Introduction
Now
that the “feel good” US election is
over, investors around the world have only two main worries. The first is the
released enthusiasm will be found dissipated by the time a budget is signed at
the White House, assuming that Valerie Jarrett approves. However, what could be
worse is that the enthusiasm leads to a surge of buying, creating a parabolic
price chart. The second worry is one that few are watching: the unidentified
growth in leveraged fixed income transactions.
“Happy Talk” for Stocks
While
the Chair of the Federal Reserve is publicly worried about potential volatility
when interest rates begin their inevitable rise, I am worried by the volatility
on the upside. There is very little in the popular press about upside
volatility. When stock prices go up the pundits claim that it is due to some
economic statistic, they don’t attribute the gains to market structure
imbalance. Because academics want their students to be aware that prices can go
down as well as up, they label the gains as rewards and declines as risks;
which fundamentally misinterpret the nature of risk.
For those that have the responsibility of managing other people’s money, risk is the permanent loss of large enough amounts of capital that threaten long-term goals for the use of the money. The academics wanted (and many still do) a mathematical formula for risks and adopted standard deviation of returns which has led to far too many counting risk as volatility of returns, not impacts on outcomes. To solve the need to be able to define the volatility of “the market” our friends in Chicago created the Volatility Index on the S&P500 which then could be traded with the moniker of VIX.
For those that have the responsibility of managing other people’s money, risk is the permanent loss of large enough amounts of capital that threaten long-term goals for the use of the money. The academics wanted (and many still do) a mathematical formula for risks and adopted standard deviation of returns which has led to far too many counting risk as volatility of returns, not impacts on outcomes. To solve the need to be able to define the volatility of “the market” our friends in Chicago created the Volatility Index on the S&P500 which then could be traded with the moniker of VIX.
VIX can miss
We
have just finished a four month period when the VIX index doubled off a
historically low base and then returned to low levels. However, this move to be
did not capture the true saw-tooth movement in the market place. My firm has been
charged with managing a series of portfolios largely invested in mutual funds
for different needs. In this four month period we are tracking 51 separate funds and
separately managed accounts for this client. While most of these portfolios invest in stocks, a
number invest in fixed income. The movement of the VIX did not really capture
the price movements. In July, 39 out of the 51 declined which was echoed in
September when 49 were flat or declined. Our client should have been pleased
that in October 43 out of the 51 rose. Perhaps, much more significantly over
the four month stretch 32 rose. At no point was the ability of these accounts
to meet future funding needs ever in question. Thus, there was no real risk to
their goals.
Good news, bad
news
In
a recent investment committee there was a discussion as to moderately changing
asset allocation in favor of domestic equities. There was an expressed belief
that we are entering a period of increased upside volatility. This view makes
sense to me in the short run. In previous posts I referred to the media’s use
of “handles” to describe surpassing round number levels. S&P 500 at 2000,
Berkshire Hathaway* at $200,000, Apple* at $100 and now
we could add Alibaba at $100. It will be interesting to see whether Moody’s*
can rise to $100. The stock appears to have stalled out at $99. Also can
Goldman Sachs* go over $200?
If investors, both institutions and individuals, translate these handles
as rungs in a ladder reaching materially higher levels we could see a wall of
money coming out of cash instruments and into the stock market. (One investment
banking firm is predicting a 3000 handle for the S&P.)
*
Securities owned personally or
in our private financial services fund.
If
this wall of money enters the global stock markets without discipline, stock
prices could gyrate upward in a speculative frenzy. If that would happen, it
would fill the main remaining element needed to identify a major top.
Fixed income leverage
Most
stock investors don’t realize that the fixed income markets are much larger in
size than stock markets. Historically
price movements in these markets are less than those in stock prices. In
addition, almost all fixed income investments have a maturity date thus banks,
brokerage firms, and governments have felt comfortable allowing borrowers to
borrow up to 99% in the case of currencies and somewhat less for other types of
issues. In modern times it is not unusual to borrow money in a low interest currency
and buy a lot in a higher (more risky) currency. Often the supplier of the
leverage is a bank or brokerage firm who will be the recipient of the trading
flow of the borrower. That has worked well, in the past. Today each of the
banks or brokerage firms for regulatory purposes has had to reduce the amount
of capital than can be used by their
trading desks to provide liquidity to those fixed income accounts that need
rapid liquidity. (In part this was one of the major contributing causes for the
Lehman bankruptcy.)
The
fundamental fallacy of governments bailing out financial and industrial
companies is actually boomeranging and could make future collapses worse. Collapses occur because a large number of
people make rapid, poor judgments. One can not force sound decisions by law.
(We probably would not have the political leaders that are present today if we
could mandate sound decisions.) Governments don’t want to capitalize bailouts,
so through regulation and legislation they are attempting to reduce the size of
their exposure by limiting the size of the participants. The Fed has now
decreed that no financial company can have capital in excess of 10% of the
combined liabilities of all the other banking institutions.
This has the effect that the US will have ten or more large banks. Other nations have a much more concentrated financial community. With the US institutions being limited in the global markets, their foreign competitors will increase their share of the loans. In time they will have to deal with large global failures which will impact US institutions and put our investors at substantial risk. One of the problems facing all governments is that they can influence, but not rule the global financial community effectively. The attempts to do so is creating a false sense of security which when their balloon is popped could lead to massive movements in the market places.
This has the effect that the US will have ten or more large banks. Other nations have a much more concentrated financial community. With the US institutions being limited in the global markets, their foreign competitors will increase their share of the loans. In time they will have to deal with large global failures which will impact US institutions and put our investors at substantial risk. One of the problems facing all governments is that they can influence, but not rule the global financial community effectively. The attempts to do so is creating a false sense of security which when their balloon is popped could lead to massive movements in the market places.
I
would like to learn how big is the potential problem. There is no global tally
as to the amount of money that is being provided to fixed income investors and
these include important currency players.
When
there is a major dislocation in the bond market the institutions involved or
fear that they may get involved will reduce their support for all markets as
they husband their capital before an eventual redeployment. Thus, one of the
major risks to the stock markets is a sudden major contraction in the fixed
income markets. This is called contagion and we saw it happen to the Latin
American markets when Russia defaulted.
Question of
the week:
What
are you worried about? Let me know.
__________
Did someone forward
you this Blog? To receive Mike Lipper’s Blog each Monday, please
subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com
Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
Posts
No comments:
Post a Comment