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)

Even Better Bear Stearns Chart

From Bespoke a series of great charts on how much the brokerage stocks are down. I only show the Bear Stearns chart but the others are interesting too. click through to Bespoke to see them.

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!

Ticker Sense on Financial Sector Earnings

Ticker Sense posts this chart and a table of earnings forecasts for financial companies in this post.

Live by the sword die by the sword.

Christine Harper writes on Bloomberg:

Wall Street Credit Costs Soar on Spread to U.S. Rate

Bond buyers view the nation's largest securities firms as no safer than taking a flier on subprime mortgages. That's a nightmare scenario for the industry's chief executive officers, who relied on cheap financing for leveraged buyouts, real estate lending and proprietary trading to produce record profits -- and paychecks of $40 million or more for themselves.

This is a very good article on why wall street is squealing like a bunch little children for Bernanke to do something. You can bet if the same thing were happening to some other industry they would yawn and change sectors.

Treasury Market Volatility explodes on Black Box Retreat

Elizabeth Stanton and Daniel Kruger for Bloomberg on Black box quant traders pulling out of the treasury market:

Treasury Market Volatility Increases to Highest in Three Years

The retreat by so-called black-box traders and hedge funds caused orders for Treasuries to drop as much as 80 percent

During my lifetime of trading I have traded in and through many crisis events, Hunt silver collapse, 87 stock market crash, 98 LTCM blowout, 911 market shutdown, and the current subprime money market debacle. The one thing they all have in common is the evaporation of liquidity. I always hear stupid remarks like this one:

“We were seeing things that were 25-standard deviation moves, several days in a row,” said David Viniar, Goldman’s chief financial officer

The same kinds of idiocy were spouted by the Nobel winners at Long Term Capital Management. The flaw in these statements is the unstated assumption that the "model" is complete. The model is not complete because these models invariably make the implicit assumption that market liquidity is a constant. Nothing could be further from the truth. The one characteristic of big market panics is the shift from analysis of fundamentals like interest rates or earnings to a focus on preservation of capital and deleveraging. We all become Will Rogers who is reputed to have said "I am not so concerned about the return on my capital but the return of my capital." From return on to return of is a very significant change when the entire market place makes the switch.
If we take the distribution of prices only from periods of collapsed liquidity Mr. Viniar's 25 standard deviations become more like 1.7.
Every quant should tatoo on the back of his/her hand " the market is right not the model".

PS. there is a nice Wiki on the LTCM event.

Law suits begin for Bear Stearns

Calculated Risk writes on the beginning of law suits for Bear Stearns and one example of a tugging at the heartstrings spin on injured investors. Also I wonder if the "Tralfamadore Anti-Matter-Indexed Mystery Investment Vehicle (incorporated on Mars)" is still open to new investment?

Calculated Risk also links to a very interesting Economist Intelligence Unit article about the effects of subprime problems on the global economy and probabilities of various outcomes of increasing severity.

stock market looking troubled tonight

A distinct change to the negative in tone tonight in Bloomberg headlines:

July 31 (Bloomberg) -- Bear Stearns Cos., manager of two hedge funds that collapsed last month, halted redemptions from a third fund after investors demanded their money back.

Aug. 1 (Bloomberg) -- The yen gained, after posting its biggest monthly advance in more than a year against the euro, on concern that losses from U.S. subprime mortgages will push investors to pare riskier investments funded by loans in Japan.

July 31 (Bloomberg) -- On Wall Street, Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Goldman Sachs Group Inc., are as good as junk.

July 31 (Bloomberg) -- Jeremy Grantham, the money manager who oversees $150 billion as chairman of Grantham, Mayo, Van Otterloo & Co. LLC, said credit-market declines may force as many as half of all hedge funds to close in the next five years.

These are just some of the lead paragraphs of negative news stories much of it appearing late this afternoon. Markets are already showing nervousness in the thin overnight trade.

Whoops!

Bear Stearns Tells Fund Investors `No Value Left' (Update1)

By Yalman Onaran

July 18 (Bloomberg) -- Bear Stearns Cos. told investors in its two failed hedge funds that they will get little if any money back after ``unprecedented declines'' in the value of AAA rated securities used to bet on subprime mortgages.