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The View From 20,000 Feet

(January 25, 2007)

Dear Subscribers and Readers,

It is always difficult to argue with a trending market – even (and one argue, especially) those trends that are overbought but are still going strong.  Such was the case with the U.S. stock market in the mid 1930s and early 1950s – the latter as the Dow Industrials toppled the old 1929 high and continued on upwards to new heights – dumbfounding all the old “geezers” who were at Wall Street during the much more “depressing” 1930s and 1940s.  This again occurred as the Federal Reserve was winding down its series of rate hikes in late 1994.  The market bottomed in October 1994 and never looked back – until during one brief week in October 1996 and then subsequently the height of the Asian Crisis during October 1997.

Ticker Sense recently reported that the S&P 500 is now on its eight straight month of gains, assuming that the S&P 500 closes positively in January.  Never mind that the S&P 500 only gained 0.11 points during June of last year.  According to Ticker Sense, a positive streak of 9 months or more in the S&P 500 hasn't occurred since the month ending March 31, 1983 (and that streak ended at exactly 9 months), and prior to that, the month ending October 31, 1958 (that streak ended at 11).  The longest such streak – 12 – ended during the month ending November 30, 1935.

With the exception of the 8-month streaks ending July 31, 1964 and ending June 30, 1996, all such streaks have usually occurred near the beginning of a great secular bull market.  When the U.S. stock market was trying to hammer out a bottom in July and August of last year, I argued at the time that we were making a significant bottom (subscribers can go back to our archives and check out my last year's comments) – judging by the amount of mutual fund outflows (mutual fund outflows for the four months ending August 2006 were the highest since the four months ending October 2002) from domestic equities, as well as the relative valuations between equities and bonds.  Based on the latter indicator, (and in some cases, straight P/Es) the valuations of U.S. large caps were at their cheapest levels since 1994 – and for selected companies like Sysco, since 1988.

The $64 trillion question is: At what stage are we in this bull market?  Can the current period be compared to, say, the period ending October 31, 1958?

The answer to the second question is, obviously, “no.”  Besides traditional asset classes like stocks and bonds – which had been in existence in the United States since the 1790s – many standardized and massively-traded financial instruments have appeared – such as the CDO market, the Eurodollar markets, the flexible exchange rates, options on futures, options on financial events, housing and weather futures, and so forth.  Since the late 1970s, the Federal Reserve (and one could argue, since 1996) has gotten much more transparent.  Not to mention the collapse of the Berlin Wall in 1989, the subsequent collapse of the Soviet Union in 1991, and the “democratization” of information with the proliferation of bandwidth and access to the internet starting in the late 1990s.  China opened up her markets in 1978.  India in 1991.  Today, China is the fourth largest economy in the world with GDP at approximately $2.5 trillion (behind the US, Japan, and Germany) but only 10% of the Chinese population has access to the internet.  India is further behind with a GDP of approximately $800 billion.  The story of “emerging” China and India is just getting started.  Not only with this have a continuing influence on America's and the world's labor markets, this will also have a great effect on world consumption going forward.

As for the answer to the first question, I would say “it depends on what you are looking at.”  Okay, I know this is somewhat of a “cop-out,” but consider this: Sure, both (as the bears would tell you) absolute P/Es and corporate profit margins are near all-time highs, but relative valuations of stocks vs. bonds (as exemplified by the Barnes Index) are still decent.  Moreover, the “global labor arbitrage” – while not as widely advertised as two years ago, is still strong and growing.  Productivity in the United States, Japan (capital spending has been growing at double digits for the last three years), and even Western Europe (with Germany as the star performer) has been growing at a decent pace.  Given the recent decline in energy and commodity prices in general – I would not be surprised if corporate profit margins can continue to expand for the foreseeable future.

In other words – as I have been trying to communicate over the last six months – the U.S. stock market is still relatively healthy and most probably still has some ways to go before making a significant top, but other markets are definitely much closer to a top than a bottom, such as stock markets in Western Europe as well as selected emerging markets such as Eastern Europe, India, and China, and other developed market such as Australia, South Korea, and the United Kingdom (the Middle East collectively crashed long ago and will probably not make an all-time high again for the next couple of years).

This game, however, can continue to go on as long as liquidity remains ample – and given the recent decline in oil prices and the financial IPOs in China, (the banking sector in China now has an extra $70 billion to play with and multiply), this game should continue for the foreseeable future.  That being said, this author is starting to see a few chinks in the armor.


The recent decline in oil prices and IPOs in the Chinese financial sector notwithstanding, primary liquidity (liquidity made available by the world's central banks) has declined substantially in 2006 and will continue to decline at least during the first half of 2007.  For example, the European Central Bank has made it clear that there will be two more hikes for 2007.  Central Bankers in Japan are just itching to raise overnight rates to 0.5%, and possibly to 0.75% later in the 2nd half of 2007.  As I have been discussing numerous times, the Japanese monetary base has been plunging over the last six months – which surprisingly, hasn't caused any concern at all for folks engaged in the Japanese Yen carry trade.  As for the U.S. Fed, the current Fed Funds futures are now implying no ease in the Fed Funds rate at least until December of this year.  China has also made it clear that it will continue to tighten this year – by either mandating higher reserve ratios or increasing interest rates – anything to curb excessive capital spending and real estate speculation.  Ditto for the Indian central bank.

In the meantime, bankers, brokers, private equity shops, subprime lenders, hedge funds, etc, have made it their point to continue to lend and multiply liquidity in the world's financial system.  And pension funds, foundations, endowments, investment consultants, retail investors, and even sovereign governments have taken the bate – by investing in emerging market securities, CDOs, lower-rated tranches or mortgage-backed or asset-backed securities, or directly investing in leveraged deals within hedge funds, private equity funds, etc.  Confidence – on the morning of January 25, 2007 – reigns supreme.  According to Hedge Fund Research Inc, today's hedge funds control over $1.4 trillion in assets, growing from $1.2 trillion at the end of 2005.  There are also more than $160 billion in cash sitting on the balance sheets of private equity funds trying to find a home.  Investors essentially shrugged off the downgrading of GM and Ford's bonds to junk status, the Refco bankruptcy, the Thai Coup, and the collapse of Amaranth Advisors over the last few years.  Both corporate bond and emerging market yield spreads remain near historical lows.  Are we getting too complacent?

Liquidity is a curious thing.  It usually disappears at the time you need it the most.  One day it is here.  The next day it is gone.  To understand liquidity is to understand how markets function – especially at the extremes.  Basically, liquidity – when it comes to the financial markets – is composed of four factors: the cost of money, confidence, financial leverage, and asset class correlation.

The following passages from former Secretary of the Treasury Robert Rubin's book “In An Uncertain World” captures the interaction of the four above factors very well.   The following passages discuss the situation at the time of the 1998 Russian Default and the subsequent spillover effects – culminating in the near collapse of the hedge fund Long-Term Capital Management.  I will quote:

The Fed had last moved the federal funds rate … in March 1997, tightening it a notch to fight inflation against the backdrop of a strong economy.  In the eighteen months since, the official interest rates had been on hold and the market rates for government and corporate borrowing had broadly followed the Fed's lead.  But developments in the bond markets now became extremely troubling … In the Fall of 1998, investors were fleeing from risk.  This was now affecting not just emerging-market debt but countries and companies around the world, including in the United States.  As a result, companies had to pay more to borrow from the capital markets.  At the beginning of the year, lower-grade corporate debt had been yielding only around 2.75% more than Treasury bonds with similar maturities.  Now eight months later, the spread over Treasuries was 6%.

… Moreover, credit wasn't just becoming more expensive.  It was also getting harder and harder to obtain as both creditors and investors became less willing to take risks.  Fed and Treasury officials focused on how to relieve these strains before a severe crunch took hold … But a cut in U.S. interest rates alone seemed unlikely to quell the sense of a world in crisis.  Now Larry [former UnderSecretary of the Treasury Lawrence Summers] and I agreed with President Clinton: we should try to elicit as powerful a statement as possible from the world community, and the President himself should deliver a message to the American people.

The two above passages captures the “essence” of liquidity quite well.  The overriding factor in this case (and many other cases) was confidence – with financial leverage and asset class correlation playing a significant role as well.  Financial leverage had helped precipitate a crisis in the “Asian Tigers.”  The spillover effects – including a loss of confidence in emerging markets overall – caused investors to subsequently lose confidence in Russia.  Combined with the poor governance in the Russian government at that time – not to mention the financial leverage and its lack of ability to repay its debts – Russia had no “choice” but to default.  The fact that many market participants were invested in the same financial instruments or the same financial strategies made an exit from “general risky trades” in 1998 virtually impossible.  What ultimately resolved the crisis was a dramatic lowering of the interest rates around the world (lowering the cost of money) and a restoration of confidence in the financial markets – which the Central Bankers of the world helped brought about.  However, the crisis caused another casualty before it was resolved.  That casualty was LTCM.

Based on the impressive resumes of those who worked at LTCM, and based on their outstanding investment performance since its founding in 1994, LTCM had always had no problem in obtaining liquidity.  In Robert Rubin's words:

… In fact, LTCM's models may have been valid, over a long enough time frame.  As a theoretical proposition, yield spreads probably would have returned to the mean, and I gather that many of LTCM's positions would have worked out in time.  But LTCM was essentially betting that a return to normal would come without some prior highly aberrational move.  The unusually high degree of leverage LTCM employed meant that the firm lacked the staying power to weather severe temporary aberrations.  Creditors would require additional margin as spreads moved against LTCM.  LTCM's forecasts might be vindicated long after it had gone broke.

I remembered this kind of situation well from 1986, when Steve Friedman and I had taken over responsibility for the fixed-income division at Goldman Sachs.  As in the LTCM case, the problem then wasn't just that one company had a set of bad positions.  Traders at other firms had similar kinds of positions, because they all used similar models and similar historical data.  [Editor's note: this is the “asset class correlation” we mentioned above]   When positions began to move against them, they all wanted out at the same time, exacerbating the movement.  And since the major players already had these positions, there were no buyers.  That meant that traders and investors had to unload other, better investments to obtain cash.  This selling skewed the ordinary relationships and patterns that traders expected.  Bond spreads that according to historical norms should have contracted instead got wider, and spreads that should have widened got narrower.

Everyone who had similar positions lost money.  But LTCM was faced with massive losses that threatened to become much larger than the remaining capital the firm held.

In other words, as confidence in the financial markets eroded, many firms strived to unload their positions, in the hope of raising cash to weather the system.  Since LTCM had put on many of the same types of trades that others at Goldman Sachs, Morgan Stanley, UBS, etc. had put on, many of LTCM's positions – against all odds – to continue to move against them.  And given LTCM's huge financial leverage, many of LTCM's brokers started to demand more margin.  At one point, Bear Sterns even threatened to stop clearing LTCM's trades.  What started as a loss of confidence in the financial markets turned into a disaster for LTCM – as it could not dump their holdings (since many others had similar holdings and were trying to get rid of them at the same time) and as it had acquired huge financial leverage in the process.  Within the space of two months, liquidity had all disappeared for LTCM.

Can This Happen Today?

A typical financial crisis – a financial crisis that is significant enough to envelope a region (such as the 1989 bubble in Japanese stocks and real estate, the Asian Crisis, the bursting of the technology bubble, and so forth) – is usually preceded by rampant speculation in a particular market by a broad range of participants, utilizing significant leverage based on cheap money.  Other examples include the attempted Gold Corner of 1869 (the “cheap money” came in the form of a supposed government assurance that President Grant will not interfere in the gold markets), the U.S. stock market in 1929, and the U.S. stock market in 1987.  While it is attempting to label the most recent “U.S. housing bubble” as one of these events, this author would disagree – for two reasons:

  1. The speculation in residential real estate was not as widespread as many have claimed.  Sure, many major housing markets in the U.S. got very overvalued (and still are, at least relative to rents anyway) – but the practice of “flipping houses” were not embraced by a broad group of the society.  Contrast this with scenes witnessed during 1999 to early 2000, when many folks who had been invested in CDs all their lives plunged their monies into technology stocks.  Besides, it is so much easier to buy a stock over the internet vs. buying a physical property such as a house (and having to do all the paper work, inspections, etc.)

  2. Much of the financial press had been talking about a “housing bubble” way before it topped out earlier last year.  Not only did this manage to contain the housing bubble by discouraging more speculation, it also had the effect of preparing many ordinary folks for the eventual bursting of the bubble.  Such talk was totally absent in late 1999 and early 2000, as many in the financial press and ordinary folks were extrapolating their recent gains in the stock market indefinitely into the future.

Looking around the world today and from a height of 20,000 feet, the obvious potential crisis is the area of emerging markets.  Valuations in countries such as India and in the Chinese financial sector (ICBC has just surpassed Bank of America has the world's second largest bank by market capitalization) are at or close to bubble territory.  The rapid growth of India and of China has captured the public's imagination – causing investors (and professionals alike) to believe that investing in emerging countries in general is now a one-way street.  Everyone is now in the same trade (the long side of emerging market equities) – and a significant part of this is being fueled by cheap money – that in the form of the Yen Carry Trade.

Fueled by another burst of liquidity from the recent decline in oil prices and the most recent IPOs in the Chinese financial sector, the party in emerging markets is still alive and well.  But given continuing tightening by many Central Banks around the world, and given the increase in emerging market participation (as I had mentioned in our discussion forum, the correlation between hedge fund returns and the MSCI World Index has increased at a steady rate over the last few years, suggesting that hedge funds have been getting increasingly invested in international equities), 2007 may ultimately end up being a bad year for emerging market securities.  Readers please stay tuned.

Signing off,

Henry To, CFA

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