Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Thank God for the World Cup
“No matter how barren the past may have been, ‘tis enough for us now that the leaves are green.” – James Lowell, “What is so Rare as a Day in June.”
We really mean it – thank God for the World Cup to come along and provide a welcome diversion. We don’t know anyone on the buy side who isn’t fed up with this churning, aimless market action that rattles around capriciously from blurb to blunder.
The market rallied last week, for that we’re not complaining. Why it did is an open question. Are the economic signs really getting better, or is the market just tired of worrying? One could argue that so far the correction is mostly a case of damaged expectations and Lehman-redux fears that turned into a momentum trade.
It might not be over yet, either. We wouldn’t say that the market is overvalued, but while good valuations abound, the market isn’t quite screamingly cheap either, the way it was back in the spring of 2009. It’s in a place where many prices favor long-term investment, but in the short term you could still be rewarded with some stomach-churning volatility for your efforts.
The correction has been made up of several moving pieces. Some of the larger ones are sovereign debt concerns, planted by Greece and watered by central bank hand-wringing; a concomitant sense of disappointment that the sold-out “V”-recovery concert tour has been scratched with no return date yet fixed; and the fact that money managers had spent most of their money at the beginning of the tour. The exodus of cash in May from stock funds didn’t help either - this time, the dips had to be sold.
Another good-sized part of it was pure opportunism. A favorite routine in the months following the Lehman debacle was to lean on the market with naked CDS, a.k.a. the notorious credit derivative swaps. Perhaps it’s naïve of us to be amazed that such a scam can be run for so long – after all, this is America, where money greases the wheels and nowhere more than on Wall Street.
This is not a game that most can play, because it takes lots of capital. But if you have several hundred million for starters, ideally a billion or more, you can have yourself some fun. Start by building some nice short positions in whatever sector you think is ripe for a bout of nerves. Say, some bank stocks, or maybe the government bonds of some country.
Then you go to a big investment bank that’s dying for trading profits – meaning any one of them big enough to do the trade - and buy yourself some credit derivative swaps on the beast you’ve been shorting. What you are doing, in effect, is buying a life insurance policy on somebody else with yourself as the beneficiary.
For obvious reasons, this is usually illegal in the insurance industry (buying insurance on yourself, like buying CDS on bonds that you actually own, is perfectly legitimate because you don’t gain if the policy pays off). However, in our wise corridors of high finance, this tainted racket is so lucrative that we are all supposed to look the other way, much as we did with subprime mortgages. With the latter, the magicians fed us patter about home prices never falling; with the former, it’s all about liquidity and price discovery.
The banker selling the CDS rubs his hands with glee, because he’s booking such a swell fee for doing the swap. Hamptons, here we come! But the bank still has to hedge its risk, since it would be irresponsible not to do so. One option is try to lay off the risk with a CDS at a cheaper price, but with AIG out of the business they are likely to go to the listed markets instead and take offsetting positions with such things as shorting stock, buying puts, or selling futures.
Regardless of the approach, the selling pressure will intensify as other players in the chain lay off risk. Prices fall, fears rise, the press quotes the rise in CDS prices in shocked tones. CDS guerillas count on this, and keep leaning on the trade in a self-reinforcing spiral for as long as possible. Ideally, one buys more CDS so long as they aren’t too expensive. Shorting more stock can work too, it it’s liquid enough – after all, there is still no uptick rule.
You can try leaning on prices in the listed markets too, but there are limitations. Selling stock short is limited to the stock available, and the immediate risk is to the seller. Large short positions in stocks are watched over by humorless margin clerks and competitive traders looking for a short squeeze. Buyers of CDS don’t post margin, while shorting can bust you before you can get to the finish. Above all, there’s no waterfall effect of agents adding to downward pressure with their own hedging, as can happen in derivative markets.
A big player could hit also the tape with a massive sell order in the futures markets and the tape would collapse, no doubt about it. The CDS bandits loudly proclaim that it can be done in other markets, so why single out CDS?
Right. Any market participant who tried to drop a massive sell order in the futures markets had better have a very, very good reason for doing so, because the trade will be traced right back to you. The presumption will be market manipulation, and you will soon be watching stenographers take down your testimony at the SEC, the New York Attorney General’s office and possibly even the U.S. Congress. You could even get to meet the legendary Bernie Madoff.
Ah, but the CDS market is private, unregulated and undisclosed. The banks prefer it this way because they think they can make bigger profits if pricing is cloaked in secrecy. Certainly they book larger profits up front, but it may well be uneconomical for the banks to be doing these trades in the larger picture, since adding to negative pressure in the credit and equity markets might delay recovery in the bank’s own existing book of loans.
Oh, the banks would never do deals that imperil their business for the sake of short-term profits, would they? Yeah, right. Those problems are for another department and another quarter.
The buyers of naked CDS want anonymity for obvious reasons. Although it’s a nefarious game in which few benefit and many suffer, it’s been incredibly hard to stop. Talk of regulating any derivatives market, and the players immediately get on the phone to the press and politicians, feeding them lurid tales of vanishing liquidity and withering markets, killing all hope of economic recovery. Remember “Godfather” consigliere Tom Hagen feeding stories to the press for the benefit of the Corleone family? Nothing personal, just business.
A fair bit of money has been made in recent weeks by pushing the tape down, and some players are probably ready to take profits. The rest of the market has been turning course, from the “V”-story to the defeated “V” letdown, to a possible double-dip. But without another financial panic, a double dip in the economy isn’t in the cards, so the next stretch for the market could soon be elation that the double-dip isn’t going to happen. There are already some early traces of relief buying.
Should the market go into July still fearful of doom, it should reverse hard to the upside when earnings results reveal that we are not quite on our way to hell. It’s tricky to say what the state of mind will be until we get there, though. There is still some big ugly to be crossed, particularly in May home sales (if you thought retail sales were a disappointment, you ain’t seen nothing yet).
Given the post-tax-credit depression in housing that is crushing what would normally be a seasonal pickup in construction activity (and jobs), the employment report for June could be another clunker, even to sobered expectations. It comes out on Friday, July 2nd, just before a big holiday weekend in the U.S., a setup ripe for big tape volatility.
Next Friday is a quadruple witching day. Given the massive number of puts written in recent weeks, the normal thing for the market to do would be to rally, aided by traders trying to push the options back out of the money and holders dumping rapidly decaying positions. We suspect that Friday’s last-hour rally was probably helped along by options dealers working the tape.
Thus, players with effective short positions in the CDS market may choose to stand aside a few days and then come back with renewed efforts to take advantage of weakness in the data the following two weeks. The odds favor going through more maddening back-and-forth action over the next few weeks, a crummy market of the kind that keeps leading retail investors to pull out more money.
The CDS maneuvers are only one facet of a market dominated by trading ploys, charts and capital devoted to volatility rather than investment. The silver lining is that the economy and business conditions are still growing, and one may pick up some real bargains and possibly bask in a late summer rally. Besides the volatility, the cloud is the effect on the public. One can hardly blame people for believing more than ever that the markets are rigged - sometimes they are.
Change comes slowly, though. It took four years after the great stock market crash of 1929 before we finally got the Securities Act of 1933 (that created Glass-Steagall, amongst other things), then another seven years until the Investment Act of 1940. Some good Cup action and a spot of good news out of the Gulf of Mexico would be very welcome.
We had misgivings last week about the retail sales report for May, and it came in worse than we feared. Despite the headlines, it wasn’t quite as bad as the headline drop of (-1.2)%. Core sales, which exclude autos, gas and building materials, actually rose by 0.1% after falling 0.2% in April, which was revised upward from 0.4% to 0.6%.
The weakest category was building materials, partly attributable to the springtime repair effect (April sales had jumped), but we suspect a large part of it was the housing market. May has seen a terrific sales falloff after the expiration of the homebuyer tax credit. Ordinarily it’s a month that bridges to the peak selling season, with prospective sellers touching up properties. The rush of sales in April, however, pulled activity forward, with subsequent decline signaled by the big drop in building permits. Conversely, April’s new owners pushed furniture sales higher in May.
Motor vehicles were reported to be down (-1.7)%, but that seems at odds with the industry’s own sales reports. Car dealer Autonation (AN) CEO Mike Jackson could be seen on CNBC the previous week positively glowing about the business (a week ahead of the report, he also scoffed at the government’s monthly numbers on the sector). He drew particular attention to a robust pickup in pickup trucks, which he and others take to be a sign of confidence in the recovery. The monthly total was probably pulled down by Toyota’s (TM) dialback on incentives.
Gasoline prices declined, pulling down that total. Apparel sales have been off two months in a row, as have department stores, leading some to suggest that people are willing to step up for what they perceive as useful investments (pickup trucks, smartphones, iPads) but are being thrifty in areas such as clothing and groceries.
Another important factor was the calendar shift that pushed holiday weekend (Memorial Day) sales into the June total. Indeed, the first week of June sales showed a strong pickup. The data was also somewhat belied by a surprising increase in the University of Michigan’s consumer sentiment survey, which like the Conference Board’s last report showed a bigger jump than hoped for. The result (75.5) is more impressive in the light of the fall in the stock market and downbeat headlines in the press.
That again seems to point to better employment conditions. Weekly claims only fell by 3,000 to a still-elevated total of 456,000, but the stock market rallied on a big drop (255,000) in continuing claims. It’s ironic that both numbers may prove to be misleading. The unadjusted total for claims fell below 400,000 for the second time this year, which is a good sign, but the drop in continuing claims may only represent expiring claims. We’ll have to watch the emergency claims (EUC) data to see if claimants simply rolled from long term to longer term.
Wholesale and business inventory data showed increases that were a bit below expectations. Apparently business is still being cautious, disappointing the lustier bulls, but we’re rather hopeful about the fact that inventory-to-sales ratios continue to fall to new lows. That will necessitate more production later, bringing a recovery that is less steep but perhaps steadier and more solid. It doesn’t suggest a double-dip.
The April trade deficit fell a fraction more than expected, with both imports and exports declining. It shouldn’t come as a surprise, since most data has indicated that the growth rate slowed coming into the quarter. The NFIB small business optimism index inched up in May, backing the notion that the economy is recovering at a modest pace. It’s the usual form for a credit recession.
There was some good news in international data, between Germany’s good increase in factory orders (thank you, lower euro) and China’s increase in exports. That helped the markets step up a bit, particularly overseas.
Next week will tell us about prices, production and homebuilding. The homebuilder sentiment index comes Tuesday afternoon, and we wouldn’t be shocked to see it turn back down again. Ditto for May housing starts that are released Wednesday, where we expect a big drop (April building permits were down by over ten percent).
The PPI and CPI come out Wednesday and Thursday, and both are expected to show energy-led monthly declines, with minimal increases (0.1%) in the core rate. One good thing about stock market corrections is that they chase speculators back out of commodities, where modern prices mostly ignore supply and demand.
On the business activity side, we’ll get May Industrial Production data on Wednesday from the central bank, with the New York (Tuesday) and Philadelphia (Thursday) regional reserve banks reporting June surveys. Leading Indicators are released on Thursday.
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