Washington Square Capital Management Blog

A series of measures were announced today to provide support for troubled Euro-zone states.  The broad outline of the plan is that the European Union (EU) and the International Monetary Fund (IMF) are committing almost $1 trillion to support bond issues by Euro-zone states.  We see three reasons to question the initial market euphoria surrounding this announcement:

• The immediate issue is that this measure, and its cost, will likely need be voted on by all member-state legislative bodies. There is a good chance it faces stiff opposition in at least one Euro-zone nation, potentially setting the stage for a political standoff reminiscent of the US congress’s initial vote on the TARP plan in September 2008.  The entire process will be controlled by member-states and the EU institutions have been largely bypassed.  The EU leadership has decided they want to sell this deal in 27 member-states simultaneously, with the markets breathing down their neck.  It is hard for us to believe they will find buyers in every member-state’s legislature.  Imagine if TARP had to be voted on by every US state legislature.  The UK government (after last week’s election, we aren’t sure who that is) has already decided it wants no part of the 440 billion euro loan guarantee program, others may follow upon reconsideration.  In any case, we suspect member-state legislators will not be as easy to corral as finance and prime ministers.
• This announcement undermines the fiscal soundness of all European Union countries, especially if austerity measures are still resisted by the member states who are in very weak fiscal positions.  David Roche writes in the FT that “this deal is a form of contagion by official action”.
• The German provincial election in Rhineland this past weekend did not go well for the Christian Democratic Union (CDU).  German voters handed Angela Merkel’s party an effective loss based on her support for a much smaller bail-out of Greece.  We do not believe German voters, or the constitutional court will be pleased about this announcement and the European Central Bank’s plan to purchase member-state debt.

A number of the fundamental issues raised as our generation’s financial crisis runs its course are summarized in an excellent Statfor piece titled The Global Crisis of Legitimacy.

In other news, Moody’s announced they may downgrade Greece to junk-bond status (S&P already has).   The European Central Bank (ECB) has announced they will buy these junk-rated bonds and the prevailing mood in Europe is to blame the rating agencies and banks for the debt woes of profligate member nations.  The ECB’s reputation for monetary stability and responsibility has been deeply compromised by this weekend’s announcement, and we fear it will be impossible to regain in the short-term.

The sovereign credit crisis in Europe is not over yet, and the questions surrounding the Euro have not been laid to rest.

Further reading:

• Europe agrees rescue package
• In a must-read analysis titled It’s not the way to solve Eurozone debt crisis, David Roche writes in the FT: “Initially, markets may be wowed by the size of the package. But the size just means that more debt has been added to a problem that is about too much debt! EU governments and the European Central Bank are now obliged to guarantee or buy the sovereign debt of other members as a solution to the Eurozone’s debt crisis. But the solution to a hangover is not more alcohol.”

One of the financial commentators we follow (for his trader’s eye view from the NYSE) is Art Cashin.  Art wrote today about the brief free-fall in stocks last Thursday afternoon.  To quote:

Nothing Sold For A Penny On The NYSE

There was a lot of discussion on the floor Friday about the huge air pocket that stocks hit on Thursday afternoon.

As the day wore on, skepticism began to grow about the “trader error” (fat finger) rumors that circulated late Thursday. There didn’t seem to be a telltale brief volume spike. Traders began to speculate that the trigger might have been a sudden spike in the Japanese yen which may have briefly panicked carry traders.

The other item was the finger-pointing among trading venues. Some competitors claimed the designed safety speed bumps in the NYSE hybrid system caused the air pocket. I may be a bit prejudiced but that borders on the ridiculous.

No $40 stocks traded at a penny on the NYSE. One trading venue, the Nasdaq canceled trades in 281 securities. David Kotok points out that 193 of them were ETFs. There are no ETFs listed on the NYSE floor. Therefore, they could not have been impacted by speed bumps. Further the NYSE canceled no trades.

It would appear that some trading venues may not be as deep and liquid as their marketing brochures imply.

To us this goes to show that investors must be aware of technical factors and market mechanics, since these sometimes create opportunity.  More importantly, however, understanding the mechanics of the market for our investments allows us to correctly analyse price action in a stress environment and avoid making bad decisions.

Like most market participants, we watched the market moves yesterday afternoon with a certain degree of amazement.  Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop.  But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery.  It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009.

While there have been some theories put forth to explain what happened yesterday, we do not have a definitive explanation for the rapid decline and subsequent recovery.  That said, we would like to share a few observations about yesterday’s trading and its broader implications:

1. Equity markets were already down substantially (on the order of 3-4%) before the sudden drop occurred between 2:30 and 3:00pm. During their (brief) lows, the broad indexes were down over 9% before recovering.  We closed the day down 3-4% across the major indices.
2. The sudden decline took us through multiple significant technical support levels. Volume was steady through the morning, picked up around noon and rocketed after 2:30.  Yesterday was the second highest-volume day on record.
3. There were various (as yet unsubstantiated) rumors of “trader error” causing the decline. There have also been reports that many high-frequency trading operators stopped trading entirely since they hit internal limits which kick in under extreme conditions.
4. Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets.

The last point is the most significant for investors. There is a reasonable suspicion is that yesterday’s activity in the currency markets was part of an unwinding of the carry trade. Carry-traders are very sensitive to risk since they run large, leveraged positions which can be quickly wiped out. If this is correct, the events of this week were broadly similar to moves that occurred in August 2007, which affected quantitative hedge funds mostly, and marked the beginning of the declines of 2008 and 2009. See Andrew Lo’s paper, What happened to the quants in August 2007.

The technical reasons for the stock market decline are what have received the most scrutiny in the press. In our view, the steady surrender of volume and responsibility from trading floors (where participants meet market-makers face to face) to electronic exchanges with liquidity provided by automated high-frequency trading systems certainly exacerbated the sudden acceleration of the decline, but did not cause it.

Not-withstanding purely technical reasons affecting the speed and steepness of a 15 minute decline, the underlying reasons for increased risk-aversion are real. We also believe it betrays extremely short-term memory to claim that such sudden declines do not occur in a specialist managed market. We only need to point to Black Monday (October 19, 1987), when the market dropped 22% over the course of the day.  In 1987, most stock was traded via specialists on the physical floor of the NYSE.   In that instance, automated selling by “portfolio insurance” providers accelerated the decline.  Yesterday, the NYSE maintained a relatively orderly market, the extremely low-priced trades appear to have occurred on secondary exchanges with low liquidity where numerous market sell or stop loss orders may have encountered a limited number of bids and shallow order books.   In and of itself, this is not unusual, stocks always decline suddenly when there are a lot of sellers and no buyers.

This is an interesting debate, but in our view is largely irrelevant for investors.  One market commentator remarked:

For starters, let’s all keep in mind that these things don’t happen in a healthy tape. The jitters from Greek rioting and possible contagion were the necessary preconditions for a crash like that.

The major conclusions we draw from the trading action of the past week is that:

1. Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
2. The Euro-zone crisis will continue to roil markets until it is properly addressed.
3. There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.

Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.

Further reading:

Felix Salomon’s initial take: How a market crashes

Felix after taking a deep breath: Deconstructing the crash

Bloomberg’s Nina Mehta and Craig Nagi: Market fragmentation may get review after stock drop

For the past several months, we have been thinking about the broader Euro-zone’s economic malaise.   In the course of conversations, we sometimes use analogies, and we thought we’d share this one with our readers.

As part of the aim to integrate Europe and limit the future likelihood of war, European countries have sought to develop deep political links (by joining the European Union) and integrate their financial markets (by joining the shared currency regime).  As a result of this process, large, developed, stable economies in Europe (Germany, France etc.) have lashed themselves to smaller, relatively under-developed, unstable economies (Greece, Portugal, etc.).

Imagine each of these countries as boats on the open ocean.  Some of them are large, modern vessels carrying many passengers, while others are smaller, rickety affairs.  In creating the European Monetary Union, these countries sought to create a larger water-craft by roping together many different boats.  There are definitely advantages to doing this.  Passengers on the boats (citizens) can now easily trade and transact with those on other boats.

However, it takes generations for all passengers to develop a sense of common destiny and values.  The Eurozone has not had that much time, yet finds itself in the middle of a large storm.  The big problem is that there is no mechanism defined to detach the larger unit from a vessel that has begun to sink in a storm.

Passengers on the sound, stable sea-craft (German burghers) do not want to put themselves at risk by stepping onto the sinking ships to help bail water, yet their captains are calling for them to do so.  Meanwhile, the combined craft made of many mis-matched boats continues to tilt and take on more water.

To compound the problem, we saw a riot on one of the sinking boats yesterday.  Some passengers (Greek nationals) on that boat tried to set it (literally) on fire.  The rest of the world does not expect such things to happen in developed economies and looks on in disbelief.

What we find remarkable, is the speed with which assumptions have changed.  Nine short months ago, virtually everyone was calling the demise of the US dollar and the rise of the Euro as the new global reserve currency. Now we are at a point where the dissolution of the Euro is being openly debated.  Greek citizens riot in the streets because their elected representatives have chosen to call a halt to profligate policies and crack down on pervasive tax-dodging and fudging of statistics.  The rest of the world stares aghast. Meanwhiles, the rats (speculators) are deserting the ship.

For a less metaphorical take on the crisis, please read Edward Chancellor’s FT Opinion piece  Greece a bad omen for others in debt.