The Ouroboros, Deflation, and 2008

The Ouroboros, Deflation and 2008

2008 was disastrous but fascinating year in the financial trading marketplace. I recall no period with such widespread misunderstanding of market conditions and policy needs. The problems that devastated the markets began to reveal themselves in late 2007 when two Bear Stearns funds collapsed because securities they held could not be sold. Then Libor rates exploded as banks began to take a look at their own portfolios and became suspicious of the portfolios of other banks and stopped lending to one another. This was misinterpreted as tight money so the Fed responded with rate cuts.
But the real cause was a slow realization that bogus triple A rated mortgage securities based on mongrel pools of thousands of subprime mortgages mixed with prime mortgages were grossly mis-rated by ethically challenged, fee seeking, rating agencies. The asset class collapsed and thus seriously impaired bank capital ratios. But not until Bear Stearns failed was this widely recognized. Solvency was the problem not tight money, and that is why Fed rate cutting was not generating any result. They were treating a virus with an antibiotic.
The Ouroboros pictured above is a mythical creature that eats its own tail and is generally used to represent eternal recurrence. But it also represents a system consuming itself, and that is what we have. Inattentive regulation of new securities fed by greedy and over confident investment bankers led to a massive over leveraging aided by loose policies under the Greenspan Fed. Collapsing asset values in the huge mortgage backed securities market turned leverage ratios of 40-1 backward and bank and hedge fund equity consumed itself.
Fear began to spread and the 3 week period surrounding the seizure of Fannie and Freddie and the bankruptcy of Lehman set off panic in the public and in institutions. Margin calls triggered wave after wave of liquidation of positions and equities, commodities and corporate debt all plummeted. Game over.
The reason central banks always fear deflation more than inflation is deflation is self sustaining. Rational behavior by the individual to increase liquidity is a disaster for the economy which is losing systemic liquidity. The central banks are relatively powerless to stop the feedback cycle until the panic subsides and the fear begins to dissipate. The actions they can take are too slow to take effect for the results to dampen fear quickly and thus the Fed and Treasury appear inept. That was 2008.

2009 will be quite different. The panic has ended, though it could reignite, as positions were largely liquidated by leveraged funds and institutions before year end. Furthermore the natural optimism of a new year, the extraordinary optimism attached to the incoming Obama administration, and finally some effects of the massive monetary stimulus initiated by Fed and Treasury programs put in place beginning in August should coalesce to create a more positive psychological environment for investors. This will be a year where sentiment will be more important than ever.
At Infinium we have always believed personal psychology is the most important component in success. This year group psychology will be just as important. Three trillion plus dollars was pulled back in to money funds and probably equal amounts to bank accounts and other non market exposed mattresses. Will confidence or greed for yield be enough to start dragging that money back into the market? Or will continuing negative economic news and ballooning unemployment maintain a level of fear that continues to depress money velocity? That is the pivot point for the market and the economy. The positive in this for us is continued volatility and opportunity for intelligent risk taking and edge collection.

Big Themes
Reflation trades still good. The central banks will continue to fight deflation longer than necessary and now fiscal stimulus will be in place as well. Trading opportunities will exist in short versus long rates, spreads between treasury and investment grade and high yield bonds, forex crosses; also individual stocks and equities that benefit from or are harmed by specific pieces of stimulus legislation.
Country Indices outright or spread based on differentials in growth estimates or policy proposals and national financial solvency.
Commodity trades will be more differentiated than last years correlated boom in the first half and even more correlated crash in the second half. Examples are: precious metals as the only not currency specific trade, grains on weather and carryover. base metals and oil on rising demand from infrastructure projects fueled by government stimulus.
Politics will play a much bigger part of the action because of a new administration and one sided Congress rather than just bluster surrounding the election contest. Infrastructure companies, utilities, autos, healthcare and pharma are all likely to be heavily affected by legislation. Type and quality of fiscal stimulus proposals will push the debt markets around. Geopolitical policy will move currency, debt and country indices.

Specific Themes

Some I favor now.
Infrastructure stocks that operate worldwide based on stated stimulus plans in the US, China, Mexico, Brazil, and India, Europe likely.

Precious metal are the currency alternative in an era of competitive debasement of paper currency. Platinum is outperforming.

Strong balance sheets versus cash poor companies.

Fed will hold short rates low to press for shrinkage of quality risk spreads.

China relative strength

Long corporate and high yield bond funds outright ( these have had a big move during last week) and spreads of etfs of different underlying quality and maturity length

Conclusion

I do not expect nearly as much high correlation or so many enduring trends as 2008 because I believe positions are smaller and there will be more crosscurrents among trading instruments. I do expect significant opportunities for the alert. Surprises are likely to come from geopolitical conflict, legislative proposals after the first quarter, state and municipal finance, and crop failure, failure of large European banks tied to credit default swaps.


Fire away criticism is welcome. (except about my weight)

Coxe weekly broadcast

UPDATE: click here for link to Donald Coxe's Basic Points newsletter at the Investment Postcard's From The Edge website.

Bear Market

From Bloomberg:

March 16 (Bloomberg) -- JPMorgan Chase & Co. agreed to buy Bear Stearns Cos. for about $240 million, less than a 10th of its value last week, after a run on the company ended 85 years of independence for Wall Street's fifth-largest securities firm.

Shareholders of New York-based Bear Stearns will get stock in JPMorgan equivalent to about $2 a share, compared with $30 at the close on March 14, the two companies said in a statement today. The U.S. Federal Reserve will provide financing for the transaction, including support for as much as $30 billion of Bear Stearns's ``less-liquid assets.''

And further down in the article a perfect example of why you don't add to losing trades:

Joseph Lewis, Bear Stearns's second-largest shareholder, has spent more than $1 billion on the firm's stock since September, paying as much as $150 a share. Lewis, a 71-year-old billionaire, wasn't planning to reduce his stake, a person close to him said March 11.

Shareholders to get about $2 per share of J P Morgan stock for their Bear Stearns shares which were near $150 a year ago. Not Good!

A More Positive View Of Fed Actions

I have been pounding pretty hard on the Fed recently so a colleague pointed out and article with a more positive take on Fed actions. A Dash of Insight gives his thoughts:

When so many people have the same reaction, and we think it is incorrect, it provides an unusual opportunity. Leading critics think that the Fed members are not as intelligent as they are, that they are all academics and therefore out of touch, that they are "behind the curve," that another 25 bp's of fed funds would have made the difference, and that the Fed should include trucking company executives and fund managers (to pick at random two recent comments). More on these criticisms in future articles.

The criticisms often point to the lack of reaction in current LIBOR rates (using many incorrect time periods and many irrelevant expirations), while declaring the Fed's innovative TAF as dead on arrival. Anyone thinking this through should realize that the impact on LIBOR cannot be expected to happen until the auctions take place. We shall see this week.

Fed seems to be firing blanks.

Federal Reserve policimakers continued ineptness reflected in these three charts of Libor rates to government short rates in Dollars, Sterling, and Euros. Gavin Finch at Bloomberg writes on the subject:

Dec. 14 (Bloomberg) -- The biggest concerted effort by central banks in six years to restore confidence in global money markets is showing little sign of success.

It may be some time before the banks work through their capital constraints and get back to lending and risk-seeking again.'' William O'Donnell, head of U.S. government-bond strategy in Connecticut at UBS Securities LLC, wrote in a note to clients today. ``The recession risk grows daily.'

The academically oriented Board of Governors at the Fed are addressing technical issues but the current problem has a huge psychological component that they seem incapable of understanding. The Bloomberg article addresses this several times. The Fed must slash the discount rate below market rates and act as the clearing house for interbank loans until mutual trust between the banks is restored. Banks are suffering from the Will Rogers problem: What concerns me is not so much the return on my money as the return of my money. Until the central banks solve the trust issue the problem will worsen. The Libor spreads will signal us if things improve.

Bernanke: What I really meant was...

The Fed does a big whoops after the market urps on its shoes. (see bloomberg description) Helicopter Ben better stop leading from behind. I think maybe he has confused the Fed chairmanship with the Senate.

Bernanke: Was it something I said?

Me: Yes!

BCA: The Fed is falling behind.

The Bank Credit Analyst has 2 articles with charts illustrating their belief that the Fed is falling behind and must ease aggressively. article 1, article 2

Hussman: A Pop Quiz

John Hussman has another great article this week titled "An Irrelevant Fed: Thimbles of Water in a Forest Fire". You should go read the whole thing but here is the opening :

Pop Quiz

How much “liquidity” has the Federal Reserve “pumped” into the $12.7 trillion U.S. banking system since March 2007?

a) $1.2 trillion, which banks have used to firm up their balance sheets

b) $600 billion, which banks can now use to make new loans

c) $16 billion, all of which has been drawn out of the banking system as currency in circulation

If you answered c, move to the head of the class. Investors who answered a or b have not only been misled by analysts and media stories, but have no idea how irrelevant the Fed's actions are likely to be, except on short-term market psychology. More charts and data below.

BCA: "Fed Falling Behind The Curve"

from the Bank Credit Analyst:
The rioting in the financial markets this month must be reversing this economic complacency. Credit conditions are tighter than they were before the Fed began cutting rates, and strains could be spreading into the prime mortgage market (as previously noted). Bottom Line: The financial markets are warning of real economic damage, which will force the Fed to drop its concerns over inflation and provide a significant amount of additional easing.

Bernanke Between Inflation Or Investment Banks

The current market is alternating between liquidity worries and inflation fears. Helicopter Ben has to decide between bailing out greedy investment and mortgage bankers who got into trouble relying on the Greenspan put, or containing a risk of inflation stemming from global demand for energy and raw materials combined with money supply expansion from central banks that don't want their currency to be strong. (which is practically all of them) Mr. Bernanke also suffers from low expectations on the inflation fighting front due to his pre chairman speech about air dropping paper currency to stop deflation. All of this is reminiscent of the late 70's and G. William Miller which was not a terrific investment environment for equity markets, though a great period for futures markets. Perhaps that is why the CME stock price is so strong.
Jeff Matthews discusses inflation sightings at company conference calls this week:

There you have it: on top of “cost spikes,” “personnel and equipment shortages” and “dramatic” raw material cost increases, add the declining non-OPEC oil supply to the list of problems next week's Fed rate will exacerbate, as Bernanke continues his apparently ceaseless efforts to rescue Wall Street's banking goliaths from their self-created CDO tar pits.

Expect the Fed to give in and help out the bankers. After all there are future consulting jobs at risk here and no one wants to be blamed for a recession. For my part, I just hope Mr. Volcker is in good health 3 or 4 years from now when we need a fed chairman with balls.

Helicopter Ben Throws Deep

The Fed drops the funds rate a full half a point and the discount rate too. I didn't think they would do it. But CNBC and all the wall street weenies were squealing because their stock options were sinking rapidly and then the Brits were lining up at the banks pulling their money out so Ben and company rode in to the rescue.
One function of the central bank is to provide liquidity and be a lender of last resort in times of panic. So the Fed probably did have to act. But bubblevision has amplified the problem beyond all recognition. I fail to see how lowering the rate on a loan one can't get a bank to make in the first place changes anything. But that is just me. The stockmarket loved it. The Dollar did not. ( chart on the left is the SP500 etf and to the right is the Eurocurrency etf ) I guess only time will tell if Bernanke will have the luck of Greenspan or of William Miller.

Accrued Interest has pertinent remarks on the rate cut. I agree with him except for one thing. I believe there is a risk of moral hazard. But it is not the subprime borrrower who will be effected. It is the investment banker community who learns that the fed will always come to the rescue. Those are the guys who coerced the rating companies in to giving a pass to these motley securities and then sold them to every sucker they could find.

Update: I linked to the wrong charts so have replaced them with charts from Stockcharts.com.
Some reactions to Fed rate cut:
Calculated Risk
Aleph Blog
Crossing Wall Street