Third Quarter in Review: You Have Got To Be Kidding Me
If the unthinkable has already occurred, more unthinkable things can occur, in spite of what we think they should be doing.
-Legendary hedge fund manager Michael Steinhardt
The Quarter in Review: So You Wanted Volatility?
Sometimes, particularly in the markets, you must be careful what you wish for. Because, sometimes, it may be what you wished you had not received.
For what seemed like eons, many investors (present company included) were tired of the lack of volatility in the markets. Stocks seemingly rose each day, albeit by a small amount on most occasions, but there was little if any 'vol' (Street lingo for volatility). There was also a compression of interest rate spreads on corporate bonds, emerging market bonds and mortgage backed securities compared to Treasuries. This lack of vol was frustrating for those that wanted to trade market swings and get compensated for taking credit risk. Admittedly, I was frustrated as well, but did not cave in to the market and did not take credit risk without being fairly compensated. I have always lived by the investment management commandment of "if you are not being compensated for taking risk (including credit risk), do not take risk."
While the S&P 500 ended the quarter up just 1.56%, there was plenty of volatility to go around. Nimble traders finally had their chance to trade the market, while investors rode the volatility train all quarter without much to show for it. As for bonds, yields swung violently in Treasury bills (more on that later) and credit spreads began to widen only to contract again when the FOMC (Federal Open Market Committee) and ECB (European Central Bank) stepped in to the credit markets to stop a credit crisis from starting. The FOMC actually changed course so quickly that in 15 days, it went from saying that it was concerned about inflation to easing monetary policy aggressively by lowering the discount rate (the so-called 'lender of last resort rate' that is charged directly to banks) by 100 basis points and the Federal funds rate by 50 basis points.
Also of note during the quarter, the U.S. dollar collapsed to all-time lows against a basket of trade-weighted currencies, including the euro, yen and Canadian dollar. The asset backed commercial paper market stopped functioning normally, major "quant funds" showed losses of 25% and more, 19 hedge funds went under and the number of mortgage companies that went under climbed to 161 for this year alone. The housing market basically came to a standstill, Countrywide Financial (CFC) had to raise emergency capital as did Thornburg Mortgage (TMA) (two of the largest mortgage originators), Bear Stearns (BSC) had its share of problems and the sub-prime mortgage market continued its road to implosion.
Let's see. What else happened? The money supply continued to expand at a double digit pace. Oil rose to a record high, gold and commodities surged and China's bubble continued to grow (more on all of this later). I have to admit that we had the macroeconomic picture down cold and yet, stocks are within 1 or 2%of their all-time highs. Which leads me to the title of this quarter's newsletter- "You Have Got To Be Kidding Me."
Part I: The Dollar Collapses
It is now a well-known fact that the greenback has tumbled to all-time lows against a basket of trade-weighted currencies known as the DXY index. A client stopped by yesterday to chat at my trading desk. He said to me, "I want to buy dollars, how do I do it?" Keep in mind, this is a rather successful businessman with excellent knowledge of the economy. I asked him why he wanted to buy dollars, and he replied that he wanted to buy dollars because surely U.S. currency was worth more than a "loonie" (lingo for the Canadian dollar). And $1.425 to buy a single euro? I explained to him why I thought it was a potentially profitable trade in the near-term, but wanted to explain why the dollar has collapsed.
Market prices are determined by supply and demand: Yes, it is that simple. The supply of dollars has been growing at double digit rates as the U.S. tries to finance its way out of twin deficits (trade and budget). This printing press has led to a huge supply (too many dollars) which simply lowers the price at which the dollar trades. From an ultra short-term perspective, of course the dollar can rally. Longer term, however, in order for the dollar to rally, we need to get our economic house in order. To do this without a recession, which the Fed continues to try to stop from happening, will be a difficult task. Please see the chart below. which is a multi-year, logarithmic picture of the DXY. With the dollar now being front page news, it may indeed be ready to bounce because, as the old saying goes, "what the market knows isn't worth knowing".
Trade Weighted Dollar Index
Click here to enlarge.
Note that in 1992 or so, the dollar had a "false breakdown" which then led to a 50% rally. The weeks ahead will tell us if the dollar is now discounting our economic mess or not. I sense either a sharp rally, or a complete collapse. Since a complete collapse is not in the best interest of international investors who own so many of the U.S.' securities, I would lean towards the bounce camp-but honestly I have no position either way. Here is the great part. During the 5 year Treasury note auction on Thursday, "indirect bidders" of foreign accounts bought over 45% of the issue, their highest participation rate of the year, despite a collapsing currency that the bonds are denominated in. This makes no sense to me. You have got to be kidding me!
Part II: The Economy Stalls and Stocks Rally
Without question, a debt bubble has formed in the U.S. Just how big is the debt bubble? Consider this. Five decades ago, debt grew at a somewhat similar rate of new GDP being created. Today, according to Ned Davis Research, new credit market debt has grown at five times the rate of incremental GDP during this decade. The table below tracks many decades of debt and GDP growth. A while back, I wrote an article entitled "Zero Hour," or the point at which a debt-laden economy no longer responds to monetary growth. We may not be there yet, but we seem to be getting close.
Debt Growth Relative to Incremental GDP Growth by Decade
Click here to enlarge.
It is becoming clearer each day that a financial day of reckoning is approaching and that those taking loads of credit risk without getting compensated will loathe the fact they did so. In this regard, I continue to shun credit risk in favor of Government Sponsored Entities--Fannie Mae (FNM), Freddie Mac (FRE), and Ginnie Mae. Now for the important question-if someone had given you all of this data ahead of time, what would you have guessed stocks and credit spreads would do? I would have gotten it wrong and said that stocks would sell off (they did until the Fed stepped in) and credit spreads would explode (they did for a while until the Fed stepped in). Again, you have got to be kidding me!
Part III: Treasury Bills Go Bananas
One of the best ways to park cash in times of uncertainty is in three-month Treasury Bills. Three-month Bills are the most often used in analytical circles as the risk free rate of return. What if I told you that Treasury Bills would fall from 4.75% on August 8 to 2.25% on August 20, rise back to 4.50% on August 27 only to fall back to 3% by quarter end? You would likely come to the conclusion that the financial system would be in disarray, which it was until the Central Banks stepped in. Please see the chart below of the yield of the Treasury bill due 10/11/2007 for the entire quarter just ended.
Yield of Treasury Bill Maturing 10/11/2007
Click here to enlarge.
Furthermore, what if I told you that the asset-backed commercial paper market would cease functioning normally and that the amount of commercial paper in that space fell by 23% from $1.182 trln dollars on August 8 to $912 bln on September 26? Please see that chart below.
Asset Backed Commercial Paper Outstanding (in billions)
Click here to enlarge.
Given all of this data, we would likely assume that there was a huge credit problem somewhere. And indeed there is. Why else would the Fed panic and lower rates and begin accepting everything from junk bonds to sub-prime mortgages at the discount window? Because they had to do so to keep the credit markets operating "normally." All I can say is that any financial system that needs this much stimulus is one that is not on stable footing. Should we not conclude that spreads would explode and stocks would fall, which happened for a while until Central Bankers stepped in to "save the day"? CNBC commentators were no longer frustrated, and Congressmen rejoiced as the Fed rode in with a white hat to "save the day". Stocks rallied and credit spreads again collapsed. If you had told me all of this ahead of time I would have said, "You have got to be kidding me!"
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