by Brian Pretti CFA, Contrary Investor. August 17, 2007
At the end of March of this year, I penned a discussion entitled, "It's Delightful, It's Delovely, It's Deleverage!." If you don't mind, just a quick snippet from the final paragraph of that piece to set the tone, if you will.
"It's clear that market participants of today are wildly complacent about, or simply do not understand, the potential for risk in structured finance vehicles and the layering of levered investment, especially in the hedge community. The fact that a number of hedge funds were "surprised" to find they had sub prime exposure in their CDO investments simply tells us that even the masters of the universe do not have all of their hands around the question of investment risk. In straight up markets, there are few questions. But in the current environment, there will also be very few questions asked if meaningful downside is to unfold. Rather, those being hurt by leverage in what could become a punishing market environment will shoot first and save the questions for later. The double edge sword of leverage tends to evoke those types of responses. Little time for philosophical debate when one is losing money. Funny how that works."
So, about four and one half months after this was written, here we now stand today in full view of "the other side" of many a levered investment strategy. A bit of an education for those unfamiliar with the raw force and power of changing human emotions and perceptions. Hopefully to put it calmly and tactfully, financial market stress levels have elevated in a big way. So for the moment, not only do we have to deal with the very important fundamental question of whether what we are now experiencing is indeed the peaking of the macro credit cycle of a generation, but also important to financial asset prices of the here and now will be how human beings physically respond to heightened stress. In very simple terms, it’s the human fight or flight mechanism that has been essentially programmed into the human brain over thousands of years of human experience that we need to keep in mind as we watch the rapidly changing colors on the Bloomberg screen each day. Flight from risk, or stress, is an unavoidable human reaction. Although I clearly do not want to turn this into a discussion of human physiology, studies done regarding human stress are clear – once stress levels elevate the nervous system (sympathetic nervous system - SNS), the body is very slow to shut down the SNS and allow the PNS (parasympathetic nervous system that promotes relaxation) to take over. Simple English translation? We're going to be in for having to deal with heightened financial market stress for a while yet, so get used to it. Stress management, and hence investment risk management, is the order of the day.
There is no doubt in my mind that one of the most important questions that will be asked again and again in the period immediately ahead is whether the macro credit cycle we have come to know and love over the past few decades, but particularly decade to date, is now over. During the years I have been writing market commentary, I have probably annoyingly repeated one theme over and over again on far too many occasions. It's the theme that the US economy, and really global economy, has not been running on a traditional business cycle, but rather a credit cycle. So at least from my perspective, the peaking credit cycle question has implications far beyond investments in sub prime paper alone. Far beyond. Of course the unfortunate part of the equation at the moment is that no one really knows the correct answer to the question of a peaking credit cycle with any certainty. One thing I can virtually guarantee is that if indeed the credit cycle begins to decelerate, which is the telltale sign of age, fatigue and ultimately failure, it will be met by a huge fight from the global monetary powers that be. Let's be honest with each other -- they have no other choice. They have no other options.
Having said all of this, maybe one of the most important exercises we can undertake ahead is to listen to the messages of the market itself, with particular emphasis on those sectors that have been the longer term beneficiaries of the credit cycle that has brought us to this point. As you might imagine, there is plenty to watch as the financial sector that has been the locus of the credit cycle is broad and the players varied. Let's face it, who isn't a lender these days? So for the purposes of this discussion, let's keep it simple and home in on one very important tell as a start – the investment banking and brokerage community. Why? I'll try to keep this short, but a quick bit of very generic history. As the current credit cycle has evolved in the US over really the past three decades+, what was really the primary purview of the banking system itself in terms of creating and allocating credit gave way to increasingly sophisticated capital markets and ultimately a plethora of non-banking system related credit creation.
I've argued for years that in many senses the Fed has been marginalized in the current environment. Non-bank credit creation is largely out of their control. And, at least in my mind, who is at the epicenter of non-bank credit creation? None other than your friendly neighborhood global behemoth investment bank/broker. Think about it. Who funnels those packaged residential mortgage backed securities into the investment hands of insurance companies, university endowments, pension funds, hedge funds, etc? Who guarantees private equity financing? Who is right there to encourage levered M&A? Who is more than happy to help facilitate debt financed corporate stock buybacks? In essence, who is directly involved in non-bank credit creation in most every important segment of their business? By now I'm sure you've got the picture. There's a lot to watch when it comes to the credit cycle and I'll further elaborate on this in future discussions, but for today and in the period ahead, I believe the first line of attack is to home in on the state of stress/change in non-bank creation. Although this may sound simplistic, I believe this is the first area where risk will be re-priced and leverage rationalized if indeed the macro credit cycle is decelerating. After all, isn't this exactly what we've seen over the past month or so?
First, and as always, it will be important to watch the "message" of the price action of the stocks themselves. The message of the XBD is straightforward.
Although there has been some meaningful price damage done as of late, the long-term uptrend begun in early 2003 remains intact for now. The XBD will meet up with that trend line near the lows of 2006 if indeed a rendezvous is in store. Certainly this is as far below the 50 week MA as this index has been since the current equity rally began in 2003, so I'd suggest it’s a meaningful interlude.
But I believe stock price action in an absolute sense is only one part of the story. The second critical issue is response of the stocks to credit market conditions. Yes, these folks have been roughed up as yield spread widening for risky debt has occurred, and many parts of the wild west non-banking credit market have simply been boarded up and closed down for now. Yes, the investment banks/broker have taken a few serious body blows related to failures and troubles in their sponsored hedge fund affiliations. But there is something much more simple that may indeed be speaking quite loudly and saying something not too pleasant about the immediate future of non-bank credit creation. As I've tried to illustrate in the chart below, the brokerage stocks have responded very positively to declines in longer term interest rates since the current equity rally began in 2003. Every time 10 year Treasury yields have experienced declines of meaning over this period, brokerage stocks have moved higher... until now, that is. The history of this relational experience is clear.
Not only is this relationship clear, but not surprising in the least. In an economy driven by credit cycle dynamics as opposed to more pure productive capital investment business cycle dynamics, declining interest rates provoke the Pavlovian response of increasing leverage. And from a macro or systemic standpoint, an increase non-bank credit creation increases investment bank/broker revenue and bottom line opportunities. Hence, my belief that the investment banks/brokers will be a key tell as to the state of stress and forward direction and magnitude of non-bank credit creation.
I'll leave you with one last historical view of life in the investment bank/broker dealer world. It's the longer-term history of broker dealer liabilities in aggregate. Since year-end 2003, B/D liabilities have doubled (please note that this is based on annualized 2007 to date experience).
But what may be more important than the nominal increase in B/D liabilities over time is the annual rate of change in the acceleration of those liabilities. As is clear, during times of financial market stress (1994 and 2002 specifically) in the past, the investment bank/brokerage community actually engaged in deleveraging. Exactly the process most of their current clients (hedge funds and other levered investment pools) are going through right now. Is the investment bank/brokerage community soon to follow? That is the key question with meaningful ramifications for the macro credit cycle as we look ahead.
A few final comments. Please remember that the investment bank/brokerage community is only one slice of the greater macro credit cycle pie. I've chosen this sector as simply a start in trying to decipher and "see" what lies ahead, as I believe the most egregious credit risk has been undertaken in non-banking system credit creation activities. If indeed the macro credit cycle as we have come to know it over the last three plus decades is set for meaningful change, we're going to see it first in the non-bank credit creation/facilitation community. Stress in the credit cycle is here. What has been previously untested is now being tested. It's an emotional time and the best investment advice I can dispense is to manage risk, manage risk and manage risk. Any questions? From adversity ultimately comes opportunity. From destruction ultimately comes reconstruction. As we live through this current credit market testing process, remember to keep your eyes open for opportunities. Those opportunities may be months or years away for all I know, but they will come. Try as best as possible to maintain personal and emotional balance. Allow the emotional imbalances of others and the crowd as a whole to ultimately deliver opportunity to you on a platter, best served with a heaping side dish of patience and discipline. At least in my mind, these are the key personal characteristics of successful investors.
© 2007 Brian Pretti