While I have been wrong a lot over the past few months, I would point out a few important factors that we should keep in mind. 1) The time to buy is when recession is confirmed [I've been beating the Sep/Oct/Nov drum for this to occur for a long time] 2) The recession is not just starting as most believe - it's in the 6th or 7th inning [I finally found an article that shares my viewpoint that the recession started in Q4 2007: http://news.morningstar.com/articlenet/article.aspx?id=262592&pgid=hparticle] 3) Once the economy turns around [which requires two things to happen a) credit crunch to end which it mostly has and b) a restoration in trust in the economy which could happen at any time] it will likely be "too late" to buy (it won't be, but it will feel too late as we'll be far from our lows).
We may or may not revisit the 10/10/2008 lows, but I believe the 2002 lows will hold in any case -- because I believe the economic outlook is a lot better than most expect.
Also, Jeremy Siegel posted a good article on Yahoo that you may wish to review [http://finance.yahoo.com/expert/article/futureinvest/118916] in which he argues for a 20% return over the next year. One of his big points is also one of mine - that it's unreasonable to use trough earnings as the denominator in a P/E and compare to "normal". He claims that Ford, GM, and Sprint are less than 0.2% of the S&P 500 yet reduced the S&P's earnings by over 20% due to massive losses.
Look for high volatility to continue, but subside over the next 3 to 9 months. Conservative investors should strongly consider intermediate term investment grade corporate bonds.
Showing posts with label Financial Panic. Show all posts
Showing posts with label Financial Panic. Show all posts
Wednesday, November 05, 2008
Wednesday, October 22, 2008
The Sky Isn't Falling (Again)
Contrary to popular belief, the US economy is not failing. Nor is the world economy.
Therefore when the market is more than 4 standard deviations below its 2 year moving average [go to Yahoo! finance and graph an index, add Bollinger Bands for the 499 day period with 4 standard deviations, and you'll see that we're below the bottom line) it may be a GOOD TIME TO BUY [my guess, and it's just a guess, is that the S&P 500 sees an intraday low of 768 to 825 which implies downside of 8 to 15% from here -- however during bottoming periods like this the "bottom" can be very short -- sometimes less than an hour -- so hitting "the bottom" is unachievable].
PS: High yield bond spreads to treasuries are at an all time high. Unless defaults are far worse (or recoveries far less, or both) than at any time since the market was created in the mid 1970's then now is probably a terrific time to buy junk bonds.
Many happy returns.
Therefore when the market is more than 4 standard deviations below its 2 year moving average [go to Yahoo! finance and graph an index, add Bollinger Bands for the 499 day period with 4 standard deviations, and you'll see that we're below the bottom line) it may be a GOOD TIME TO BUY [my guess, and it's just a guess, is that the S&P 500 sees an intraday low of 768 to 825 which implies downside of 8 to 15% from here -- however during bottoming periods like this the "bottom" can be very short -- sometimes less than an hour -- so hitting "the bottom" is unachievable].
PS: High yield bond spreads to treasuries are at an all time high. Unless defaults are far worse (or recoveries far less, or both) than at any time since the market was created in the mid 1970's then now is probably a terrific time to buy junk bonds.
Many happy returns.
Saturday, October 11, 2008
Thoughts
We live in the most interesting time for finance since the Great Depression – that much is sure. We’ve seen the worst one year return for the S&P 500 and Dow since the Depression – same with the worst 30 day return. This crash should be known as the “Panic of ‘08”.
Because this is the worst panic since the 30’s, the temptation is to compare this crisis to ones from before the end of the depression. This is a bad comparison – and would be akin to seeing the roaring twenties bubble bursting, and making predictions using the dark ages in Europe as a template for what happens when an unprecedented expansion crashes.
Institutions were created as an effect of the depression, such as the FDIC, unemployment insurance, the SEC, and many others. These have changed the world for the better, and our downside economic risk is much less now.
Similarly, economic data and news are much more available, and current. Many believe that the Depression was caused by central bankers tilting at inflation windmills that had been extinguished years before – in the United States Andrew Mellon was raising rates until 1932 – 3 years into the Great Depression. We should note that today the Fed Funds interest rate was first cut over a year ago – and we’re seeing governments around the world that had been fighting the inflation windmill too long, like the EU and China, now cutting rates.
So we should not be surprised when this panic is over much faster than the doomsayers expect.
Finally, Rebecca asked me to comment on Credit Default Swaps – why they are unregulated, what part was played in the downfall of AIG, Lehman, or the freezing of the credit markets:
CDS are unregulated because of the way they came into existence – they started as agreements between financial firms to insure debts. If Bear Stearns owned debt from Russia, and wanted to buy insurance, they could agree with AIG and a contract be entered into. Insurance is a legitimate and needed product that should exist.
Problems began when it was realized that Credit Default Swaps could be used to speculate on a default without having owned the debt. To use an example: I might say “I’ll bet you $100 that the Steelers will win the Super Bowl next year” – and you might have to pay me $10,000 if I’m right because it’s such low odds today. Credit Default Swaps are almost exactly the same thing – a hedge fund would say to AIG “I’ll give you $17,000 per year for the next 5 years for you to guarantee $10 million in Fannie Mae senior debt for those 5 years”, they agree and write up a contract.
This led to failures for a simple reason – our financial institutions are based on trust and faith. Just watch “It’s a Wonderful Life” and you’ll see that a bank doesn’t have a vault where they make a neat stack of the money each account deposits with them waiting for the day it is withdrawn – they keep some liquidity but invest the vast majority of their deposits. When everyone asks for their money back at once (because they don’t trust the bank) it causes a run on the bank, leading to failure. This is what happened to Bear Stearns and many other institutions this year. Credit Default Swaps led to these runs on the banks because when people began betting on a failure – by buying the CDS of Bear Stearns – it drove up the price of that protection – and people notice that. So when the CDS of Bear Stearns began trading at such high prices that was implied there was over a 50% chance of a failure – everyone who had money there started pulling it, because it was obvious trust had been lost.
So regulating Credit Default Swaps will help many things, but unless regulation requires that you actually own the bonds being insured through a CDS it will not stop this phenomenon whereby we see speculative buying of CDS which ends up bringing down the institution [people blame the shorting of the common stock, but it is more the speculative buying of CDS that casuses these runs on banks].
CDS led in part to our credit freeze for a different simple reason – there is too much of them and no one knows how much exposure firms have. Buffett called derivatives (talking about CDS presumably) “weapons of mass financial destruction” years ago – and he was right. AIG “failed” because they had been writing an extreme amount of these contracts – and when things got worse than anyone had predicted – it put all of AIG’s AAA balance sheet at extreme risk. Now credit between financial institutions has been frozen because each firm wants to hoard cash and doesn’t trust their neighbors.
Another problem with CDS is counterparty risk – they’re agreements between two parties – so your counterparty better be sound. The way firms account for these is they offset their exposure – i.e. if AIG has written trillions of dollars of CDS – but some benefit AIG if Lehman fails, and some hurt AIG if Lehman fails, they net these positions. The problem is that those agreements are with different parties, and if one side fails the result won’t look like they netted. So how does one firm trust another when you can’t tell what their risk is?
So we need regulation of Credit Default Swaps where the amount is limited – just like a bank cannot lever up infinitely, neither should AIG have had so much discretion as to the amount of CDS they would write. We also need a universal counterparty, so that the risk that the other side fails goes away. I believe that universal counterparty is in the works currently. However, I don’t think that changes to restrict the amount of CDS you can write is in the works [but will happen eventually because it’s so obvious], nor do I think anyone in power wants to make CDS into an insurance policy rather than speculative bet.
This last factor is important – if you had to own the debt being insured in order to buy a CDS (and had to sell them together as well), then they wouldn’t be nearly so speculative (and CDS prices would reflect the actual perceived risks of institutions from the parties doing business with them, rather than the perceived risks of speculative gamblers). I believe it is highly unlikely this change will be made, which is unfortunate. There’s a huge difference between someone that I owe money to being able to insure that debt, and someone being able to take my bet that the Steelers will win the Super Bowl next year – one is a legitimate financial activity that is needed and desired, while the other is enabling speculation.
Because this is the worst panic since the 30’s, the temptation is to compare this crisis to ones from before the end of the depression. This is a bad comparison – and would be akin to seeing the roaring twenties bubble bursting, and making predictions using the dark ages in Europe as a template for what happens when an unprecedented expansion crashes.
Institutions were created as an effect of the depression, such as the FDIC, unemployment insurance, the SEC, and many others. These have changed the world for the better, and our downside economic risk is much less now.
Similarly, economic data and news are much more available, and current. Many believe that the Depression was caused by central bankers tilting at inflation windmills that had been extinguished years before – in the United States Andrew Mellon was raising rates until 1932 – 3 years into the Great Depression. We should note that today the Fed Funds interest rate was first cut over a year ago – and we’re seeing governments around the world that had been fighting the inflation windmill too long, like the EU and China, now cutting rates.
So we should not be surprised when this panic is over much faster than the doomsayers expect.
Finally, Rebecca asked me to comment on Credit Default Swaps – why they are unregulated, what part was played in the downfall of AIG, Lehman, or the freezing of the credit markets:
CDS are unregulated because of the way they came into existence – they started as agreements between financial firms to insure debts. If Bear Stearns owned debt from Russia, and wanted to buy insurance, they could agree with AIG and a contract be entered into. Insurance is a legitimate and needed product that should exist.
Problems began when it was realized that Credit Default Swaps could be used to speculate on a default without having owned the debt. To use an example: I might say “I’ll bet you $100 that the Steelers will win the Super Bowl next year” – and you might have to pay me $10,000 if I’m right because it’s such low odds today. Credit Default Swaps are almost exactly the same thing – a hedge fund would say to AIG “I’ll give you $17,000 per year for the next 5 years for you to guarantee $10 million in Fannie Mae senior debt for those 5 years”, they agree and write up a contract.
This led to failures for a simple reason – our financial institutions are based on trust and faith. Just watch “It’s a Wonderful Life” and you’ll see that a bank doesn’t have a vault where they make a neat stack of the money each account deposits with them waiting for the day it is withdrawn – they keep some liquidity but invest the vast majority of their deposits. When everyone asks for their money back at once (because they don’t trust the bank) it causes a run on the bank, leading to failure. This is what happened to Bear Stearns and many other institutions this year. Credit Default Swaps led to these runs on the banks because when people began betting on a failure – by buying the CDS of Bear Stearns – it drove up the price of that protection – and people notice that. So when the CDS of Bear Stearns began trading at such high prices that was implied there was over a 50% chance of a failure – everyone who had money there started pulling it, because it was obvious trust had been lost.
So regulating Credit Default Swaps will help many things, but unless regulation requires that you actually own the bonds being insured through a CDS it will not stop this phenomenon whereby we see speculative buying of CDS which ends up bringing down the institution [people blame the shorting of the common stock, but it is more the speculative buying of CDS that casuses these runs on banks].
CDS led in part to our credit freeze for a different simple reason – there is too much of them and no one knows how much exposure firms have. Buffett called derivatives (talking about CDS presumably) “weapons of mass financial destruction” years ago – and he was right. AIG “failed” because they had been writing an extreme amount of these contracts – and when things got worse than anyone had predicted – it put all of AIG’s AAA balance sheet at extreme risk. Now credit between financial institutions has been frozen because each firm wants to hoard cash and doesn’t trust their neighbors.
Another problem with CDS is counterparty risk – they’re agreements between two parties – so your counterparty better be sound. The way firms account for these is they offset their exposure – i.e. if AIG has written trillions of dollars of CDS – but some benefit AIG if Lehman fails, and some hurt AIG if Lehman fails, they net these positions. The problem is that those agreements are with different parties, and if one side fails the result won’t look like they netted. So how does one firm trust another when you can’t tell what their risk is?
So we need regulation of Credit Default Swaps where the amount is limited – just like a bank cannot lever up infinitely, neither should AIG have had so much discretion as to the amount of CDS they would write. We also need a universal counterparty, so that the risk that the other side fails goes away. I believe that universal counterparty is in the works currently. However, I don’t think that changes to restrict the amount of CDS you can write is in the works [but will happen eventually because it’s so obvious], nor do I think anyone in power wants to make CDS into an insurance policy rather than speculative bet.
This last factor is important – if you had to own the debt being insured in order to buy a CDS (and had to sell them together as well), then they wouldn’t be nearly so speculative (and CDS prices would reflect the actual perceived risks of institutions from the parties doing business with them, rather than the perceived risks of speculative gamblers). I believe it is highly unlikely this change will be made, which is unfortunate. There’s a huge difference between someone that I owe money to being able to insure that debt, and someone being able to take my bet that the Steelers will win the Super Bowl next year – one is a legitimate financial activity that is needed and desired, while the other is enabling speculation.
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