Even the Greatest of Events have no Special Causes
Markets continue their upward march since we last marvelled at investors' lust for risk and possible causes for this ... lunacy or "forward looking behaviour", depending on who you listen to. To be sure, the speed of the advance diminished and volatility increased, but the fact remains that every selloff of the doubting was countered by buying of the faithful. A Monday selloff that brought the NASDAQ down by 2% was met on Tuesday morning by vigorous buying within the first hour. Markets then recovered throughout the week and by Thursday afternoon we had climbed back up to the highs of the previous week. Friday morning, markets got another dose of reality, as the ISM index declined more than expected (more on that below) and market participants prepared for another ugly day. Markets almost tested Monday's low again, but were saved by a late day buying spree that pushed us almost back up to the highs. Volatility, it seems, has returned. No wonder. Investors have a lot to deal with. On one hand they are being bombarded with more and more statistics indicating a slowing or actually weakening economy. On the other hand, the interest rate picture is so benign and supportive of higher stock prices that it tempts many people to ignore the dangers lurking about. The threat of weakening profits in a recessionary environment is being offset with almost record low interest rates, which allow investors to put extraordinary multiples on earnings. The question then becomes whether this environment is attractive or dangerous or both for investors. But one step at a time. Lets first look at the economy before we actually look at the stock market.
The ISM index, formerly known as the "Purchasing Managers Index" (left chart above) was weaker than expected, falling to 49.5 in November from 51.2 in October. This is the first time that the index dipped below 50.0 (signifying a contracting manufacturing sector) since April 2003. New orders placed with manufacturers (right chart above) also continued to decline. Another statistic showed that new orders for non-defense durable goods in October had a more pronounced decline than had been expected, led by a plunge in transportation equipment. Durable goods are items designed to last for three or more years. Orders fell last month by $19 billion, or 8.3%, to $210 billion, according to data from the Commerce Department's Census Bureau. Economists had been anticipating a 5% drop in durables orders. The goods producing sector is clearly being hurt by ongoing weakness in housing and autos. Nevertheless, an index reading of 49.5 (contraction in manufacturing) corresponds to a positive growth rate in the overall economy of 2.4% according to the Institute of Supply Management. After all, this economy is only 20% manufacturing and 80% services. The other 80% of the economy are contributing more than their fair share.
The Federal Reserve, however seems to live on a different planet or knows more than we mere mortals. In it's most recent "beige book" (official title: "Summary of Commentary on Current Economic Conditions by Federal Reserve District") released last week, the Fed describes manufacturing activity as "positive overall" despite evidence to the contrary. They also are upbeat about consumer spending depite back-to-back declines in retail sales (ex autos) and slow chain store sales. The Fed's describtion of the housing market says that the housing market remained strong in a few markets. This somewhat nonchalant view of a clear weakening in the goods producing/moving sectors of the economy is somewhat disturbing. While it is true that our economy is 20% goods and 80% service oriented, manufacturing still is an important sector of our economy. This is the reason why the Fed always has switched from a tightening mode to an easing mode, shortly after the ISM index dropped below the 50 mark. The two charts below show that fixed income markets have been discounting some sort of easing to come soon. The yield curve started to invert in July of this year and has stayed that way going on 4 months now. Obviously, fixed income investors see low or no inflation and expect the Federal Reserve to ease short term interest rates soon because of sharply deteriorating economic conditions. So, who is right?
Is it possible that two very intelligent groups of people are watching the same movie and come away with different conclusions? Economics is all about what we see, but more importantly, what we do not see! What people might be overlooking right now is that the rocket scientists on Wall Street have created instruments that have become extremely complex and whose behavior can only be simulated on even complexer computer models. The instruments are credit derivatives such as Credit Default Swaps and Constant Proportion Debt Obligations. Needless to say, the credit derivatives market is growing at a pace unprecedented in the history of financial markets. From a non-existent business 10 years ago, the value of outstanding notionals stood at more than $26 trillion as of June, according to the latest survey from the International Swaps and Derivatives Association. That's more than four times the size of the over-the-counter equity derivatives market. Credit default swaps are in their simplest incarnation an insurance against a corporation defaulting on their bonds. Constant propotion debt obligations are multibillion-dollar instruments that take investment grade indices, leverage them up to 15 times the amount invested and offer yields of 2% over LIBOR with a AAA rating. This is an extremely enticing structure since it currently is difficult to find vanilla AAA bonds yielding more than 0.5% over Treasury Notes.
AAA securities are by definition blue chip with rare, only infinitesimally small annual default rates. But this AAA rating is subject to numerous (more numerous than usual) subjective assumptions on the part of the rating services and in turn vulnerable to quicker downgrades than your normal AAA credit rating. In recent months, more and more of these CPDOs have been created and they have to suck in a lot of long credit exposure to issue these instruments, which puts downward pressure on credit spreads. You know what I am about to say: “Somebody will invariably engorge on a good thing and pay the consequences when (not if) something goes wrong.” The question is, what could go wrong and why? In May, world markets felt like they were going to desintegrate (due to liquidation of yen carry positions) but then they righted themselves during the summer months and continued to recover ever since. Some, like the US large cap markets, went on to higher highs. Some, such as the US small cap markets and most emerging markets are just now testing their old high from May. The system seemd to be deleveraging too fast but then miraculously stabilized itself. Why did we not go down the tube back then?
I found an interesting attempt to answer to the question in the book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. As usual, John Mauldin turned me on to it. The authors asked the following question: Why do catastrophes happen? What sets off earthquakes, for example? What about mass extinctions of species? The outbreak of major wars? Massive traffic jams that seem to appear out of nowhere? Why does the stock market periodically suffer dramatic crashes? Why do some forest fires become superheated infernos that rage totally out of control? Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds up and it seems like one whole side of the pile slides down to the bottom. The authors used a computer and instructed it to drop imaginary grains onto an imaginary table with simple rules dictating how grains would topple downhill as the pile grew steeper. The researchers ran a huge number of tests, counting the grains in the millions of avalanches in thousands of sandpiles looking for common denominators that might determine the size, direction or cause of an avalanche. The result? Well … there was no result, for there simply was no typical avalanche. Some involved a single grain, others ten, a hundred, or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain tumbling down. At any time, literally anything, it seemed might have caused an avalanche and might have caused it to spread or to stop. No rules could be found. Next, Bak and collegues played a trick with their computer: Imagine peering down on the pile from above, and coloring it according to its steepness. Where it is relatively flat and stable, color it green; where it is steep and, in avalanche terms, "ready to go", color it red. What did they see? They found that at the outset the pile looked mostly green and stable, but as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by dominolike action, could cause a sliding at other nearby red spots. If the red spot network was sparse, and all trouble spots were well isolated from each other, then a single grain would only have limited repercussions. But when the red "fingers of instability" come to riddle the pile, the consequences of the next grain became fiendishly unpredictable. It might trigger only a few tumblings (such as we saw in May of this year) or it might set off a cataclysmic chain reaction involving millions of grains and bringing the whole mountain down. The more the sandpile grew the more it seemed that it had configured itself into a hypersensitive and peculiarly unstable condition in which the next grain could trigger a response of any size whatsoever. The astounding discovery here was that each sandpile eventually reached this "Critical State" quite naturally. The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world and also applies to the financial markets. Lets go back to the world markets and the correction this May. Why, you might ask, does what happens in Iceland matter to Brazil? Or Turkey? Their economies are not exactly any more similar than their cultures. The answer is that all are linked together by common set of carry-driven investors. In other words, these countries are unrelated geographically, but they are not unrelated in portfolios. For example to the trader who had borrowed in euros and invested in Iceland's krona, the krona's sharp slide wiped out more than a year's worth of carry trade profits in one fell swoop. Those very same speculators, many of them hedge funds, had built long positions in a plethora of other high-yielding currencies as well. Hence, selling mushroomed, as positions in one country were closed to fund losses in another, prompting further losses. Fingers of instability in one currency affected fingers of instability in another currency and before we knew it, an avalanche of sell orders extended from Iceland to other high-yield, high-risk currencies, from currency markets to fixed income markets and from fixed income markets to stock markets wordlwide. Nobody knows why and how the selling stopped but the system eventually was able to contain the avalanche without external help. Alan Greenspan had to support the system in 1998 because of the LTCM crisis. In the spring downturn of 2006, the system was able to sustain itself. What could go wrong and why? We will never know beforehand, but we will know when it happens. When enough fingers of instability are riddling the sandpile and are close enough to each other so that avalanches in one finger can cause avalanches in another, then we will have reached the “Critical State”. When will we be at this critical state? Bill Gross thinks we are close. All I know is that leverage will always be a double edged sword. Does that mean we should stay away from stocks, bonds and currencies? Not at all. You will always give up more by trying to avoid disaster than you protect by not being exposed to it! Just be circumspect!
"It is easier to perceive error than to find truth, for the former lies on the surface and is easily seen, while the latter lies in the depth, where few are willing to search for it."
-- Johann Wolfgang von Goethe