Archive for October, 2011

A Different Kind of Short Squeeze

Ever since the markets started to destabilize in late 2007, regulators around the world have come up with new edicts to ban short selling, particularly of bank stocks. By squeezing out the shorts and making it tougher for new negative bets to be put on, the fervent hope of the regulators in the US and Europe was to buy the banks enough breathing space for the crisis to pass.

When it became obvious, in the darker hours of 2008, that the problem was not a short term one, Central Banks and Governments stepped around the equity markets and went directly to the source of the funding problem. The answer was to guarantee the liabilities of the banking system. In the US, this happens with depositors automatically through the FDIC but this was the first time such a massive, coordinated effort was undertaken to guarantee all bank creditors, even those with subordinate claims.

The gambit allowed most banking systems to start the rebuilding process although in countries like Ireland, it has landed the tax payer with a crushing new liability (estimated at nearly 40% of GDP). The financial authorities also recapitalized selected banks and in the case of the Federal Reserve, threw open the short term lending windows to push liquidity out on terms not seen in several generations.

This last week, we have now seen the advent of a new type of short squeeze, and most likely an unintended one at that. By changing the game for the CDS (Credit Default Swap) market (a voluntary writedown of Greek debt is not a default event), the EU has caused the issuers of CDS’s to change their view of the cover they need. Since CDS’s are unlikely to be triggered, the need for the CDS writer (typically an investment bank) to hedge is much diminished.

In the case of Euro sovereign debt, that means there is less need to hold short positions on the big banks that would get whacked by a sovereign default. The unwind of those shorts is part of the reason why the markets have greeted an otherwise unimpressive announcement from the EU with such enthusiasm.

How “Wall Street” really works

As we have argued in the past, the bulk of the professional financial world does not view the markets the way the mainstream financial press would have you believe. The trading floors are not populated with swaggering “Masters of the Universe” betting the balance sheet on single ideas.

Although there is the occasional story of tremendous profits (Soros breaking the British pound, Paulson betting against home mortgages), the bulk of financial firm profits derive from managing risk (and charging for the service). Firms take on liabilities (derivatives agreements, for example) and then try to match off the risks in correlated assets. If done correctly, the firm can profit by exploiting the different prices available in the market. At the bigger firms, a whole department is charged with adding up all these assets and liabilities on a real time basis so that managers can determine just how exposed the firm is at any one time.

The plan goes wrong from time to time in one of three ways: fraud, overconfidence and liquidity squeezes.

For fraud, we have an excellent recent example in the UBS case in September. A trader, Kweku Adoboli, managed to “fool” the system and blow a $2.3 billion hole in the bank’s finances (to say nothing of the reputational damage).

For overconfidence, the emerging story of how former Goldman Chairman, Jon Corzine has transformed MF Global from a profitable derivative broker into a flailing investment bank is a fresh take on an old problem.

But the most common pitfall is liquidity squeeze. Since the margins between the liabilities and assets which banks use are often very small (due to the competitive market forces), investment firms leverage their balance sheets to make their activities sufficiently profitable (on an equity basis). Leverage ratios of 20:1 are considered very prudent in most parts of the professional financial world (whereas individual experience is usually limited to an 80% Loan To Value mortgage which equates to a 5:1 ratio). Going into the Global Financial Crisis, many top tier names were sporting leverage ratios above 40:1. When markets are stable and funding is abundant, this is a formula for minting money. Indeed as late as 2006, financial firms accounted for over 40% of corporate profits in the US. However, when market values become volatile and funding dries up, leverage works against the system, losses pile up quickly and insolvency is a serious risk.

Why does this matter?

Since better than 80% of market transactions are initiated by financial intermediaries, it is important to understand what drives their behaviour. Listening to Financial “Captains of Industry” waffle on about capital raising and discovering tomorrow’s new opportunities will tell you as much about their firms’ trading plans as Coke’s latest ad campaign will tell you about the risk of getting fat. That doesn’t mean you should not invest any more than it means you cannot enjoy a sugary cola from time to time. It does mean that you need to make sure you tone out the marketing fluff and concentrate on the useful information available in the market.

That is why using objective tools to measure the market is so important. If we rely on emotions, which is what financial news writers get paid to stir up, we will end up most despondent at the bottom of the price range and most euphoric at the top.

Curbing your enthusiasm

If we look at the Fund King rankings, it is still evident that the “melt up” (yes, the mainstream financial media is working hard to peddle that as a legitimate term) is still looking very short term in nature. When you consider that the latest source of buying pressure is driven by trading desks rebalancing their risk exposure, one can see that this is not a typical building block for a multi-year bull market. We would expect a serious lack of follow through this week.

Two Fund King Portfolios to look at:

The Global ETF Portfolio would only have you positioned in Bonds, Gold and Japanese Yen.

Global ETF Ranking

The T Rowe Price portfolio, which boasts some top performing equity funds would have you all in cash.

T Rowe Price Rankings

Bond Insurance…or Not?

Sure, it has been in the rumor mill for a while now. But, now that the French and Germans have imposed their vision of a “voluntary writedown” on private investors, it is still amazing to see the lengths that the authorities will go to declare the event a non-default.

The Wall Street Journal has a good blog on the subject: “So, about that insurance you bought on Greek Debt…” which covers the key details.

For the market, the dance will go on. Anyone who might suggest that this little manouver will disrupt the fragile fabric of the market is more than a little desperate for attention.

For investors, this little drama should serve as a “Caveat Emptor”. Not all investments are created equally and not all of them have the rights to the underlying assets that their promoters might hint at. When commentators brush off the risk of an ETN, which is backed by the sponsoring bank’s balance sheet, versus an ETF, which should be backed by assets that are subject to periodic audit, think back to the “smart money” hedge funds who will soon have to explain to investors why they were unable to capitalize on a sure thing like Greece’s default (oops, sorry, voluntary restructuring).

Running out of Steam

The Bear Market rally is running out of steam as we expected although a bit short of the mark we anticipated. The rally will likely stumble on for a few days this week (there have been some good earnings releases) but is unlikely to have enough momentum to carry the S&P500 index above the 200 day moving average. It has been an energetic rally but since there is no confirmation of the start of a new bull market in risk assets, now is time to dial back whatever risky bets one put on over the last two weeks.

S&P500 200 day moving average
Source: Bloomberg

Our view is not just based on divining patterns within the charts. The various portfolios we track are all showing very low ratings at the top of the rankings with some more aggressive portfolios suggesting a hefty weighting in cash. Given the precarious nature of the European Sovereign Debt crisis and the likelihood of a slide back into recession in the US, we are comfortable waiting for confirmation of market strength and missing some of the early upside if it turns out that we are being too conservative.

One short term factor which may put pressure on risky assets is the year end hedge fund redemption season (firms generally have 30-60 day notice periods).

Although on balance it is unlikely that the major institutions which make up the bulk of the hedge fund investment audience will abandon the “asset class” overall, there should be some significant withdrawals from some previous high flyers. As the notified hedge funds liquidate assets to meet the redemptions, do not expect other institutions to bid aggressively until the end of the year. When the money is reallocated to new funds, we could see a stronger than usual “January Effect”.

Mind Your Head

October has dealt risk investors a nice bear market (or counter trend, if you prefer) rally. As we pointed out last week, these are not uncommon and are just as sharp (large magnitude, short time frame) as the more familiar bull market correction. So, although there is no catchy “buy the dips” analogue, one should think about “selling the peaks”.

But what about the positive noises coming out of Europe and retail sales in the US?

While there is a slim possibility that the lows plumbed at the beginning of the month will mark the end of the bad news and the beginning of a new bull phase for risk assets, the Fund King System suggests that the momentum is just not there yet. Much digital ink has been spilled on the subject of “short covering” but the real story is that many funds were underinvested in terms of risk. The rally has been fast and furious because these investors have been scrambling in the past 5 or 10 trading sessions to participate in the rally in an attempt to patch up otherwise dismal performances for the year. Even legendary investor Bill Gross (a.k.a. “The Bond King”) has been compelled to play catch up. However, once European leaders fall short of hopes for a bank recapitalization on November 3rd and/or the next US data point on employment or retail sales disappoints, the momentum will fade quickly.

Where’s the ceiling?

This rally is all about emotion so there is no reason why it should not end at the otherwise arbitrary 200 day moving average for the S&P 500 (currently around 1276). With a 16% rally from the October 3rd close in their pockets, look for institutions to scamper for safety by lowering their exposures to risky assets once again.

As we advised last week, by all means participate in the rally but do not confuse a bear market rally with the start of a new bull market. Be prepared to return to a defensive posture on the sidelines as soon as momentum breaks down. If you only wanted to watch one indicator, the S&P500 (SPX) at 1276 would be the number to watch.

Other important factors

The most important development over the last few weeks is the announcement by ECRI that the next recession is imminent (if we are not already there). ECRI does a very good job at calling the big turns in the major economies (and, perhaps more importantly, avoids “false alarms”) because business cycles are their specialty.

One should also revisit some of the implications of the unavoidable Greek default on other EU countries. In his letter from a trip to Ireland, John Mauldin reminds us that the Irish expect to be able to renegotiate their situation in line with the terms offered to the Greeks. Expect a few more “nasty surprises” to surface in the wake of the default.

Fund King Portfolios

The various portfolios have taking a bit of a hit in the last few weeks, especially relative to the major equity indices. However, the ratings and rankings suggest that the counter trend rally will be short lived and we are due for a return to pre-October market conditions.

Occupy Wall Street – where is the rage coming from?

What is the “Occupy Wall Street” movement angry about? Our $0.02
1. Massive organized fraud is committed by Wall Street firms with respect to the subprime mortgage market.
2. Despite knowing the risks of the collateral they were creating, most of these firms ran into serious trouble, and asked for a bailout. Almost all got it.
3. The Finance lobby played an enormous role in writing the new regulations designed to prevent this sort of blow up again (Frank-Dodd). These regulations have gone from reasonable to neutered.
4. The heads of many banks are incredulously disdainful of those who suggest that banks should be subject to more scrutiny and cap requirements.

The current economic morass we find ourselves in is the penance we are forced to serve for the felonies these individuals committed, and the incompetence they exhibited in managing the subsequent risks. If this doesn’t make you outraged, nothing will.

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