The Thing from another market!
Posted on September 3, 2007 by Richard Beddard
Filed Under Markets |
The stock market is infected by fear and paranoia from the lonely wastelands of the debt market. But if it’s fear of the unknown that’s causing the panic, we need to face it, not run blindly.
I’m starting this blog with a quote from a press release from Fisher Investments. But first, to explain the picture, masterful though he is, that’s not Ken Fisher on the left. At least, last time we met he wasn’t green and calloused. In my version of ‘The Thing’, Ken is the fearless hero, The Thing is debt, and many of us are experiencing emotions ranging from complacency to concern, confusion, and blind panic. A bit like the other characters on the DVD cover.
In his press release Ken, says mortgage defaults in the US simply aren’t big enough to derail the economy:
Fisher believes, like many corrections, the recent market movement has been fueled by the market’s inability to properly scale the magnitude of current circumstances. Recent default rates in the US sub-prime mortgage markets have been about 5% and there is a total of $1.3 trillion in sub-prime mortgages. Even if the default rate rose dramatically from 5 to 20%—which Fisher views as unlikely—the result would be $260 billion in defaults. Although in absolute terms that number is large, when put within the proper context of the $13 trillion US economy, the sub-prime market lacks the weight to bring this bull market to an end even in a worst case scenario. Further, supposing the US experiences 5% nominal growth this year, the worst case scenario would simply slow growth 40%—to 3%—not halt or reverse growth.
Taken with his view on credit spreads, published on the Interactive Investor mothership last Thursday, he makes the case for an impressive rally this autumn. He says the spread between the Merrill Lynch US Treasury and Merrill Lynch US High Yield (B) indexes, which he uses as proxies for high and low quality intermediate 7 to 10 year debt, has returned to normal after a period when spreads were outrageously small. If this was a real credit crunch, the yield on risky debt would be much realitive to treasuries, because investors would require a higher return to compensate them.
This is the first time I’ve quoted from a press release in this blog, though I receive more press releases than spam. Usually they’re opinions you read everywhere else, opinions that you can’t learn from because they’re bereft of fact. Ken, on the other hand, gives us spreads and scenarios to track*1. Spreads of around four per-cent are normal he says. Six, seven, eight per cent and we’re in a crisis territory, if past crunches are anything to go by. Even if he’s wrong, and the market tanks, we learn what works, and what doesn’t, by following his analysis.
Assuming debt is not significant to the overall economy, why the panic? I got a little insight in Starbucks last Thursday, where I was meeting Tim Price, a private banker and author of ‘The Price Report’, a newsletter. We met to discuss financial blogging, which is big in the USA, but has yet to really take off here. Tim’s a blogger, and I suspect we’d both like to change that. But, being investors first, the conversation soon turned to the markets, and The Thing.
Sadly, I haven’t seen the film. I don’t need to, because Tim’s blogging about it too, and he has seen it:
A dozen Americans are assailed by an extraterrestrial with the ability to change shape at will. Because the alien can easily imitate human beings, pretty soon the atmosphere of tension, mutual distrust and paranoia becomes almost unbearable. As the small band gets whittled down further and further, self-preservation wins out over camaraderie. As helicopter pilot MacReady comments in a diarised recording to tape,
“Nobody.. nobody trusts anybody now, and we’re all very tired.. there’s nothing more I can do, just wait..”
He makes this observation:
‘The Thing’ bears further comparison to current markets in that the carnage is unbelievable.
I could probably overdo his analogy, but its easy to see how lack of knowledge and fear of the unknown breeds paranoia and panic. What’s a less obvious to the outsider is why institutional investors should be fumbling around in the dark. Yes, the toxic debt festering at the heart of the crisis is complex, but they created it.
It’s probably the fault of financial journalists that we think of The City is a monolith. In fact it’s made up of countless specialists, and often they’re remarkably ignorant of each others specialities. There’s no guiding hand, just Adam Smith’s invisible hand, with the market’s propensity to overreact. Rumours and suspicions are passed by word of mouth, instant messaging, and terminals. I can see how the City could be as effective an environment for fear to propagate as the Arctic. Especially now…
Being a private investor, not a City boy, I’m fairly insulated from the paranoia, in my own tent say, some miles from the Arctic base. I hear about trouble on the radio, but feel quite cozy with my rations. I meet investors like Ken and Tim only occasionally on supply runs to base.
Listening to Tim recount fears that a substantial British bank will go under*2 and learning that some portfolio managers are considering spreading their life savings across a number of banks, suddenly the debt crisis took on mythical proportions. I must have exclaimed at some point, because we both laughed when we realised, I had been touched by The Thing.*3
Footnotes:
- I have yet to find a site that quotes 7-10 year high yield bond yields, so please tell me if you know one.
- For more on the problems facing banks, see Ceri Jones’ survey of the investment banking industry, to be published here on Wednesday.
- I don’t mean Tim. He’s even better looking than Ken, if that’s possible.
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8 Responses to “The Thing from another market!”
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Lol, funny Richard.
Personally I think the market is going to take quite the hit for fundamental reasons, not because of fear.
Britain, with the most greatest population density on the planet, has more support for housing prices because of scarcity of land. I couldn’t believe how constant the lights are when you fly over Britain at night. For that reason I would expect less price corrections in your housing market relative to wages.
The US on the other hand had a supply shortage of housing that enable prices to go up so much because of the time constraints for developing land and due to people jumping into the market for speculative reasons. There is a glut of extra housing in the US market and there is vast amounts of relatively cheap land for new development so people’s perceived wealth will decline as the housing market corrects downward.
That construction boom fueled jobs and spin-off jobs and there are huge layoffs in the industry happening. Everywhere the money those people were making was circulating in the economy is going find margins squeeze as these displaced workers HALT spending. Others who find their household balance sheet wealth decline will cut back on spending as well.
In the US the dollar as gotten weaker. That means the cost of those cheap imports go up in price, so there will be a higher level of inflation, but wages are stagnant for those still working. Household budgets simply have to be squeezed, which puts pressure on business and they see their leveraged margins decline — they will decline more rapidly than the degree of reduced spending because of leverage. Business margins will be squeezed on both sides, by cost increases from imports and by consumers cutting back on spending. It will be easy to see a company with a P/E of 20 today to increase to 30, or 40 or 50 over the next year or two.
More people will lose their jobs because of these squeezed margins, and so the cycle goes…
And to further get my point across, this is my reaction to the economy.
If anything, I ought to be someone with a higher level of spending — I am part of a professional working couple with no kids to support. I was looking at the past year’s finances and the extra income we had that we do not expect this year and I was stunned at how far it did not go and I experienced huge financial stress over it.
All of sudden I’m thinking about how I can save money and basically cut spending. And then I’m stressing over how much my mortgage is going to go up when the rate re-sets next year. Right now it is looking like perhaps a 3% higher rate, which will increase payments by 15% or lengthen the mortgage by 18% (two years). And looking at that makes me want to reduce spending even more and try to pay down the mortgage as much as possible this year.
I think that this is the economic reality for many households, and that will play out by squeezing margins in the greater economy.
Were Countrywide considered sub-prime lenders, or for that matter some other lenders who got themselves into trouble? To pin everything under the label of sub-prime enables you do do some number crunching as to the size of the sub-prime problem, but to do so is making a faulty assumption in assuming the problem ends there.
Hi Deborah, and Daniel.
Thanks for your comments. Deborah, you depict a credible scenario. It might happen, the question is to what extent, and whether it will happen now. I guess, what I’m trying to do is form an opinion on when a variant of your story happens (or something else entirely) - ‘the big one’ using Ken’s tools primarily as a way to measure the state of the market.
Daniel, the fact that America’s biggest mortgage lender is in trouble is worrying. It sold subprime mortgages, and so-called piggy-back loans. This from the LA Times:
“Beginning in 2004, it stepped up its origination of two products: sub-prime mortgages (made to borrowers with poor credit, minimal down payments or both) and home-equity lines of credit.
Many of the latter were “piggyback” loans at fixed interest rates to cover all or much of a borrower’s down payment, thus bringing the total mortgage close to 100% of a home’s value. Piggyback home-equity loans, which fall delinquent at as much as twice the rate of conventional floating-rate home-equity lines, accounted for roughly 40% of Countrywide’s $60-billion home-equity loan portfolio as of June 30, the company says.”
So if that’s typical, and its significant, and if piggy-back loans are not already included in the subprime category, then you’re right. More number crunching is required.
You asked if anyone knew of a US high yield bond index. After reading Ken Fisher’s article I had a hunt around and came up with the following. Hope its useful.
http://www.kdpyield.com/dayindex.cfm
Hi there Charlie. Thanks for the suggestion. I’m not sure, they’d need to be 7 to 10 year bond yields to be comparable. I found treasury yields here: http://www.investinginbonds.com/MarketAtAGlance.asp?catid=33
And the site has data for both Merrill Lynch funds mentioned in the blog, but no yields. I could of course ask Merrill Lynch periodically but I’m hoping to find the information on an Interactive Investor/Yahoo Finance style site so that private investors can do it independently.
It’s a funny old world isn’t it. Enjoyed the distant arctic article Richard. Cool.
But The Thing(s) that we should be facing up to, sitting up to with a start, are ‘Peak Oil’ and the fossil fuel fired mass home planet destruction orgy that we are at the end of.
Renewable energy, ultimately, is the one thing that can drive the renewal of economies. Energy is money and money is energy and nothing happens without investment of energy. Britain is currently near bottom of the global ranking of installed renewable power per capita. China is at the top!
Solar derived power is free, everlasting, leaves no residue, and can power our re-engineered low carbon economies ever after. If the UK embraces the renewables industry now, we will weather the storms ahead and lead the world saftely home.
If we don’t ‘The Thing’ (whatever we feared financially) will be the least of our worries. There’s the ‘funny weather’, storms, loss of food, water, unrest, chaos, these are the sorts of things that fat cheque books cannot always overcome.
Wasn’t it Chief Seattle that said “Only when we have felled the last tree, caught the last fish, poisened the last stream, etc etc will we realise that we cannot eat pound/dollar/euro notes.”
For me, the imminent climate crisis we face, and its shadow over my children’s future, is the only nightmare worth dreaming about.
[...] Though the the bail-out of Northern Rock and the fragility of banks in the face of a credit crunch seem serious, the stock market has actually risen since the news broke nearly two weeks ago. It’s an indication, perhaps, that things are not as bad as they seem, an observation borne out by credit spreads. [...]
Well the interesting aspect of this is the effect that money supply has. US and UK have massively increased money supply. The UK under Brown at 15% per year for over 4 years I hear. To fund wars, always inflationery and a massive % governement debt despite raising the taxes paid from a low (was it 39% to nearer 44% today).
Everything that cant move in the UK is hit. Manufacturing has gone so all we mainly do is service ourselves and keep property prices rising (it helps with a distorted long bond yield due to Browns stiffing the UK pension fund requirements to buy long bonds ‘matching liabilities’.
So whats left is trying to keep the property market up and spending up by lowering interest rates.
What about inflation? well truly we have lots of inflation but due to Browns Labour spin doctors they have removed the awkward items and included the big beneficial items (computers double in power and halve in price each year so thats a big negative inflationery factor every single year) Not like your standard loaf of bread!
America are set up to reap a high price for their wheat and get cash back from the rest of the world.
Now we have all the deficits (money out of the country in trade put back in by the IOUs of bond issuance to catch us potentially in the future)
Chinas store of Bonds of america and UK have allowed the spinning Labourites to give away value in return for feel good electoral success. No the Chinese are going out to cash in these bonds and buy real assets before the real assets are inflated away. See china trying to buy commodities, oil companys, natural resources commodities that go up with inflation and that China need for their industrial revolution economy.
Likely outcome more inflation less assets owned in the UK. More private sector takeovers as Ken Fisher points out the Bond yield is 2 %+ below the earnings yield of significant listed companies. Bonuses would continue once the banks relend again on solid assets.
Then there will be the wipe out of yet more govenment income as the private equity guys load up the debt so the tax paid to Browns Labour stain of economics goes near to zero like Asda in Wal Mart.
Finally after Brown has now trashed our education system, borrowed and sold off real assets, he will have a hollowed out property owning island with dumb people hoping that Brown will print more money.
Northern Rock will chuck yet more money to the north backed by Labour and the South East full of conservatives will be plundered for cash to send up north to Labours poor voters.
Sad very sad considering the marvellous legacy left by the conservative government.
Kick out Labour Kick out Livingstone and return to proper management.