PPT - Fact or Fiction?

The current run-up in stocks has spurred much speculation about the actions of the so-called Plunge Protection Team (PPT), real or imagined.

As we all know, the US economy is now highly dependent on the smooth functioning of financial markets. Indeed, almost all markets have now become financial in nature as commodity, real estate prices and even pollution permit prices are set via derivatives and a tangled web of securitizations. Even "communist" China has become hooked on share speculation - an obviously oxymoronic situation.

Thus, the PPT has an increasingly important role to play: market movements are manifestations of fickle human psychology - a dangerous situation at all times and more so today, given the supreme importance of markets relative to the shrinking "real" economy. Confidence must be maintained at all times. What seems to be true is infinitely more important than what is true. Perception is reality, since most of us do not have the means or ability to independently verify what we are told is true.

There is a steady stream of negative developments coming from the US economy: real estate plunge, devastated manufacturing sector, rising costs for food and energy, weakening retail sales, negative saving rate, extreme household debt, zero growth in non-financial corporate profits. Even total after tax corporate profits, when financial firms' are included, are now rising just 7.5% y/y. This means that corporate profitability growth is very narrow and contained within just the financial sector, which is now also coming under pressure from the mortgage crisis and the widening of risk spreads.

US Non-financial corporate profits - Y/Y % change

Therefore, the run-up in share prices is indeed puzzling and so the "invisible hand of the market" is being suspected of belonging to the PPT and to be manipulative in the extreme. Can this be true? Would the government of a democratic country fully committed to the principles of free markets, manipulate share prices? And if so, how?

I will answer not with speculation, but fact. I have first-hand experience of how the democratically elected government of a western, free-market country (not the US) became in the past heavily and directly involved in market manipulation. It did so for two reasons:

a) It needed to claim the economy was vibrant in order to achieve several important milestones.
b) There were elections coming up.

But, for this discussion, what is most important is not the why, but the how.

This is how it was done:

1. State-controlled banks and the mutual funds they sponsored bought heavily on the opening and closing of each trading day. They smashed bid-offer spreads by lifting all offers, causing shares to gap up. They did this almost exclusively with index-heavy issues.
   
2. Ditto for state-controlled pension funds.
3. Major speculators, though formally unconnected with the state, also saw the opportunity for quick gains and jumped on the bandwagon by heavily manipulating smaller issues. This broadened the artificial rally.
   
4. Through friendly media, government and speculators embarked on a huge PR campaign of hot tips, innuendos and general market boosterism.
5. Market regulators were encouraged to avert their gaze and shut up.
6. The government publicly credited the rising market on its policies and predicted much higher levels after the elections - provided they won, of course.
   
7. Anyone that questioned these practices was immediately branded an enemy of the Nation and the People. The main opposition party tried to object at first, but quickly shut up fearing losing votes from the "investing" public.
   

These actions were obvious, amateurish and crude - but, for a while, successful. The ruling party won the elections and met the milestones, even if it was all done by smoke and mirrors. Alas, what quickly followed was a relentless 3 1/2 year market drop that slashed 75% off the top.

Is something similar happening in the US today? I honestly don't know and if I did I certainly wouldn't say. One can, however, connect just the visible dots and come to some valuable conclusions.

How Industrial Is Dow Jones Anyway?

It is common knowledge that the US has gutted its industrial base and now depends on inflating financial and real estate assets, borrowing against them and spending the proceeds on imported goods. As such, the Dow Jones "Industrials" is clearly a misnomer. But, how much of a misnomer?

To help answer this question, here is a chart tracking the ratio of Dow Jones Industrials Index to the Industrial Production Index.

No Dorothy, this most assuredly isn't Kansas anymore.

Purity In Charting

For those pure chartists amongst you (I am not, but frequently a picture is worth a lot more than babble), here is one to ponder: $TNX, the yield of 10-year Treasurys (click to enlarge). I have marked a couple of patterns that chartists will immediately recognize:

1. An inverted head and shoulders that has already broken conclusively on the upside.
2. A flag, trend- continuation, pattern.

The first "reads" to a yield of 5.40% (essentially already reached) and the second to 5.90%-6.0%.

OK, some more fun with this chart, from a longer perspective (click to enlarge).

Another couple of patterns being formed here, both of which are on the "cusp" of resolution, but have not yet confirmed:

1. Another inverted H&S - reads to 8%
   
2. A down trendline penetration - reads to 8.50%

It all boils down to this, IF you are a pure chartist: both short and long-term chart patterns are coming together to form a powerful technical picture, arguing for significantly higher long rates.

I'll shut up now and let the pictures talk.... OK, I can't resist just one comment: with all this debt sloshing around, money has got to get expensive at some point.

Margin Debt

Today, one simple chart that mostly speaks for itself. Click to enlarge.


Two comments:

1. It is apparent that the market's move up in the last 6-8 months has come on the heels of a vertical rise in margin.
2. When margin increases vertically, as right now, the market becomes toppish and vulnerable to forced liquidations (margin selling).

Common sense? Of course...

P.S. Below is an updated version of the chart, current to May 2007 (latest data available from NYSE). In just one month margin debt jumped by $35 billion, or 11%. Vertical, indeed. I have also added an exponential trendline, for comparison.

Also, notice this interesting coincidence:

• In the previous period of near vertical margin growth (Oct. 1998- March 2000 = 17 mos.) margin balances grew by 113%, or 80% annualized.
• In this current run (Aug. 2006 - May 2007 = 9 mos.) margin balances grew by 56%, or 75% annualized. .. and we don't have the June data yet.

We all know what followed March 2000 and I think we are now experiencing the same sort of speculative frenzy, albeit with a different cast of characters.

P.P.S. The nature of the NYSE margin data is such that it portrays mostly retail and small money manager borrowing. Hedge funds and other large sophisticated speculators usually borrow from other sources (e.g. they use bank credit lines and trading limits).

Therefore, I must conclude from the above chart that the retail speculator is jumping back into action in a serious way. Just in time to take advantage of the serious underpricing in equities, eh?

Raindrops Keep Falling On My Head...

Once again... credit spreads are widening:

The CDX index tracking CDS's on junk bonds has reached 375 bp...

CDX NA HY

...and the one tracking investment grades to 47 bp.

CDX NA IG

In the greater scheme of things this is still a light shower, a pitter-patter of summertime raindrops on a tin roof. But it feels as if the barometer is dropping, too, so this may well be just the beginning of a major storm. Best to cover and ask questions later. Because if the raindrops turn into golf-ball sized hail, as often happens in the summer, those caught in the open will hate the title song forever...

P.S. I have rarely, if ever, commented on the performance of individual companies. Today will be an exception, given the news from Sears. I won't go into the whole story, just remember that it was taken over by K-Mart and chose to keep the historic Sears name. K-mart had just prior gone bust under allegations of management's misleading shareholders and gutting the company through loans, large bonuses, etc. It emerged from Chapter XI in 2003 and, through the magic of leverage took over Sears a year later. The stock went from $20 to $200 (give or take..) and everyone in the business turned green with envy. Ain't debt grand?

Until retail sales start notching down and the bank/bondholder/CDO-CDS holder demand their pound of flesh, regardless.

Look up the SHLD price chart and ponder if Fama's monkey is a good way to pick stocks...

Fama's Monkey

The random walk theory of equity prices (and everything else that trades in a so-called "efficient market") has been a perennial favorite of financial academics since it was pronounced by Eugene Fama in his doctoral dissertation in 1965. But it has also been the target of just about everyone else involved in markets. After all, how can you possibly justify mega-million bonuses if your job can be relegated to a monkey throwing darts at stock tables?

Despite reams of analytical data supporting Fama's theory during the last four decades, the finance industry has raked in trillions of dollars in research, management and performance fees. It seems thatit is not so difficult, after all, to continuously convince the gullible that the financial profession is always in possession of a better mousetrap. As for the suspicious, there is the ultimate weapon: no-load, low-fee index funds and other passive products: the industry's lucrative version of a (well-paid) monkey.

Despite the above, there are stellar exceptions to Fama's "you can't beat the averages" rule: Warren Buffet has been doing so consistently for nearly half a century. (Rumor has it that he is an alien in possession of time travel technology. I mean, c'mon... what sort of billionaire prefers Omaha over the Bahamas?) But, seriously, assuming that consistent market outperformers are not from a galaxy far, far away, how can their success be explained given Fama's theory?

As usual, the devil is in the fine print: Fama said that his theory holds for "...randomly selected securit(ies) of the same general riskiness". And within these last three words there is enough room to hold an ocean of water. When John Templeton was making a name for himself by investing in foreign and emerging markets, a Japanese automobile stock was considered so exotic as to constitute a whole different class of risk vs. GM. Likewise, when Buffet was buying small private companies at huge discounts to market multiples (See's Candy, anyone?), no one would include them with regular equities.

The secret of the game is to be early, patient and possess enough staying power so that properly selected "exotic" investments eventually become re-classified as "regular" risks and get re-priced accordingly (notice the word "properly": not applicable to monkeys). But this is a blog about the pernicious dangers of excessive debt - what is Fama and his monkey doing here? Hang on...

The connection between debt and risk assessment has always been there, of course. But until the emergence of Credit Default Swaps there were no pure-play instruments in existence to trade business risk (i.e. default risk). They were either connected to interest-rate risk (bonds) or equity market risk (stocks). The latent hunger for such pure plays was so huge that CDS's went from $1 trillion to $32.5 trillion in just 5 years. Now, that's what I call a growth business.

And this development, dear reader, has collapsed all risk categories into one: a bubbling stew of exotic and regular risks, all thrown together into the same pot. All of a sudden, a zero coupon bond issued by a private equity fund to finance the takeover of a listed company at 10+ times EBITDA is considered to be in the same general risk category as a bond issued by General Electric. Or, how about a synthetic CDO - a "bond" made up from CDS's? Or a curve steepener, a bet on the shape of the yield curve, also dressed up as a "bond"? All are considered bonds, so into the same pot they go. And since Fama's efficient markets are supposed to immediately and perfectly discount all available information, all that is needed is a monkey and a set of darts. Result? Down went all risk premiums, willy-nilly...

It gets more interesting: because of CDS's, the connection between credit instruments and equities has become very tight. It is a sort of self-perpetuating, self-reinforcing loop, with equity traders looking at CDS's for risk assessments and CDS traders looking at stock performance to price CDS's. As long as business prospects look bright the system keeps chugging upwards, pressuring risk premiums and volatilities to record lows. All are happy.

But it seems logical that when prospects dim, the process will work in reverse: we may experience a grinding, remorseless and long-lasting drop in financial asset prices as risk premiums and volatilities go higher, churning inside the loop. The current system is so new that it has never been tested during a bear cycle, so no one really knows what will happen.

Where does this leave us today? The defining characteristic of all markets right now is exactly that collapse of all risk premiums, i.e. the convergence of just about every investment instrument into one hyper-category, connected through the CDS market. In other words, Fama's monkey is throwing darts onto one huge board containing everything from Brazil ethanol producers and Zimbabwean gold miners, to US Treasurys and CDO bonds made up of Polish mortgages priced in yen. The proof lies in the way risk, volatility and equity markets now trade in tandem all over the world. Nothing seems to diverge - everything goes up or down together.

But, as the success of Buffet, Templeton et. al. make abundantly clear, the secret for superior investment returns is to predict which kinds of seemingly dissimilar risk categories are going to converge and be re-priced upwards - or seemingly similar ones diverge and be marked down. For example, back in 1999-2000 most dotcom stocks were not equities per se, but enormously overpriced lotto tickets. Once it was made clear, dotcoms got a massive haircut.

I believe the emergence of this global hyper-category of investment instruments is an important contrarian signal and we should be paying close attention for any signs of (a) its working in reverse and/or (b) sharp divergences within it.

On the Beach

Given the overwhelming importance of CDS's to the current credit and equity markets, I think it useful to examine the relevant indexes (CDX) a bit more in depth.

The CDX.NA.IG index tracks CDS's for 125 investment grade bonds issued by North American corporations and it is followed closely by traders for indications of credit risk perceptions. But just how solid are the ratings of the underlying bonds? It turns out that on average this is essentially an index of BBB+ bonds, as the pie chart below shows. In years past such a rating would hardly be considered "real" investment grade, being just a couple of notches above junk. (I know of several pension funds that refused to buy bonds rated below AA; this is almost impossible right now, if any sort of name diversification is to be achieved.)

So, not only are investment-grade credit spreads abnormally low by historical standards (though rising during the past two weeks), they currently apply to bonds that barely qualify as investment-grade in the first place. This clearly poses a double potential risk for CDS prices, should business conditions weaken.

If this was storm insurance, it would be akin to setting premiums to rock bottom prices, even for houses located in the second row from the beach. Why? Because there hasn't been a storm in several years and underwriters are greedy. Or, think about it in cinematic terms, as the title implies...

Is The Tide Turning?

The first half of 2007 saw a record $1 trillion in junk bond issuance (up 70% from last year), almost all of it going to finance massive LBO's by private equity firms. As the envelope was stretched, more shaky deals made it through until such old stand-by's like PIK bonds (payment in kind, i.e. interest is paid in more bonds, not cash), zero coupons and toggles had to be used to make the deals possible. And then something snapped - as it always does.

A combination of sharply higher interest rates for long Treasurys, a junk mortgage bond meltdown and a slowdown in the US economy is finally pushing on the breaks from the demand side. And not a moment too soon: almost 27% of all new bonds issued were rated CCC, really malodorous junk. In my experience, such highly risky paper almost always runs into serious trouble - and rather sooner than later.

But where was all this demand for junk coming from, at least until recently? Desperate pension fund managers? Greedy 2/20 hedge fund managers? Colluding foreign central banks? Yes, to an extent... But the real boost has come from CLO's, structured finance's equivalent to CDO's for corporate junk, complete with heroic default assumptions, the usual tranche structure and the ultimate transformation of lead into gold by teams of apprentices sorciers. Oh yes, the usual game of turning CCC junk into AAA bonds... and the rest was easy, as we all know by now.

As I wrote in the previous post on CDS's, the tide now appears to be turning. During the past two weeks buyers are less willing to buy junk, driving risk premiums higher. The CDX index tracking high yield bonds with an average B rating has gone from a spread of 250 b.p. to 325 b.p. - a very large move in such a short time. Several deals were altered, re-priced, postponed or cancelled altogether. I am convinced that we have seen the high water mark for high-yield finance, at least for this economic cycle.

What comes next? The buy-out premiums for stocks should narrow significantly, since takeovers and LBO's are now harder to finance. The significance for equities, worldwide, is obvious.

Have a very nice week-end.

The Coming Demise of Growth Economics

"Growth is the Holy Grail of Economics."

I will let that statement stand on its own. I am certain that informed readers need no elaboration, with the proviso that I am referring to the last 150 years, or so.

Economic growth (positive or negative) is simply a measure of the rate of change in human activity and thus directly related to global population growth. So, here is a simple population chart with decennial population growth rates (click to enlarge).

Data: UN

We immediately understand why we chose "growth" to describe economic activity in the 20th Century: human population has been rising fast. The peak decade of 1960's even saw population rise by an astonishing 22% - the Baby Boom. More mouths to feed, more clothes, more of everything - "Growth", made entirely possible by cheap and abundant fossil fuels.

But this is not a posting about Peak Oil, though it is obviously of overwhelming relevance. Rather, I am making a more basic observation: if the UN's population projections prove accurate, in the next few decades we will witness a fundamental growth slowdown, simply because global population will rise at a much slower rate. Indeed, by 2040 global population will be growing at almost half the rate it grew between 1800 and 1850.

Certainly, one could argue that higher economic activity could be sustained by making fewer people work harder, but this is an apparent oxymoron. Work harder for what? If the number of consumers is not rising fast enough to use the goods and services of this more productive labor, there will simply be no sense in doing so. High productivity is a boon when the number of potential buyers is rising fast, but a curse when it is not.

What I am trying to say is that we should all start thinking hard about what is inexorably coming down the road. Population dynamics is like a steamroller: slow and deliberate, but also possessing immense inertial force. Pension funds, who by nature are forced to think long-term, are sweating bullets about covering retiree benefits and are already going out on a limb in their risk/reward profiles, investing in hedge and private equity funds, CDO's of sub-prime mortgages, structured finance bonds, etc. But it is a fool's errand, of course. They may patch things up for a short while, but the steamroller will eventually first reach and crush exactly those portfolio holdings that depend on consistent growth: equities and residential real estate.

If anyone thinks 2040 is too far away to worry about, just ponder this: it is as far in the future as the US Bi-Centennial celebrations are in the past. I bet lots of you clearly remember 1976 and Jimmy Carter getting elected President. Or, for those younger and just starting their families: a girl born in the US today will have another 50 years to live by 2040.

Bottom line: Growth economics is going to get crushed by the population steamroller, even if we avoid resource crises and environmental disasters. What's next? I think we need a whole new paradigm. Medieval Economics, anyone?

P.S. A comment by a reader (thks miju) prompted me to include a chart of the regional breakdown of population projections, also by the UN (click to enlarge).

Contrary to popular wisdom and based on population dynamics alone, Asia may be the worst place to invest, given that it will be the region with the fastest drop in population growth rates.

Gorillas In Our Midst

While the Debt Bubble was getting pricked here and there for several months (sub-prime, commercial real estate loans), I patiently awaited the next shoe to drop: Credit Default Swaps on corporate bonds. As I have written ad nauseam in this blog, within "modern" finance CDS's are the equivalent of a 3-ton gorilla raging inside a rather shoddy cage.

It is my firmly held belief that the explosion of CDS trading since 2000 was responsible for pushing long-term rates lower, even as the Fed kept raising short rates. In simple terms, risk premiums collapsed and produced what Greenspan termed "a conundrum" just before he left the Fed. This development produced truly monumental effects: it created the ocean of cheap liquidity that sloshed from Shanghai to Brazil and lubricated the dealings of thousands of hedge and private equity funds, pushing asset prices higher. But if this faux-bijoux liquidity (cheap & ugly) is taken away, the ocean will turn into a mudhole.

Indeed, this may be happening right now: CDS spreads are rising fast, as can be seen from the various CDX indexes that track them. Investment grade CDS's have jumped 10 basis points and high yield (i.e. junk) almost 90 b.p.

CDX-US Investment GradeCDX - US High Yield

CDS premiums are an excellent indication of effective interest rate spreads, i.e. what businesses and other non-government borrowers have to pay to finance their operations, from making mouthwash to placing multi-billion takeover bids. And the sheer size of the CDS market ($34 trillion at the end of 2006) is such that its effects cannot be ignored or be swept under the carpet, as was attempted with the sub-prime mortgages a few months ago.

Market "visitors" are therefore warned to quickly leave the grounds and let the attendant "pros" deal with the gorilla. After all, it was the latter that brought him in: I am reminded of the scene from King Kong where the beast is being exhibited to New York's tuxedoed and frocked social elite, chained on a Broadway theater stage. In this most American of films, the chains proved flimsy and the gawkers got the equivalent of a sharp lesson on the dangerous effects of low risk premiums.

Enjoy the fireworks!