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The Risk in Mispricing Risk


The liquidity train rolls down the tracks unabated but one of these days it will derail, as it has a habit of doing.


Will Global Liquidity Continue to Raise All Global Asset Boats?

"It's a liquidity driven market, yet there's evidence that access to capital is getting a little more difficult."
(Jack Albin, Chief Investment Officer at Harris Private Bank.)

The Quarter in Review

I have to confess: I couldn't have said better myself. According to many, the market has been driven by excess global liquidity. I have noted here many times in the past that liquidity has been making its way into the market for the better part of 12 years, since the global boom in equity prices began in 1995. Between the period of 1985 and 1995, the broadest measure of money supply growth in the U.S. grew at a relatively meager annual rate of 3% or so. From 1995 to 2005, however, the money supply as measured by M3 grew at a rate approaching 9%. Since then, it is estimated that M3 growth, even though it is no longer provided to me as it is deemed 'irrelevant'(though I humbly beg to differ), has been growing at 13%. What is the point of all of this?

First there was a bubble in stock prices from 1995 to 2000 which, of course, was followed by a bear market approximating 50% in the S&P 500 and 80% in the NASDAQ Composite. Then there was a housing bubble that ended in 2005 and the ensuing correction that continues to this very day, but more on that later. There are two troubling parts to all of this money growth. First of all, debt has exploded across all parts of the economy. For example, total credit market debt as a percentage of GDP has grown from 150% to nearly 350% and household debt has exploded to 100% of GDP.

This is frightening stuff as all that debt needs to be serviced somehow. Further, as the debt bubble grows, it is plain to see that it takes more incremental money growth to keep the real economy rolling, something I pointed out some time ago in my "Zero Hour" piece. Simply stated, in 1980 $1 of new M3 was required to increase GDP by 1%. By 1990, that number rose to $2. By 2000, $4, by 2005 it took an additional $5 and it now takes approximately $7-8! Consider this. Money supply is currently growing at 13-14% and the real GDP grew at a measly 0.6% annualized rate in the first quarter.

To be perfectly frank, this concerns me as lack of economic response to such aggressive stimulus is a warning sign that the economy is finally approaching a point at which money supply growth no longer has an impact on the real economy, otherwise known as the "Day of Reckoning" or "Zero Hour," as was initially pointed out by Barry Bannister of Legg Mason (LM) in 2003. Asset prices continue to head higher worldwide, however, so we must respect the message of Mr. Market while not forgetting the sanguine longer-term view. So I remain invested, yet conservatively so.

The Long-Term Interest Rate Picture

In a world with loads of debt, what is the one thing that is the single most negative occurrence? Yep, you guessed it: rising rates. Just ask all the folks with Adjustable Rate Mortgages (both prime and sub-prime) as rates tick up and housing prices falter. Not the best of circumstances. Since 1981, the year I entered the securities industry, we have been in a wonderful period of "disinflation".

Actually, the single best performing asset since that time has been long f-dated zero coupon Treasury zero coupon bonds! But I sense that trend has changed. In the first place, I continue to find it laughable that inflation is reported to us "ex food and energy". Seriously, do I not have to eat, heat and cool my home and fuel my car? I don't know about you, but inflation in my life is most certainly not 1.9% as was reported by the Fed the other day, supposedly in their "comfort zone" of 1-2%. In my life, I estimate my inflation rate to be in the 7 to 8% range, which brings me to this not so pretty picture of the 10-year U.S. Treasury yield curve in logarithmic terms(log charts are better in very long-term pictures for me) dating back to 1981. There seems to have been a breach of the trend line lately which suggests higher rates ahead.

There are a couple of potential culprits, such as international investors dramatically slowing their purchases of U.S. Treasury bonds and also the market sniffing out higher global inflation. At any rate, if this trend continues, it surely would have a negative impact on the real economy (reality) and the asset-based economy (perception). In fact, reality and perception may have a date with destiny in the not too distant future.

10-Year Treasury Yields

Foreign Purchases of Treasury, Corporate and Equity Securities

But what about inflation? Is it accelerating for real? If so, is it priced correctly by the market? My gut instinct tells me that inflation is indeed alive and well (like Todd likes to say: "there is inflation in the things that we need and deflation in the things that we want". What he means here is that the things we need, like education, health care, food, oil and gas, are increasing while things that we want, like plasma TVs, cell phones and personal computers, are falling in price. But, I ask you, how many plasma TVs can a person put in each room? How many P.C.s and cell phones does one need? Well, I hope you get my point. There is inflation. At least in my world. But the market isn't priced correctly for it.

Below, please find a chart of 10-year Treasury yields minus the GDP deflator (the amount the U.S. government subtracts from nominal GDP to arrive at "real GDP"). Note that we are scraping around the lows near 2%. No wonder bonds aren't behaving!

GDP Deflator minus 10-Year Treasury Yields

Interest rates are not just rising in the U.S.: they are rising in far-off places like Japan and Australia.

See the chart of the Australian 10 year Government Bond chart here.

Australian 10 Year Government Bond Yield

Australia has certainly entered into a bear market in bonds, which usually is relatively negative for equities, the economy in general and real estate specifically, but what about the foreign economy that owns the largest portion of our Treasuries, the Japanese? The Japanese have had an extremely low interest rate structure for quite some time as their economy teeters on the edge of a deflationary spiral, but note that the consumer is coming back to life in Japan now. This has resulted in what is called the "yen carry trade".

The trade goes like this. The Bank of Japan (BOJ) lends money in the overnight market at 0.5%. Japanese investors then take the money abroad and buy things like our corporate bonds (international investors have been net buyers of nearly $600 bln of our corporate over the last year) at prices that I am not willing to pay. For them, though, it makes sense as they are borrowing at 0.5%, buying at 6%, netting a positive 'carry' of 5.5%. Throw in a weak yen and the picture is even brighter as the interest is brought back to Japan worth more in yen.

But what if their rates break out of their downtrend above the all-important 2% level in 10-year JGB's? The possibility then exists for a spike of several percentage points to 4-5% and a potential 'repatriation' of their money back to Japan, which, you guessed it, could put pressure on corporate bond spreads and U.S. yields, which would in turn be bad for equities, end the LBO/Private Equity boom, and hurt an over-leveraged consumer and nation. This is by no means a prediction. I am simply pointing out a few imbalances that exist around the world. Markets have been coordinated to the upside and my suspicion is that when markets eventually revert to the mean (no, Virginia, stocks are not cheap, particularly with rising rates), markets could correct in a globally correlated move to the downside.

Japanese 10 Year JGB (Japanese Government Bond)

The Potential for Re-Pricing of Credit Risk

If the scenario I mention above actually did unfold, the market that would be the most impacted, in my opinion, is the corporate bond market. All of the liquidity sloshing around the globe along with the yen carry trade has resulted in unnaturally low yields in corporate bonds. For example, I recently acquired 30-year Ginnie Mae 6% bonds and received a yield of 6.20%. Similar duration bonds like large banks, brokers, REITs and utilities routinely trade at yields 0.40% less than the Ginnie Mae, which possesses an explicit "full faith and credit" backing of Uncle Sam.

This is nonsensical to me, just as it is nonsensical for Private Equity firms buying companies with "cap rates" or returns of 4-5%. It is also why when we launch our new fund in August, we will look to profit from the eventual re-pricing of risk. To give you an idea of what can actually happen to corporate bond spreads during a "credit event" like 1990, 1998 or 2002, see the charts below. These pictures speak volumes. It is also why we are void of credit risk at this time and expect to remain in that position. Note to self: If you are not getting paid to take credit risk do not take credit risk.

Thanks to my friends at Ned Davis Research for the data.

Historical Bond Yields

Truthfully, I feel the re-pricing of risk is a matter of not if, but when and of what magnitude. Only time will tell, but I continue to be defensive, particularly in light of the fact that we are, strangely, I might add, getting paid more for not taking risk in the first place. I also am keeping duration in portfolios relatively low as long as the trend remains up in bond yields both here and abroad.

Smart Money Sells: What are the Implications?

I often refer to what the smart money commercial or "hedgers" are doing. When the market dipped, they bought the S&P, NASDAQ, DJIA and Russell 2000, both "big contracts" and electronic "e-mini" contracts, in near-record size. Well, they have sold that position into the recent rally, which I take note of. They are often early, but they are also often right. So I respect this and the fact that they are still net short the 10-year futures but long the 2-year note futures and also long the 30-year bond futures making them neutral from an "overall duration" perspective. See the charts here.

Combined Hedgers Positions in S&P Futures

10 Year Treasury Futures Position of Commercial Accounts

Homebuilder Update and the Effect on the Overall Economic Picture

I opined as early as late 2004 that there was a bubble brewing in housing and housing stocks. In retrospect, that is what we were experiencing and the aftermath we are experiencing is less than pleasant. Home prices are falling year after year for the first time since the 1930s and it is spreading to areas like "sub-prime" loans and offshoots of these loans, like ABX indexes and CDOs and CLOs. In my opinion, in the vote of "contained versus contagion", I have to confess to being in the 'contagion' camp and think this credit rot will eventually spread, and again, is why I am so cautiously positioned from a credit perspective. My goal is to be able to buy from the fearful when the market eventually adjusts. One only gets a couple of those chances every decade, in my experience, but I must indeed be properly positioned to benefit.

Below, please see an updated bubble chart that compares the bubble in Japan in the late 1980s, the NASDAQ bubble of the late 1990s and the broken bubble in housing stocks.

I think the decline is about to re-accelerate, unfortunately for those clinging to the hope that the industry has bottomed. I have reviewed the balance sheets of all of the major home builders and have come away believing that there will be at least one that bites the dust before it all ends. Actually, this is typical behavior for post-bubble periods and I believe the same hangover will be seen down the road from the bubble in Private Equity and LBOs. I have lived through too many episodes like this and I think I know when to play defense. This is just one of those times.

Bubble Comparison Chart

Just for grins, I dreamt up a bubble comparison comparing the NASDAQ bubble and the recent move in Chinese equities (the Shenzhen Shanghai Index in local terms) and one comes away with that similar feeling that says "here we go again". A picture tells 1,000 words, I guess.

NASDAQ vs. Shanghai Shenzhen Index

Conclusion-Why We Need To Stay On Our Toes

The picture I have laid out is admittedly sobering but what has me the most concerned (I am always a 'worry wart') is the mispricing of risk generally around the globe. Yes, the liquidity train rolls down the tracks unabated but one of these days it will derail, as it has a habit of doing. Will a yen carry unwind do it? Will it be global inflation fears? A couple of LBOs gone bad? A couple of large hedge funds wrapped up in all these illiquid "structured" products imploding? A continuation of the housing market downturn? Or a combination thereof?

I admit to not being sure from a timing perspective (the third years of presidential terms are notoriously positive for stocks while years ending in seven have had their share of financial accidents), only that I think it is out there sometime between now and 2009 or 2010. As for my positioning, I recently re-entered a few sectors, namely gold shares via GDX (Gold Miners ETF), SMH (Semiconductor ETF) and PPH (Pharmaceutical ETF). So I am not void of stocks, just being very careful which sectors should be represented in portfolios.

From a fixed income perspective, as previously stated, I continue to focus on short-term, high-quality bonds along with a smattering of Adjustable Rate Mortgages. Paradoxically, one sector that seems over valued is very short-term T Bills!

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