October 2008


The market looks dead set on trading higher. For this conclusion look no further than a combination of fundamentals combined with price action.

The fundamentals released this week have been uniformly bad.
*Falls in housing prices
*Falls in sentiment indices
*Falls in earnings
*Falls in outlooks
*Falls in GDP
*Increase in Pension Funds liabilities
*Falls in State budgets [increasing liabilities, falling revenues]
*Frozen credit markets
*Falling consumer spending
*Other

Yet, the market did not make any lower lows. Now the market has traded up. For at least the short-term, that is incredibly bullish. The psychology of the market is starting to change, once again favouring a bullish outlook.

For “sierrawater”

CNBC
Regulators to Approve Derivatives Clearinghouse
Friday October 31, 2:27 pm ET

Regulators are expected to approve a clearing house for credit derivative swaps in the next several weeks, CNBC has learned.

Regulators and industry participants have voiced concern that the private nature of the $55 trillion market for credit default swaps poses systemic risks because no one knows the size of a counterparty’s derivative portfolio, and the failure of a large counterparty can create massive losses globally.

Creating a clearing house would remove the risk posed by a counterparty failure, provide price transparency and offer simpler, more standardized settlement of contracts when an issuer defaults, proponents argue.

Calls for regulation and centralized clearing of credit default swap trades has gathered steam in the wake of Lehman Brothers’ failure last month.

The New York Federal Reserve Bank Friday said it “welcomes” progress in clearing credit default swaps and urged “broader action.”

The Chicago Mercantile Exchange, or CME Group, and Citadel Investment Group unveiled plans earlier this month for an electronic exchange for credit default swaps, which they said would be integrated with a central clearinghouse.

Clearing operations will be in place for CDS indexes in November and for single-name CDS in January. Depository Trust & Clearing Corp. will begin releasing total stock and trade data on Nov. 4.

About $24 trillion has recently been netted of the gross exposure in the CDS market, almost a third of the total.

—Reuters contributed to this report

From The Economist

BUNGEE jumps may be exhilarating, but they can also be frightening. They end up with the participants much lower than when they started—and with their safety hanging by a thread.

That has been the experience of investors this year. There have been some phenomenal stockmarket rallies, like the one on October 28th that carried the Dow Jones Industrial Average almost 900 points higher. But there has been a much greater number of dismal dips.

Clearly, bad news about the global economy has played its part. Investors are worried that a widespread recession will prompt corporate bankruptcies (and thus bond defaults) and a sharp fall in profits (hitting equities). The prospect of an economic slowdown has also prompted them to call the end of the commodities bull market (see chart).

But the speed of market movements suggests another factor has been even more important. When investors are in trouble, they sell what they can, not what they would like to. It looks as if they have been dumping a whole range of assets.

Emerging stockmarkets, for example, have lost more than half their value this year, while emerging-government bonds were yielding more than eight percentage points above Treasury bonds, at least until a rally on October 28th. Leveraged loans (debts to finance management buy-outs) are trading at just 70 cents on the dollar.

Who is being forced to sell? One obvious answer is banks that have ended up owning far more risky assets than they would like. Barclays Capital put $970 million of leveraged loans up for sale in October; in the face of disappointing offers, it ended up selling just 30% of the lot. Other banks have been winding down their trading, a big source of revenue earlier this decade, in an attempt to reduce risk.

Another group of sellers is the hedge funds. After a disappointing performance this year, many are facing calls for redemptions from clients and are having to sell assets to raise cash. But their problems also stem from their use of leverage, or borrowed money.

The great deleveraging, as it has become known, has also had a big impact on the currency markets. Many investors have been following a version of the “carry trade”, borrowing money in a low-yielding currency. All they had to do was earn a higher return from assets than the cost of their financing. Since the two big currencies with the lowest yields over the past year have been the dollar and the yen, those were the natural ones to borrow.

When asset prices fall, however, this strategy is disastrous. Investors dash to sell assets and repay their debts. Since those debts were incurred in dollars and yen, that means they have to buy back those two currencies—hence their sharp recent rises. (The yen has performed even better than the dollar because it had even lower rates, and thus was a more popular financing vehicle for carry trades.)

This process can be self-perpetuating. As the dollar and yen rise, those investors that have borrowed the two currencies face an increased cost of repaying their debts. So they sell assets to meet the bill, causing other speculative investors to cut their positions and so on.

The result of all these shifts looks like investment xenophobia. According to State Street Global Markets, American investors hold more than $5 trillion of foreign equities and are repatriating their money. Dismally though Wall Street has performed this year, it has still fallen less than emerging markets. Figures from AMG Data Services show that international mutual funds suffered $31 billion of redemptions in the third quarter, whereas American-based funds attracted $28 billion of inflows. As American investors bring their money home, that boosts the dollar.

So the pattern of recent financial markets has been pretty consistent. On bad days, equities, corporate bonds and commodities fall, while the yen and dollar rise. On the good days, the trends reverse.

What are the prospects for a few more good days? The most encouraging signs are in the money markets, which had threatened to bring the entire financial system to a halt. As of October 29th, three-month dollar Libor (the rate at which banks borrow from each other) had fallen for 13 straight days and was nearly one-and-a-half percentage points below its October 10th level. Thanks to a new Federal Reserve programme, companies are now able to borrow at longer maturities in the commercial-paper market. On October 27th and 28th, the amount of three-month paper shot up to $108.7 billion from $10.9 billion on the previous two trading days.

The Fed has also done its bit in terms of monetary policy, with its half-point cut on October 29th. Others are weighing in. China cut interest rates for the third time in six weeks on the same day. A quarter-point cut from the Bank of Japan was also expected. As the money markets thaw, those cuts should be passed on to borrowers.

Unfortunately, so many things have gone wrong this year that further shocks seem inevitable. Take emerging markets, where gathering economic woes are bound to lead to more bank losses, particularly in Europe. Alan Ruskin, an analyst at Royal Bank of Scotland, points out that European banks have more than seven times the claims on developing countries of their American rivals; in eastern Europe, the ratio is 25 to 1.

Then there is the continuing fallout in the structured-debt market. As more companies default, ripples will spread through a host of complex derivative products. Recent worries have been sparked by the failure of the Icelandic banks, which have caused some collateralised-debt obligations (CDOs) to plunge in value. The Bank of England, in its latest six-monthly financial-stability report, sharply raised its estimate for total global losses in the financial services industry to $2.8 trillion.

In these turbulent times, even good days for the markets can bring ruin, since some investors will be betting on the downward trend continuing. In the weeks to come, we will doubtless discover that the market’s latest bungee ride has made some funds violently sick.

From The Economist

THERE is such a thing as a free lunch. That, at least, is what pension funds have been told in recent years. Diversify into new asset classes and your portfolio can improve the trade-off between risk and return because you will be making uncorrelated bets.

Boy, did pension funds diversify. They bought emerging-market equities, corporate bonds, commodities and property, while giving money to hedge funds and private-equity managers with their complex strategies and high fees.

The idea was to “be like Yale”, the university endowment fund run by David Swensen, a celebrated investor, which started to diversify into hedge funds and private equity in the 1980s. Compared with other institutional investors over the past 20 years, Yale had very little exposure to conventional equities. It also produced remarkably strong returns.

But those who thought Yale had found the key to success have been disappointed. Every one of those diversified bets has turned sour this year. In retrospect, it looks like the strategy had two problems. The first was that all risky assets were boosted by the same factors: low interest rates and healthy global growth. That encouraged investors to use leverage, or borrowed money, to enhance returns. The result was what Jeremy Grantham of GMO, a fund-management group, describes as “the first truly global bubble”. As confidence has unravelled, investors have been forced to sell all those asset classes simultaneously, driving down prices across the board.

The second, and related, problem is that some of the asset classes were quite small. Initially, this illiquidity was attractive since it seemed to offer more alluring returns. And as more investors became involved, their liquidity duly improved. But they still suffer from the “rowing boat” factor. When everyone tries to exit the asset class at once, the vessel capsizes.

Furthermore, some of these asset classes were always likely to be driven by the same factors as stockmarkets. Private-equity funds, for example, give investors exposure to the same kinds of risks as quoted companies, only with added leverage.

So was the whole idea of diversification a write-off from the start? The strategy’s defenders say no. They argue that pension funds (and other institutional investors) had made too big a bet on equities in the 1990s. When the bet went wrong with the bursting of the dotcom bubble, funds went into deficit.

They accept that, in a crisis, correlations head towards one; in other words, all asset classes (except government bonds) tend to fall together. But the diversifiers have three counter-arguments. The first is that any correlation less than one is still worth having. Hedge funds may have performed badly this year but their losses have been far lower than those of equity markets.

Second, there is a difference between short-term correlations and long-term ones. If you take a five- or ten-year view, it still looks as if property, commodities and the rest offer some diversification benefits. They did so during the equity bear market of 2000-02, for example.

Third, consultants like Colin Robertson of Hewitt Associates argue that diversification does work when it is applied in a sophisticated way. There is no point in diversifying if the investment does not offer a genuinely different source of return (much of private equity falls into this category) or if the asset is already overvalued.

Yet even allowing for this, diversification has surely not offered the benefits most pension funds expected. Indeed, it may have had perverse results. In the old days, with equities trading at below-average valuations, funds would now be on a buying spree. They could afford to ignore the short-term risks because of the long-term nature of their liabilities. Pension funds thus acted as an automatic stabiliser for the market.

This time round, that does not seem to be happening. One reason may be accounting changes which make pension-fund managers more focused on the short term. Another, however, may be the strategic drive to diversification. The Wall Street Journal has reported that CalPERS, America’s largest public-pension fund, has been selling shares to meet commitments to put more money into private-equity firms.

The final problem with diversification has been the cost. Investing in quoted shares via an index fund is very cheap—a fraction of a percentage point. But diversified asset classes cost more to trade and involve higher management fees, expenses that eat into pension-fund returns.

So perhaps diversification has been a free lunch after all. Not for the pension funds, but for the fund managers.

Chart of the Day
Today, the US government reported that gross domestic product (total output of goods and services) contracted at an annualized rate of 0.3% in Q3 2008. The GDP report showed that consumer spending (about 70% of the US economy) declined 3.1% during the quarter which is the biggest decline since 1980. For some perspective on the US economy, today’s chart illustrates the ECRI Coincident Index. This index is a composite of several economic indicators (includes measures of production, employment, income and sales) that provide an indication as to the current state of the US economy. Since 1950, the ECRI Coincident Index has (on average) peaked one month before the beginning of a recession (as measured by the NBER – the official arbiter of recessions) and troughed at the same time that a recession ended. Today’s chart illustrates that the ECRI Coincident Index peaked back in September 2007. This suggests that the US economy has been in recession since Q4 2007 and that the recession is ongoing.

Some unemployment data that provides some confirmatory bias to my thesis of unemployment having an important impact on this particular stockmarket cycle. From FS. [I have altered the graph as the original wouldn’t load]

Employment is what will ultimately drive the economic engine and once again fuel consumer consumption. A look back at the past 8 expansions/contractions in employment since 1960 show that the peak in the average monthly payroll gains run just shy of 300k.

The most recent expansion only made it to 240k. In the contractions, the average monthly payroll loss was about 150k. The current contraction is a loss of 43k. When looking at the time from peak to bottom, the numbers get skewed by long periods of payroll gains that were positive, but well below the peak – from 1984 to 1991 and again from 1995 to 2002.

Skipping these two periods, the average peak to bottom in payroll contraction is roughly 3 years. Including these two pushes the average to just beyond 4 years. Looking at the current contraction, I would argue that it looks more like a “normal” contraction and should last between 30 and 40 months. Since the peak in payroll occurred in March of 2006 would argue that the payroll data should bottom somewhere between February and August of 2009.

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