation. Rates at which money is lent hasn't changed in any meaningful way. Even the banks haven't benefited, although maybe their results would be worse if they weren't able to pay virtually zero percent on deposits. Take the cuts back, and use other means to help out the financial system.
First, I don't think I need to go into the details of the extreme level of irony that is conjured up by the raft of Missouri politicians clamoring for anti-trust protection for Anheuser-Busch, a company that holds roughly 50% of the domestic beer market. As much as I'd rather not see A-B sold off to the Brazilians (it is also ironic that the popular press, not the financial press, keep referring to InBev, as a Belgian company even though senior management all came from AmBev and are Brazilians), anti-trust isn't the way to go. Here's a thought: How about coming up with a plan where A-B would be better off on its own and convincing the stockholders that they should side with current management. It maybe too late for that, but that would be the free market way to handle it. Hiding behind anti-trust means they can't compete effectively. That speaks volumes with regard to A-B as a company.
Next we have Barack Obama criticizing John McCain on changing his mind on offshore drilling. The reason Sen. Obama given is weak, but at least it was different from the tried and true objection of the potential environmental disaster potential of offshore drilling. I think that no one would want to see an environmental problem, but some comfort should be taken in the fact that during Hurricane Katrina, certainly a significant event, no real environmental damage occurred. Sen. Obama stated that offshore drilling won't help lower prices for five years, so it should be allowed. For a guy that is holding himself out as an agent for change in America, that is an odd stance. At $10/barrel, it was easy to say don't drill offshore (or in ANWR, or in the Rocky Mountains, where the largest reserves of oil in the world is trapped in shale) because it didn't make economic sense. The Cubans have already sold drilling rights to the Chinese 60 miles off Key West. The technology is much better than it was almost 30 years ago when most drilling on the Continental Shelf was banned. Just announcing the opening of the shelf to drilling will take some of the speculative bid out of the oil market, the real cause of the spike in oil prices. However, the decision to drill shouldn't be made in a vacuum (which it will, for now). It needs to be part of a comprehensive national energy policy, one that focuses the nation on a day when we are not utterly dependent on foreign oil. If that means a sliding-scale carbon tax, then so be it.
Finally, the Fed needs to raise rates now. For those of you that are regular readers of this blog, you would recall that I was opposed to the easing in the first place. The tangible benefits, of which there really haven't been any, have been far outweighed by the detriments, most notably being a significant contributor to global inflation. Rates at which money is lent hasn't changed in any meaningful way. Even the banks haven't benefited, although maybe their results would be worse if they weren't able to pay virtually zero percent on deposits. Take the cuts back, and use other means to help out the financial system.
Friday, May 2, 2008
Recap
I apologize for the hiatus. I took some time to explore the natural beauty of the United States. In the meantime, judging by the level of the stock market, everything seems to be OK in the financial world. Corporate bonds are tighter as are MBS, although both are still ridiculously cheap on purely a historical basis. Munis look better, although, here again, still look like a good value. Treasuries have backed off their "Get me in at any price!" levels, but there is still room to move there. Even Bill Gross went on CNBC on Wednesday exhorting individual investors to call their broker and buy preferreds (of course, that means he is looking to develop a bid for the securities he bought when the market was 10-15% lower). All in all, to steal a non-word from President Harding, the markets are returning to normalcy.
Months ago, I made the case the case that the Fed should have left rates alone. I would still make that case. The lowering of Fed Funds hasn't really helped. Real rates where actual borrowing occurs hasn't dropped that much. HELOCs are lower, but the people that would access that type of facility have little or negative equity in their homes. Lower rates should have helped banks make money, but I don't think observed experience bears that out. Banks have been helped much more by the other Fed actions than a lower Funds rate. Lower Fed Funds should have drawn more money out of money funds, but with the uncertainty around markets and the continual economy bashing going on in the media investors have been reluctant to do so. Maybe with more certainty which leads to greater confidence that will happen, as is normal in a rate cutting cycle. What lower rates have caused is less interest income to people that could use it, less incentive to invest, especially in housing as buyers wait for lower rates and price bottoming, and the acceleration of a trend out of dollar assets and into foreign currencies and commodities. Now that the Fed is done (hopefully), the rate cuts can have the stimulative effect.
The commodity price inflation was helped along by Fed actions, but they weren't the cause. Just because demand somewhere or in aggregate is 10% higher does not justify 100-400% increases in raw commodities. Supply at the margins isn't that bad regardless of how many experts are paraded on TV saying that this is the cause for high prices. These are the same that benefit from the increases: commodity traders; commodity investors and commodity producers. It is really a masterful propaganda job; Goebbels would be proud. Speculation is the cause of high prices, pure and simple. Take the speculative bid out of the market, and prices mover back to real levels. Everyone was up in arms when it was disclosed the Bear Stearns was levered 30 to 1. Commodity speculation is even move highly levered and quite easy to do. The more people investing allows the relative small futures market to be easily propped up. Hedgers are the major players anymore., it's hedge funds. Changes need to be made as how this market operates. I would suggest having the same margin requirements as they do in the equity market. This alone would bring prices back to reasonable levels.
This sounds like some kind of left wing drivel along the lines of "Workers of the world, unite!". It isn't. Rules are necessary to maintain some kind of order in markets. When market problems spill over into the real world, that is when disaster strikes. The Crash of '29 and subsequent Depression were started by an overlevered equity market that fell apart (leading to margin rules against it) and bad decision making later on that helped it along. The commodity price spiral could push the world into the same type of bad decision making that would be ugly. Better to do the right thing now than to forced into action later.
Months ago, I made the case the case that the Fed should have left rates alone. I would still make that case. The lowering of Fed Funds hasn't really helped. Real rates where actual borrowing occurs hasn't dropped that much. HELOCs are lower, but the people that would access that type of facility have little or negative equity in their homes. Lower rates should have helped banks make money, but I don't think observed experience bears that out. Banks have been helped much more by the other Fed actions than a lower Funds rate. Lower Fed Funds should have drawn more money out of money funds, but with the uncertainty around markets and the continual economy bashing going on in the media investors have been reluctant to do so. Maybe with more certainty which leads to greater confidence that will happen, as is normal in a rate cutting cycle. What lower rates have caused is less interest income to people that could use it, less incentive to invest, especially in housing as buyers wait for lower rates and price bottoming, and the acceleration of a trend out of dollar assets and into foreign currencies and commodities. Now that the Fed is done (hopefully), the rate cuts can have the stimulative effect.
The commodity price inflation was helped along by Fed actions, but they weren't the cause. Just because demand somewhere or in aggregate is 10% higher does not justify 100-400% increases in raw commodities. Supply at the margins isn't that bad regardless of how many experts are paraded on TV saying that this is the cause for high prices. These are the same that benefit from the increases: commodity traders; commodity investors and commodity producers. It is really a masterful propaganda job; Goebbels would be proud. Speculation is the cause of high prices, pure and simple. Take the speculative bid out of the market, and prices mover back to real levels. Everyone was up in arms when it was disclosed the Bear Stearns was levered 30 to 1. Commodity speculation is even move highly levered and quite easy to do. The more people investing allows the relative small futures market to be easily propped up. Hedgers are the major players anymore., it's hedge funds. Changes need to be made as how this market operates. I would suggest having the same margin requirements as they do in the equity market. This alone would bring prices back to reasonable levels.
This sounds like some kind of left wing drivel along the lines of "Workers of the world, unite!". It isn't. Rules are necessary to maintain some kind of order in markets. When market problems spill over into the real world, that is when disaster strikes. The Crash of '29 and subsequent Depression were started by an overlevered equity market that fell apart (leading to margin rules against it) and bad decision making later on that helped it along. The commodity price spiral could push the world into the same type of bad decision making that would be ugly. Better to do the right thing now than to forced into action later.
Monday, April 14, 2008
The Rational Market
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.
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.
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.
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