Wednesday, November 19, 2008

Bond market distress continues

I've been through several bear markets (1987, 1990-91, and 2000-02), but this one takes the cake because it just keeps going. As soon as one key fundamental turns the corner (e.g., swap spreads declining), something else rears up to take its place. In the past week or two, one new problem has arisen in the market for the debt of GSEs (e.g., Freddie and Fannie), with the spread between their yields and Treasury yields blowing out to unprecedented levels, as shown in this chart. I mentioned this problem three weeks ago, before things got really crazy, and thought it would be fairly easy for somebody in Washington to put the market's fears to rest by making the government guarantee of Agency debt more explicit. But things have only gotten worse since then; the market is in full panic mode. Another recent problem is the apparent meltdown in the market for asset backed and commercial mortgage-backed securities (ABX, CMBX). The selling is intense, and the pirates are pouring over the transom, as one former colleague puts it.

I don't have a good explanation for what is going on, but I'm tempted to blame this latest problem on foreigners and not deteriorating fundamentals (the news has been so awful for so long that it's hard to see how the fundamentals could get much worse). Foreign central banks, sovereign wealth funds, and foreign insurance companies have accumulated gigantic volumes of our debt (most of which was rated AAA when they bought it) in the past decade, and those funds are being managed in most cases by people who have never lived through a financial crisis or have never managed risky assets. Agency debt was once thought to be virtually risk free, but now it is behaving almost like BAA corporate debt behaved in the 2000-02 period. That is a shocking reality that has destroyed the confidence of investors all over the world.

In short, there is not a great deal of institutional memory or expertise overseas, whereas the collective wisdom of Wall Street and large U.S. institutional money managers runs deep and spans decades. As a result, and in my experience, foreign money managers tend to be trend-followers, not contrarians.

Being a trend-follower in today's market has been a good thing, because the selloff has been long and extended. Selling has saved people lots of money. So now, despite the fact that many prices are absurdly low, any bit of bad news, including news that prices are falling, invites a new wave of selling.

Just put yourself inside the head of an overseas money manager in charge of many billions of dollars of asset-backed securities that were once considered almost gold-plated. If you sold 3 months ago, you are a genius, but if you don't sell today on bad news and prices end up going lower, you will be branded a moron by your superiors. How could anyone not understand that this is a bear market of unprecedented proportions? Bad news must always be a reason to sell.

This can go on mindlessly, but at some point most of the selling will have been done. At some point the economic news will start to get less bad, and here and there we will see glimmers of improvement. And at that point we can expect to see prices head much higher. I just wish I knew when that point will come.


The Therapist Is In said...

do I notice a hint of capitulation in your blog today?

Scott Grannis said...

I'm not capitulating, I am still losing money and wondering why. If the reason I've been wrong is that the world is behaving irrationally (for a lack of experience and a surfeit of panic), that is all the more reason to not capitulate.

But I sure wish I had sold awhile ago!

This is the stuff of which bottoms are made.

The Therapist Is In said...

yes I agree with you. I, like you, spent 27 years in the securities bus. (1976-2002) and witnessed a lot; nothing compares to this. I was a specialist on the options floor in Chicago and mostly in SF. I am now a licensed marriage and family therapist after a long period of adjustiment, recovery, and return to sanity, a slow process. The only thing I can counter with is that my elders (older than us) reflect that in the early 70's stocks were trading at a 6 multiple and no one cared.

Mark Gerber said...

I'm wondering if the Feds balance sheet has expanded enough. I've seen estimates that the shadow banking system extended about $10T in credit. The shadow banking systems is now gone, but the Fed's balance sheet has only grown about $2T. This difference is a great deal of credit contraction.

I know that you often point to the Fed charts that shows bank lending has been growing along the historical trend, but my understanding is that much of this lending is forced upon the banks from businesses pulling down previously established lines of credit because they are afraid they won't be able to find funding elsewhere. Thus, loans are not flowing via free market mechanisms where they are most valued.

Scott Grannis said...

Therapist: the 70s were ugly indeed, but like the Depression there was a good explanation: Nixon's dollar/gold devaluation and subsequent deflation. Inflation is VERY bad for stocks. And we have had some "undesirable" inflation in recent years, and that could explain part of the lousy market we've seen.

Scott Grannis said...

Mark: The "banks were forced to lend" argument has been going around for well over a year. I think it's lost whatever credibility it might have had by now. When ALL measures of banking lending, securities lending, and money supply are rising and at all-time highs, I have to conclude that something real, not fake or forced, is going on.

By any measure that I've come to respect, the Fed has blown past any measure of "extremely accommodative monetary policy" that was ever applied to an advanced economy. There is simply no doubt that they have done their very best to practice massive quantitative easing. Check one of my earlier posts that cited some stats from Japan's quantitative easing period. Today's Fed makes the BoJ look timid.

But as you note, all the money being pumped into the system is having trouble finding its way out into the economy.

In the end, I fall back on my long-held belief that if the Fed tries very hard to do something, they WILL succeed given time.

Jeff said...

Are foreign money managers naive or are they smart? When they see the Fed quintupling the monetary base they know that a devaluation of the dollar is not far behind. If the dollar drops like a rock someday, would you want to be holding US assets?

LetUsHavePeace said...

Last week I read a quote from Wally Weitz that said (my paraphrase) "If you are not comfortable with having your assets down 50% at some point, you have no business being in the stock market." Clearly, this is one of those minus 50% periods for Mr. Weitz and many of the rest of us. The clear implication of Mr. Weitz's comment is that you also have to willing to stay in the stock market AFTER you were down 50%. Or, as a trader I recently met puts it, the time to buy is not when the guy at the desk next to yours is throwing up; it is when his desk is empty and you have already thrown up everything you ate and are having dry heaves. It is one thing to talk about buying when there is blood in the streets; it is quite another to do it. Thanks for the sage advice, Scott.

Scott Grannis said...

Peace: you have added some good advice to this post, thanks. Another thing for people to think about is that if the market returns to where it was a year ago, you will double your money. Even if it takes 10 years to return, that's an annual return of 7.1% and that sure beats cash or Treasury bonds.

Scott Grannis said...

Jeff: I would put that in the category of inflation being bad for stocks. Everyone, foreign and domestic, can look at what the Fed is doing and figure out if it's inflationary. Curiously, though, the market is now concluding that there will be absolutely NO inflation for the next 10 years--the spread between 10-year TIPS and 10-year Treasuries is essentially zero!

chaim said...


As to your/ our bewilderment regarding the stock market, Andy Kessler has a very interesting article in the WSJ today:

He conjectures or asserts that occasionally (and now is an extreme example), the market is "inefficient" (does not reflect the true economic situation and the true price of stocks).

The causes of these "inefficiencies" are: Tax-loss selling, Mutual fund cap-gain distributions, Hedge-fund redemptions, and Margin calls.

He states that are some of the usual culprits for price inefficiencies; however we are in a unique extreme situation (perhaps exaggerated by lack of confidence in the government "experts" who seem to floundering blindly ) that severely aggravates the problem.

What's disconcerting is that according to this presumption, December (and perhaps January) is going to be even uglier, if that's possible.

[Some have postulated that the Market is pricing in Obama's and the new Congress' expected economically deleterious policies.]

As an aside, there are potential adverse political effects of Andy Kessler's theory, if it comes to be: If February, 2009 will indeed demonstrate a significant Market bounce, the new administration may point to the optimism in its proposed policies. (Rahm Emanuel in a perhaps subconscious Orwellian moment recently stated "a crisis is a terrible thing to waste".)

The New, New Deal- bigger, better and improved.

Heaven help us.