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The Bank of England Financial Stability Review

(February 9, 2006)

Dear Subscribers and Readers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday at DJIA 10,840.  We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon at DJIA 10,900 – thus giving us an average entry of DJIA 10,870.  As of the close on Wednesday (10,858.62), our position is 11.38 points in the black – and at this point, we believe that the correction in the stock market is not over yet.

It is important to keep track of what Central Bankers are saying – given their importance and influence on the international financial system as well as their ample contacts in the market place.  If anything, keeping track of what they are saying will give you an idea of the indicators they are tracking, and the latest December 2005 “Financial Stability Review” published by the Bank of England is no exception.  In going through the report, one can see how far the developed world's Central Banks has come since the days of the 1970s.  That is, the report outlined – in a clear and concise manner – the state of the UK and world's financial system as well as any potential risks up ahead.  In the BoE own words, the aim of the “Financial Stability Review” aims to:

  • to encourage informed debate on financial stability issues, domestically and internationally
  • to survey potential risks to financial stability
  • to analyse ways of promoting and maintaining a stable financial system

And this author believes that this report has done an admirable job of doing just that (the “Global Financial Stability” report published back in April 2005 by the IMF also did a very good job of addressing such risks).  For the purpose of this commentary (and for the purpose of our readers), I will attempt to address the question of “Where are the risks?” focusing on the international financial system using the research from Bank of England – as well as give our own opinions on the most likelihood scenario going forward this year and into 2007.

On the surface, the world economy seems tranquil.  Everywhere we look we see ample liquidity, huge buildups of foreign reserves in developing countries, lack of trade barriers, as well as booming stock and bond markets all around the world (with the exception of U.S. large caps).  Since the end of 2005, even domestic Chinese equities have gotten into the act – as exemplified by a 15% in local issues over the last six weeks.  This author does not mean to be dramatic, but in times of such peacefulness – we must not forget the State of the Union Address as given by Calvin Coolidge in December 1928:

The paragraph below is taken from the first chapter of "The Great Crash," the most famous book written about the Crash of 1929 by John Kenneth Galbraith.

"Vision and Boundless Hope and Optimism"

On December 4, 1928 President Coolidge sent his last message on the State of the Union to the reconvening Congress.  Even the most melancholy congressman must have found reassurance in his words.  "No Congress of the United States has met with a more pleasing prospect than that which appears at the present time.  In the domestic field there is tranquility and contentment ... and the highest record of years of prosperity.  In the foreign field there is peace, the goodwill which comes from mutual understanding ... "

And we all know what happened afterwards.  Many armchair political scientists or economists may have been surprised by the riots in France earlier last year (and many of the same folks who have not set foot in New Orleans and who don't know the demographics of Louisiana may also have been surprised by the lack of order in New Orleans in the wake of Hurricane Katrina – especially youngsters around the world who have always admired America), and are probably even more surprised by the recent unrest over the offensive cartoons recently published in Denmark and republished by many of the major newspapers in Europe.  One can easily be caught flat-footed if one does not pay close attention – and that cannot be more true when it comes to the financial markets.

In our last weekend commentary, I stated: Our mid-cycle slowdown scenario continues to remain in effect.  In our January 8th commentary “Identifying Risks in the Upcoming Year,” one of our chief concerns for 2006 is the extreme lack of complacency in the emerging markets – as characterized by the record low emerging market spreads we have witnessed since the beginning of January.  Despite having a fanatic as a dictator and despite rampant corruption and purchase of firearms, S&P has just upgraded Venezuelan government bonds – primarily based on the assumption that both crude oil and foreign currency reserves will continue to remain at current elevated levels.  Make no mistake: When Venezuelan bonds are trading at only a 230 basis point premium to U.S. Treasuries – with Russian bonds at a 100 basis point premium (which in 1998 famously defaulted on all their debt) and Iraqi 22-year bonds at a 400 basis point premium (this author highly doubts that Iraq will exist in its current form 22 years from now), there is really no other way to label emerging markets other than a “bubble” and there is no other way to label investment sentiment other than as “extreme complacency.”

This extreme lack of complacency in emerging market securities can be witnessed in the following chart from the Financial Stability Report.  As the chart shows, both emerging market sovereign and corporate spreads relative to U.S. Treasuries have been declining consistently over the last few years and are making record lows week in and week out:

Bond spreads

The message of the December 2005 Bank of England's Financial Stability Review (FSR) report is no different to our message.  I will begin our summary with this quote: “Since the June Review, the immediate circumstances for borrowers and lenders have suggested few reasons for a reassessment of credit and market risks. The UK financial system remains healthy. However, the persistence of the ‘search for yield' across financial markets continues to fuel an increase in highly leveraged and potentially illiquid financial products. It has placed pressure on financial intermediaries to ease lending terms, challenged operational controls within the financial sector, and may have heightened the vulnerability of the UK financial system to adverse developments…”

Over the last few years, the use of derivatives and the trading of such derivatives as well as other financial instruments and securities have exponentially increased.  Many of these trading are done over-the-counter, but a significant portion of this explosion can be witnessed in the record setting volumes on exchanges such as the Chicago Mercantile Exchange, the Chicago Board of Exchange, the Chicago Board of Trade, as well as the Intercontinental Exchange.  Of course, such growth in volumes has also been amply rewarded, as exemplified by the following daily chart of CME from August 1, 2004 (approximately the time when Google's shares started trading) to the present:

Chicago Mercantile Exchange

As can be seen in the above chart, the rise in the CME stock price has been nothing short of phenomenal – only to be equaled by the unbelievable rise in Google's shares in recent years.  Note that the relative strength of CME to Google is now at its highest since late October 2005.  As this author is typing this, the parabolic rise in trading volumes is still showing no signs of slowing down.

Of course, the realm of leverage is not complete without a discussion of debt and the LBO market.  While corporate debt issuance has been relatively low relative to government bonds (due to high cash flows and quality balance sheets), players have sought to increase returns by leveraging existing assets and by increasing the volume of leveraged loans.  Over the last few years, strong competition among such deals have led to easier lending terms – leading to CALPERS recently declaring that the private equity market is now in a “bubble” and subsequently decreasing its allocation to such deals going forward.  The exponential growth in the LBO and leveraged loan market (this encompasses UK as well as international data) is evident from the following chart from the FSR – as we need now is a “signature deal” ala the RJR Nabisco deal of 1989 and this author will then have no hesitation of calling a top in the private equity/LBO market:

Leveraged loan issuance

From a modern finance (and CAPM) standpoint, however, such leveraging up via either derivatives or issuing debt makes a lot of sense, given the recent lack of actual volatility and implied volatility in the world's financial markets – as exemplified by the following chart showing the implied volatility of the S&P 500, the US$/Pound exchange rate, and the 10-year U.S. Treasuries over the last few years:

Implied volatility of financial markets

As can be seen, the implied volatility of the world's financial markets has significantly decreased over the last few years.  The bulls will argue this is a structural change – given better and instantaneous information, lack of trade and financial barriers, as well as the proliferation of securitization over the last decade – thus allowing the financial system to spread out its risks to more willing participants.  This argument is further strengthened by the fact that the markets functioned very smoothly in recent years despite a surprise downgrade of GM and Ford's debt and despite Delphi's and Refco's surprise bankruptcies earlier last year.  20 years ago, these events would have created tremendously volatility in the financial markets.

In other words, the hedge funds and the pension funds have no choice.  In a world of historically low actual and implied volatility, returns have significantly declined and one can only generate “excess alpha” by investing in more risky assets or buying more of the same assets by utilizing leverage.  This is dictated by the Capital Asset Pricing Model (and especially by the models that the hedge funds utilize) as well as the modern concept of finance and investments.

Just as with other cycles, what started out as a structural story may ultimately turn out to be just another cyclical story.  No doubt, the advent of the internet, globalization, and securitization may have resulted in more sophisticated deals being done – and given the latter two, one could also have found more willing participants than ever before.  This has the fortunate result of spreading the systematic risks among a greater number of investors than ever before – creating a more liquid marketplace – which is a God-send in times of great financial distress.  However, the effects of such structural changes in the financial system are not infinite.  For example, total assets as held by hedge funds rose from $600 billion to over $1 trillion over the last two years.  At the same time, American investors have grown more sophisticated, and globalization in recent years has brought in a number of new investors from both China and India.  But can such structural changes “handle” the continuing exponential explosion in derivative products and leveraged loans, such as the 55% increase in options volume on the CBOE or the 71% increase in futures volume on the Intercontinental Exchange?  The more sturdy the car, the faster I drive.   At some point, the pool of new, willing participants will be exhausted – which brings us back to square one unless such volumes and transactions are curbed.  And judging by the numbers and complacency that this author is witnessing (and given that hedge fund inflows actually turned negative for the first time in a decade in the fourth quarter of 2005), we may be coming to such a breaking point.

As expected, the Bank of England certainly shares some of the same concerns.  In asking why “the price of risk” has stayed so low despite rising borrowing costs in the last 18 months, the Bank of England cited two main overriding reasons.  The first reason is the “structural story” I have just mentioned, and the second reason is the one which keeps me (and I am sure Greenspan and Bernanke) awake at night.  Quoting from the FSR: “Second, other, less fundamental, factors may also have lowered the price of risk. Investors may not have adjusted fully their target nominal returns to a lower inflation environment. They may also hold overoptimistic expectations about the ability of policymakers to offset shocks to the economy; and underestimate the potential for new channels of contagion in the financial system if a crisis were ever to develop. This second set of factors raises the possibility that market participants may be mispricing risk.”  In other words, the Bank of England is rightly (and responsibly) stating that this structural story may ultimately turn out to be a cyclical story after all, and therefore that “this time will not be any different.”

The game of “the search for yield” continues on – but in our opinion, this game is coming close to a breaking point.  The LBO and private equity market is still flowing freely, but given that both the U.S. Fed and the ECB is still set to hike rates again this year, how long can the LBO and private equity game go on?  Sure – one can always borrow in Yen, but the Yen is hugely undervalued, and in most likelihood, the Bank of Japan will halt its quantitative easing program as early as this April, and start hiking rates in the second half of this year.  This game of “search for yield” is now also being accompanied by extreme complacency – as characterized by record low yield spreads between emerging market securities and U.S. Treasuries, as well as a fundamental shift by pension funds into commodities (note that pension funds are one of the best contrarian indicators).  Make no mistake: A pension fund buying a forward contract of copper at $2.25 per pound (with little or no backwardization) is a huge breach of fiduciary duty.  In fact, the Market Vane's Bullish Consensus sentiment indicator reached a level of 95% for copper on Monday evening – a record high close and suggesting that virtually all shorts in the copper markets have been squeezed out of their positions.  This is not the time to buy copper, folks.  The mid-cycle slowdown is happening as we speak – and if we are not careful, a financial crisis may emerge later this year in the form of a panic in a marginal emerging market country, a GM bankruptcy, or a hedge fund blowup (although as the FSR suggests, the current leverage in hedge funds is nowhere near as obscene as they were during the late 1990s).

Finally, readers should note that in terms of financial innovation and financial speculation, we are now in uncharted territory.  I will end this commentary by quoting parts of a recent speech by Sir Andrew Large, the Deputy Governor of the Bank of England.  Sir Andrew is definitely not getting much sleep at night nowadays:

“… it seems to me that the search for yield also highlights some less benign aspects of today's financial system: the opacity of markets in some new instruments; the difficulty of knowing the real value of assets and contracts; reliance on models that have not been tested in the full range of economic conditions; the uncertainties over behaviour of new participants in the markets should events turn adverse; and the difficulty we have in judging just how deep markets will prove to be should a substantial number of investors decide simultaneously to try to realise their investments.

On a more practical level, there is no lack of evidence that things can and do go wrong. We have recently seen lack of operational discipline in some financial markets leading to documentation backlogs and to uncertainty over the enforceability of transfer of risks. We see more relaxed lending criteria in the LBO market, increased reliance on potentially illiquid instruments in trading strategies, and questionable quality of some IPOs. We have seen specific examples of significant downgrades or outright failures such as GM/Ford, AHBR and, more recently, Refco and Delphi.”

“One reaction to these episodes is that they show the market doing its work and are testimony to the effectiveness of market discipline. The fact that the financial system has coped with these problems may well also be testimony to the strengths of that system. On the other hand, might not these episodes be a potential sign that all is not well? The question is: are vulnerabilities mounting, and will they one day crystallise when a bigger shock arrives that the market simply cannot absorb?”

“The fact is, we just don't know. And that is why we need to be particularly vigilant and to think through the implications.”

Signing off,

Henry K. To, CFA

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