Wednesday, April 7, 2010

1st Qtr 2010 Review and Imploded Volatility


The first three months of 2010 have come and gone and not much changed from the momentum and liquidity driven market of 2009. Volatility continues to hit lower and lower levels while the S&P 500 seems unstoppable toward that 1200 level which, when broken to the downside in 2008, ushered in an almost terminal stroke to our financial system.

In the first quarter, the S&P 500 benchmark produced a net gain of 4.84% while the Volatility Index (VIX) collapsed almost 20%. Among other benchmarks we follow, gold in its ETF format (GLD) put on a positive 1.53% and our beloved MLP sector roared ahead by 6.22% (AMZ index).

The equity market did have a sizable yet incredibly short lived correction which started – in full accordance with seasonality – in the second half of January. This 9% correction stopped short of the traditional 10% pull-back mark and a bit short of the 200 day moving average and produced yet another V shaped rally which took the indexes to new relative highs.

This rally has made stocks not so attractive on a fundamental basis. Discounted cash flow models such as the Morningstar Fair Value model are now oscillating between overvalued and fair valued. Also, the general rise in Treasury yields is not helping valuations as fixed income becomes more attractive and valuation multiples like P/E ratios tend to shrink in a rising interest rates environment.

Most sentiment driven indicators are now in overbought mode; the percentage of stocks above the 50 day moving average and most Put and Call ratios for instance. On the other hand, one input which indicates smooth sailing ahead was highlighted by Bloomberg today: only 28% of operating profits are now spent in buybacks (2009 numbers) by companies in the S&P 500, and the last time we saw such a low levels in buybacks equities rallied for four years.

The “risk trade” is on for most asset classes, except the Treasuries. When one looks at the 10 month moving average cross-over indicator US equities, global equities, commodities and real estate are all above the average and therefore in long term buy mode. However, 10 year Treasuries are on sell mode.

On the fixed income side, we happen to agree with PIMCO, and we favor inflation protected securities in countries with large deficits and traditional sovereign debt in surplus countries. In light of this analysis, we repositioned many accounts and increased exposure to inflation protected securities (via TIP) and German sovereign debt (via closed-end fund RCS whose largest single position is a 2015 German Sovereign bond).

In the emerging markets space, we still like Brazil and we still think this is the better place to be in the long term out of the BRICs. Brazilian fixed income is also very attractive but we have no positions in it at the moment.

The US Dollar also increased since the beginning of the year by almost 4% (DX). One of the biggest relative losers was the EUR which shed about 6% thanks to, among other reasons, its inability to produce a crisis management protocol to deal with situations such as the Greek farce. We think the EUR is still a sell but are careful at this level since the short position is dramatically large. We did not trade the EUR particularly well this past quarter and while our thesis was correct, our execution tried to be “too cute” and our attempt to trade on a short term basis the long side inside our core short position unfortunately backfired. We are not so hot about the Yen either as we think that Japan will continue to keep rates low while the US may be more proactive in normalizing.

On the commodity side, as mentioned earlier, the 10 month moving average indicator triggered a new buy signal confirmed by break-outs in crude and copper. This may reflect that inflation is starting to creep into the equation. TIPs anyone?

--Davide Accomazzo, Managing Director
(This article was written on April 5, 2010)

Hamilton and Minsky's Instability Hypothesis

"Men often oppose a thing merely because they have had no agency in planning it, or because it may have been planned by those whom they dislike." ~Alexander Hamilton

Almost exactly two hundred years before Hyman Minsky published his paper The Financial Instability Hypothesis in 1992 (the relevance which will become apparent), a blind pool[1] known as the “six percent club” was engaged in the first market corner in the history of the United States. According to traditional accounts,[2] the Panic of 1792 was caused by the scheming and operations of William Duer, a well-connected businessman and speculator, who had recently resigned from his brief post as assistant secretary of the treasury of the newly formed country.

It all started when Treasury Secretary Alexander Hamilton put into action a plan to buy at par value the millions of dollars in promissory notes that the bankrupt Continental Congress and state governments had issued to soldiers, farmers, and other’s who had supported the Revolution. Duer, who combined government service with a passion for quick profits, leaked word to his fellow “grandees” that Hamilton intended to consolidate these debts with federal debt. Recognizing Hamilton’s plan as a way to make a killing, agents of Duer’s secret circle were soon galloping across the countryside buying up state paper at a few cents on the dollar.[3]

As a homily to the present-day bailout of the financial system wherein information asymmetry has become a recurrent headline about the markets,[4] Duer’s anecdote has some interesting parallels were it to end here. This brief episode, however, set in motion a series of events which ultimately led Hamilton to invent what in time would be termed Bagehot’s rules[5] for how a central bank should act in a crisis some [eight] decades before Walter Bagehot “rediscovered” them.[6]

In December 1790, Congress adopted Hamilton’s recommendations.[7] Old evidences of debt were already being exchanged for new federal debt in the form of 6% bonds, 6% deferred bonds and 3% bonds starting in October 1790.[8] These bonds were soon trading on America’s first “stock” exchange under a buttonwood tree at the foot of Wall Street. Hence, it was these very same events which presaged the origins of the New York Stock Exchange when twenty-four New York City stockbrokers and merchants signed the Buttonwood Agreement in 1792.

Around this time Hamilton had also called for Congress to incorporate a Bank of the United States capitalized with 25,000 shares of $400 par value each.[8] Noting that speculation was already brisk in federal 6% notes, Hamilton attempted to check a similar fever in the Bank’s stock by requiring $100 in specie[9] along with $300 in new United States debt securities. However, “Congress, already demonstrating an eagerness to please as many people as possible,” reduced the opening payment to $25 for a scrip”[10] which effectively served as a subscription right.

The initial offering took place on July 4, 1791 and was heavily oversubscribed. In five weeks the value of scrip soared reaching 264 bid-280 ask in New York and more than 300 in Philadelphia before tumbling. The so-called “U.S. sixes” rose from 90 at the time of the Bank’s offering to 112.50 on August 13th before falling to 100 by August 17th. In response, Hamilton convened a meeting of the Commissioners of the Sinking Fund which authorized open market purchases of U.S. debt. Working through various agents, Hamilton restored confidence by supporting the bond market.[8]

It turns out that the mini-panic of August 1791 served as “a trial run for the crisis-containment techniques Hamilton was to employ during the more serious price collapse in March-April 1792.”[8] In fact, Hamilton’s actions in 1791 illustrate the mixed blessings of crisis management in that his response may have encouraged the speculative bubble that followed. Almost two centuries later Alan Greenspan responded similarly to the stock market crash of 1987 as well as subsequent crisis during his tenure. As been argued, by coming to the aid of the market and creating the notion of a “Greenspan put,” the moral-hazard problem may have sowed the seeds of our current crisis.

This is where Minsky enters the picture. A little over a decade ago, the term “Minsky moment” was coined to describe the Russian debt crisis in 1998 which proceeded the fall of Long Term Capital Management. Minsky observed “that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control.” The Minsky moment occurs after a long period of prosperity in which debt is increasingly used to finance investments, in turn causing the value of assets to rise, which reflexively encourages speculation using borrowed money. At the point when investors’ cash flow no longer supports debt, a major selloff begins leading to a precipitous collapse in asset prices and market liquidity.

Theoretically, one could link the current financial crisis to a Minsky moment caused by the failure of two Bear Stearns hedge funds circa June 2007 resulting in the “reverse Minsky journey”.[11] The irony is hard not to miss in the following passage of Minsky’s paper:

Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities… For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts... Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts. [Bold added]
As Minsky points out, if authorities attempt to exorcise monetary constraint in “an economy with a sizeable body of speculative financial units… then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate.” Notwithstanding the obvious inference to the Madoff affair, the Oracle of Omaha, Warren Buffet, concisely summarized that, “Only when the tide goes out do you discover who's been swimming naked.”

The common factor distinguishing the difference between Minsky’s hedge, speculative, and Ponzi finance units is liquidity. Liquidity is conventionally defined as, “the ability of an asset to be converted into cash quickly and without any price discount”.[12] It has been said that the root of the current liquidity crisis is a lack of confidence—confidence basically disappeared and liquidity evaporated. But this behavioral observation is both simplistic and obscures turnkey concepts.

The exchange of money involves a valid and legal offer of payment for debts when tendered to a creditor. A debtor who is unable or unwilling to meet the legal obligations of a debt contract by not making a scheduled payment is said to have defaulted. In a very narrow sense, legal tender is a form of payment that, by law, functions in the settlement and discharge of debt. “There is, however, no Federal statute mandating [a person] must accept currency or coins as for payment for goods and/or services.”[13] A case study in non-payment is the recent default by debtor Tishman Speyer Properties on the Peter Cooper Village and Stuyvesant Town complex in Manhattan.

In 2006, Tishman Speyer headed a venture to acquire the 11,000 unit property for $5.4 billion—the most ever paid for a residential property in the U.S. Of that price tag, Tishman Speyer only invested $168 million; however, CalPERS, Church of England, Hartford Financial and even the Government of Singapore are in danger of having their investments wiped out. The venture’s acquisition was controversial to begin with as plans were to raise rents in the middle-class haven. The strategy backfired because of the economy and a court ruling which prevented conversion of rent-controlled units to market rates. As a result, the property depleted what was left in its reserve funds.[14] Tishman Speyer, having been closed out of the capital markets, essentially faced a liquidity crisis from a levered deal which could not be supported by the property’s revenues from rentals.

William Duer also faced a liquidity issue in March of 1792. After Hamilton intervened in 1791 by purchasing “U.S. sixes,” confidence was quickly restored. However, rather than learning his lesson, Duer and other members of his speculative “company” borrowed large amounts of money and rapidly drove up securities prices during the latter half of 1791. When Duer finally defaulted in 1792, it caused a contagion of defaults and panic selling. In response, Hamilton began “a series of lender-of-last resort operations that would last for several weeks as the panic went on”.[8]

- Mack Frankfurter, Managing Director

Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.

Fleming, Thomas (2009). “Wall Street’s First Collapse.” American Heritage Magazine, Volume 58, Issue 6.

Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life.” Harper Perennial.

Lahart, Justin (2007). “In Time of Tumult, Obscure Economist Gains Currency.” WSJ (August 18, 2007).

Madison, James. “The Federalist No. 44, Restrictions on the Authority of Several States.” (Jan. 25, 1788).

Markham, Jerry W. (2001). “A financial history of the United States.” Armonk, N.Y.: M.E. Sharpe.

McCulley, Paul (2007). “A Reverse Minsky Journey.” October 2007.

Minsky, Hyman P. (1992). “The Financial Instability Hypothesis.” Working Paper No. 74, The Jerome Levy Economics Institute of Bard College, Prepared for Handbook of Radical Political Economy, edited by Phylip Arestis and Malcolm Sawyer, Edward Elgar: Adershot, 1993.

[1] A “blind pool” is an investment vehicle that raises capital from the public without telling investors how their funds will be utilized.

[2] According to Cowen, Sylla and Wright (2006), “Although specialists in financial history have known of the 1792 panic for decades, at least since Davis (1917) explored it in some detail, it did not make a strong impression on others.” Further, “The traditional account is not incorrect, but it is incomplete. Other events were unfolding at the time that are ignored or slighted in the traditional account.”

[3] Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6. See also: Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life,” HarperCollins.

[4] Information asymmetry encompasses “insider trading” (eg, indictment of Galleon Group founder Raj Rajaratnam); and “front-running” (eg, trading ahead of customer orders, trading ahead of research reports, etc.)

[5] “[T]o avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at ‘high rates.’” Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.

[6] Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.

[7] Knowledge that the new federal bonds could also be used at par to subscribe for three-fourths of the cost of a share in the Bank of the United States was officially made public in the Bank Report of December 13, 1790.

[8] Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.

[9] Latin phrase. It is used to indicate that distribution of an asset will be “in its actual form,” rather than cash.

[10] Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6.

[11] Term “reverse Minsky journey” is attributable to Paul McCulley of PIMCO, “A Reverse Minsky Journey,” October 2007.

[12] “Glossary of Terms”, Federal Reserve Bank of St. Louis, September 2009

[13] U.S. Department of Treasury,

[14] Wei, Lingling and Spector, Mike. “Tishman Venture Gives Up Stuyvesant Project,” WSJ (January 25, 2010).