Category: Market Action

An unsigned article in the Globe had some interesting quotes from Dr. Robert Schiller:

In early 2000, the Yale University economics professor’s soon-to-become hugely influential book, Irrational Exuberance, was about to hit bookshelves – illuminating the world on how market bubbles form and how they burst. The book essentially foretold the popping of the dot-com bubble only a few months later.

Now, in the aftermath of the second major stock market collapse in less than a decade, Mr. Shiller is again being asked to help explain why stocks have become so volatile.
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Mr. Shiller’s less-than-comforting answer: We’re mostly doing it to ourselves.

“I think it has to do with a different world view that we have adopted. We’re much more of an investing culture, all over the world, really, than we were in the past. There’s much more of an expectation of volatility.”

Mr. Shiller says our mass psychology is much more one of speculation and risk-taking than it was a generation or two ago. We’ve come to rely on rising markets to create our wealth and well-being, at the expense of savings.

With all respect to Dr. Schiller, I can’t help but feel that his judgement is somewhat harsh – or, at least, that part of the judgement that the Globe saw fit to publish.

We are living in an age of profound disruptive technologies. Computers … before 1980 they didn’t have much impact. Sure, mainframes made many things possible that hadn’t been possible in 1960; but they had nowhere near the impact on everyday business that they do now. Telecom … just having cheap telecom is in itself disruptive, and it only started getting cheap in the early 1990’s. Who had a cell-phone in 2000? The Internet … you can say what you like about the excesses of the Tech Bubble, but if you claim that the Internet is not a profoundly disruptive technology I won’t listen any more.

I claim that dayto-day business has been more disrupted in the past thirty years than at any other time in human history. And it seems to me that this will inevitably lead to market volatility. I’ll also note that it probably directly and indirectly allows charlatans to achieve influence in financial markets, but maybe that’s just my personal hobby-horse.

The politicization of corporate finance is picking up steam:

Bondholders with 70 percent of YRC’s $150 million of 8.5 percent notes due in April offered to tender, meeting the required threshold, the company said yesterday in a statement. That’s an increase over the 59 percent that participated by Dec. 29. Holders of 88 percent of all of the company’s outstanding bonds, with a face value of $470 million, participated in the exchange, the company said.

YRC’s $150 million of 8.5 percent notes rose 4.8 cents to 65.1 cents on the dollar yesterday, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“The most difficult bondholders to deal with were investors with credit-default swaps that paid off if the company went bankrupt,” Zollars, 62, said in a telephone interview. “It doesn’t seem right that individual investors would make money against companies surviving, particularly in this economy.”
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The “risk of public rebuke,” along with “even more legislative threats” to the market for credit-default swaps resulting from the bankruptcy of a large employer of organized labor, helped the exchange pass, CreditSights Inc. analyst Sam Goodyear in New York wrote in a report yesterday.

Hoffa said the YRC debt exchange marked “our first time doing a campaign like this where we really had to get into high finance.”

“It’s a new breakthrough for labor unions working on Wall Street to make something happen,” Hoffa said yesterday. “It’s very positive for a major company.”

There’s not enough detail in the story to take a view: maybe the exchange offer was simply a good deal; maybe CDS prices and physicals were aligned so that the CDS writers had incentive to do asset swaps with holders of physicals and then tender; maybe – as I think happened with CIT – prices aligned so that writing protection was hugely profitable for the banks, who then had extra incentive to work on the tender; it could be a lot of things.

More interesting, though, is the role of organized labour, particularly in view of GM’s sweetheart deal. Extrapolate these trends long enough and maybe you’ll eventually have mid-size companies courting the unions in order to have more political clout when things get dangerous!

In highly surprising news, artificial government inspired demand has caused prices of senior sub-prime tranches to jump:

Only months after it was started, the U.S. program designed to purge debts of no immediate discernable value from the balance sheets of troubled banks has helped transform the frozen debt into a money-maker as the bonds have rallied. Bank of America Corp. and Citigroup Inc., who received 22 percent of the $418.7 billion American taxpayers loaned to troubled financial institutions, boosted holdings on their trading books of home- loan bonds that lack government guarantees while investors were raising cash for the program, according to Federal Reserve data.

Charlotte, North Carolina-based Bank of America along with Citigroup, Morgan Stanley and Goldman Sachs Group Inc., all based in New York, added a combined $2.74 billion of the debt, for which there were few buyers as recently as March, to their short-term trading assets during the third quarter, up 13 percent from the second quarter, the most-recent data show.
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Prices for some of the securities that the funds were supposed to buy have almost doubled since March. The rally was fueled in part by traders jumping in before PPIP funds could get off the ground, said Steve Kuhn, who helps oversee about $440 million of mortgage-bond investments for Pine River Capital Management LLC in Minnetonka, Minnesota.

“Anytime people know there’s a buyer coming, they position for that, and that’s clearly what happened here,” said Kuhn, who is co-manager of the Nisswa Fixed Income Fund.

In between a motivated buyer and a motivated seller … how’s that for a trader’s dream?

The new year got off to a roaring start, with PerpetualDiscounts up 33bp and FixedResets gaining 10bp, taking the yield of the latter down to 3.57%. Volume was moderate.

Update: Assiduous Reader prefhound writes in and says:

I am quite fond of Prof Shiller (no “c”) and irrational exuberance. It was he and his database that taught me the basics of long run rational stock market return expectations as the sum of Dividends + Inflation + Real EPS Growth + Changes in P/E. The reason we can’t expect the 10% returns of the 20th century from stocks are than Dividends are now 2% not 4+% and we can’t reasonably continue to expect the P/E to grow by 1% per year.

Thus, the forward outlook for gross stock returns BEFORE fees is 2% yield + 2% inflation + 1.6% + 0 = 5.6%. That is a big problem for pension plans and the CPP (which assumes more like 7+%). AND it is a great opportunity for taxable pref share investors and prefblog! Who needs stock volatility when you can get the same return with lower volatility from discount prefs and augment it with sensible switching trades?

Anyway, I mention rational expectations as a forward to another reason why I respect Shiller: the long run Real EPS growth rate does not fluctuate very much and did not fluctuate hugely around innovations like computers etc that you mention. Indeed, early innovative companies were not that profitable until recently. Competition ensures that ROE on a national scale does not vary due to innovation in the medium to long run. P/E might (and did — skyrocketing from 7.5 for the S&P-500 in 1979 to 35 in 2000).

With respect to volatility, Shiller may be right about the short-term casino-like behaviour being more common today, but I don’t see any effect on volatility. The recent credit crunch saw VIX (S&P-500 index volatility) rise to similar levels as in the 1987 crash and ease off. Volatility itself fluctuates over time (which is why there are derivatives on VIX): long run Vix data for 24 years doesn’t show a gradual decline or increase — it shows periods of spikes, mounds and retreats — and it is mean reverting. [It is hard to check out CBOE data which currently goes back only to 1990, but the old VXO precursor started in 1986 — I have an older CBOE spreadsheet with it. Even since 1990 you can see the same picture — but the VXO levels went as high as 150 on Oct 19, 1987].

Secondly on the volatility side, I’m not sure about the strength of the seemingly attractive argument about more casino-like behaviour being the “cause” of “extra volatility” not even observed.

My sense is there is more trading volume than their used to be (turnover), but that many buys are broadly matched by sells (by funds and other institutional investors, for example). As John Bogle, founder of Vanguard, often notes — weve gone from individual stock owners to mutual fund owners over 40 years. Mutual fund owners don’t change their asset mix that rapidly to affect market volatility. When they switch from Fund A to Fund B so their “advisor” can continue to receive a trailer fee there is no net buying or selling to affect market volatility.

My guess is that the “herd instinct” is as alive and as operative in amateur and professional investors alike as it ever was, and that explains why volatility is more or less the same as it has been for (at least) 25 years of the VIX.

Indeed, using Shiller’s database of 140 years of S&P monthly average data, one can show that the average annual volatility has no discernible trend over a much longer period – other than frequent spikes (see figure). Let’s not lose the forest for studying one tree in detail!

[Note: To get volatility of a magnitude comparable to VIX (which uses daily data), multiply the standard deviation in this figure by about 2.5]

I’m not sure if you and Prof. Shiller and I are all talking about the same “volatility”. VIX is a measure calculated daily using option data; I think Shiller’s comments relate more to boom-bust cycles and their frequency and severity.

Update 2010-1-6: prefhound points out that I didn’t reproduce his chart:

Click for big

… but I must say that I am not a big fan of standard deviation as a measure of volatility. Not for this kind of stuff, anyway.

James Hamilton of Econbrowser has an excellent post on the Fed and the proposed term deposit facility:

We sometimes describe fiscal policy as determining the overall level of the public debt, while monetary policy determines the composition of that debt between money and interest-bearing federal obligations. By that definition, the Fed has clearly now entered the realm of implementing fiscal policy, by issuing debt directly in the form of interest-bearing reserves, reverse repos, and now term deposits.
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But I fear that as this marriage between fiscal and monetary policy becomes consummated, an amicable divorce is not the most likely outcome.

My advice would be the sooner the Fed can return to plain vanilla central banking, the better.

I have heard reports that driving in the country has become a process of counting windmills … but I have my own way of counting. Say a standard wind farm has the following specifications:

The facility is expected to be completed in one year at a cost of CA$285 million, and will generate 300 GWh of wind energy a year from 43 Siemens 2.3 MW turbines.

So each turbine costs about $7-million bucks and generates about 7.5 GWh electricity per year. Ontario will pay 13.5 cents per kWh for on-shore wind. A profligate energy user (i.e., somebody who uses a toaster while the kitchen light is on) will pay 6.7 cents per kWh. So the loss to Smitherman’s ex-ministry is … call it 7 cents per kWh … and remember, we have assumed that transmission and administration is free, never mind the fact that wind power needs back-up plants built, and will accrue extra costs as this back-up switches on and off.

So, a loss of 7 cents per kWh on 7.5GWh annually is … um … carry three … 52.5 megacents per annum; in more familiar units, over half a million bucks. Enjoy the view! And remember – it’s not just empty-headed feel-goodism … it’s also an exciting new class of parasitic pseudo-industry creating jobs for pseudo-entrepreneurs!

The US Municipal Bond Insurance market is still trying to find its feet:

Insured bonds reached a peak of 57.1% of new issuance in 2005, but as most insurers were downgraded after they unsuccessfully ventured into the hazardous territory of structured finance, that number dwindled to just 8.7% this month, according to Thomson Reuters.
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But responding to claims that the insurance market has a much-diminished future, Dominic Frederico, chief executive officer of Assured Guaranty Ltd., has a pretty simple reply.

“If there are naysayers, I would say, ‘Okay, then: explain my third quarter,’ ” he told investors in a conference call last month.

Assured, which operates the only two legacy insurers to have made it through the recession with investment-grade ratings, saw operating earnings — excluding net-realized investment gains and losses — jump to $70 million last quarter, compared to $26 million in the third quarter of 2008.

Preferred shares closed the year strongly on light volume, with PerpetualDiscounts up 26bp and FixedResets gaining 13bp.

PereptualDiscounts closed yielding 5.85%, equivalent to 8.19% interest at the standard equivalency factor of 1.4x. Long Corporates closed yielding 6.0% – maybe just a hair over – so the pre-tax interest-equivalent spread (also called the Seniority Spread) is about 220bp, a slight tightening from the December 16 and November 30 figures of 225bp.

Pop quiz! What do the securities and airline industries have in common?:

If these customers can’t use laptops or wi-fi and have to waste half their day going through security, they may abandon airlines at a faster rate than they are already, turning instead to modern business tools such as the web and teleconferencing, Kokonis said. Over the past year, he added, international premium flights were down 30 to 35 per cent.

What makes this even worse, [Robert] Mann [president of R.W. Mann & Company Inc., a consultancy in Port Washington, N.Y.] said, is that most in the industry realize new security measures are essentially political moves aimed at assuaging the public.

“It’s security theatre,” Mann said, noting that “there are a lot of us in the business that roll our eyes when these things happen.”

CIBC has issued covered bonds:

Series CB3 (CHF 375 million) covered bonds have a coupon rate of 1.75% and a maturity date of January 30, 2015. Series CB4 (CHF 300 million) covered bonds have a coupon rate of three-month CHF LIBOR plus 0.1% and a maturity date of December 30, 2011.

Swiss Government 5-years (there must be a cool name for them!) are now yielding 0.16%. Three month CHF LIBOR is 0.25%.

The last Canadian 5-Year NHA MBS auction was on October 16 with an average yield of 3.268%, as part of the Insured Mortgage Purchase Plan. Five year Canadas averaged 2.71% in October.

Preferred shares got on the up escalator today, although volume remained seasonably light. PerpetualDiscounts were up 31bp, while FixedResets gained 22bp, taking yields down to … 3.59%!

PerpetualDiscounts now yield 5.86%, equivalent to 8.20% interest at the standard equivalency factor of 1.4x. Long Corporates are now a hair over 6.0%, with a total return of -1.63% on the month-to-date, so the pre-tax interest-equivalent spread is now about 220bp, slightly tighter than the 225bp reported on December 16, but still wider than “Credit Crunch Normal” of 200bp and far above the long-term range of 100-150bp.

The boo-hoo-hoo crowd was in full cry December 24, with Dealbook exposing the revelation that Goldman Sachs occasionally trades as principal:

Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.

Goldman’s own clients who bought them, however, were less fortunate, Gretchen Morgenson and Louise Story write in The New York Times.

Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.
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While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.
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Michael DuVally, a Goldman Sachs spokesman, declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.

The last paragraph says it all, really, and Goldman’s response was not necessary. Who are the investors? Were they prudent? Did they do due diligence? Did they merely have the misfortune to have A SMALL PART OF THEIR PORTFOLIO caught up in the train wreck? The ever-so-diligent reporter at the New York Times doesn’t bother even to ask such questions. It’s simply boo-hoo-hoo, a client bought something and it went down, it must be the seller’s fault.

The biggest danger the capital markets now face is over-regulation (as alluded to in a speech by John Taylor). Until performance becomes a serious consideration when placing assets for management (with risk firmly in mind at all times) and Portfolio Managers as a group start taking responsibility for their performance (which they certainly don’t want to do), we will keep seeing this friction … which basically means, until human nature changes.

There are some complaints that the Financial Crisis Inquiry Commission is making it stretch. I have no doubt but that there will be a star-studded roll of witnesses and some first-rate data collected … just how objectively that data is turned into recommendations will be another thing entirely! I think it entirely likely that regulation will become so stifling that a huge wave of hedge funds forms to compete with the banks at the margins, taking the old-style merchant-banking partnerships and trading houses as their models.

There is, surprisingly, some difference of opinion on the future course of 10-Year Treasury yields:

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York.
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Ten-year notes will end 2010 at 3.97 percent, according to the average of 60 estimates in a Bloomberg News survey that gives greater weight to the most-recent forecasts.

Edward McKelvey, senior economist in New York at Goldman Sachs Group Inc., the top-ranked U.S. economic forecasters in 2009, according to data compiled by Bloomberg, expects yields to drop to 3.25 percent.

Forecasting is a mug’s game.

A massive financial industry investment in the UK may be reconsidered:

Jamie Dimon, chief executive, made the coded warning to Alistair Darling in an angry phone call after the Government revealed its 50pc super-tax on bonuses in the pre-Budget report. Although Mr Dimon did not explicitly threaten to can the 1.9m square foot Docklands development, he pointedly used it to demonstrate the bank’s commitment to London.

When JP Morgan bought the land for £237m in November last year, it wrote into its contract with Songbird Estates, the owner of Canary Wharf, an option to pull out. A decision has to be made before the option expires by the end of 2010.
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Bankers say regulatory pressure and the shifting tax regime have made Britain a far less attractive place to do business. International banks, which assess where to place their capital at the end of every financial year, now plan to scale back investment in the UK. Even Paris, which has introduced a watered-down version of the super-tax on cash bonuses alone, is stealing a march over its traditionally superior rival, London.

It was a quiet day for preferreds, with not much volume or price volatility. PerpetualDiscounts gained 7bp, while FixedResets gained just under 5bp.

California’s in trouble:

The state also has struggled to implement cost-cutting measures that were part of the $85 billion spending plan approved in July. Courts blocked part of the budget that cut funding for home care for the disabled and another part that borrowed $800 million from an account that sets aside money for local transportation agencies.

An accounting error means the state has to spend almost $1 billion more on schools than budgeted. Officials also underestimated the cost of health care for the poor by $900 million, and lawmakers failed to pass legislation to realize $1 billion less in anticipated prison spending.

Combined, the state faces a $6.3 billion gap in the current year and another $14.4 billion in the next.
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Democrats, who control both chambers of the Legislature, are expected to oppose wholesale cuts to health and welfare programs. Such resistance, along with Republican opposition to tax increases, will be exacerbated as election-year politics heightens the partisan divide. Half of the state’s 120 Assembly and Senate seats go before voters in November.

The basic problem is gerrymandering:

I’d place California’s ridiculous two-thirds majority vote requirement for budget passage higher on the list of culprits that create gridlock. But I wouldn’t argue with Schwarzenegger’s thesis: Gerrymandering tends to reward extremism in both parties and punish compromise, locking lawmakers into ideological corners.

Districts were shaped to be “safe” for either a Democrat or a Republican. As a result, the real election battles have been waged in the party primaries. And since low-turnout primaries normally are dominated by party purists, the contests usually have been won by candidates who run the furthest to the left or the right.

Republicans pledge not to raise taxes. Democrats promise a laundry list of social programs the state can’t afford.

Then they come to Sacramento and can’t compromise.

Without wishing to be overly dramatic, it is this sort of legislative impasse that has enabled many dictators in the past to come to power – most famously, Julius Caesar.

The markets closed early today, in order that members of the most highly paid profession on the planet will have additional opportunity to bark at counter-clerks and restaurant personnel who have to work. Me, I’m just going to put my feet up and sneer at the unemployed.

In the spirit of Christmas, the TSX has not yet made closing data available, despite the fact that the market closed three hours ago. I will update the indices … later.

…later: A quiet day, with PerpetualDiscounts basically flat at FixedResets losing (yes, losing!) 4bp.

Volume held up today, as PerpetualDiscounts slipped 14bp but FixedResets continued to defy gravity, gaining 3bp to take yields down to 3.66%.

So much for the Christmas lull! Trading was heavy today and PerpetualDiscounts were down 14bp, while FixedResets were up 13bp as investors realized that a lot of the product available was not the YPG.PR.D new issue.

Goldman is burnishing its credentials as the toughest dealer on the Street:

Goldman Sachs has threatened the UK Treasury with plans to move up to 20 per cent of its London-based staff to Spain in a standoff over tax and bonuses.

It’s believed that the Wall Street investment bank, which paid more than £2bn to the Exchequer’s ailing coffers in corporation tax alone last year, has fired a warning shot across the Government’s bows in response to the tax measures unveiled in the pre-Budget report earlier this month.

Goldman Sachs International was the biggest contributor from the financial services sector to Britain’s purse last year. Previous reports suggest that in some years the firm’s staff have contributed more than £1bn in personal income tax to public coffers.

PerpetualDiscounts were off today, losing 8bp, but FixedResets just kept on keeping on, gaining 6bp on good volume. How Low Can They Go?

Deutsche Bank is marching to a different drummer – worrying about competition, of all things!:

Deutsche Bank AG, Germany’s biggest bank, plans to spread the costs of the U.K. bonus tax to all employees worldwide, risking a backlash from bankers outside of London.

Chief Executive Officer Josef Ackermann, in an interview with the Financial Times, said the bank wouldn’t restrict the cost of the tax to the U.K. bonus pool.

“We will clearly globalize it,” Ackermann said. “If parts are paid out of the bonus pool, we would seek to globalize it. It would be unfair to treat the U.K. bankers differently.”
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Ackermann told the Financial Times today that governments shouldn’t interfere in setting pay, saying bonuses should be the result of “supply and demand for skilled people.”

The Federal Reserve Bank of Cleveland has published the December edition of Economic Trends. The article on “Supply and Demand Shocks in Residential Mortgages” was interesting, although not noteworthy enough to merit a dedicated post.

A solid, though hardly spectacular, day for preferreds today, with PerpetualDiscounts up 9bp and FixedResets gaining 3bp. This is the eighth consecutive day of gains for FixedResets and they’re up about 78bp on the month-to-date. Volume was good; it should slow down next week, but the pending settlement of the YPG new FixedReset should give the traders something to do.

PerpetualDiscounts took a hit today, losing 15bp, but FixedResets just kept on keeping on, up 8bp to close with a weighted-median-average YTW of 3.68%. How Low Can They Go? Volume was moderately good.