Friday, January 19, 2007

Goldilocks At The Slimming Salon

For the past three years we had "everything up" markets: stocks, bonds, commodities, real estate, FX. Goldilocks had a field day in the kitchen. A little bit of this, a little bit of that - she ended up binging on a whole lot of everything. Is she heading for the slimming salon soon? I think so.

First, let's consider the precipitous drop in oil and basic metal prices. Welcome by consumers, it is not at all welcome by those producers who took the buyers' money and invested the excess. We know that some 55 mbpd of oil is sold at or around market prices (the rest going to heavily subsidized local consumption); the difference between $75 and $50 per barrel thus equates to $500 billion dollars less per year. Similarly for copper, nickel, zinc, lead, etc. Let's call the whole thing $750 billion in extra cash per year. And this has now been taken out very, very fast.

Given the rapid rise in hedge fund and private equity inflows during 2005-06 it is natural to assume that this excess oil and metal revenue money had found its way there, too - where leverage reigns supreme (5:1 leverage is not at all uncommon). All the extra money was not invested, of course, so let's say that the effect was $1 trillion annualized, leverage included. What I mean is that this money will not be available to further pump up markets. There are indications this is already happening: according to Hedge Fund Research, net inflows to hedge funds were down 64% in the 4th quarter of 2006 compared with the previous three months.

Secondly, consider leverage. Prof. Markowitz (of portfolio theory fame) recently showed that high leverage increases prices for all risky investments, even those that are un-leveraged and thus results in more disequilibrium and higher potential volatility. In this blog I have posted ad nauseam about high total debt in the US (i.e. high economic leverage). Derivatives are another form of leverage, too: the explosion in total derivatives outstanding is well documented by the Bank of International Settlements. Over the counter derivatives held by the reporting large international banks reached $370 trillion in notional value in June 2006, up from $220 trillion in June 2004. Almost all of the increase came from interest rate contracts and credit default swaps. Another sign of high leverage is margin debt: as of November 2006 (latest available) margin debt reported to NYSE is up to $270 billion - very close to an all time high, see below.

Hmmm.. seems like Goldilocks has to go on a diet pretty soon, eh?

3 comments:

  1. After reading your blog and then I see articles like this one
    http://www.bloomberg.com/apps/news?pid=20601109&sid=a0uqSyVKVINY&refer=home
    makes me wonder what koolaid they are drinking and where this will all end and how many people will get hurt.

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  2. Hellasious: Most of the people who read your blog are probably well versed in market speak and such. Little ol' me needs help to keep track.

    Would it be possible for you, e.g., to put up a glossary, maybe on the right panel, and as you develop your themes I and others can refer to the glossary.

    For example: derivatives. No need to do a whole glossary, just add to it a simple definition when you use a word that is more specialized. Not trying to make work for you, but...

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  3. Sorry, the link to the Bloomberg story didn't work..what was it about?

    Glossary is a good idea, but why re-invent the wheel in the digital age? www.investopedia.com will do the trick for most cases. However, I will also try to provide brief explanations in the body of my texts from now on.

    Thks for the suggestions

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