Liquidity Conditions Continue to Deteriorate
(May 31, 2007)
Dear Subscribers and Readers,
I apologize – but this commentary will be a little bit abbreviated since I've been using my spare time to try get through Dr. Bookstaber's latest book “A Demon of Our Own Design” – which is a book about the derivative and hedge fund industry and discusses the “perils” of financial innovation. Dr. Bookstaber has worked in various risk management roles at Morgan Stanley and at Moore Capital – and had been involved in the derivative industry in Wall Street since the early 1980s. In fact, his firm was a major seller of “portfolio insurance” to both U.S. and Japanese companies back in the early 1980s – which, as you know, was a major contributor to the October 19, 1987 stock market crash. In other words, this book is a must-read, since he had a front-row seat, and since he is still very actively involved in the hedge fund and derivative industry today.
In the “Introduction” section of the book, Dr. Bookstaber mentioned that despite the recent newfound stability of both the U.S. and world economy (fluctuations of both unemployment level and GDP have been getting tamer over the last 25 or so years, which makes sense, as more Americans are now employed in non-cyclical industries than they have in the past and as workers have more social safety nets, etc.) the volatility and returns of the market have remained uneven. Quoting Dr. Bookstaber: “The market remains volatile and the returns widely uneven. In spite of 40 years of progress and a drop in real economy risk by 50 percent or more, the average annual standard deviation in the S&P 500 index was higher than the past 20 years than it was 50 years earlier. The fact that the total risk of the financial markets has grown in spite of a marked decline in exogenous economic risk to the country is a key symptom of the design flaws within the system. Risk should be diminishing, but it isn't.”
Dr. Bookstaber would go on and argue that one culprit of the increased volatility in our financial markets is the proliferation of leverage (the derivative markets) and the hedge fund industry. However, as I have mentioned before, something else is also at work here. That “something else” is the fact that today – despite a general population that is much more financially savvy than ever before – the proliferation of the internet and the availability of low-cost trading tools have enabled all investors to get their information almost instantaneously. And thus, it is no surprise that the technology bubble occurred when it did (the doubling of a major index like the NASDAQ Composite in a mere five months is unprecedented), as the internet allowed folks to move in and out of their stocks much faster than ever before. In such a world, liquidity can also disappear very quickly and from out of nowhere, as we saw during the February 27th decline – not to mention the crash of the technology market from 2000 to 2002.
In our mid-week commentary last Thursday, I discussed the latest signs of a continuing deterioration in liquidity in the world markets. They were:
- The hugely oversold condition of the Yen against the Euro, Pound, and other currencies, such as the Australian dollar, the New Zealand dollar, and so forth. During the first quarter alone, margin currency trading by retail investors in Japan alone increased 41% to a whooping US$896 billion – the highest ever. Quoting a Reuters article: “``Japanese individuals' trading volume accounts for 20 percent to 30 percent of the interbank foreign-exchange market in the Tokyo time zone,'' Fukaya said. ``They are also active in London time after going home. They are becoming a rival to be reckoned with for institutional investors.''” The fact that the rally in global equity prices had been so dependent on the Yen carry trade and the fact that the Yen carry trade is now hugely stretched suggests that world liquidity conditions are now deteriorating.
- According to S&P, the peak of borrowing conditions in the LBO market occurred in February. Quoting a Bloomberg article: “The high-yield loans that provided the most favorable terms to firms like Kohlberg Kravis Roberts and Thomas H. Lee Partners as they completed their biggest leveraged buyouts are drying up. Investors have scaled back such credit to leveraged buyouts by about 33 percent since February, according to Standard & Poor's. Yields on loans to buyout firms and companies considered below investment grade rose to 7.76 percent from 7.47 percent three months ago, S&P estimated.” This really should not come as a surprise to subscribers – given the outsized deals we have witnessed in recent months and the leverage and the “covenant lite” conditions that were attached with these loans.
- The effects of the subprime debacle that began in 2006 and that culminated in the bankruptcies of many subprime lenders (not to mention subprime borrowers) during the February to March period of this year. Make no mistake: This “pillar” of liquidity of the U.S. housing market has fallen and will have a depressing effect on the U.S. housing market and on U.S. households' liquidity for many years to come.
- The deterioration of liquidity can also be witnessed in the recent rise of ten-year yields. From the most recent bottom in equity prices on March 13th, ten-year yields have risen 37 basis points – from a low of 4.49% to 4.86% at the close yesterday. As I have mentioned in our commentaries and discussion forum before, this will not be bullish for equity prices both in the short and intermediate term.
Since that time, the Euro-Yen cross rate took a stab above the 164 level but was turned back. As I am typing this, the Euro-Yen cross rate is trading at 163.77. The fact that the 164 level has been a major resistance level and the fact that the British Pound has failed to surpass the US$2 level suggests a non-confirmation of the carry trade of the latest highs in the U.S. stock market. Given this, and given that the commercials currently have the biggest Yen long position since late February (see the chart below courtesy of Softwarenorth.net), and given that the Japanese retail investor is currently short around US1 trillion in Yen along, my guess is that the Yen carry traders – and thus the world's stock markets – will have a tough time this summer.
As mentioned by the minutes of the latest Federal Reserve meeting yesterday, there is no question that the latest crash in the subprime market will continue to have a lingering effect for months to come. Despite what the bulls would like, however, my guess is that the Federal Reserve most probably won't be lowering rates anytime soon, given the current all-time highs in the U.S. stock market. Bulls would like to point out that the Fed did indeed cut rates in late 1994 and early 1995 even as the stock market was rising – but that was a different era – and we also had a different Fed Chairman. The late 1994 to early 1995 Fed cut campaign occurred in the wake of the severe 1994 correction (the biggest since 1991) – not to mention a bond market rout which led to the bankruptcy of Orange County. Interestingly, Alan Greenspan has gone on the record in recent weeks suggesting that the Fed most probably won't be lowering rates anytime soon. The fact that current Fed Chairman, Ben Bernanke, is a “closet” inflation-targeter also suggests that he is still more worried about potential inflation than a recession in the U.S. economy – especially given the still-tight labor markets – not just in the U.S. but now in Japan and potentially India and China as well – where the benefits of “offshoring” are gradually going to dissipate over the coming two to three years.
Moreover, since our mid-week commentary last week, the yield of the ten-year Treasuries has again moved up – from a level of 4.86% to 4.88% at the close yesterday. As I have mentioned before, I now think there is a high possibility of seeing a 5% yield in the ten-year Treasuries sometime this summer. None all of this bodes well for the stock market going forward, as the relative valuation of the S&P 500 vs. bonds – as implied by the Barnes Index (see our March 30, 2006 commentary for a refresher on the Barnes Index) – which is now at its highest reading since May 7, 2006 – just a mere three days before the May 10th top and the subsequent correction in the world's stock markets:
Indeed, while many of the world's stock markets are still at or near all-time highs – we are already seeing some markets struggling, such as the Chinese stock market, the Japanese stock market, and the Russian stock market. Given that the latter is not a market that most of our subscribers keep track of, it is instructive to see how far the Russian stock market has deteriorated since mid April (following six-month chart is courtesy of Decisionpoint.com):
Interestingly, the Russian stock market has declined approximately 15% since mid April and is now close to its early March lows – suggesting that liquidity is now disappearing on the fringes (this can be observed in the decline of oil prices as well). While a decline of the oil price is bullish for the U.S. economy in the long-run – in the short-run, a decline of the oil price most probably suggests a further deterioration of liquidity, which is bearish for the stock market. Back in 1998, the Russian currency and the Russian stock market were leading indicators for a worldwide equity market crash – could the latest rout in the Russian stock market signal the same? It is especially interesting given that practically no one in the mainstream media has discussed the latest rout in the Russian stock market. We will continue to keep an eye on this and other liquidity indicators over the coming few weeks.
Henry To, CFA