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Monthly Archives: February 2014
fixed income speculation and tapering
One of the earliest attempts by technical analysts in the US to link their work to economic variables was in charting the relationship between growth in the domestic money supply and stock market advance.
This wasn’t Milton Friedman.
This was–and is–a common sense attempt to create a barometer to measure the degree of speculation inherent in the stock market. The idea is that the economy needs a certain amount of money to grease the wheels of commerce–to keep factories humming, meet payrolls, build inventories. Anything in excess of that amount will inevitably find its way into financial speculation in equities, real estate and commodities. Speculation, in turn, will lead to intervention by the Fed , “to take away the punch bowl,” as William M. Martin, a former Fed Chairman put it. (Or, in the most recent case, where the punch bowl was heavily spiked and stayed out forever, a near-meltdown of the world financial system.) So it’s an early warning indicator of a market decline.
Although still used by at least one famous hedge fund, this simple rule has lost much of its usefulness in a globalized world with supply chain management systems, ubiquitous, but only semi-visible derivative contracts and the increased prominence of businesses based on intellectual property.
I think, however, that the Fed is using this rule, but has reversed the inference, as part of its rationale for tapering. I think the Fed sees increasing speculative activity in fixed income markets as evidence that there’s too much money sloshing around in the world. (I know I am.)
Three areas worry me:
—pik bonds. Pik stands for payment-in-kind. It’s a type of junk bond where the issuer has shaky cash flows and may not be able to afford to make interest payments on its debt. So lenders allow the firm to pay interest “in kind,” meaning issuing more junk bonds to cover the interest expense. As is always the case in investment banking, there are variations on the theme: the bond may be pik from inception; the issuer may have the right to convert the bonds from cash to pik, if he needs to; or the issuer may be able to “toggle” back and forth between cash and pik as he desires.
In my limited junk bond experience, pik bonds only rear their heads at bond market peaks. And they’re here again.
—contingent convertibles, or “cocos.’ The original cocos, spawned by the financial crisis, are bonds issued by financial companies that can be forcibly converted into equity–thus shoring up regulatory capital–if the issuer gets into financial trouble. In my view, the buyer is exposed to all the downside of owning an equity with few of the rewards.
According to the Financial Times, a new variation on the coco theme has recently appeared. The new securities are called “sudden death” or “wipeout” bonds. Their attraction is that they pay coupons of around 8%. The catch is that if the issuer’s regulatory capital falls below a ratio specified in the bond indenture–so far its been if a bank’s Tier One equity ratio falls below 7%–then coco holders lose all their money.
To me, this looks like an equity put dressing it up in bond clothing so fixed income managers can buy it.
—the Fragile Five. 2014 opened to a bout of bondholder angst about their positions in the debt of places like Argentina. Argentina? Really? Isn’t this the same place that nationalized Repsol in 2012? …the same place that defaulted on its sovereign debt in 2001? …where capital flight has accelerated to the point that the government has shut down online shopping to prevent money from leaving the country? Talk about risky.
I think these areas worry the Fed, too. They’re why I think we’d have to see considerable economic weakness in the US before tapering comes to a halt.
what’s wrong with having Congress audit the Fed?
I was driving in southern New Jersey yesterday, where car radio reception is spotty. So I ended up, as usual, listening to Bloomberg Radio on Sirius. So I heard a lot of Janet Yellen’s testimony before Congress.
Ms. Yellen has a terrible speaking voice.
It’s hard for me to judge how much of the apparent lack of basic economic/financial knowledge evinced by members of the House Committee on Financial Services was real, and how much was political theater aimed at advancing political agendas. Michael McKee, who formerly covered Congress and who I think is one of the brightest spots on Bloomberg Radio, believes the former.
Anyway, to auditing the Fed.
Let’s be clear. This isn’t about auditing in the sense of making sure the financial statements are pertinent and accurate. Nor is it about making sure that every expenditure is documented and every penny accounted for.
It’s about a Rand Paul proposal to give the Government Accountability Office, an arm of Congress, the ability to publicly second-guess the decisions of the Fed on monetary policy. GAO activity would presumably include not only public criticism of the soundness of policy itself, but also questioning of the Fed policymakers’ opinions and their professional qualifications. This would be the first step in restricting the independence of the Fed and making it subject to the will of Congress.
What’s wrong with that?
Two things:
–if members of the Fed become targets of public Congressional pillorying, then the list of highly qualified economists lining up to make careers in public service at the Fed will shrink to nothing. We could end up with unlicensed people driving the school bus.
–the Federal government has currently borrowed $17 trillion+, at relatively low rates of interest.
The primary concern of lenders to the US is that they will be paid back in full. One of the primary criteria they consider is whether a given sovereign borrower has a monetary authority run by highly skilled economists, free of political influence. They know that politicians are often short-sighted and in tough times may try to wangle out of their repayment obligations. ( The standard way of doing this is by running an over-loose policy that creates inflation, reducing the real value of what they owe.) A strong, independent central bank is lenders’ assurance that this won’t happen.
Implementing the Rand proposal calls this into question. The response by lenders would be to demand higher interest rates in compensation for the additional risk. If we assume this would raise the interest rate the government would pay by 50 basis points (I’m making this figure up, but it seems like a good guess to me), that would mean an extra $85 billion a year in interest expense. This wouldn’t happen right away, and the rise would predominantly be on the longer end of the yield curve, but still…
The US$ is the world’s reserve currency. This gets us lower borrowing costs and easier access to funds since we’re the bank. The rest of the world isn’t thrilled by this, but willing to put up with the current system. That’s in large measure because of the independence of the Fed. Lose that and creating a replacement (the renminbi?) becomes an urgent concern for the rest of the world. Again, higher borrowing costs for the US–not right away, but suddenly the possibility has to be on investors’ radar screens.
my recent Pink Sheet experience
what the Pink Sheets are
I’ve written about the Pink Sheets before, in much greater detail than here.
Basically they’re an electronic marketplace for trading equities not registered with the SEC. Some are stocks of foreign issuers and the Pink Sheets is the main place they’re traded. Others are domestic. Some of the latter are small, illiquid and haven’t filed financials (if they have any) with the SEC. This second group, and the rough-and-tumble trading that sometimes occurs with both, are the source of the Pink Sheets’ shady reputation.
In the pre-computer days, quotes for such stocks were delivered to traders in daily lists printed on long strips of pink paper. That was to distinguish them from quotes for bonds of similar ilk, which were printed on blue paper. Hence the name.
anyway, what happened–
About an hour before the close in Hong Kong last Wednesday, the Macau casino regulator issued its report of the total amount lost by gamblers in SAR in January. The figure was a surprisingly weak +7%, year-on-year. The Macau casino stocks sold off immediately, and were down at the close by about 10% from their pre-announcement levels. At the New York open, WYNN and LVS sold off by more than 5% as well.
As the New York morning progressed, reports began to circulate that the Macau market had actually been strong–that the apparently weakness was caused solely by the timing of the Lunar New Year. The US stocks rallied.
During the afternoon, I checked the Pink Sheet quote for Sands China (SCHYY). I noted that average daily volume is US$1.6 million vs. US$145 million for HK: 1928 in Hong Kong. More important, the stock hadn’t budged an inch; it was still stuck at the Hong Kong close. Weird.
So I bought 150 shares. Yes, it was a risky thing to do. It took maybe ten minutes for my (puny) limit order to be filled, another warning sign. But I was curious.
The Macau gambling stocks rose on Thursday in Hong Kong by around 10%.
SCHYY mirrored the Hong Kong close. I sold as fast as I could.
The following day, Friday, the Macau gambling stocks were flat to down in Hong Kong.
here’s the interesting part:
SCHYY opened down 3%, at $76.53, on 21, 952 shares.
After that one trade, the market became 200 shares bid at $74.29, 300 shares offered at $76.29.
In other words, liquidity dried up completely.
The stock traded about 10,000 shares during the rest of the day, at what the chart shows as prices below $75.
Monday, the stock traded only 6,866 shares, or about $500,000 worth of stock, all day.
what you should notice
–no mutual fund or pension plan portfolio manager is going to buy SCHYY. It’s just too illiquid. So there’s going to be no buying support for the stock from this quarter. (Let’s say an average position size for one of these professionals is $10 million and that they thought they could be a a quarter of the daily volume without anyone figuring out they were in the market (fat chance). Even if so, it would take a month+ to buy or liquidate.)
–after the big (for SCHYY) opening trade, market makers widened the bid-asked spread to almost 3% and pushed the market down. They also committed themselves to only trading a tiny amount of stock at the price they showed–meaning the market would sink further if more stock followed the next trade.
All this is designed to signal they’re only willing to take more stock on their books at a heavily discounted price–that is, to stop the selling. As the rest of the day showed, this tactic was successful.
–in most cases, the best course of action for a seller who thinks he must get out of the stock for some fundamental reason is to accept the discounted price and be the first out the door. Yes, selling will be ugly. But that’s better than having the market 10% lower, with you having sold nothing.
Welcome to the Pink Sheets!!
breaking companies apart: the cons
Many times, separating a conglomerate into its component parts creates value. Sometimes, it can produce enormous gains. Spinoffs of corporate stepchildren are often particularly lucrative. Take Coach (COH) for instance. Its stock rose by 40x in the first five years after it was spun off, unloved and starved for expansion capital, from Sara Lee.
There are other instances, however, where breakup can be disastrous. This may not be evident at first in the stock price action of the separate components, but the ultimate bad news can happen in a number of ways:
1. Onerous corporate liabilities–debt, lawsuit liabilities, incompetent executives…may all be shunted into one of the new parts, which is more or less designed to fail. No one will say this, of course.
The first place to look for this kind of imbalance is in the part where the CEO and other top executives aren’t going. Often, executives in the disfavored part of the split will be so excited to finally be the top dog that they’re delusional about their ability to deal with the negatives they’re being loaded down with. After all, Davy Crockett might have survived the Alamo if he’d been a step quicker; the Donner party might have gotten through those mountains…
2. Sometimes a proposed split will end up forcing apart two businesses which need each other to be successful. In the current hedge fund era, when individuals with little operating experience can wield large amounts of financial capital, this is a particular danger. Activists. for example, have wanted Target (TGT) to sell/divest its credit card operations a couple of years ago. Yes, TGT would receive a large one-time payment, and its stock would probably go up. But its credit-related operating costs would rise. And the company would have lost the considerable “Big Data” advantage that it gets from being able to see all the credit transactions of its cardholders–not merely transactions done at Target stores.
I think the current talk of splitting up Microsoft (MSFT) is well worth monitoring in this regard. Sure, spin off the consumer device business. To my mind, though, splitting Windows, Office and the cloud from one another is just asking for trouble.
3. Another issue that has emerged in recent years–the activists may be bunglers. Look at J C Penney (JCP). Activists correctly saw that JCP was crediting profits it got from its control of valuable real estate to its retailing operations. That covered up the true weakness of the company’s retail offering. But their attempt to “fix” retailing before breaking up the company went horribly awry. Worse, they persisted in their mistaken direction so long that they created a downward spiral the company has yet to pull out of. The stock, which some speculated could be worth $50 a share, has dropped from around $30 to $5 or so as a result of their “stewardship.”