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Changing the Benchmark


In tough market, strive for capital preservation.


The securities industry is full of long legal disclaimers. When my firm advertises performance results the common disclaimer is 'past performance is not indicative of future results.' Maybe we should eliminate the page-long disclaimer and just say 'What Have You Done for Me Lately'?

The best market calls are almost always very early. Friends of mine have sensed this frustration when I watch from the sidelines prudently as others make tons of money and have dubbed my earliness "The Bennet Factor." They think it's funny but I can tell you first-hand that it's not fun to watch a party from the outside even though you were invited. In 1999, when my hedge fund was up 'only 20%' or so, I felt a bit silly as others were blissfully making 80% in the NASDAQ.

A couple of funny stories from 1999; one was that I "didn't understand the new paradigm" which I later said became a "pair of nickels" as the market fell hard. The other story is when a friend of mine called and said his mother was making 30 points a day in "YooHoo stock" (of course she actually owned Yahoo! (YHOO) which later traded down 90%). So when the tech bubble burst, my firm avoided the pain, even though we were painfully early. The same can be said for the real estate bubble and the biggest of them all, the credit market bubble.

But that is all history, isn't it? The results are in the record books, and my firm is pleased with our past results, but the only thing that really matters is what comes next and how do we stay properly positioned. In other words, we must always be wary of "Great call, but what have you done for me lately"?

The Great Credit Unwind: What Can Stop It?

For the better part of the past ten years, I have been discussing the amount of debt and credit that was being created. Two of the greatest trading commandments are:

  • Never let the big picture get in the way of your trading, and...
  • Never let trading get in the way of your big picture analysis.

Both of these commandments are vital, but the big picture has bothered me so much that I have begun to trade less and less as the big picture gets worse and worse. I would simply rather miss some of the small moves in an environment that might be more toxic than any other market in history. I know this may sound negative or unpatriotic, however understanding the big picture is far more important than knowing what individual stock or bond to buy in my opinion.

We need to carefully navigate our way through the unwinding of excess credit and do our best to generate positive returns while others pay for their mistakes of leveraging up at precisely the wrong time. Just how much debt is out there to be unwound? Nearly four times the size of the economy. Even more frightening is the amount of CDS (Credit Default Swaps) at nearly 10 times the amount of corporate debt that is outstanding and accelerating at 30 to 40% per year (although I expect this to be reduced rapidly in coming months and years as the unwind gets into high gear).

Total Credit Market Debt as a Percentage of GDP

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Total Notional Derivatives Outstanding at U.S. Commercial Banks

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This leveraging process has been referred to as 'The Great Debt Experiment'. What should follow the debt excess is a reversion to the mean, which in this case, I like to call 'The Great Credit Unwind'. But can it be stopped? Maybe the unwind can be detained but not avoided completely. The Fed has its hands tied because they are supposedly here to help provide 'price stability' but that is awfully hard to do in an unstable world accompanied by soaring commodity prices and a plummeting dollar. It is quite possible that this was brought on directly by the Greenspan and Bernanke Fed.

Greenspan, or 'The Maestro', played a big part, along with President Clinton, who helped start the stock market bubble that began in 1995 and ended abruptly in 2000. The chart below shows how M3 (the broadest measure of money supply) began accelerating just as stocks took flight in 1995 which really isn't a coincidence.

M3 vs. S&P 500

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There are three distinct thoughts I take away from this graph. First, note how stocks took flight in 1995 when M3 began accelerating. Second, note how, in 2000, M3 kept accelerating and stocks sold off 50%. Finally, and perhaps most importantly is that the M3 line ends in 2006,just as Ben 'Boom Boom' Bernanke was about to take office as Fed Chairman.

I am still amazed that Bernanke actually said:

'My understanding is that the Federal Reserve decided to discontinue publication of the monetary aggregate M3 because the costs of collecting and processing the underlying data were judged to exceed the benefits. The Federal Reserve will not withhold the M3 data from the public; rather, it will no longer collect and assemble that information. The Federal Reserve will continue to collect data for and publish the monetary aggregates M1 and M2 and their components'.

The problem is that every place I turn I see more and more debt; at the consumer level, at the corporate level, at the hedge fund level, at the bank and financial company level and lastly at the government level. As I have stated many times, with debt you can either pay the interest cost, refinance it, pay it off, or default. We are now seeing the defaults, and there are likely more to come.

M3(b) and Credit Growth

Click to enlarge

If money is growing at double digit rates per annum and credit and credit derivatives are growing parabolically, one would conclude using traditional economic theory that the economy should be exploding and wealth would be created. Sadly, this is not the case and is specifically the Fed's dilemma.

The United States, and most likely other developed nations which are in the same boat, are already in recession. Millions of homes are vacant, unemployment is rising, banks and brokers are running, hat in hand, all over the world to stay capitalized well enough to conduct 'business as usual'. Business, however, is anything but usual at this time. Banks are paying out tons of dividends at the same time that they're begging foreign investors for capital and raising money in the preferred stock market at rates between 8 and 10%.

Shouldn't they be eliminating their dividends to conserve capital? I'm sure that it wouldn't make many of their shareholders happy, but it would certainly allow them to stay solvent longer. In my opinion, there will be one or more (possibly many) financial institutions that go under during this credit unwind, there just can't be enough rescue capital to keep them all from peril. To wit, when I look at the Lehman Brothers' (LEH) balance sheet and see it levered 40 to 1, I wonder how on Earth did anyone allow it to get that leveraged? Consider that Lehman has four times as many 'Level 3 Assets' (those that are 'hard to price') as it does capital. Hard to price in my book equates to 'hard to sell'.

Perhaps the most interesting part of all of this is that Lehman recently announced a share repurchase of 100 million of its shares for a cost of $5 billion or so. At the same time, it floated a preferred stock deal at 7.95% and issued billions of dollars of new debt for itself. This occurred just as the firm's mortgage and other debt related write-downs began that will likely run into the tens of billions of dollars. In other words, rather than de-leveraging, it's adding leverage. I guess this is why my firm is short Lehman debt.

The same goes for Bear Stearns (BSC) and many others. To prove the point, what do you think would happen if Lehman and Bear were told by regulators to sell its 'hard to price' assets? I find it highly doubtful it would be able to sell them and hence, this leads me to question their solvency. What about the other $600 billion of assets on Bear's balance sheet? Could it sell them? Doubtful. The reason is that everyone else owns the same type of securities and the company is being instructed to sell, yet cannot.

So the 'daisy chain 'has started whereby when one firm is forced to sell, it must 'mark to market' which means everyone else who owns the same security has to mark theirs down as well. Wouldn't one conclude that firms like Lehman should have been shrinking its balance sheet over the past year? Of course, but lo and behold, its balance sheet grew by over 30% year over year.

Continued on Page 2

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Positions in BSC and LEH debt.

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