Tuesday, January 30, 2007

Nail Salon Tips

The market is so hot lately that 20-somethings are borrowing money from their parents to plunge in. Then their parents jump in, too. Money managers are making huge bonuses. Brokerages have run out of floor space and rush to install screens in floor landings. Day trading from home via the Internet is zooming. One mutual fund raised $5 billion in a single day. Everyone is asking for trading tips. “When I go to the beauty salon, even the girls who give me a manicure are talking about stocks! They ask me, ‘What should I invest in?’ They say they are doing research.” Everyone's dream is to get rich, rich, rich. The NY Times lays it all out in a story today.

Sound familiar? Of course it does. It is the standard bubble scenario that has played out in dozens of markets and places for centuries. It may involve tulip bulbs, the South Seas, railroad stocks, silver, dotcom IPO's or - as in this case - Chinese stocks, but the scenario is always the same. And so, sadly, is the preordained end. Crash and burn for those unfortunates that climb aboard the "rocket" just as it runs out of fuel - and those that "double up" on the way down.

The Chinese stock market has tripled in just 18 months: the chart below tells the whole story.

The last time I saw this was in late 1999: I was on my way to work and right outside the train station there was this gypsy woman with a makeshift "shop" (a piece of fiberboard on folding legs) selling home-made bead jewelery. What surprised me was that she completely ignored her potential customers. Her ear was glued to a small transistor radio, raptly listening to the stock market report. A few days later a broker friend told me that an 18-year old kid had walked into his office and demanded to open an account with $30. It seems he wanted to buy a $3,000 motorbike and needed the money in a hurry. When told that stocks were not sure thing lottery tickets, the 18-year old got offended and huffily proclaimed he would take his business elsewhere.

Astute investors and speculators are always on the look-out for just such signs of excess. There is an apocryphal story that Barnard Baruch decided to get out of stocks in 1929 when his shoeshine boy asked him for a stock tip. There is a real, fundamental reason for this: markets set prices based on supply and demand. If demand has reached the point where even nail salon girls are trading, who is left to buy? Where is the incremental demand going to come from?

Oh, but of course...."This time it's different". Isn't it always?

P.S. I would not normally write about stocks but there is a debt tie-in here. Please remember that it is Chinese savings that finance a very large portion of US deficits. If it all goes up in smoke in their local market, it is unlikely that they will have the stomach - or the money - to keep buying US Treasuries.

5 comments:

John J. Xenakis said...

On the BBC this morning, I saw a report that said that over 2% of the Australian population has a significant gambling problem, the highest rate anywhere in the world. My immediate thought was that this couldn't true -- the percentage was much higher on Wall Street.

Anyway, you recently wrote: "A BBB+ rated corporation can now theoretically borrow at just 32 basis points (0.32%) over what the US Treasury pays – according to where CDS’s are trading right now."

After searching around, I finally came to the conclusion that you must be referring to the "Dow Jones CDX.NA.IG" index to be found on http://www.markit.com/information/affiliations/cdx , where the "spread" column had a value of 32 yesterday (31 today).

Is that correct?

Looking at the columns of this table, I gather that the spread is approximately equal to (100% - Price + Coupon) = (100% - 100.370% + 0.400%) = 0.030%, corresponding to a spread of 30, which approximately equals 31. (I assume there must be some kind of interest rate adjustment in there.)

Is that correct?

And finally, doesn't this index measure the same thing as the ABX-HE-BBB 07-1 index on http://www.markit.com/information/affiliations/abx -- namely risk of credit default -- when restricted to subprime mortgages, as opposed to the general credit market? Is there any way to relate the price of the ABX-HE-BBB 07-1 index to the price of the CDX.NA.IG index?

Thanks,

John J. Xenakis
GenerationalDynamics.com

Hellasious said...

Dear John:

a) You are correct, the 32 bp spread was from the CDX index for CDS's on investment grade corporate bonds.

b) The ABX HE series of indexes tracks CDS for "insuring" collateralized bonds backed by home equity loans (thus HE), from AAA down to BBB-. Each rating has its own sub-index, as do the separate series for 2006, 2007 etc.

The BBB and BBB- tranches have already been hit hard, both the 2006 and the just released 2007 series. The reason is that loans in their reference portfolios are already going into default.

You could follow the values daily and construct a ratio of, say, the ABX HE 07 to that of CDX IG to follow the widening or narrowing of the quality spreads. However, despite the fact that both indexes track CDS's, the ABX one tracks mortgages which behave differently from straight bonds. But not a bad way to do it, in gross qualitative terms.

Regards

ross said...

Yes, and when the Chinese can no longer pony up to buy our government debt, the government will have to buy, er monetize government debt. The dollar will then collapse. Watch what gold and silver do then. Can you say four figure gold and three figure silver?

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