Author: subir

The collapse of 2:45pm and it’s broader implications.

The collapse of 2:45pm and it’s broader implications.

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DominosLike most market participants, we watched the market moves yesterday afternoon with a certain degree of amazement.  Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop.  But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery.  It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009.

While there have been some theories put forth to explain what happened yesterday, we do not have a definitive explanation for the rapid decline and subsequent recovery.  That said, we would like to share a few observations about yesterday’s trading and its broader implications:

  1. Equity markets were already down substantially (on the order of 3-4%) before the sudden drop occurred between 2:30 and 3:00pm. During their (brief) lows, the broad indexes were down over 9% before recovering.  We closed the day down 3-4% across the major indices.
  2. The sudden decline took us through multiple significant technical support levels. Volume was steady through the morning, picked up around noon and rocketed after 2:30.  Yesterday was the second highest-volume day on record.
  3. There were various (as yet unsubstantiated) rumors of “trader error” causing the decline. There have also been reports that many high-frequency trading operators stopped trading entirely since they hit internal limits which kick in under extreme conditions.
  4. Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets.

The last point is the most significant for investors. There is a reasonable suspicion is that yesterday’s activity in the currency markets was part of an unwinding of the carry trade. Carry-traders are very sensitive to risk since they run large, leveraged positions which can be quickly wiped out. If this is correct, the events of this week were broadly similar to moves that occurred in August 2007, which affected quantitative hedge funds mostly, and marked the beginning of the declines of 2008 and 2009. See Andrew Lo’s paper, What happened to the quants in August 2007.

The technical reasons for the stock market decline are what have received the most scrutiny in the press. In our view, the steady surrender of volume and responsibility from trading floors (where participants meet market-makers face to face) to electronic exchanges with liquidity provided by automated high-frequency trading systems certainly exacerbated the sudden acceleration of the decline, but did not cause it.

Not-withstanding purely technical reasons affecting the speed and steepness of a 15 minute decline, the underlying reasons for increased risk-aversion are real. We also believe it betrays extremely short-term memory to claim that such sudden declines do not occur in a specialist managed market. We only need to point to Black Monday (October 19, 1987), when the market dropped 22% over the course of the day.  In 1987, most stock was traded via specialists on the physical floor of the NYSE.   In that instance, automated selling by “portfolio insurance” providers accelerated the decline.  Yesterday, the NYSE maintained a relatively orderly market, the extremely low-priced trades appear to have occurred on secondary exchanges with low liquidity where numerous market sell or stop loss orders may have encountered a limited number of bids and shallow order books.   In and of itself, this is not unusual, stocks always decline suddenly when there are a lot of sellers and no buyers.

This is an interesting debate, but in our view is largely irrelevant for investors.  One market commentator remarked:

For starters, let’s all keep in mind that these things don’t happen in a healthy tape. The jitters from Greek rioting and possible contagion were the necessary preconditions for a crash like that.

The major conclusions we draw from the trading action of the past week is that:

  1. Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
  2. The Euro-zone crisis will continue to roil markets until it is properly addressed.
  3. There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.

Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.

Further reading:

Felix Salomon’s initial take: How a market crashes

Felix after taking a deep breath: Deconstructing the crash

Bloomberg’s Nina Mehta and Craig Nagi: Market fragmentation may get review after stock drop

The Euro-zone is like…

The Euro-zone is like…

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Image of boats

For the past several months, we have been thinking about the broader Euro-zone’s economic malaise.   In the course of conversations, we sometimes use analogies, and we thought we’d share this one with our readers.

As part of the aim to integrate Europe and limit the future likelihood of war, European countries have sought to develop deep political links (by joining the European Union) and integrate their financial markets (by joining the shared currency regime).  As a result of this process, large, developed, stable economies in Europe (Germany, France etc.) have lashed themselves to smaller, relatively under-developed, unstable economies (Greece, Portugal, etc.).

Imagine each of these countries as boats on the open ocean.  Some of them are large, modern vessels carrying many passengers, while others are smaller, rickety affairs.  In creating the European Monetary Union, these countries sought to create a larger water-craft by roping together many different boats.  There are definitely advantages to doing this.  Passengers on the boats (citizens) can now easily trade and transact with those on other boats.

However, it takes generations for all passengers to develop a sense of common destiny and values.  The Eurozone has not had that much time, yet finds itself in the middle of a large storm.  The big problem is that there is no mechanism defined to detach the larger unit from a vessel that has begun to sink in a storm.

Passengers on the sound, stable sea-craft (German burghers) do not want to put themselves at risk by stepping onto the sinking ships to help bail water, yet their captains are calling for them to do so.  Meanwhile, the combined craft made of many mis-matched boats continues to tilt and take on more water.

To compound the problem, we saw a riot on one of the sinking boats yesterday.  Some passengers (Greek nationals) on that boat tried to set it (literally) on fire.  The rest of the world does not expect such things to happen in developed economies and looks on in disbelief.

What we find remarkable, is the speed with which assumptions have changed.  Nine short months ago, virtually everyone was calling the demise of the US dollar and the rise of the Euro as the new global reserve currency. Now we are at a point where the dissolution of the Euro is being openly debated.  Greek citizens riot in the streets because their elected representatives have chosen to call a halt to profligate policies and crack down on pervasive tax-dodging and fudging of statistics.  The rest of the world stares aghast. Meanwhiles, the rats (speculators) are deserting the ship.

For a less metaphorical take on the crisis, please read Edward Chancellor’s FT Opinion piece  Greece a bad omen for others in debt.

Bond Buyer: Moody’s Lifts Up 34 states

Bond Buyer: Moody’s Lifts Up 34 states

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The Bond Buyer reports that:

Moody’s Investors Service kicked off a wide-scale “upward shift” in municipal credit ratings yesterday, assigning stronger grades to 34 states and Puerto Rico.

the article contains a complete list of ratings for all US states Moody’s assigns ratings for.  The new ratings are comparable to ratings for other entities.  Prior to the recalibration, US municipal issuers was rated on a different scale from all other credit ratings.  California’s credit rating was upgraded from Baa1 to A1.

WSQ Capital Quarterly Letter: 2010 Q1

WSQ Capital Quarterly Letter: 2010 Q1

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For this letter, we’ve attached a brief summary of the investment highlights for the first quarter along with our analysis.  We hope you find this useful.

Two major economic developments not covered in this attachment we thought worth mentioning are:

Landmark Health Care Legislation. Congress and the Obama administration finally managed to pass the much debated health-care bill.  We believe we will see further attempts to control the costs of health-care in the US, including an emphasis on preventive medicine and result-focused care. These additional efforts and the implementation of various phases of the bill recently passed will impact the health-care system for years to come.  Also important to note is that the successful passage of health care related legislation leaves Congress and the Obama administration free to focus on the equally important issue of financial reform.  On that note, we believe the proposed ‘Volcker rule’ is a good start and is the appropriate equivalent of Glass-Steagall for our age and the infrastructure of modern finance. We would also like to see reformed compensation criteria across the financial industry and large corporations, but that is a corporate governance concern best saved for another letter.

Withdrawal of Economic Stimulus. The other major theme we expect to impact our economy over the rest of the year is the withdrawal of extraordinary fiscal and monetary stimulus programs put in place during the crisis. Various measures by the Fed, European and Asian central banks to provide liquidity support to banks and markets will be withdrawn over the course of the next several months.  Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China.  As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.  We will also keenly track developments in trade agreements since various countries have enacted or are considering trade barriers and currency related moves to protect key industries and exporters.

We look forward to speaking with you during the quarterly review.

2010 Q1 Highlights

Equities. The S&P 500 started the year at 1115 and began a moderate sell-off in mid-January, bottoming out at an intraday low of 1044 on February 8th before rallying to a new 52 week high on March 25th, peaking at an intraday level of 1180.  The stock market rally is now more than a year old and much of the recent gains have occurred on weak volume, indicating a lack of conviction from investors.

Our view: We remain skeptical of this rally and believe stock prices have gotten ahead of themselves and are currently over-valued.  We would like to see stronger underlying economic data emerge (lower unemployment, higher consumer confidence, improved housing numbers, etc) before becoming more bullish on stocks.  For now, we continue to believe a defensively positioned portfolio is prudent.

Interest Rates.  On Feb 18th, the Federal Reserve raised the discount rate (the rate at which banks pay to borrow money from the central bank) by 25 basis points to .75%.  This was viewed as a relatively positive event, since it meant that the Fed felt confident enough in the economic recovery to start charging banks more to borrow money.  The more widely followed Fed Funds rate (the overnight rate depository institutions charge each other to borrow money in order to meet reserve requirements) remains at historically low levels (effectively 0%).

Our view:  We don’t expect the Fed to raise the Fed Funds rate until the 4th quarter of 2010 (at the earliest) as the consensus amongst the FOMC will likely want to wait until the economic picture shows stronger signs of a sustained recovery.

Taxable Bonds.  Taxable bonds have continued to perform well, particularly in the high yield (lower quality) space.  The high yield rally has corresponded with the stock market rally as investors continue to feel more comfortable taking on risk.  As a result, many high yield bonds are trading at levels virtually unfathomable a year ago.

Our view:  In anticipation of a likely rate hike coming at some point in the next 6-12 months, we are positioning client portfolios to be on the shorter end of the yield curve (preferring short-term bonds to long term bonds).   For bond funds, we prefer the following categories: short/ultra short duration, international and inflation protected.   For individual bonds, we see the most value in BBB rated manufacturing, energy and consumer goods names.  We also like stepped note bonds/CDs as they provide a hedge against rising interest rates (which are pretty much inevitable given where rates are now, it’s just a question of when).

Municipal Bonds.  On March 16th, Moody’s announced they will shift to a long anticipated universal ratings scale in an effort to make it easier for investors to compare ratings between corporate and municipal bonds.  This move will likely boost the ratings on many of the municipal bonds they cover.  These higher ratings will not be viewed as an upgrade, but rather a recalibration to the new scale.

Our view: With record federal government deficit levels and the recent passage of the Obama health care bill, we believe federal income taxes will likely be raised in order to offset these costs.  We believe municipal bonds remain attractive due to their tax status (federally tax exempt and occasionally state/local exempt).  We prefer high quality general obligation bonds (bonds backed by the taxing authority of a state or municipality) and essential service revenue bonds (bonds backed by the revenues generated by utilities, universities or water and sewer projects).   We believe default risk (particularly for general obligation bonds) is low given the senior status debt service payments enjoy in most municipal budgets (in California, for example, bond holders are junior only to the public school system in terms of how tax revenues are spent).

Sovereign Debt.  The major story this quarter was Greece and its escalating budget crisis.  A tentative bailout agreement was reached in late March, backed by the European Union and the IMF (International Monetary Fund).  The concern here is that this will set a bad precedent as other countries in the European Monetary Union with debt problems (of which there are many, notably Portugal, Italy, Ireland and Spain) will expect similar assistance from the IMF for debt relief.  Meanwhile, back home, US treasury rates have steadily crept up this quarter as the government continues to issue record amounts of debt and the market requires a higher yield payout to own this debt.

Our view:  We expect treasury rates to continue this upward trend.  We prefer short dated treasuries to intermediate and longer term treasuries.  We believe the situation in Greece has not been fully resolved yet and expect more bailouts/aid packages will be necessary to shore up the debt problems for some of the other Euro zone countries mentioned above.   We believe the European Monetary Union faces a grave crisis since the common currency (the Euro) leaves sovereign states unable to devalue when faced by a budget crisis.  The solution is either greater political and budgetary synchronization, or accepting that EU countries may default and defining a mechanism for them to do so without impacting the surviving members.  The uncertainty and perceived lack of a resilient solution is weighing on the Euro.   We believe the Euro will continue to weaken against the US Dollar until these problems are properly addressed.

Greece, the Euro and currency union.

Greece, the Euro and currency union.

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We’ve been following the revelations of prior administrations fudging budget numbers in Greece with some interest and thought we’d pick out a couple of the more interesting articles we’ve read on the subject.
Stratfor on Germany and the future of European currency union

Stratfor on Germany and the future of European currency union

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A lot of ink has been spilled recently on the weakness of a currency union without a federal political system (i.e. the Euro).  The most interesting background article we’ve seen on this topic is Stratfor’s Germany’s Choice which takes the long view and is well worth a read.

Simply put, Europe faces a financial meltdown.

The crisis is rooted in Europe’s greatest success: the Maastricht Treaty and the monetary union the treaty spawned epitomized by the euro. Everyone participating in the euro won by merging their currencies. Germany received full, direct and currency-risk-free access to the markets of all its euro partners. In the years since, Germany’s brutal efficiency has permitted its exports to increase steadily both as a share of total European consumption and as a share of European exports to the wider world. Conversely, the eurozone’s smaller and/or poorer members gained access to Germany’s low interest rates and high credit rating.

And the last bit is what spawned the current problem.

Deep dive into the BLS model

Deep dive into the BLS model

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Bloomberg is running a report on pending amendments to the BLS labor statistics which may result in sharply higher unemployment statistics in 2008/2009.  The reasoning is that the BLS model’s mechanism to account for newly-created and recently-closed businesses does not consider the sharply higher number of closures over that time period.  More recent data will not be revised till next February.  The article is well worth a read.

Must watch debate on financial innovation.

Must watch debate on financial innovation.

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Jeremy Grantham and Rick Bookstaber debate Myron Scholes and Robert Reynolds on whether or not financial innovation boosts global growth.   We found this particularly engaging since one of the debaters (Myron Scholes) was a principal at Long Term Capital Management and another (Jeremy Grantham) is a manager whose views we follow very carefully.  As an aside, Grantham’s latest quarterly letter is a must read.  There are a few particularly juicy exchanges towards the end, so it’s worth watching all the way through.

Political uncertainty at a critical juncture.

Political uncertainty at a critical juncture.

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400px-Illinois_Railway_Museum-Switch_1We are frequently amused by the myriad explanations pundits present for any moves in the market. Our view has always been that single day moves are largely inexplicable, and that it often takes investors time to incorporate events into their thought-process, and to translate them into action. An example is the market rose yesterday in the face of much bad economic news. The explanation from pundits was that investors were celebrating the potential victory of a Republican candidate in the Massachusetts special election to fill the senate seat left vacant after Ted Kennedy’s death. Numerous commentators noted that “gridlock in Washington is positive for wall street”. The thinking is that government action creates uncertainty, this leads to businesses spending time and resources trying to compensate for changing rules, and this slows down economic activity and lowers earnings.

Now that we know the results of this special election, we believe investors should be concerned about the Republican candidate’s victory. The US finds itself in a particularly delicate position three years after the bursting of the biggest credit and real-estate bubble in decades. The hesitant stabilization of economic activity and confidence we have seen so far has been brought about by extremely large amounts of government spending and aid. Regular readers will know that one of our concerns has been the manner in which this government support is removed. At this juncture, gridlock in Washington is more likely to bode extremely poorly for the US economy. Congress has to find a way to pass health care reform, renew the term of the Fed chairman, reform financial regulation and evaluate the need for continued fiscal support. Did we forget to mention it has to do all of this in the face of the largest budget deficits since the second world war and a rising tide of populist sentiment in an election year?

Risk assets have recovered dramatically over the past few months in response to a massive, concerted effort by governments the world over to inject liquidity and support aggregate demand for goods and services.  This effort was led by the US and the UK, where the parties in power enjoyed comfortable majorities.  With Scott Brown’s election yesterday and an election looming for Gordon Brown’s Labour party, political certainty is in short supply on either side of the Atlantic.  At this sensitive moment, we believe this is a damaging development and that this uncertainty does not augur well for business or markets.

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