the 21st century stock market cycle

Last Friday, I started to write about the stock market cycle, prompted by a phone call from my younger son.  This is the second installment.

the old model

In a closed economy, unaffected by imports and exports and untroubled by external shocks, the cyclical rhythms of GDP growth–and therefore of the stock market–are controlled by the government.  In the US this has meant, theoretically at least, applying stimulus when GDP begins to falter and taking it away when the economy begins to expand at an unsustainably high rate.  The peak-to-peak or trough-to trough cycle that this action produces has averaged about four years during the post-WW II period–broken out into 2 1/2 years of up and 1 1/2 years of down.

Not over the past two decades, though.

the world has changed

After almost a half-century of globalization–of governments forging ever stronger economic links with one another–the rest of the world is much more important than previously to almost any nation’s domestic stock market.

In the case of the US, the available data suggest that only about half of the profits of S&P companies now come from the domestic economy.  The rest derive in roughly equal amounts from Europe and from the Pacific + other emerging areas.

Surprisingly, this increased economic openness hasn’t been an important disrupter of the US stock market cycle so far.  The culprit has been government policy instead.

policy mistakes in the US

In hindsight, Alan Greenspan made a series of monetary blunders in the 1990s and early 2000s that extended economic cycles but created in both cases stock market/economic bubbles that ultimately collapsed of their own weight.  The damage these collapsing bubbles created was severe.

1997-1999:  the internet bubble

In 1997, a banking crisis in heavily indebted Thailand began to spread to other smaller Asian economies.  Mr. Greenspan chose to open the domestic money taps to offset possible negative economic effects on the US, at a time when domestic considerations alone would have had him either neutral or tightening.  Two years later, he expanded the money supply further.  He feared the possible economic disaster that might occur if all the world’s electronic devices stopped working on January 1, 2000–as prophets of doom like Ed Yardeni were predicting (horse-drawn plows were in short supply, for example, as survivalists planned for a post-Y2K apocalypse).

These actions, however, also allowed the Internet Bubble to form.  That was a heady concoction of hype and fraud concocted by investment banks and the loony predictions of internet “analysts” like Henry Blodget (subsequently barred from the securities business) and Mary Meeker. The bubble collapsed when earnings reports showed the so-called TMT business had begun to contract in early 2000, not expand.

2003-2007:  the housing bubble

This was a much more devastating episode and a much more complex one.

–The Fed supplied the easy money.

–Mr. Greenspan failed to supervise the mortgage industry the way he was supposed to.  “Liars loans” proliferated.

–Congress, which had barred commercial banks from the securities business for their role in causing the Great Depression, let them back into the fray during the late Clinton years–just in time to work their “magic” again.

–Bank and securities regulators failed to stop the spread of complex, badly understood–but nonetheless toxic–derivative securities spawned by commercial and investment banks.

The resulting house of cards began to implode as large numbers of borrowers were unable to make their mortgage payments.

flying by the seat of our pants

That’s where we are now, I think.

The old four-year economic cycle idea hasn’t worked recently.  I don’t see much to generalize from in the two most recent cycles that would provide a framework to replace it. Both downturns were caused by systematic shocks.  But both emanated from the US.  Both had excessively easy money policy at their root.  The Great Recession added in regulatory and Congressional incompetence.

The only practical tool I can see is the general principle that government policy is accommodative while the greater worry is economic weakness.  It turns contractionary (and upward stock market movement ends) when the greater fear is inflation.

Despite my periodic worries about the apparently high current level of the S&P, I think we’re still in accommodative mode, not contractionary.

One other comment:  given that interest rates are zero and that Washington is dysfunctional, the US is especially vulnerable at present to external shocks–though I see none on the horizon and have no strong ideas of when/where one might arise.

Gavyn Davies on Bernanke’s change of heart

keeping inflation low

Since the tenure of Paul Volcker began over thirty years ago, the mantra of the Federal Reserve has been to do what is necessary to keep inflation under control.  Over time, this morphed into the narrower target of keeping inflation under 2%, but the intent has always been to drive inflation lower.  Yes, the Fed has a “dual mandate,” both to conduct monetary policy in a way to achieve maximum sustainable GDP growth and to promote employment.  But the former has invariably trumped the latter.

…until now

In the September 12th pronouncement from its Open Market Committee, the Fed unveiled new monetary stimulus measures targeted at reducing unemployment.  For the first time, they are open-ended both in terms of time and of money.


…especially when there’s a lively debate, even within the Fed, over whether we are in fact already at full employment.  If so, the new measures won’t create any new jobs.  It will only ignite wage inflation, as companies poach employees from rivals in order to expand.

Personally, I don’t know.  I think that if the Fed decision has any immediate implications for financial markets, they’re positive for stocks and neutral (at best) for bonds.  So arguably as an equity investor, I don’t need to know.

Still, I’m curious.  The best I can do is to fall back on the old saw that inflation is better than deflation, since the world’s central bankers have plenty of experience dealing with the former but have gone 0-for when confronted with the latter.

the Davies answer

Gavyn Davies, former chief economist for Goldman Sachs and now a blogger for the Financial Times, has a better answer in his 9/16 post for the newspaper.  It’s worth reading.

The thrust of the post is that, in Davies’ view, Mr. Bernanke’s QE3 decision implies he believes the US is at a tipping point with the chronically unemployed.

As workers remain out of the workforce, the theory goes, their skills gradually erode–and, with them, their chances of finding new employment.  At the same time, former workers’ enthusiasm for the job search effort also wanes.  Eventually, they drop out of the workforce permanently–becoming unfulfilled as persons, burdens on the rest of society for decades and–crucially–inhibitors of future GDP growth.

Recent surveys by the Labor Department suggest the “dropout” rate in the US is starting to accelerate, putting into motion the downward spiral just described.  In Davies’s view, this is what has changed the balance of risks in the Fed’s mind.

MF Global: the story gets weirder and weirder

MF Global

Man Financial, the trade-processing subsidiary of the UK hedge fund manager, Man Group, was spun off from the parent in 2007 and renamed MF Global.

My take, without having studied the transaction carefully, is that Man Group was trimming away a low-growth, low PE multiple peripheral operation.  Sans MF Global, Man Group would look growthier and presumably achieve a higher PE rating from investors.  MF Global would have a chance to write its own history.  So maybe the separate parts would also be worth more than the whole.

In 2010, the board of MFG hired Jon Corzine, former crack trader, former head of Goldman, former US Senator, former governor of New Jersey (perhaps best remembered for having been in a high-speed auto accident while not wearing a seat belt) to be its new CEO.  His first-year compensation was $14 million+.  The idea was that Corzine would turn MFG into an investment bank like Goldman.

On Halloween 2011, MF Global filed for Chapter 11 bankruptcy, as the financial markets lost confidence in the aggressive proprietary trading strategy Mr. Corzine had crafted.  That’s when–like a train wreck in slow motion–the weirdness began.

investment significance

There may be a certain perverse fascination associated with looking at cases like this (after all, Schadenfreude is a word–or two).  Nevertheless, there is an important investment point as well.

It’s that when a company begins to struggle, the first signs of distress, however awful, are rarely the last.  The trail of bad news is, in my experience, almost always longer than initially expected.  It can also reach destinations never dreamed of on day one.  Therefore, betting that all the bad news is out can be very risky.

what’s come out so far

In this case, what’s happened has been highly publicized (the best account I’ve read of the run-up to Chapter 11 is in Vanity Fair):

–in August 2011, MFG issues bonds that promise to pay a higher interest rate if Corzine were to leave the firm for Washington (rumors suggested he would become the next Secretary of the Treasury)

–in October 2011, MFG declares bankruptcy–undone by Corzine’s aggressive proprietary trading strategy

–a last-minute deal to save the firm falls through because of possible accounting irregularities

–the bankruptcy trustee indicates that up to $1.6 billion in customer money is missing

–the first of many claims of “sloppy bookkeeping” are made by the authorities–the assertion that in an age of ubiquitous, cheap management control software, MFG had no procedures for recording the trades it made.  I’ve got no experience with commodities, but I find this particularly hard to believe.

–the former chief risk control officer, fired after repeatedly warning the Corzine trading strategy was too risky, says he thinks the warnings were a reason for his dismissal.

–Mr. Corzine testifies he has no idea where the missing money is.  Although he’s the CEO, he says he had no knowledge of, or involvement in, the day-to-day operation of MFG.  He names the employee who he says assured him that no client money was delivered to lenders to meet margin calls.

–the named official refuses to answer questions without being granted immunity from prosecution.  Other company executives, including the CFO, say they, too, have no idea what happened to the missing money.

the latest wrinkle

After five months, you’d think that everything about the last days of MFG would already be out on the table.  But that’s not right.

Customers who tried to close their accounts with MFG shortly before the Chapter 11 filing did not receive the wire transfers which they requested and which are the customary way of liquidating accounts.  It’s not yet clear, but it sounds like at some point MFG decided to stop wiring money to customers who closed their accounts but to send checks in the mail instead.

The use of checks has two consequences.

For customers, instead of getting their money through a wire transfer on the same day the accounts were closed, checks dated, say, October 28th arrived only in November–after MFG declared bankruptcy.  Those checks, of course, bounced.  The holders are now unsecured creditors of MFG.

For MFG, check issuance would create in effect a “float” of customer money that it could use for several days–without the same regulatory restrictions on customer accounts–until customers received and cashed their checks.

Lawyers for the clients in question are now approaching the Justice Department with collections of “float” data, which they hope will convince the government that the check issuance was not as innocent as simply shoddy bookkeeping.

is the story over yet?

My guess is that we still don’t know everything.

In my early days as an oil analyst, a veteran geologist told me that wells come in two types–good and bad.  The former continually exceed expectations.  The latter, no matter how far down you ratchet your expectations, somehow manage to still disappoint.

To me, MFG feels like a really bad well.

TVIX: an expensive lesson about an exotic exchange traded note


TVIX is the ticker symbol for “Velocity Shares Daily 2x VIX Short-Term” ETNs (exchange traded notes), sponsored by Credit Suisse.  What a mouthful!

They’ve been in the news recently because of very big losses some buyers of them have suffered.

what it is (hang onto your hat)

An ETN is something like an ETF, except that what the holder is buying is not an ownership interest in a collection of equity securities but rather a piece of a debt security issued by the investment bank that sponsors the ETN.

In the case of TVIX, the debt instrument in question is a promise by Credit Suisse to pay the holder an amount that’s tied to the performance of futures on the CBOE Volatility Index, or VIX.  Although in form the actual note issued by CS is a debt instrument, in function it’s very much like an OTC derivative contract.

The 2x in the name means the ETN is leveraged.  It’s designed to deliver 2x the return on the VIX.

Daily means it’s re-leveraged each day to deliver 2x the return on the VIX.  The significance of this daily recalibration is that the return over longer periods of time can be significantly different than 2x leverage over that span, depending on the sequence of daily gains and losses.

The VIX is a measure of expected volatility, or movement of the S&P 500 index away from the current level–up or down–over the coming 30 days.  It’s calculated based on the prices of near term puts and calls on the S&P.

what happened

ETFs and ETNs typically act like open-end mutual funds.  When new buyers want the securities, the sponsor satisfies demand by issuing more.  When sellers want to redeem, the sponsor cashes them in.

In the case of TVIX, Credit Suisse hedges the risk it takes in issuing the note by maintaining an offsetting position in the actual VIX futures contract. A month or so ago, however,  CS reached the maximum position size allowed by the Chicago Board of Exchange.  When it did, CS stopped issuing new ETN shares.  At that time the net asset value of TVIX was about $15/share.

Over the ensuing weeks, as the S&P 500 meandered, the VIX fell sharply and the NAV of TVIX plunged to about $7 a share.

And here’s the strange part…

…retail buyers didn’t notice. 

They continued to pay $14-$15 a share for TVIX, despite the plunge in value of the underlying note!.   At the worst point investors were paying over 2x NAV!!!   That’s like going to the bank to get change for $20 and being satisfied with $10 in coins.  Who would do that?  From looking at the charts it appears that at least a million shares or so traded at this level of misvaluation.

Then short sellers appeared and the bottom fell out. TVIX, which is trading a bit below $7.50 now, bottomed around $6.

the lesson(s)?

1.  Unlike mutual funds, ETFs and ETNs don’t trade at net asset value.  They trade at whatever price willing buyers and willing sellers meet.

2.  As far as I’m aware there’s no publicly available data on average bid-asked spreads for any ETFs or ETNs.  But the VIX price is available in real time, so it should have been easy to make a rough guess at NAV–and theefore the premium one would be paying.  It’s hard to believe that no buyer did any homework.  The broker acting as an agent in the transaction certainly knew what net asset value was.

3.  The broker you place the order with is an agent.  He has no obligation to tell you you’re doing something incredibly stupid.  (Caveat emptor.  Welcome to Wall Street.)

4.  I wonder who the short sellers were and how they got the idea to sell TVIX short.

5.  Where do you think the stock the short sellers borrowed to sell came from?   …from the accounts of the retail investors who held TVIX and whose brokerage agreements allowed their firms to led out their holdings, that’s where.  Translation:  from just about any retail holder.

According to the Wall Street Journal, which doesn’t seem to get the misvaluation–which I think is the most interesting part of the story–the SEC is investigating.  Why?   …because the shares plunged just before Credit Suisse announced it would begin to issue new TVIX shares.

collective action clauses: Greece’s deus ex machina

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.