As the US equity market rally continues, many point out that the S&P500 is still 21% below last year's level. We still have ways to go just to get to last year's levels. Stocks are still cheap. Right.
The chart below shows the S&P500 level as well as the PE ratio, both the trailing ratio and the estimated PE (based on Bloomberg survey). Both PE ratios are at multi-year highs. The projected PE number of nearly 17 times earnings is particularly troubling because it's a forward looking measure. These levels indicate that equities are really expensive.
So why are people buying stocks with such enthusiasm? A few possible reasons here: 1. analysts are completely underestimating next year's projected earnings, 2. earnings growth in the next few years will significantly exceed historical growth, 3. stock market euphoria is back.
According to Credit Suisse, number 3 is more likely, or at least on the way there. The following chart shows the levels of risk appetite in the system, and we may be on our way from "panic" to "euphoria" in a matter of a few months.
Euphoria has been known to carry asset levels way beyond fundamental valuation, and that's exactly what may be happening here.
The People's Daily (the government sponsored newspaper) published a blurb a couple days ago called "China massively offloads U.S. debt holdings first time in 2009". Readers around the world particularly focused on the word "massively". Given that this publication is censored, there must be a message there. Some in China heralded this as a sign of China's new strength. Is China retaliating for the recent US trade victory in WTO ruling? Some believe it's a form of intimidation - trying to spook the Obama administration into compliance on trade issues.
Yin Zhongli, a senior researcher with the financial research institution of the Chinese Academy of Social Sciences, believes that the share of US dollar-dominated assets in China's foreign exchange reserves is too large.
"So, we have to diversify our portfolio for risk aversion," Yin said, adding that the country might buy more assets denominated in other foreign currencies, such as the euro, the Japanese yen and the Australian dollar.
One would think in order to diversify reserves, China can simply sell their dollar cash holdings and buy some Yen, Euro, or AUD instead of selling notes. But there is no evidence that China is in a hurry to do much of that. What's really going on?
The reality is that it simply doesn't matter. So they sold some notes and let some bills mature without reinvesting them. This change and even a larger sale by China will have a very modest effect on the treasury market. The chart below shows just how immaterial the "China massively offloads" action really was in the larger scheme of things. The foreign holdings of US Treasuries continues to grow even as China is moderating it's holdings.
China simply has little choice in the matter. Allocating $2.13 of China's foreign reserves will roughly get them to the same place every time - they have to keep a significant part of it in dollars (currently estimated to be at 70% of the reserves) and they have to hold US debt. The rapidly growing supply of US debt is clearly an issue, but the alternatives for them are no better. Many of the markets that have some depth to them such as UK gilts or JGBs carry as much or more risk than the US government debt.
The significance of this reduction in China's holdings is simply overblown.
New York law firm Weil, Gotshal & Manges was approved for $55 million for work done on the Lehman bankruptcy for September through January of last year and has requested the bankruptcy judge approve another $45.2 million for hours billed February through May.
Not a bad gig. Of course people are getting angry over this, watching these attorneys raking it in. But these fees impact only one group of people - Lehman creditors. And the creditors don't seem too concerned about the attorneys' fees. An institution as complex as Lehman will need all the help it can get to recover assets.
Apparently Weil, Gotshal & Manges has been doing something right. Lehman debt has been gradually trading up. The medium term senior unsecured notes (below) are at almost 19 cents on the dollar and actively traded.
Credit Default Swaps are often thought of in terms of providing protection against credit events. However in many instances CDS are used to simply hedge against mark to market losses even if there is no default. Some use Index CDS to reduce volatility of portfolios due to spread fluctuations. The concept is that if the underlying portfolio spread widens, the CDS premium should increase as well, providing some cushion against losses.
However the basis spread between cash securities and CDS can widen dramatically, making the hedge fairly ineffective on a mark to market basis. In 2008 some investors wanted to take advantage of that spread, hoping for convergence. The idea is that if a bond yield, less the financing cost (to leverage the bond), is higher than the CDS protection, one can make a "riskless" return by owning the bond and the CDS.
The assumption however is that one has the ability to hold these bonds and the CDS to maturity. But in 08 that assumption went out the window, as banks asked for additional margin to leverage bonds even if they were hedged with CDS. In addition to that, hedge fund redemptions forced managers to raise liquidity. These two events combined to force the unwind of the basis trade, making the bond-CDS spread widen even more. The wider spread created mark-to-market losses for other basis trade holders, forcing them to unwind as well. It was a punishing cycle.
Those who hedged their portfolios with Index CDS saw their hedges fail, as the CDS premiums did not rise nearly as much as the portfolios got marked down. It was particularly painful for those who had to unwind the portfolios, crystallizing the mismatch.
The chart below tracks the value of the Credit Suisse High Yield (a diversified basket of cash bonds) index vs. HY CDX (index CDS on a basket of HY names). CDX here is shown in terms of price equivalent rather than spread (if premiums increase, the effective "price" drops). End of 08 spelled disaster for many who had these types of hedges on, particularly if they beleived their portolios were neutral. The hedge stopped tracking the portfolio completely.
A similar scenario occured with leveraged loan portfolios. The hedge (LCDX) broke down. In addition, during that period the loans and the LCDX became illiquid, making it even harder to unwind. LCDX performed so poorely as a hedge, it never really recovered from the "ineffective" image and continues to be illiquid.
"Neutralizing" credit portfolios with Index CDS hedges is no longer viewed as reliable strategy. Managers still use these products, but it's no longer considered a dependable hedging program on it's own.
For those who are interested in learning more about Index CDS, please see the Credit Indices primer from Markit (below):
For the past 20 years, managing a short-bias or short-only hedge fund has been a little like one of the stunts performed by street magician and certified masochist David Blaine. Like Blaine, short-only fund managers have voluntarily put themselves in highly uncomfortable, cramped, painful situations in pursuit of their mysterious craft. ... Aside from those who await the arrival of a much-anticipated alien invasion and subsequent collapse of society, many short-bias managers are in the game for the right reason: alpha. In fact, some research has shown that while short-bias funds fight a constant uphill battle, they are actually quite adept at producing alpha. In other words, they lose less than one would expect them to lose (like Blaine only falling into a coma, rather than dying during one of his stunts - a stunning success!).
The article was promptly followed up by a single and direct comment from Jim Glazen: "you're a moron."
Well at the risk of getting another strong comment from Jim Glazen, it's worth taking another look at Dedicated short-bias hedge funds. As of July-09 here is what the performance of the various hedge fund strategies looks like (from CS/Tremont):
Most hedge fund strategies are down for the past year, but up year to date - some are doing really well this year. Short-bias fund performance clearly stands out. The strategy is down for the whole year as well as year to date. In fact no matter what statistic you use, the strategy has lost money:
The one-year return statistic is particularly strange, given that the equity markets are significantly below the levels from the same time last year. Doesn't that mean that these funds should be up from the same time last year? In fact the Dedicated short strategy is down almost 18%! What happened?
The chart below compares the Dedicated short-bias strategy with the S&P500 as well as the Proshares Short ETF (ticker symbol SH) over the past couple of years.
As expected the Dedicated short-bias composite tracks SH for much of the period (they are both short US equities portfolios), but then something happens in the late summer/early fall of 08. Dedicated short-bias strategy begins to significantly lag SH. In fact if you look at the regression graph, the 9/08 point stands out:
If the hedge fund strategy continued to track the short ETF, it would be up for the year. What was it that caused such dispersion? There is some anecdotal evidence that many short biased funds shorted financials during the summer of 08 - which was a good thing for them. They started doing well, but there was a "head-fake" rally as some thought a government action may stabilize the banks.
Feeling a bit of pain from the rally, some short-bias funds took profits to get out of what they thought may be a market recovery. It's easy to spot the mistake now, but at the time some of these funds were up for the year and they didn't want to risk it. Many now had a bunch of cash, going into the crash - so much cash that they ended up underperforming SH by a large margin. The SEC action to restrict shorts later did not help matters either.
Late last year or early this year, some reloaded on their shorts going into an actual rally in 09.
Bad timing seems to be the key reason for the underperformance relative to SH, and being short made these funds lose money this year. For many, it will be tough to continue marketing their funds going forward as investors will undoubtedly question the value they are providing. But as Christopher Holt points out, they can always discuss their great historical alpha.
The industry comments are in for the proposed FDIC rules dealing with failed bank acquisitions by private equity funds. If these rules go into effect as they are, the FDIC will not be able to sell another failed bank directly to an alternative investment firm - one of the few sources of private capital still available. And in some instances failed bank liquidation may become the only option, putting FDIC and the taxpayer deeper in the hole (see FDIC looking for half a trillion dollar life )
The rules, as proposed, make no sense. If a bank wants to acquire another bank, the target bank must have a post-acquisition capital ratio (book equity to assets) of 5%. If someone wants to start a brand new bank, the ratio needs to be 8%. But under the new proposal if a private equity were to purchase a bank, the capital ratio needs to be 15%.
One of the reasons the FDIC is pushing for this rule is their concern that private equity firms expect to make high teens to low twenties returns on their bank purchases. How dare they! Making money is a crime these days. So let's force them to put up more capital to bring the returns down to single digits. That will teach those PE firms. Now if you are a state pension fund and a private equity firm told you they are targeting an acquisition with a 9% expected return, would you invest? No way.
The other rule the FDIC is trying to impose is to force PE firms who have more than one bank in their portfolio to use profits from one bank that's in good shape to prop up another bank that may be struggling. If you are an employee or a creditor of the healthy bank and the regulator tells you that it's time to give up some profits to feed a failing bank that has nothing to do with you, you would call that socialism.
FDIC would also require that private equity firms hold on to banks they have purchased for at least 3 years. If you buy a bank, turn it around in a year, and now a larger bank offers to buy it from you, why should you be forced to wait?
Here is another example of a US agency cutting off the nose to spite the face. The FDIC should ensure that the new owners run the bank effectively and prudently, working to rebuild a failed institution. Setting up socialist type rules will only serve to keep private funds away from failed institutions, ultimately hurting the FDIC and the taxpayer.
Here is a quick follow-up to our post on China called Fresh signs of China's asset bubble. Looks like the Chinese government is taking this potential bubble issue quite seriously. They've been forcing banks to significantly cut lending to reduce all the liquidity making it's way through their economy, manifesting itself in asset inflation. People's Bank of China even issued a low yielding note and forced some banks to buy it to limit cash on their balance sheets.
It worked. Here is the recent lending amount statistics from China:
This reduction in liquidity is showing up in the stock market as well.
This was a timely and prudent move on China's behalf, as the asset bubble was clearly beginning to build. Let's see if they can maintain the discipline going forward.
The recent rally in leveraged loans is making it's way into the secondary CLO market. In the dark days of late 08 - early 09, secondary CLOs got hit from several sides. On one hand the natural buyers for senior paper have all but disappeared due to the collapse of the ABCP markets. On the other hand concerns about the collateral quality continued as leveraged loan default rates escalated rapidly. The junior tranches were trading cents on the dollar as participants anticipated cash flows being cutoff from due to expectations that deals will hit their OC triggers (see Moody's pounding CLOs with downgrades ).
There were a few buyers of AAA CLO tranches who felt that AAA CLO paper has what's called "positive convexity". If credit deteriorates, OC triggers get hit and AAA starts getting paid down. Even though collateral gets worse, the principal is getting reduced. And unlike other types of CDOs, the cushion for AAA in CLOs has generally been sufficient - so far. If credit does not deteriorate enough to hit OC triggers, the principal would not get reduced, but spreads will tighten. A few saw this positive convexity as an opportunity to get long secondary AAA CLOs (the primary market is virtually shut down) and at 60-70 cents on the dollar some took a chance. Anything below AAA was viewed as highly speculative and traded at massive discounts.
How the times have changed. As the collateral rallied (see Leveraged loan rally continues), the securitized product is starting to rally as well. The projected collateral default rates have dropped in part due to all the amend-and-extend activity. There is clearly an arbitrage opportunity when the senior most tranche of a loan portfolio is yielding more than the portfolio itself. The AAA rally in turn is pulling with it the lower tranches.
From Wells Fargo:
CLO bull market is raging on. After a big rally in May and June many customers expected a pullback in July, and while we had a couple of weeks of summer lull, the last four weeks prices trended straight up, aided by low supply. A lot of activity was on top of cap structure, with most 1st pay AAA improving from high 70s to mid 80s and AAs from low 50s to mid 60s.
.....
What lies ahead? CLOs are STILL cheap to loans and HY, fundamentals are clearly improving, there's negative net supply of paper, and rating agencies haven't gone overboard with downgrades. Unless there is a meaningful pullback in credit and stocks (SP500 back to 900), we don't see much weakness coming up.
It's certainly impressive to see a rally in a structured credit market, given the dirth of natural buyers. However with the recent equity markets' correction, it may be time for this market to take a pause.
