Amit Chokshi
submits:
Technology's Breaking Point
On May 6, 2010, US equity markets basically saw an entire four
months of gains nearly wiped out in one day. According to
Bloomberg, the Dow Jones Industrial Average ("DJIA") lost 600
points from 2:42PM-2:47PM, a story that is sure to be extensively
covered for the next few days. I personally think this was a
healthy correction and was needed in that it resulted in high
volume (19.2B across US exchanges, highest since October 2008) and
flushed out a number of investors. The volatility index ("VIX")
screamed up to over 40 before settling at 34, much higher than the
high teens where the VIX has traded in recent months. The sharp
sell-off will be discussed over the next few weeks but there seems
to be a much larger problem that hopefully the media and
policymakers will address.
While technological innovations can provide a number of massive
benefits, they can also threaten system stability if improperly
accounted for. It seems that this is the trend in financial markets
whereby "innovation" continues to ironically contribute to more
systemic risk. This was the case not only in the origination of a
variety of derivative securities but also with a number of
technological "innovations". For example, dark pools have grown in
recent years and have often been touted as a source of extra market
liquidity. However, it's clear that market liquidity disappears on
days when it's most needed, despite the growth in dark pools. This
area should be examined by policymakers.
Another more critical area policymakers should focus their
attention on is program/flash and algorithmic trading. May 6, 2010
probably provided the clearest example of the limitations and risks
associated with having programs handle order flow with minimal
intervention from floor specialists. For example, Procter &
Gamble (
PG
), one of the most stable global companies, saw its stock drop from
the $60s to $48 in a matter of minutes before sharply
rebounding.
This pales in comparison to the performance of other stocks. For
example, Accenture (
ACN
), which sports a market capitalization of roughly $26B, saw its
share price drop from $41 down to $0.04 in a matter of minutes
before rebounding back to its initial level. The same phenomenon
occurred with the iShares Russell 1000 Value Index ETF (
IWD
) which plunged from roughly $60 to $0.08 before bounding.
The technology behind the trading systems supporting financial
markets worldwide clearly has its limitations. As more trading and
portfolio management activities have fallen into the realm of
complex programs, it appears that more bizarre occurrences are
manifesting themselves.
Fundamentals do win out in the long-term but policymakers should
consider the circular downward impact these extreme trades can
have. The notion of rational investors has generally been dispensed
of and these types of trades, whereby a company like ACN can
essentially be valued at zero because investors are worried about
riots in Greece (which somehow overwhelms global trading
infrastructure), should stoke some serious concern by market
participants and regulators. Even if there is no fire in the movie
theatre, if investors believe there is, they will react accordingly
and these trading anomalies only reinforce the agony of market
participants. Volatility in capital markets is normal and healthy,
but when the infrastructure behind trading has blatant flaws,
volatility is unnecessarily amplified and reduces confidence. The
actions by the Nasdaq and NYSE, which both elected to rescind
certain trades that occurred during the most volatile time period
on May 6, will only spur an additional lack of confidence in the
backbone of financial markets.
The Fed Needs to Take Charge
The market sell off on May 6 was accompanied by live feeds of
rioters in Greece who were protesting the recently passed austerity
plans that were a condition for Greece receiving the bailout
package from the International Monetary Fund ("IMF") and European
Central Bank ("ECB"). Markets were in part selling off because of a
lack of confidence in the ability of Greece to actually implement
the austerity plans. While the government passed these measures,
large crowds of rioters suggested the actual adoption of these
austerity plans would be challenging at best. Since the bailout
Greece needs is tied to the ability to address its budget deficit
and debt levels, the inability to pass these measures would
increase the likelihood of default, which would rattle continental
European banks. It would also set a bad precedent for other PIIGS
countries to follow and further pressure the Euro.
The Euro is widely held and its rapid devaluation due to the
crisis is what contagion is all about. Financial institutions
worldwide have Euro holdings and this contagion is what is
pressuring global markets. With the rapid devaluation in the Euro
relative to the USD and JPY, financial institutions' capital
positions are under stress. European banks may fund many of their
assets with Euros but the current crisis is pressuring the Euro,
requiring these banks to find alternative funding sources for some
assets (i.e. USD). This in turn is what spooks the markets.
The ECB is also much less sensitive to market activity relative
to the Federal Reserve, which may have resulted in further market
pressure as participants have less confidence in the ECB relative
to the Fed. However, if the Euro continues to decline in value, the
Fed should step in as they did after 9/11 and in 2007 with the
establishment of foreign exchange swap lines ("FESL").
While the Fed deserves considerable criticism for a variety of
actions over the decades, including a number of actions during the
height of the financial crisis, the FESL program was a crucial
program that helped alleviate global financial and funding
pressures, both in the first month or so following 9/11 and then
during the financial crisis starting in 2007. With a rapidly
declining Euro, establishment of FESLs would be a way to calm
markets because it would eliminate exchange rate risk between
central banks and provide a solid funding source for financial
institutions in Europe.
Under normal conditions, foreign central banks ("FCBs") can
provide funding in USD for the banks under their purview, either by
depleting their USD reserves or through open market transactions.
The problem is that in times of stress, these actions exacerbate
the problem. First of all, FCBs don't typically stock up on large
amounts of USD, so in a liquidity crunch these USD reserves could
be rapidly depleted. Second, in open market transactions, FCBs
would be selling their domestic currency to buy USDs, which would
add to the pressure on their domestic currency and increase the
value of USDs, expanding the exchange rate and funding gap.
This is why the FESLs were needed and why they alleviated
funding pressures. Under FESLs, the FCB would sell a set amount of
its currency to the Fed in exchange for USD with an agreement
whereby the FCB would repurchase its currency at the exact same
exchange rate in the future. From there the FCB could dispense the
USD as it saw fit to banks under its authority. The FCB would also
pass on interest from its USD lent to its member banks on to the
Fed. In addition, the Fed agrees to hold the FCB's currency on its
balance sheet as opposed to circulating it into financial
markets.
The FESLs could provide some much needed stability to the Euro
because it eliminates exchange rate risk, in effect providing
back-stop funding for the Euro's value. In addition, the FESLs have
precedent for successful implementation both after 9/11 and during
the credit crisis of 2007-2008. In fact during the credit crisis,
the FESLs were established between a number of FCBs including the
ECB, Swiss National Bank, Bank of Japan, Bank of England, Bank of
Canada, Reserve Bank of Australia, Reserve Bank of New Zealand,
Sveriges Riksbank, Norges Bank, Danmarks Nationalbank, Banco
Central do Brasil, Banco de Mexico, Bank of Korea, and the Monetary
Authority of Singapore.
This period may arguably have been more challenging in that it
included an inflated asset backed commercial paper ("ABCP") market
that was imploding along with the implosion of SIVs -essentially
poor, short-term and widely used funding sources ((
ABCP
)) for generally perceived garbage assets (SIVs) that needed to be
carefully worked down. This period also included the bankruptcy of
Lehman Brothers. Unlike other programs, the FESLs were wound down
in an orderly fashion once stability was established as
demonstrated in the
graph
above. As illustrated, outstanding amounts on FESLs peaked near
$600B before being wound down.
Given the fumbling by the ECB, the Fed should seriously consider
intervention due to the ongoing pressure on the Euro. Market
participants have indicated that they have significant doubts about
Greece's ability to execute its austerity programs, thus posing the
risk of a default. The $500B question is whether a Greek default
could be a Lehman Brothers redux in terms of cascading, negative
market impacts or if establishment of support systems like the
FESLs are worth the effort in heading off a potentially huge crisis
at the pass. Given the previous successful implementations of
FESLs, I'm hopeful that the Fed will consider utilizing this tool
once again.
Stimulus Plan Part II?
USD bears have been slowly realizing that in a relative value
world the USD reigns supreme. While deficit hawks were screaming
bloody murder about the US debt when US Ten Year rates hit 3.9% (US
funding costs were about 6% when the US had a surplus but
surprisingly deficit hawks ignore this or are unaware of this), the
Greek crisis has sparked a flight to safety with rates now at 3.4%.
With unemployment incredibly high in parts of the world - much of
it structurally - and funding for many of these countries such as
the PIIGS highly constrained, the US should capitalize on the cheap
funding and launch a second stimulus plan.
Countries such as the PIIGS, which include the world's 9th
largest economy in Spain, will be adopting austerity measures that
are likely to foist even more economic malaise on these countries
and in effect the global economy. The US, given its cheap funding,
could pick up the economic slack for these countries which would
also benefit the US and the many unemployed. In addition, the
current US recovery is very anemic and if global markets are
expressing a strong appetite for USD, we should take advantage of
it.
The first stimulus program, although not ideally structured for
maximum benefit, produced roughly 2MM jobs. These estimates come
from Moody's, IHS Global Insight, Macroeconomic Advisers, and the
Congressional Budget Office ("CBO"). However, by H2 2010, the
stimulus programs will have been expended and current economic data
suggests the recovery is very fragile. Given a funding cost of 4.2%
for 30 year paper, the US could borrow considerable capital and
invest it in the country, providing jobs and improving the
country's diminishing infrastructure.
Activity in certain commodities such as copper and oil suggests
that these economically sensitive asset classes could roll over.
The US could be getting a good deal on these assets which would be
required for rebuilding infrastructure as they decline in value. So
not only would those that are having the most difficulty in
obtaining jobs have the opportunity to be employed, the actual cost
for the US to improve infrastructure could be fairly low as funding
costs are low and commodities such as cement, copper, and oil
appear to be rolling over.
Deficit and debt hawks would state that the US is borrowing "too
much". History demonstrates that this is not the case. The US is on
track to have Debt/GDP of roughly 60%. That may sound like a lot
but Debt/GDP exceeded 100% in the late 1940s
after World War II
. Despite having this sizable consumption source eliminated,
Debt/GDP still steadily declined. Of more
relevance is the data presented by Kenneth Rogoff and Carmen
Reinhart in This Time It's Different, which suggests that borrowing
costs for countries are not impacted until Debt/GDP exceeds 90%,
suggesting the US still has significant borrowing capacity.
What's important to note is that Debt/GDP can be reduced either
by actually paying down debt or increasing GDP. In most cases
increasing GDP is what reduces the ratio. So as an investor, I see
that the US can fund its capital projects for 4.2%. I can observe
that with considerable slack in the labor force, labor costs will
be lower than normal. I can also observe that electricity usage is
tepid such that power costs would be low. Key commodities like
copper and oil appear to be rolling over which would also present
lower input costs. So cheap funding and cheap input costs should
allow for a high net present value and internal rate of return on a
number of infrastructure projects which can provide long-term
societal benefits and stoke the economy. Unfortunately, this seems
politically untenable although economic data such as US light
vehicle sales, Chicago Fed's National Activity Index, and
stubbornly high unemployment suggest the US could use an extra shot
in the arm. Market data, with US rates pulled in, also suggests
market participants are more than willing to fund US projects for
very cheap rates, in the hopes that it can spark the global
economy.
Don't Trade Yourself Out of Big, Long-term Gains
The past two weeks have had more action than the past four
months. Markets ran into a brick wall in mid April, sparked first
by the SEC's civil suit against Goldman Sachs (
GS
), followed by the ongoing European sovereign debt crisis, and then
the British Petroleum (
BP
) oil spill in the Gulf of Mexico. On May 6, US equity markets
essentially wiped out gains for 2010 in one day. After twelve
months of rapid gains across various asset classes, the possibility
of a pullback was on investors' minds and the recent flurry of
events contributed to this pullback.
Now investors that were waiting to "get in" and hoping for a
pullback when markets were on a tear are balking at the chance to
invest, with the events of 2008 still seared into their psyches.
Some investors that bought smaller amounts of stocks that they
liked and wanted to add on a pull-back are not, preferring to wait
and conduct a séance for guidance.
While these times are scary, investors should not shy away from
legitimate, deep value opportunities. For example, I was recently
interviewed
by Seeking Alpha regarding Sprint-Nextel Corp (
S
). At the time S was trading for about $4.15. Whether it trades at
$4.15 or $4.30 or $3.60 is not a huge factor relative to my
intrinsic valuation of the business and it's hard to lose a lot of
sleep if it gets beaten down from a fundamental perspective. As a
fund manager, however, it is very painful to see big drawdowns
irrespective of your conviction and track record, since fund
marketing is always predicated on your most recent monthly
performance. However, investors that can take a 2-3 year time
horizon and are willing to accept a 50% drawdown on some special
situations that have the potential to return 300% should step away
from the noise, focus on fundamentals and valuation, and dive in.
The current crisis is likely to serve up a number of those types of
opportunities.
Original post
See also
No More Love for the Australian Dollar
on seekingalpha.com