Looking Out the Window
by Brian Pretti CFA, Contrary Investor. March 16, 2007
Many moons ago in what seems a lifetime far, far away, Barton Biggs was not running a hedge fund, but rather found himself penning weekly strategy commentaries at Morgan Stanley. I was pretty much a religious devotee in terms of checking in on what Barton had to say about life at the time. I can distinctly remember a particular piece written before the equity peak early this decade he titled, "Looking Out The Window." The gist of the article was that Barton felt investment professionals of the era spent far too little time simply looking out the window and thinking. From my perspective, he was conceptually right on the money. But little did Barton know at the time, the world of instantaneous 24/7 information flow was about to accelerate in a very big way. In today's world, who has time to look out the window when their eyes are glued to the screen?
In the spirit of the "Looking Out The Window" commentary written by Barton, and in light of the events we've lived through in the financial markets over the last few weeks, I thought I'd spend some of my own time simply looking out the window and reflecting on what financial market messages of the moment may be suggesting to us. Personally, I'm as guilty as anyone in terms of following the day-to-day information overload flashing on the screen in colors my mind now reacts to virtually unconsciously. Filtering out white noise in this information miasma world of the moment has become one of my most important daily activities. And as crazy, or overly simplistic as this may sound, in looking out the window I try to force myself to distill recent market events into one or two macro ideas. What's the big message here? How are recent market events interconnected? Do I have enough individual pieces of the puzzle to allow me to step back and see a larger picture perhaps unseen by those following every price tick in red and green?
Although this may be very self indulgent on my part, after spending some time looking out the window, I have a few thoughts. Cutting directly to the bottom line, I'm wondering whether the financial markets find themselves at perhaps a very important crossroads at the moment. And I would describe this inflection point as being driven by the initial anecdotes of what may become a much larger repricing of investment risk in the broader financial markets. Without sounding melodramatic, I'll put my neck on the line and suggest that repricing of risk may be a key theme for the months and quarters directly ahead. As you'd imagine, let me explain a bit further.
At least in my mind, two key points of financial market consensus thinking for some time have been that global liquidity/credit is and will continue to be plentiful. Additionally, I believe the thought that the Fed and their global central banking friends stand ready and willing to put out any and all financial market forest fires at a moment's notice has driven the pricing of financial risk, or really lack thereof, in many an asset class (conceptually toward zero in many cases). First, it’s been such a good while now since we've run into any macro financial market speed bumps, if you will, that credit spreads in the world of fixed income a number of weeks back stood at levels most investment professionals probably thought they would never see in their careers. Of course these wildly tight intermarket spreads have been explained away in the headlines by the force of the carry trade, the magnitude of the global savings glut, the layering of risk and leverage in the hedge world, etc. As you know, Wall Street always has a rationale for what has already happened, but they often come up a bit short in seeing what's to come. The following is simply an example of tightness in credit spreads up to this point. And without showing you decades of this relationship, you're going to have to trust me that reversion to the mean and cycles of spread widening and contracting are virtual guarantees in the credit markets.
At least for now, the events in the world of sub prime paper have turned a bit of this complacent consensus thinking on its proverbial head. Credit spreads in sub prime have blown out, and many a sub prime lender has simply been blown away in the winds of credit market repricing. This has happened fast. Moreover, as I see it, when looking at the pyramid that is mortgage financing in this country, we've just stripped away the entire bottom layer of the credit pyramid. So what happens to the real world of nominal dollar housing sales when your marginal buyer has now been shut out of the game? Can pricing really hold up in thin air above the now non-existent bottom level of the mortgage credit structure? The mortgage credit food chain of recent years just lost its most important marginal driver. And as always, change at the margin can be incredibly powerful in terms of ultimate trend change.
That's in the real world of housing prices. What about the world of trading paper promises backed by these very same real world houses called collateral? As you most likely know, intermarket credit spread widening has not been contained to sub prime residential mortgage paper at all. Alt-A mortgage paper and high yield bond spreads have also widened. We are seeing actual repricing of risk, but looking ahead the most important question is ultimate magnitude of this repricing as it directly bears on the character of the credit market. A credit market that has underpinned the economy. I think it’s very important to realize that many of the holders of this now deteriorating in credit spread paper are levered investment players. So the question isn't solely how mortgage backed, asset backed, high yield, etc. paper will act as "investments" in the marketplace ahead, but rather how the levered holders of this paper will react in terms of human decision-making. My own observation is that levered holders of a deteriorating asset spend very little time looking out the window and thinking. Know what I mean? What's the upshot of all of this? Quite simply we find ourselves in a credit contraction driven by the repricing of risk in credit markets by levered holders of sub prime and other high yielding paper. And quite importantly, we are now in the process of testing how leverage will respond to changing market conditions and financial asset prices. Isn't this exactly what has started? It sure looks this way to me when I'm looking out the window.
One last comment on credit market events of the moment. First, think back to the Asian currency crisis of 1997. Think about LTCM in 1998. Remember Y2K in late 1999? How about 9/11? All of these events had one very important commonality, and that was a swift and meaningful response by the Fed in terms of exaggerated monetary accommodation. Not this time. At least not overtly. We'll admit that money flowing from the Fed's NY desk has been substantial in recent weeks. Undoubtedly in deference to the deterioration in sub prime, but at least up to this point this liquidity flow has done little to halt the real world deterioration in the sector. Did some of this largesse find its way to New Century via the Morgan (really debtor in possession?) funding last week? Maybe. Of course that was too little, too late for NEW.
But overtly the Fed has not responded to the sub prime debacle with a perceptually powerful rate cut. Remember, we're talking about recent credit market events that will have direct bearing on the value of the largest of household assets – residential real estate. And the Fed is MIA? There is thought just starting to go around the Street these days that the "Bernanke put," if you will, is at a lot lower levels than most believe. In other words, the Fed will surely come to save the day at some point, just not at current price levels in the credit and equity markets. Could it really be that the Fed would like to see the reintroduction of moral hazard into financial asset pricing? I'm not so sure there is not a fair amount of truth to this idea. After all, in so many parts of the market where credit is created outside of the banking system per se, the Fed is no longer in control. I've mentioned this very idea in past discussions, especially those focused on derivatives. IF market participants begin to believe that the Fed may not call out the monetary paramedics each and every time the credit markets scrape their knees, could this perhaps growing belief influence forward credit market repricing? C'mon, do I really need to answer that question? For now, I think it’s crucial to watch events in the credit markets very closely as they are a key tell. And certainly it is indeed different this time as players in the credit markets are as highly levered as at any time in history. Potentially meaningful credit market repricing mixed with record levels of leveraged investment, quite the Molotov cocktail, now isn't it?
As you know, I've really been focusing on the credit markets up to this point. And it’s really no wonder as they are ground zero for the current credit cycle that has been so supportive to both our financial markets and real economy, especially this decade. So what about equities? Are they weighing in on what may be this very important change in macro financial asset risk based repricing? Again, in looking out the window and taking the time to think about longer-term views of life, I believe the answer is definitively yes. Although the coincidental drop in equity markets a few weeks back was blamed on Chinese officials, Greenspan mentioning the word recession, and the BOJ raising short term interest rates a wildly monumental quarter point, these short term rationales may all be noise. I firmly believe what the equity markets may also be seeing is this forward potential for a repricing of risk in many financial asset classes of the moment. A few pictures that, at least to me, paint a story.
In my early years in this business, I grew up as a hard-core fundamental analyst. But with more than a few years under the belt now, I can't live without the marriage of technical and fundamental disciplines. I've personally learned the hard way too many times now, to have an incredible amount of respect for the message of the charts -- messages human eyes rarely see with 20/20 vision by focusing purely on the fundamentals. In that spirit, what clearly caught my eye at the end of February was, at least from my humble perspective, a massive coincidental confluence of technical signals. Again, in looking out the window, I wanted to try to deliberately force myself to avoid the day-to-day and week-to-week activity. Hence, the monthly charts. Again, right to the bottom line. February month end showed us bearish engulfing candles collectively in the SPY, the DIA and the QQQQ. Do you know how many times this has happened on a simultaneous collective monthly basis since the current equity rally began in 2003? NOT ONCE! Have a look:
Without trying to sound melodramatic or over the top, I believe this collective and coincidental message is important. As you know, unlike the strict equity indices themselves, the ETF's for the headline indices can more reflect futures trading as they trade intraday. Again, from the experience of looking out the window and thinking a bit, and also trying to tie in the collective movement and message of the credit and equity markets as one, is it that the equity markets in recent weeks are also beginning to see this theme of investment risk repricing ahead as being quite meaningful? The history of bearish monthly engulfing candle occurrences since 2003, in and of themselves, have been important markers. Each has lit the way to subsequent equity market weakness of substance. Whether the current coincidental occurrence is telling us a very important cycle top of the last four plus years is now in place remains to be seen, but the collective message sure seems a clear warning. I'd suggest ignoring it at your own risk.
So there you have it. The result of turning off the screen and shutting down the CPU. The result of trying to keep the thinking simple and distilled down to a key idea or two. We'll just have to see how it all unfolds ahead, but I hope you keep in mind that the repricing of investment risk across many asset classes of the moment may indeed be a very critical theme for the months and quarters ahead. And the ramifications of such a possibility in what is a very highly levered investment environment of the moment, unlike any other we've ever experienced, may mean a few fireworks on Wall Street long before the fourth of July.
© 2007 Brian Pretti