Tagged: Bonds

Liar’s Poker

We’re back! We recommend Barbados but we didn’t see Rihanna.

We also endorse floating around the Grenadines on a big catamaran turning brown and losing track of time. We had rum off the shore of Petit Tabac where Elizabeth set Captain Jack Sparrow’s rum store afire.

Meanwhile, back in reality the dollar rose and interest rates fell, and Italy slouched into confusion, and Argentina dodged a currency crisis for now, and Venezuela…well, Venezuela is like that rum fire Elizabeth set in Pirates of the Caribbean.

I at last read Liar’s Poker, Michael Lewis’s first book (and also Varina, by Charles Frazier, a lyrical novel that sighs like wind through live oaks, imagining life in the eyes of Mrs. Jefferson Davis).

With the boat and the sea taking us far from cell towers, we hit the power buttons and blinked out and I with cold Carib at hand, the beer of the Caribbean, sailed through Mr. Lewis’s time at Salomon Brothers in the bond frenzy of the 1980s.

Mr. Lewis explains how a Federal Reserve decision in Oct 1979 by then chairman Paul Volcker to fix the supply of money and float interest rates stuffed the turkey for Salomon. Overnight, bonds moved from conservative investments held to produce income, to speculative instruments driven by bets on big swings in prices.

For Salomon, the money was in toll-taking. They bought bonds from those selling at incorrect prices and sold them to others willing to buy at incorrect prices. They kept a middleman’s sliver. Do it enough and you’re rich. If you’ve not read the book, do so. There’s verisimilitude for today’s stock market.

The Fed abandoned floating interest rates in 1982, reverting to influencing the Fed Funds rate as it still does today (setting interest rates and flexing the money supply). But speculation on price-changes is now rampant, having spread into everything from currencies to equities.

It matters because anytime supply and demand are not the principal price-setters, a market cannot be depended on to offer reliable fundamental signals. The US stock market thanks to Exchange Traded Funds now may be the most arbitraged in human history.

You might be thinking, Tim, did time on the boat not dump your ETF cache? Also, why do I care?

I return to the ETF theme because investors and public companies continue to assign the market disproportionately fundamental interpretations. You should care because Salomon is gone, swept away on the tides of history because it didn’t keep up. Are we keeping up?

The motivation behind the two parties to every ETF creation and redemption – and neither one of them is you – is capturing a price-spread.  It’s not investment.  Yes, you as an investor may buy ETFs as an investment. But the parties creating and redeeming them are doing so to make money on how prices change.

That’s arbitrage. And what determines the value of investments isn’t who holds them but who buys or sells them (this is the flaw in thinking your stock reflects value assigned by buy-and-hold investors).

In a way, it’s what Mr. Lewis describes in Liar’s Poker, where Salomon merchandised the market’s ignorance about what priced bonds.

How many people understand that ETFs are not managing the money they spent buying ETF shares? ETFs have everyone believing they’re buying a pooled investment when it’s not. Whose fault is it?  Don’t we all bear a responsibility to understand what we’re buying, or what’s affecting the value of our traded shares, companies?

ETFs are the dominant stock financial vehicle of this very long bull market. What matters to those behind trillions of dollars of ETF share-creations and redemptions isn’t the objective of the ETF – but how the prices of ETFs change versus the underlying assets used to collateralize their creation.

Thus a fundamental tremor like trouble in Italy becomes volcanic, spewing molten lava all over stocks. The true driver is arbitrage. Bets. Liar’s Poker. Let’s not be fooled again.

Balancing Act

If you want to know what a business is capable of doing, look at its balance sheet.

If you want to know what the Federal Reserve is capable of doing too, look at its balance sheet. Having scrutinized it, Karen and I are leaving today to ride bikes in the Pyrenees and will return if the Fed survives.

Just kidding.  Except for the Pyrenees. We’ll report back on Catalonia in a couple weeks.

Meanwhile, there is again a glaring focus on the Fed as markets shudder. Clients know our Sentiment Index had a “four handle” at 4.9/10.0 Sept 8, the first negative read since early July. Volatility bloomed. As with weather, the market reflects preceding patterns.

It’s the same with the Fed’s balance sheet. Monday with Rick Santelli on CNBC’s Squawk on the Street I attempted to describe in a handful of seconds that the Fed can breathe in and breath out and impact rates and market stability.

Simplifying, the Fed has two levers for pushing rates up and down. When the Fed buys assets like mortgages or Treasuries from the big banks supporting our payments system (called the primary dealers), the supply of money expands, which makes credit cheaper and pushes down rates.  These are bank reserves.

On the opposite side, the Fed can borrow money from banks, tightening supply and prompting an increase in borrowing costs.  These are called Reverse Repurchase Agreements (RRPs).

We described last week how both changed little over the two decades preceding 2008. Tweaking one or the other was simple and economical. Need to tighten 2-3%? Boost RRPs by $10 billion.

But now bank reserves are $2.3 trillion, 26,000% more than historical levels. RRPs are 1000% higher than history at $300 billion. The three-to-one ratio the Fed long maintained is now one-to-26.

These facts produce a paradox that traps the Fed. Twenty-five basis points, the increase expected when or if the Fed moves, is no biggie against $10 billion of reserves.  But the Fed pays interest on reserves (and RRPs). Now 50 basis points, the rate would jump 50%.

The interest expense alone boggles the mind. Plus, the government will lose money. A rider on the December transportation-funding bill passed by Congress requires the Fed to send earnings on its massive portfolio over $10 billion to the US Treasury general fund.

Do you see? The data driving the Fed aren’t economic but financial. It’s about the Fed’s balance sheet. And government coffers, dented if the Fed starts paying more interest.

They may still hike but it’s a hindrance. And there’s more. The same giant banks providing margin accounts to traders and derivatives to institutional investors are partners called primary dealers helping implement Fed policy. When the Fed moved $100 billion to RRPs out of excess reserves Sept 1 at the same time that its balance sheet shrank slightly, the impact rippled through all the banks financing hedges and margin-trading.

That ripple is the current tsunami hitting the stock market. The Fed has already unwound these RRPs, returning $100 billion to excess reserves. But the damage was done. The Fed tried similar tactics in December last year when it hiked for the first time since 2006, and markets caved in January and the Fed had to pump up excess reserves by $500 billion – much more than it had moved out of the money supply – before markets stopped falling.

And the Fed oversteered.  Markets shot like a rocket into May, flummoxing all. Our Sentiment pegged the positive needle for weeks.

The same happened around the Brexit vote. The Fed was in the process of tightening by lowering excess reserves and lifting RRPs.  The markets imploded. In two weeks, the Fed reversed. The market shot up, once more prompting global head-scratching.

The Fed cannot seem to calibrate its levers without overshooting or undershooting and in any case creating chaos in stocks and bonds. There is no better evidence of the folly in the size of its balance sheet.

Is there a way out? Sure. The Fed could write off 80% of its balance sheet and put us back to pre-crisis leverage.  But interest rates would explode and the entire globe would fall into depression because that would be a restructuring, a technical default.

Is there another way out?  Yes. Normalize rates and take our chances. But that demands a fortitude that’s missing in the sort of jittery lever-yanking one can observe on the Fed’s balance sheet.

Water Down

Why are my shares down when my peers are up?

The answer most times isn’t that you’ve done something poorly that your peers are doing well. That would be true if 100% of the money in the market was sorting differences and was in fact trading you and your peers, and if the liquidity for you and your peers were identical at all times.

What is liquidity? Images of precipitation come to mind, which prompts recollection of that famous quip by whoever said it (Mark Twain gets credit but there’s no proof it was his utterance) that bankers will lend you an umbrella only when it’s sunny and take it back at the first hint of rain.

The Wall Street Journal yesterday carried a story about distressing levels of assets in big bond funds locked in positions that “lack liquidity.” Public companies, your bankers and shareholders have probably complained at some point about your “lack of liquidity.”

What it means is among the most profoundly vital yet most commonly overlooked (and misunderstood) aspects of markets. Things are finite. Public companies spend the great bulk of their investor-relations resources on Telling the Story. Websites, earnings calls, press releases, non-deal road shows, sellside conferences, targeting tools, on it goes.

But do you know how much of the product you’re selling is available to purchase? One definition of liquidity is the capacity of a market to absorb buying or selling without substantially altering a product’s value.

The WSJ’s Jason Zweig yesterday tweeted a great 1936 observation by Hungarian-born German émigré Melchior Palyi, longtime University of Chicago professor of economics: “A liquid structure never liquidates. Only the illiquid one comes under the pressure of liquidation.”

Think about that in terms of your own shares.  A liquid market can absorb the ingress and egress of capital without destroying the value of the supporting assets.

What’s your stock’s liquidity?  It’s not volume. We ran a random set of 11 stocks with market capitalization ranging from $300m-$112 billion. Mean volume for the group was 1.1m shares but varied from 50,000-5.6 million. Leaving out the biggest and smallest in each data set, we had a group with an average market cap of $6 billion, average daily volume of 755,000 shares, and average dollars per trade of $5,639.

That last figure is the true measure of liquidity. How much stock can trade without materially changing the price? In our group, it’s $5,639 worth of shares. So in a market with over $24 trillion of product for sale – US market capitalization – the going rate at any given movement is about the amount you’d spend on a Vespa motor scooter.  Now look at the dollar amount of your shares held by your top ten holders.

The stock market is incapable of handling significant movement of institutional assets. It’s a critically faulty structure if investors were to ever begin to pick up the pace of stock-redemptions. They are trying.  For the 20 trading days end Sept 18, the share of market for indexes and ETFs – Blackrock, Vanguard – is up 120 basis points over the long-run average, and stocks are down measurably.  Now, 1.2% might not seem like much but that’s more than $2 billion daily, sustained over 20 trading days. The S&P 500 is down about 5%.  At that ratio, if 10% of investors in indexes and ETFs wanted to sell, the market could decline 50%.

We’re not trying to make you afraid of water!  But this is the market for the financial product all public companies sell: Shares.  That it’s demonstrably ill-formed for a down market is partly the fault of us in the issuer community, because we’re participants and ought to be fully aware of how it works and when and where it may not, and should demand a structure supporting liquidity, not just trading.

Action items:  Know the dollar-size of your average daily trade (a metric we track), and compare it to the dollar-amount held by your biggest holders.  When your management team needs a risk-assessment, you’ll be ready.

Infinite Money Theorem

“What do you see out there?”

Out here in Crested Butte, CO, where the overnight temperature was 35 degrees, we see vast beauty, perhaps unparalleled on the planet.

As for the other “out there,” it’s the No. 1 question we’ve gotten the past two weeks, even with clients reporting financial results. They’re most concerned with the macro view: What do we think will happen to the stock market if and when the Fed stops buying government-backed securities?

Some observers predict doom. If the Fed quits printing money, the helium goes out of the balloon and down it comes. Others see the opposite. Just yesterday Jim Paulsen at Wells Capital said the Fed’s exit means markets can normalize, shifting from arbitraging data to investing in economic growth. He says stocks will rise.

It’s important to understand what the Federal Reserve is doing. The Fed isn’t printing money per se. It’s in effect engaging in a massive derivatives swap – trading one thing for another, neither of which is a hard asset. The Fed buys about $85 billion of Treasury securities and government-backed mortgage derivatives every month. Since these instruments are backed by US taxpayers and derive from either future tax receipts or underlying mortgages, both are derivatives. (more…)

Market Mayhem and Large Traders

Why are markets dropping like the thermometer at 8pm on Pike’s Peak?

Debt chaos, sour economic data, sure. We’re not market prognosticators, we track behavioral data. Under the skin of the news at market level, institutions shifted to managing portfolio risk about July 21. These events were observable. Algorithmic execution changed, and we saw what started it and what followed.

Large diversified asset managers swapped out of equities. That means they assigned the risk in portfolios to others through agreements that traded risk for safety at a cost. Why not just say “investors sold to manage risk”? It’s not accurate and it won’t be reflected in settlement data.

Of course, hedging produces a range of consequences too. Those underwriting hedges themselves hedge the risk they assume. That prompts speculating in whatever instruments are being used to hedge the hedges. The idea is to offset every point of exposure – like double-entry accounting, a credit for every debit.

Consider the Treasurys market – the one in peril till today. Primary dealers ranging from Banc of America to Goldman Sachs make markets in Treasurys. Average daily trading volume in Treasurys is more than $500 billion. Bond trading in total in the US averages more than $950 billion daily and nearly 80% is government securities.

(more…)

Don’t Roller-skate in Buffalo Herds

Karen and I caught the PBR rodeo at Denver’s National Western Stock Show. I grew up on a ranch and Karen likes four-footed creatures. So we support cowboys and their furry fellow athletes. Those bull riders are tough guys, but what got me thinking was the team-penning competition.

It reminds me of the challenge IR folks face. We’re in the middle of earnings, with options expiring Wednesday through Friday and capital moving like a herd loping from one corner of the corral to the other while riders try to cut one here and there.

In team-penning, that’s what you do. You’ve got three folks on smart horses and a herd of calves with numbers on them, and a clock. Tom Bailey, founder of Denver’s Janus Capital, is in the sport. The announcer might say, “Four, four, four,” and the team of riders tries to cut three calves with the number four on them from the herd and pen them at the other end of the arena in about 45 seconds. If one of the herd that shouldn’t be cut gets by, you’re disqualified.

The hardest part is getting the few away from the many. Calves don’t want to leave the herd. It’s like stocks (aptly named). There’s a great herd of equities. If investors are cowboys and cowgirls on horses trying to cut the few from the many, it’s a tall task. The herd sways the behavior of the ones they want to single out.

When the herd is rattled and scattered, it’s nearly impossible to get the three you want without mixing in others you don’t want and getting disqualified. One thing that can scatter and rattle the entire equity herd is options expirations. This week, these include the VIX and RVX volatility measures Jan 19, stock and index options with morning expirations (often favored by European and Asian structured products) Thursday Jan 20; and the whole kit and caboodle Friday from stock and index puts and calls, to treasury, bond, currency and interest-rate derivatives. (more…)

It May Not Be About You

In Denver we get sun, rain, snow, sleet, hail. And then comes the next day. Today, a clear, bright and breezy 75 degrees Fahrenheit, photographers out snapping chamber of commerce pictures, the power goes out. It’s put us behind schedule.

Speaking of power outages, starting April 22 equity markets developed voltage problems. IR professionals, we’ve got two words for when you meet the CFO in the hallway and she asks, “What’s up with the stock market?”

Risk Management. What two words did you think we were going to offer? “Risk Management” is why the same stocks that were up yesterday can be down today. We saw surging European and Asian inflows April 22, and a reversal of the same inflows on April 27.

From the IR chair, it’s flummoxing. Your nearest peer, in the same industry, about the same market cap, doing similar things, reports results on April 22 and beats expectations and soars 10% in a day. You then report the same good results almost pound-for-pound, a handy beat. And your stock declines three percent.

What gives?

Time for those two words: “Risk Management.” Large portfolio trading schemes such as pension and investment funds may hold an array of securities. Let’s say euro-zone bonds, currency futures, US Treasuries and US growth stocks. Suppose these investments are protected with risk metrics software from SAS, and trading-desk level systems from prime brokers JP Morgan and Deutsche Bank. These systems are designed to monitor and maintain portfolio risk and return within certain parameters.

Greece’s bailout is approved. The systems determine that this will strengthen the US dollar, thus weakening inflows to US equities from European and Asian sources. The systems themselves execute automated trades, complete with offsetting derivatives, to control risk.

This behavior causes a domino effect. The same securities the system said to buy last week are now the ones it sells. That triggers other limit orders and stop-losses, changes the nature and size of passive market-making trades, and attracts statistical arbitragers finding fleeting imbalances. And because ONE variable in the overall risk-management schematic is different – maybe a risk metric is the ratio of dollars on reserve at the European Central Bank, which has just returned a bundle of them to the US Federal Reserve – it over-corrects.

The next day, the system tries to rebalance the overcorrection, producing a spike in US securities again. Commentators bray about renewed enthusiasm for US economic growth, which in fact plays almost no role. Leveraged ETFs had just today adapted to yesterday’s big risk-management change. Now those are out of balance.

Suddenly, inefficiencies abound. Passive market-making systems aren’t getting liquidity to the right spots fast enough. Stat arbs are executing simultaneous offsetting trades in ten different market centers, creating the illusion of movement where none exists.

And the next day, the risk-management system tries to rebalance again.

This is how you get great volatility in markets designed to function smoothly and efficiently.

You don’t need to explain it in detail to your CFO. But you should be able to say, “We have integrated global markets. Our results, which were great for our active investors, now are secondary to global risk management. That’s the reason we’re under pressure. It’s a portfolio problem.”

But portfolio problems are our problems too. What’s the answer? We invite your suggestions. Meantime, be sure management doesn’t take it personally. It’s not always about you.