Market Observations on a Tough Day
This is the sort of day that scares the daylights out of most investors. If they read news or tuned into CNBC it was even worse.
The News versus Real Information
Much of the bearish commentary involves long causal chains of events — one domino after another. It sounds erudite. It seems persuasive since dominoes were falling today.
What is lacking in most analyses is an effort at quantification. Frequently, those who try to provide such information are shouted down. Ultimately, the refinancing of mortgages, the unwinding of hedge fund positions, the response of homeowners and government agencies, and the actions of corporations are all marginal actions. It is not like a light switch.
There is a stereotype in the market that everyone who took a sub-prime loan cannot pay. That all Alt-A borrowers are liars. That none of the teaser-rate borrowers have acted to refinance during the last few years.
What is needed is some sense of magnitude, and the numbers are so easily misconstrued. A mortgage executive was interviewed on CNBC last week and admitted that defaults were up 100%! They had 30,000+ mortgages and defaults and gone from 25 t0 50, well within their loss reserves.
Most of the stories about "subslime" spreading to prime mortgages are completely lacking in quantification–the aggregate impact. Added to this is the assumption that these borrowers are not qualified to refinance.
The problems are obvious, but the effects are difficult to predict. When the market lacks information, sellers act on each piece of information and potential buyers back off.
The Hedge Fund Effect
Some of the best commentary today came from James Altucher, who manages a fund of funds and sees hundreds of hedge fund pitches. He explained on RealMoney, TheStreet.com’s paid site, that many hedge funds borrowed at 5.5% and bought mortgage obligations yielding 6.5%. To get the "holy grail" of hedge fund performance, they leveraged this 12-1 or so and seemed to show consistent strong yields with little volatility. We know this to be true, since this is the environment in which hedge funds like ours have been competing for assets. The leverage method looked good until the fund’s longs went down and the shorts went up. With 12-1 leverage, it takes little to blow out the entire fund.
It was the quest for yield….
On CNBC’s "On the Money" Altucher cited another strategy — put selling. This strategy has worked for years — until today. These funds are also blowing out.
Implications for the Average Investor
For the average investor it means that quality stocks are on sale. The hedge funds must sell to cover marginal calls and redemptions. Many observers noted that today’s trading had plenty of selling in good stocks and buying in (widely shorted) marginal stocks. To the savvy observers this looked like hedge fund liquidation.
The Time Frame
The process did not necessarily end today. The psychology of Fridays has now changed. A few weeks ago everyone was worried that big mergers would be announced on the weekend. No one wanted to be caught short. Now everyone fears that more bank and hedge fund news will come out. How much anticipation was built into today’s trading? Who knows?
At "A Dash" we are less concerned about follow-on economic effects, although the economically sensitive stocks got hit today. Everyone’s forecasts build in some effect on GDP from the housing situation. The extreme views forecast recession, while others see a haircut of 0.5% or so. It was interesting that even Nouriel Roubini, interviewed by Maria Bartiromo tonight on CNBC, was looking only for a slowdown in growth, not a recession.
Conclusion
Those with bullets to fire are getting a chance, but most are waiting for evidence of a bottom. This is notoriously difficult to predict
We have some modeling on this process — more later.
While its obvious that Sub prime has caused a lot turmoil, its curious that the Quant funds are getting hit. I wonder if the change in the uptick rule has effected their formulas.
I agree with your concern that investor behavior and conclusions seems to be lacking quantification lately. I consider the media (even most business media) to be a lost cause on that front.
I think I disagree with your comment that investors’ marginal actions are not a light switch. Are you familiar with “The Tipping Point” by Malcolm Gladwell? Human beings and complex processes often have triggers that appear to be a “light switch” to others. I think transaction costs and human capital and time costs are often ignored in analysis of marginal actions. There is a difference between “doing nothing” and “doing something.”
“Subslime.” lol.
Obviously, not all of the subslimes are in trouble. I don’t know what the percentages are, but I don’t think it’s that large of a number.
In addition, with the French company stating their woes, we also know that bad US loans won’t all be shouldered by firms here. It’s a good thing that it’s spread out.
(I think…)
You are not technically correct about Nouriel “Grapes of Wrath” Roubini’s recession prediction. In his comments to Maria, he called for a “growth recession”, which he previously defined as GDP growth between 0% and 0.99%, but which in reality is nothing more than a way to weasle the word “recession” into any and all of his interviews.
I appreciate your well thought-out comments to a great deal. Personally, I do look for more confirmation before going back into the market, but it’s going to be within a month – I bet.
It seems to be that the majority always has to be wrong. That’s why perma-bear blogs get all the attention these days and for many years now.
Thank you.
Joe
Anyone sophisticated enough to do a histogram of trade results knows that selling options is high-percentage wins, but all the swans are black. At least with BUYING options you know all your swans are golden. History is full of people impaling themselves on that trade, I started laughing at James (not because of him personally) as soon as he got that out of his mouth, and didn’t hear the end of his talk! The problem with that trade is that it’s high-percentage, so it is psychologically easy to do. Much easier than a program with the same expectancy, but much lower max adverse incursion, lower max loss, and lower win percentage, even though the CAGRs may be equal.
OK, “waiting for evidence of a bottom?” Waddooday want, a dang bell ringing?!? There’s been ample evidence of a bottom for a while now …
“It was interesting that even Nouriel Roubini, interviewed by Maria Bartiromo tonight on CNBC, was looking only for a slowdown in growth, not a recession.”
We’re screwed.
THANK GOD FOR OVER-LEVERAGED HEDGIES AND MORONIC MORTGAGE BROKERS WHO ARE NOW ON SUICIDE WATCH.
Warehouse funding is now non-existent for 100% LTV mortgages to low FICO pilgrims with no documented income. What a surprise. There is also virtually no market for MBS or CDO’s, and the margin calls to the Hedgies which own these vehicles have forced them to sell their equities en mass. Unwinding their longs have driven the prices of good companies down, and unwinding their shorts have caused the price of crappy companies to rise.
RESULT – A short term opportunity for long term investors to pick up quality equities and mutual funds at bargain prices.