Two weeks ago, we wrote, "with US stocks up an incredible 79.5% from the March 9th, 2009 low, a pause or even a pullback is to be expected. Our forecast for the S&P 500 for all of 2010 is only 8%, so reason enough to be cautious 4 ½ months into the year." We're more annoyed than surprised that stocks gave up all the gains of the year in following 10 trading days. There still remain structural flaws in how the US stock markets currently operate, which culminated in the single largest intra-day decline of the Dow in history. Though US markets closed well off the lows, the average investor was reminded once again of how the odds are stacked against them. But if these same investors don't maintain a portion of their assets in the stock market, they won't be able to retire!
Judging from the e-mails and phone calls we received this week, the specter of the September 2008-March 2009 crisis looms large in the minds of our clients. In this letter, we'll discuss the role of leverage in pushing a conventional correction into a full-blown crisis. We'll also talk about what caused the stock market to plummet almost 10% Thursday afternoon, only to bungee right back up 20 minutes later.
Brushwood is to forest fires as leverage is to financial crises
We often look to nature to explain the dynamics of financial markets. Forest fires are naturally occurring phenomena throughout the American West. Brushwood from dead trees accumulates over time providing fuel for a fire, which is often started by a lightning strike (occasionally by human carelessness, more rarely by an act of arson.) Once started, a fire can cover thousands or even tens of thousands of acres before burning out naturally as the fuel supply is exhausted. Years or even decades can pas before enough brushwood (fuel) accumulates to support another fire.
An unlevered investment is simply buying a security with cash, for example, a ten year corporate bond with a face value of $1,000 and a current yield of 5% or $50/year. The unlevered return is 5%. An aggressive investor could use the exact same $1,000 to borrow $50,000 of a ten year treasury bond with a 2% margin requirement. If the borrowed bond is sold short, $50,000 of the proceeds can be invested in the corporate bond, yielding $2500/year in interest. The investor owes interest on the Treasury bond sold short, which at current rates of about 3.4% is $1,700/year. The "net carry" is $700/year on equity of $1000, so the total yield is now 70%/year. By levering their equity 50:1, the investor increased the investment return 14:1. So why doesn't everyone do this? If spreads widen (Treasury yield remains at 3.4% while the corporate bond yield rises to 5.3%) the price of the corporate bond falls from par of $100 to $98, wiping out the equity of the investor (at ($98, the corporate bond is now worth only $49,000.)
There's no clear line between "safe" and "unsafe" leverage ratios. Houses are typically purchased with 20% down, so a 4:1 leverage ratio. Private equity deals (where an investor buys an entire company with borrowed money) peaked at about an 8:1 leverage ratio in 2007, currently about 5:1. Long Term Capital Management, the infamous hedge fund, took on leverage ratios of about 30:1 before wiping out in 1998.
Despite this example, by 2004 the managements of Merrill Lynch, Goldman Sachs, Lehman Brother, Bear Stearns and Morgan Stanley successfully lobbied the SEC to permit them leverage ratios of 30-40:1 from previous levels of about 10-15:1We estimate that AIG's derivatives portfolio levered that company 100:1.
The more brushwood, the higher the risk of fire. The more leverage, the higher the risk of catastrophic loss. Are we surprised that AIG, Lehman, Bear Stearns and Merrill Lynch no longer exist? Are we surprised that US home foreclosures are still running near record rates? Are we surprised that private equity investors are struggling with several bankruptcies including Reader's Digest, Outback Steakhouse and Allied Van Lines? No!
Post crisis, leverage ratios are way down. The issuance of leveraged (in our opinion, bogus) securities such as Collateralized Debt Obligations (CDO's) Collateralized Loan Obligations (CLO's,) and Commerical Mortgage Backed Securities (CMBS) is nearly completely halted. So the "brushwood" necessary to stoke the next financial crisis is almost entirely absent. We used to think that investors would remember lessons of financial crises for at least ten years. But given multiple crises in the last 20 years (which includes the 1987 stock market crash, the 1998 LTCM meltdown, the 2000 Internet bubble and the most recent crisis,) we now think that these memories last only 5 years. So we'll start sweating in 2013. Between now and then, we'll continue to monitor leverage ratios and the creation of the next "financial innovation."
The significance of Greece
The GDP of the United States is about $14.6 trillion; the GDP of the European Union is about $14.5 trillion. The GDP of Greece is $356 billion or 2.5% of the Euro Zone. By comparison, the GDP of Massachusetts is $351 billion (13th of 50 US states) and the annual revenues of Walmart are $374 billion. The ratio of Greek sovereign debt relative to GDP is high at 125% versus an average of 78.2% for European Union and 84.8% for the United States. Among advanced countries only Japan has a worse ratio at 218.6% (and that country has been stuck in a two decades long recession.) It's reasonable to be concerned that Greece will not be able to roll over about $80 billion in debt over the next year. However, sovereign debt crises tend to look scarier at the time than in hindsight. The size of the Greek economy is significant but not dominant (we'd be a lot more worried if German was in this situation.) Bonus points to anyone who can remember the details of the Mexican Peso Crisis of 1994, the Argentinean crisis of 2001 or the Indonesian crisis of 1996. Double bonus points to whoever can remember the country which neared default in November 2009 (answer below*.)
The fear is that European banks which hold the majority of Greek debt (leveraged as well) will themselves be at risk of default. As we saw last September 2008-March 2009, the "flight to safety" trade is "Buy US Dollar-Buy US Treasury Bonds." The US Dollar index soared to the level last seen in May 2009.
Last week, the strengthening dollar triggered a sharp sell-off in commodities, with oil falling 13.5% in 5 days from a 19month high of $86.84 to $75.11. The only commodity rising is gold, which neared the previous all-time high set during the *Dubai crisis last year, also a "flight to safety" trade.
What happened last Thursday?
As we wrote last summer in "Long story short: ship hit an iceberg and sank," accidents never happen in isolation. Details are still developing but here's our best information about what triggered the "flash-crash."
- Stocks were slightly overvalued after hitting 19 month highs at the end of April
- After rising Monday, stocks settled back Tuesday, Wednesday and Thursday morning as resolution of the Greek debt crisis appeared uncertain and three Athenians were killed in domestic riots
- Investor confidence was further disturbed by a "hung" British electoral result and the continued inability of engineers to cap BP's damaged oil platform in the Gulf of Mexico.
- Around 2:30PM selling surged in mini-S&P 500 futures (contracts traded on the Chicago Mercantile Exchange.) Later that day it was rumored that a clerk had entered a sell order of $16 billion rather than $16 million, but that rumor has not been confirmed.
- Trading programs, which arbitrage between stock futures and the constituent stocks kicked in, buying the future while simultaneously selling the stocks
- The surge in stock sell volume overwhelmed market making on the floor of the NYSE, causing "circuit breakers" to kick in, halting trading in numerous stocks for 90 seconds. Those orders then shifted to alternate exchanges.
- However, the circuit breakers don't apply to trading on the Electronic Crossing Networks (ECN's) or NASDAQ, where the sell orders from the NYSE found no natural buyers. Trades executed at 30%, 40%, 60%, 99% off previous levels.
- Exchange Traded Funds (ETF's,) which price continuously off quotes from the National Market System (consolidated price feed from all exchanges,) plunged in value. Additional trade programs, which arbitrage between ETF's and common, sold more stocks.
- The sudden price decline triggered numerous stop loss limit orders, which suddenly became market sell orders. An investor might stipulate a stop loss at $40, but when the stop is triggered, the order is filled at the prevailing market price, which could be substantially less, breaching even more stops.
- Shares of Procter & Gamble, which traded in a range of $62.50-$64 over the last month, fell to $39.37 in the blink of an eye. Shares of Accenture, a consultancy, which ranged from $40-$44 over the last month, fell to a penny!
- Between $700 billion and $1 trillion in market capitalization disappeared for about 30 minutes.
By Friday morning the respective heads of NASDAQ and NYSE were on CNBC blaming each other. Friday afternoon, NASDAQ canceled trades in 296 stocks and Exchange Traded Funds whose price was more than 60% off the 2:40PM quote. Interestingly, most of the canceled trades were ETF's, which benefits hedge funds and high frequency traders. Meanwhile, if you're an individual investor who had the misfortune to get stopped out 59% off the 2:40PM price, you are out of luck.
Where are the "grown-ups?"
We've written many times over the last two years that "grown-ups" no longer appear to be in charge of the financial system. We're talking about people, whether government regulators or industry representatives, who have the wisdom to recognize that markets are not perfectly efficient, that leverage kills and that a little friction in the system is a good thing. The SEC in particular has to get its act together on:
- Establishing an uptick rule applied all markets including the NYSE, NASDAQ and the ECN's. The rule could be as simple as "all short sales must be done 1 penny above the previous conventional sale."
- Enforcing the SEC's own rules on naked short selling. In principal, you can't short stock without borrowing it first. In practice, this rule is widely ignored by high frequency traders who know their stocks positions will be flat by the end of the day. We saw last week and also during last year's financial crisis that concentrated selling can take out support, allowing the short seller to buy back the position later in the day (hour, minute) at a substantial profit. If the seller first had to prove that he had borrowed the stock, the resulting friction would dilute the effectiveness of this tactic.
- Assessing responsibility for last week's meltdown and handing out substantial fines in the $10 million range. Exchanges, banks, brokers, algorithmic traders need to understand that pain accrues to those firms who destroy confidence in the markets.
- Taking a hard look at whether the proliferation of ETF's and High Frequency Trading firms is actually damaging long term confidence in the markets (we would argue, "Yes!")
- Reviewing whether the current NYSE circuit breaker limits are too wide (currently trading halts apply to 10%/20%/30% move in the Dow Jones Industrials.) On only one occasion in the last 100 years has the Dow fallen more than 20% - October 19th, 1987. On Black Monday, October 28th, 1929, the Dow declined only 13.4%. We'd be a lot happier with a 5%/10%/15% rule applied to a broader index like the S&P 500 or the Russell 3000 AND require alternate exchanges and ECN's to also halt trading.
After every crisis Wall Street firms sponsor academic studies to "prove" that their particular strategy doesn't destabilize the markets. These studies are always hopelessly naïve. Plenty of studies "prove" that the uptick rule is not needed. But if reinstating the uptick rule didn't deprive certain firms of excess profits, then why would they lobby so hard against it?
Technicals rule the short term, fundamentals the long term
In the chaos of last week, no one remarked that the Friday's jobs report, showing employment gains of 290,000 was 90,000 better than consensus and the best result in three years. Also, the numbers for March were revised higher by 68,000 and February's numbers were revised higher by 53,000 for a net gain of 401,000 jobs. The unemployment rate rose from 9.7% to 9.9% because previously "discouraged" workers have started looking for work again. We regard this indicator as the single most important measure right now of improving economic conditions - people get back to work, personal income rises, confidence gains, feeding into a self-reinforcing cycle. The US must gain 15 million jobs to get back to the 4% unemployment rate that prevailed during the Clinton administration, but for the first time in a while we can see getting there.
In earnings news, with most S&P 500 companies already reporting Q1 results, upside surprises beat downside surprises nearly 5:1, which is well above the usual 3:1 surprise ratio. Earnings growth, reflecting rebounding financials, was up 45.4%. Strip out banks, and earnings still grew 40.8%. On that basis, with bond yields still at rock bottom levels, stocks have slipped back into undervalued territory.
In the short term, technical measures such as over-bought/over-sold oscillators or money flows rule stock market direction. In the long term, fundamental drivers such as earnings growth, economic expansion, low interest rates and low inflation drive stock prices. We've been net buyers of stock all year. Last week's setback gives us yet another opportunity to move more cash into the market.
Every time the stock market pulls back 5% or more, we get two questions from our clients:
- Is this the start of another financial meltdown?
- Is there any way to sidestep these corrections and come right back in at lower prices?
With the system substantially delevered and with bankers on their best behavior to avoid application of financial reform, we see close to no risk of another meltdown (until 2013.) The Greece/Italy/Spain/Ireland/Iceland issues are worrisome, but it's up to the European Central Bank and International Money Fund to solve those problems (which already appear in hand.)
Plenty of market gurus and newsletter writers claim they can time the market, but in reality even the best is right only 60%, wrong 40% of time. If there was a "magical" indicator that foretold that the markets would break last week instead of two weeks ago or two week from now, we would use it. Among our accounts, which are separately managed and taxable, we find that trading in and out generates trading costs and taxes while subtracting the income we derive from dividends for a net reduction in returns to our clients. Instead, we accept that stock market returns are volatile. We make sure that our clients draw their monthly "allowances" from relatively stable bonds, which we reload from time to time from stocks.
We like the companies we're invested in and we're comfortable for the prospects of continued economic expansion.