Washington Square Capital Management Blog

Below are links to an article, pod cast and blog post we found interesting this week.

In his article Banking Needs More Robust Stress Tests Than These, John Kay writes in the Financial Times about the inadequacy of the European Bank stress tests.  He argues that while the language of “stress tests” is borrowed from engineering, the standards being applied are nowhere near as rigorous as those demanded in engineering.  As many banks learned first hand in 2008,  ”industry-standard” stress assumptions can create complacency.  Wimpy standards blessed by primary regulators may be worse.

One of our favorite weekly radio programs/podcasts is This American Life.  The show does not generally cover finance, but does a remarkable job whenever it gets around to covering the topic.  For example, they present a very good explanation of the financial crisis in an episode titled The Giant Pool of Money.  In a recent episode, the team took a look at US state budget deficits through the unique mix of political dysfunction, profligacy and entrenched distrust that characterizes the politics of Albany.  The episode also contained a cautionary tale for states and countries with polarized political landscapes.  In what comes as close to a controlled experiment in economics as one gets, we have the tale of Barbados and Jamaica.  Both countries confronted a ruinous economic landscape in the late 70s.  The nature of their local politics and the level of social cohesion led to small difference in the way they tackled their crises, but these small differences appear to have had an out-sized impact on future growth.   The episode is titled Social Contract, and is worth listening to in its entirety.

and apropos of nothing in particular, we quote The Epicurean Dealmaker:

There are those who style themselves intellectuals—a notably large portion of whom, in my personal experience, happen to be economists—who are deeply suspicious of anecdotal data in general and anecdotes about finance, economics, and the behavior of market participants in particular. This has always struck me as revealing both a superficially shallow skepticism about the primary sense and experience data of others—which, after all, is the most reliable data each of us individually possesses—and a similarly unwarranted credulity about its opposite, broad and impersonal third party datasets.

…
Oh, and by the way, while quality has certainly improved since I started in investment banking 20 years ago, it remains true, for example, that the banker who wishes to remain employed will always check the accuracy of third party data against original sources before he incorporates it into his own work product. So much for the reliability of external datasets when real money—as opposed to, let’s say, a research grant—is on the line. Oh snap.

— TED, unpublished remarks

1. We expect to see the US unemployment rate to peak at 11% in 2010. We may have been a bit aggressive with this call.  While the US job market remains anemic, the unemployment rate now stands at 9.5% (the lowest all year), partly because of workers who have dropped out of the labor force (stopped looking for jobs).  A falling unemployment rate would normally be encouraging news, but private sector job-creation continues to be very slow, despite the record amount of stimulus that has been pumped into the economy. In addition, the most recent jobs data has been disappointing, so the looming threat of a “double-dip” recession remains high and 11% unemployment later in the year is not out of the question.
2. Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010. This scenario has been playing out as we expected.  According to ICI[1], only $7.82 billion in new money has been invested into equity funds through June 23^rd 2010, while bond funds have seen $154.35 billion of net inflows.  Over the last eight weeks (where we’ve seen equity markets correct), net inflows into stock funds have been -$31.29 billion, while bond funds have seen +$33.98 billion over that same period.  We continue to believe demographic factors in the US and Europe as well as an increasing wariness towards stocks after two major bubbles in 10 years will lead investors to allocate larger portions of their portfolios to fixed income investments with a higher claim on corporate cash-flow than stocks.
3. We expect a number of credit downgrades for developed nations as their persistent deficits come into focus.  The US Dollar will strengthen in any ensuing flight to safety. This prediction has been right.  Since the start of 2010, we’ve seen credit downgrades to Greece, Portugal and Spain, as well as a massive bailout plan for Greece.  The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated.  It reached a level of 1.1875 per Euro on June 6^th and has recently bounced back to the 1.25 range.  We expect continued pressure on the Euro until a workable solution for the sovereign debt crisis has been reached.
4. Interest rates will remain effectively at 0% until the 4^th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range. So far this prediction has been accurate.  The Fed has kept the fed funds rate at historically low levels.  It remains to be seen whether or not the Fed opts to raise rates in the 3^rd or 4^th quarters.  While most commentators believe the latest round of economic statistics have made a hike unlikely until 2011, we still believe there’s a good chance the Fed raises rates to the 1-2% level after the mid-term elections in Q4 2010 and then pauses for an extended period.
5. Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order. This trend appears to be holding up.  In May, the personal savings rate reached 4%, which is the highest level it has been in 8 months and a far cry from the .8% we saw in April 2008.  Outstanding consumer revolving debt also continues to decline.   The most recent data from the Fed (for April) shows revolving debt at $838 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
6. The US economy will see almost negligible growth for 2010. It’s a bit early for this call since we won’t see this year’s GDP data until 2011.  Current GDP estimates are on track for 3% growth in 2010.  The caveat, of course, is that this has been accomplished with record government stimulus.  If the economy is unable to stand on its own without the crutch of stimulus, it’s entirely possible the second-half will be much weaker.
7. Corporations will increasingly turn to mergers and acquisitions to grow market share. This prediction could go either way.  According to the NY Times, the first half of 2010 has seen $810.3 billion in global mergers and acquisitions.  Through the same period in 2009, this number was $814.6 billion.  However, many of the 2009 deals were a result of government activity in the banking sector, whereas 2010 has seen deals taking place across a range of industries.  A recent Ernst & Young study of more than 800 senior executives across the world showed that 57% of businesses surveyed said they are likely to acquire other companies in the next 12 months.  This number was 33% in the last survey (in November of 2009).  Whether or not these executives follow through on this sentiment remains to be seen.
8. Growth in emerging markets will continue to outpace developed economies.  But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery. This trend appears to be holding up in 2010.  After a year of gaudy returns, the global equity rally faded in the second quarter.  As of June 30^th, the MSCI emerging markets index was -7.22% year to date, the MSCI EAFE index (which tracks developed markets in Europe, Australasia and the Far East) was -14.72% year to date and the S&P 500 was -7.57%.  We continue to believe equity market returns across the world will be negative in 2010.
9. We believe there is continued risk for a massive correction in China. While we have not yet seen a “massive” correction in China, the Shanghai composite index is now at a 15 month low and is down over 25% through the end of Q2.  We continue to believe equity and real-estate markets in China are over-valued and there is further to fall.
10. In 2010, certain commodities are poised for a sharp sell-off.  Top of our lists for a correction are gold and oil. This call has produced a mixed result.  Gold is up over 13% through the end of Q2 while oil is down over 14% over the same period.  While gold remains a popular investment alternative to faltering currencies (Euro, USD), we believe its big run-up over the past few years puts it firmly into bubble territory.   We believe oil prices will remain depressed until the global economy is back on its feet.

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[1] The Investment Company Institute, which tracks mutual fund flows

In our last few letters, we have discussed the extraordinary measures undertaken by governments across the world to support aggregate demand, and the extensive borrowing required to do this.  Over the past three months, both of these issues have been thrown into stark relief by events.

The dramatic and extremely sudden deterioration of Greek sovereign credit in the marketplace forced the European Central Bank (ECB) into a rapid about-face.  Germany’s elected representatives blinked and committed to a vast fund to support Mediterranean nations. Very few people expected to see the IMF lead a rescue package for European Monetary Union member-states in their life-times.  Eroding confidence in the ECB and EMU led to a deterioration in the value of the Euro as talk of this currency supplanting the US Dollar as the new global reserve currency did a sharp 180 degree turn and even sober commentators began to talk of a break-up of the European monetary union and the Euro’s death.  Meanwhile, bond-holders have turned their sights on the increasingly precarious state of sovereign balance sheets in most of the developed world.  Shocked by the speed with which Greek bonds lost value, most bond buyers are thinking seriously about sovereign credit risk in the developed world, awakening from a period that lasted two generations during which these risks were largely ignored.  Meanwhile, treasury officials the world over review the results of their bond auctions nervously, wary of any sign of demand slacking.  In many cases, their own central banks are becoming the most reliable buyers or financiers of new debt.

Three months ago, we wrote in an earlier post:

Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China.  As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.

We believe this process has begun and the initial signs do not augur well for the global economy.  We have seen a debate re-kindled recently about whether the withdrawal of stimulus at this juncture is a repeat of “errors” made in the 1930s, when stimulus spending was reduced to control deficits.  However, with aggregate debt levels in the developed world as high as they are, we see few alternatives to a steady reduction of the extraordinary fiscal and monetary measures undertaken to control the crisis.

We also feel it’s necessary to discuss the “Flash Crash” of May 6^th.  In our blog post the next day, we wrote that:

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.   …

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 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.

All three major indices, Dow Jones Industrials, S&P 500 and Nasdaq composite closed out this quarter below the intraday lows reached that day.  The ten-year treasury is now below 3%, and no amount of commentary on US federal and municipal debt-levels appear to impact the decline.  Meanwhile, the Baltic Dry Index has dipped below 2500 again (amidst talk of expanding fleets and falling Chinese imports).  Speaking of China, we see more commentators openly questioning the solvency of Chinese banks and the reasons behind big IPOs.  All of this underpinned by the fact that unemployment and underemployment rates in western countries remain stubbornly high.

Not only is it increasingly difficult to write off the events of May 6^th as a mere technicality, we believe that sudden decline has lead to deep distrust and uncertainty amongst investors.  Investors were already wary of fundamental economic and market conditions, the flash crash gave them reason to cast suspicion on the technical organization of the market.  This coupled with the SEC’s indictment of the premier US Bank, Goldman Sachs on charges of fraud, has fueled suspicion of large player’s motives and methods.  Many individual investors now believe the market is rigged against them, for the benefit of the largest trading firms and their most senior traders.  In our view, it was always thus.   Professional traders, whether they be electronic market-makers or specialists on the trading floor have always enjoyed a privileged position, which is completely appropriate given their role as liquidity providers and their responsibility to maintain orderly markets.  What we find difficult to accept is the extension of these privileges new players, without them being asked to shoulder the same responsibilities.

We do not see many silver linings amidst a climate of mutual suspicion and bad news.

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.”

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