Five Themes for the Fourth Quarter
As we ready ourselves for an active and interesting fourth quarter, here are five elements to watch as we fit the pieces together and shape our collective fortunes...
October is here and you know what that means. Playoff baseball is heating up in the Bronx, the NFL season is in full swing and the year-end debate has started to rage as we eyeball another year of flickering ticks.
The third quarter was many things but boring was not among them. The comeuppance of credit would have been the central theme if not for the Federal Reserve's swift policy shift. It had one mission in mind and that was to buy the market time and push risk further out on the curve.
The Fed won that battle but the war, as they say, has just begun.
As we ready ourselves for an active and interesting fourth quarter, here are five elements to watch as we fit the pieces together and shape our collective fortunes:
For every action, there is an equal and opposite reaction and that extra time comes with a cost. The mainstream media has covered the dollar decline seven ways till Sunday, highlighting the benefits to large multi-national corporations. While we respect that perspective, we view the greenback through a slightly different lens.
On the back of the tech bubble, the Fed pumped massive amounts of money into the system. That liquidity levitated asset classes, from equities to commodities, across the board. We call this dynamic "asset class deflation vs. dollar devaluation" and the latter matter prevailed as the dollar lost a third of its value.
It is interesting to note that the CRB rallied 13% since the August low (trough to peak), which is precisely as much as the DJIA and S&P. That correlation supports our "rising tide" lens and, as such, the recent slippage in crude and the metals (coupled with the grabby greenback) may be offering a stealth wink to equity bears.
Bigger picture, one of two themes will likely manifest: Nationalization (countries taking possession of their own assets) or the transfer of wealth (foreigners buying paper and hard assets). The prevailing dynamic will be influenced by stateside policy, particularly as buyers emerge from China and the petrol nations.
Alan Greenspan opined on Monday, when asked about the Shanghai stock market that "If you ever wanted to get a definition of a bubble in the works, that's it."
There was a time when such strong words from the former Fed deity would reverberate throughout the world. However, after numerous false alarms including irrational exuberance (1996), previous China worries (May) and summer recession warnings, nobody seems to be care.
That, in and of itself, may be cause for concern.
With Shanghai more than doubling year-to-date-and the FXI 72% higher since August-we can't help but wonder where we are on the bubble curve. I recall similar conversations at NASDAQ 2000 and 3000 in 1999 and again at NASDAQ 4000 and, ultimately 5000 in 2000. Each plateau felt toppy at the time but the last gasp was the most vicious rip.
The one thing bulls and bears would agree on is the importance of China as a global engine of growth. I'm not smart enough to know if they can keep the balls in the air until next year's Olympics but this will most certainly remain on my radar as we find our way.
While structural influences, technical metrics and upcoming earnings jockey for market mindshare pole position, psychology will likely emerge as the primary determinant of year-end performance.
When the credit crunch arrived this summer, volatility levels more than doubled as traders emailed "crash analogy" charts to each other and reached for put protection. The VXO has since retraced that entire move as puts were puked and sentiment shifted to the 1998 mindset.
There is an unwritten rule in fund management that stresses the benefit of relative performance over absolute return. That might sound bizarre but with 10,000 hedge funds in existence, the race to keep up with the Dow Joneses has never been more acute.
That has created a reactive trading approach across the spectrum of funds, one where managers focus on reward when the market is higher and risk after we've sold off. It's a bit backwards but it's a function of the world we live in. The trick to trading is staying one step ahead of that herd.
The prevalent mindset, at present, is that central banks won't let the market fail. The reaction to Monday's news in Citigroup (C), UBS (UBS) and Netbank (NTBK) illustrates this belief as traders were quick to assume that the worst is behind us.
That might be right but given the complete reversal in the volatility market, the margin for error continues to thin.
There has been incessant coverage of the averted summer crunch and it's hard to argue with performance. By shifting the parameters of discount window collateral and slashing interest rates, the Federal Reserve effectively maneuvered the markets through a very tight situation.
While price actions speak louder than words, it would behoove us to take a peek under the proverbial kimono. Short-term lending and some LBO related financing has indeed eased but the longer-term market remains relatively chilly.
To that end, it's worth noting that the small caps have underperformed their big cap brethren since the policy shift. Historically, these names benefit the most from a rate cut as they have leverage on an incremental reduction of their cost of capital. That hasn't happened this time around.
In a finance-based, debt dependent economy, the elasticity of debt and velocity of money are the two key variables. Global central banks continue to pour money into the system but they can't force consumers to absorb more debt or companies to spend more than they want.
While the initial flood of money eased the strain on the system, a backlog of supply waits in the wings. The quantity and quality of deal structures will go a long way in helping us determine the health of the system. Archstone Smith Trust (ASN), TXU Corp (TXU), CDW Corporation (CDWC) and Sallie Mae (SLM) will serve as proxies in that regard.
Total debt in the U.S. is more than 300% of GDP. The consumer, at 70%, is the largest component of GDP. It stands to reason that the performance of the consumer will drastically influence the growth of the economy.
Despite high profile retail snafus at Target (TGT), Lowe's (LOW) and Home Depot (HD) - along with chatter that the high end will slow this holiday season despite foreign interest - the consumer has shown remarkable resiliency in the face of the ongoing mortgage mess.
Past performance is no guarantor of future returns to the mall, however, as evidenced by the fact that Citigroup almost tripled its consumer debt loan loss provision on Monday. The reserve increase "reflects a change in our estimate of loses inherent in our portfolios, but not yet visible."
Therein lies the caveat for consumers and by extension the economy. If a risk management team as savvy as Citigroup sees something under the surface that has yet to be reflected in delinquency statistics, what will be the implications for those who haven't stashed something away for a rainy day?
Given the full circle shift in the financial market mindset from risk management to reward chasing, that's a question that might come in quite handy by the time 2007 comes to a close.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at email@example.com.
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