Putting is succinctly, financial markets were again unsettled. For the week, the Dow and S&P500 dropped just over 1%. The Utilities declined almost 2%, while the Morgan Stanley Cyclical index was marginally positive and the Transports gained almost 1%. The small caps had a relatively good week, as the Russell 2000 rose just over than 1%. Technology stocks were mixed, with the NASDAQ100 dropping 2% and the Morgan Stanley High Tech index declining 3 ½%. The Semiconductors, after a big gain last week, dropped almost 6%, as its year-to-date gain was reduced to 57%. The Internets outperformed, managing a small advance for the week, while the NASDAQ Telecommunications index dropped almost 2%. The financial stocks came under more aggressive selling pressure as interest rates moved higher, with the S&P Bank index dropping 2% and the Bloomberg Wall Street index suffering a slight decline.
It was yet another atrocious week in the credit market, as the unfolding crisis took another major step forward. By the look of the marketplace, the leveraged players have been hurt and have been forced to take more aggressive actions to mitigate mounting losses. The critical middle part of the Treasury curve was hammered with 5-year Treasury yields rising 22 basis points to 6.76%, and the key 10-year note surging 30 basis points to end the week at 6.51%. Two-year Treasury yields jumped 15 basis points to 6.82%. Over the past two weeks, 2-year yields have jumped 58 basis points, 5-year yields 51 basis points, 10-year yields 47 basis points and the 30-year bond rates, 23 basis points. Ominously, Treasuries have actually outperformed most debt instruments this week. The key 10-year dollar swap spread widened 11 basis points to 130. Mortgages performed poorly with the current coupon Fannie Mae mortgage-back yields surging 35 basis points to 8.39%. Agency securities were hammered as well with the implied yield on the new 10-year agency futures contract spiking 35 basis points to 7.62%, this compared to 7.06% just 9 sessions ago. Mortgage and agency securities ended the week with the highest yields in five years. With mortgage-backs under heavy selling pressure, higher rates are being passed along to borrowers as adjustable mortgage rates hit a nine-year high this week and conventional fixed mortgage rates rose to almost four-year highs.
“First, the whole reason for a hedge fund’s existence is the supposed ability of its managers to spot market errors – stocks, currencies and so on that are priced either too high or too low given the fundamentals. The idea then is to engage in arbitrage – buying the underpriced assets, selling the overpriced. This strategy can make huge returns for the fund’s investors, but it can’t work if markets get the prices right in the first place.” Paul Krugman, The New York Times April 2, 2000
Economists and pundits alike have difficulty containing their exhilaration when it comes to the demise of Julian Robertson’s Tiger Fund Management and now George Soros’ forced restructuring of his wounded hedge fund empire. Interestingly, as Krugman’s above comment makes clear, there is anything but alarm that the brightest and most successful managers in the investment business have decided not to play the game anymore. Instead, the consensus view recent events as a great and decisive victory in a war between so-called “efficient markets” and the large hedge funds. Through the eyes of much of the economic community, free market’s and capitalism’s conquering of these large macro hedge funds was as inevitable as the fall of communism. The “new paradigmers” attribute the wondrous information and communication revolution as a critical development leveling the playing field at the expense of the big hedge funds. Now, apparently, the new kings of the marketplace are the “informed” retail investor and online trader equipped with Internet access. And, of course, the champions of theories of pure competition, efficient and rational markets, and the new era are quick to celebrate their role in the “victory” over the hedge funds.
So it is as amazing as it is ironic that concomitant with the onset of what will certainly prove a most difficult period for American and global capital markets, the majority of economists, the “efficient market” crowd, and the “new paradigmers” simply could not be more cocksure of endless prosperity that, as they see it, is the natural fruit of a profoundly sound and healthy US financial system and economy. And, to be sure, we simply could not imagine a wider gulf between perception and reality – indeed, this momentous gap is analogous to the Grand Canyon. Certainly, Messrs. Robertson, Soros, and Soros’ departing managers Druckenmiller and Roditi’s view of the unfolding financial environment is vastly different than the academics and the bullish consensus. Arguably, these brilliant money managers’ decision to retreat from the markets is a major development – we see it as an end of an era. Not only is this certainly precipitated by the dramatic heightening of risk within the US and global financial system, their withdrawal will now only exacerbate already faltering liquidity. There is clear evidence of this in the unsettled trading in equity, credit and currency markets.
And while the academics puff their chests and the media salivates over recent market losses, we are of the opinion that few individuals in the world have a better perspective for understanding the developing financial and economic crisis than Mr. George Soros. We strongly recommend reading/rereading Mr. Soros’ 1998 book The Crisis of Global Capitalism. Although it was generally panned by the reviewers (with a notable exception The New York Times talented Floyd Norris), it, as much as any book we are familiar with, provides both critical insights and a logical framework for making sense of the unfolding environment.
It is much easier reading than his classic The Alchemy of Finance, and more currentthan Soros on Soros – staying ahead of the curve. Mr. Soros shares great insights including his theory of reflexivity, or paraphrased by Floyd Norris, the concept “that reality affects perceptions and (reality) in turn is affected by those perceptions.” Others have a short-cut explanation for reflexivity as “the world that is being discounted is much determined by how it is discounted.”
Quoting from Soros’, “Our expectations about future events do not wait for the events themselves; they may change at any time, altering the outcome. That is what happens in financial markets all the time. The essence of investment is to anticipate or “discount” the future. But the price investors are willing to pay for a stock (or currency or commodity) today may influence the fortunes of the company (or currency or commodity) concerned in a variety of ways. Thus changes in current expectations affect the future they discount. The reflexive relationship in financial markets is so important…”
“I contend that the concept of reflexivity is more relevant to financial markets (and to many other economic and social phenomena) than the concept of equilibrium, on which conventional economics is based. Instead of knowledge, market participants start with a bias. Either reflexivity works to correct the bias, in which case you have a tendency toward equilibrium, or the bias can be reinforced by a reflexive feedback, in which case markets can move quite far from equilibrium without showing any tendency to return to the point from which they started. Financial markets are characterized by booms and busts and it is quite amazing that economic theory continues to rely on the concept of equilibrium, which denies the possibility of these phenomena, in face of the evidence. The potential for disequilibrium is inherent in the financial system; it is not just the result of external shocks…”
“I argue that the current state of affairs is unsound and unsustainable. Financial markets are inherently unstable and there are social needs that cannot be met by giving market forces free rein. Unfortunately these defects are not recognized. Instead there is a widespread belief that markets are self-correcting…”
Mr. Soros’ focus on reinforcing “reflexive feedback” and financial market booms and busts is certainly apropos. We also salute Mr. Soros for appreciating the great role credit plays in fostering booms and busts, something most analysts completely disregard. In a recent commentary we discussed the egregious credit excesses throughout the Internet/telecom and technology industries during the present boom cycle, and how there are ominous parallels to draw from the international/LDC lending boom and bust from the 1970’s and 1980’s. Soros’ analysis provides additional insight.
“Money is closely connected with credit but the role of credit is less well understood than the role of money. This is not surprising because credit is a reflexive phenomenon. Credit is extended against collateral or some other evidence of creditworthiness and the value of the collateral as well as the measurements of creditworthiness are reflexive in character because creditworthiness is in the eye of the creditor. The value of collateral is influenced by the availability of credit. This is particularly true for real estate – a favorite form of collateral. Banks are usually willing to lend against real estate without recourse to the borrower, and the main variable in the value of real estate is the amount the banks are willing to lend against it. Strange as it may seem, the reflexive connection is not recognized in theory and it is often forgotten in practice. Construction is notorious for its boom/bust character and after each bust bank managers become very cautious and resolve never to become so exposed again. But when they are again awash with liquidity and desperate to put money to work, a new cycle begins. The same pattern can be observed in international lending. The creditworthiness of sovereign borrowers is measured by certain ratios – debt to GNP, debt service to exports, and the like. These measures are reflexive because the prosperity of the borrowing country is dependent on its ability to borrow, but the reflexive connection is often ignored. That is what happened in the great international lending boom of the 1970s. After the crisis of 1982, one would have thought that excessive lending would never happen again; yet it did happen again in Mexico in 1994 and yet again…in the Asian crisis in 1997.”
Mr. Soros has been a key player in an historic period of leveraged speculation. He has witnessed how the hedge funds, and leveraged speculating community generally, have come to play dominating roles throughout the credit market. The speculators certainly blossomed under the stewardship of the Federal Reserve, especially with the Fed’s dramatic move to lower rates to 3% in the early 1990’s. In this regard, we don’t think the Fed and global central bankers have been given the credit/responsibility they deserve for their role in nurturing the leveraged speculating community. Although the infamous government carry trade “blew up” in 1994, the deepening financial crisis in Japan and the Bank of Japan’s move to lower rates to almost zero provided an even better “yen carry trade” for the leveraged speculators. Moreover, pegged currencies throughout SE Asia and the emerging markets provided another great “carry” and derivative trade until, of course, this bubble “blew” as well during 1997/98. Partly due to the global crisis and specifically because of aggressive efforts of the US financial sector, particularly the government-sponsored enterprises, a manic climax developed for history’s greatest interest rate speculation and credit bubble. The US financial sector became one massive arbitrage, shorting US government securities or borrowing in the money markets to take leveraged and derivative positions in US corporate securities, mortgage-backs and, importantly, agency securities. This unprecedented credit expansion fueled an historic stock market bubble, general asset inflation and a most maligned economic boom. We believe Mr. Soros understands clearly that this game is now ending, and that a major liquidation of leveraged positions and resulting bust is unavoidable. With this in mind, and considering our view that this great US credit bubble has now been pierced, the following quote from Mr. Soros is today particularly pertinent.
“Credit plays an important role in economic growth. The ability to borrow greatly enhances the profitability of investments. The anticipated rate of return is usually higher than the riskless rate of interest – otherwise the investment would not be made in the first place – and there is therefore a positive profit margin on borrowing. The more an investment can be leveraged the more attractive it becomes, provided the cost of money remains the same. The cost and availability of credit thus become important elements in influencing the level of economic activity; indeed, they are probably the most important factors in determining the asymmetric shape of the boom/bust cycle. There may be other elements at play, but it is the contraction of credit that renders the bust so much more abrupt than the boom that preceded it. When it comes to the forced liquidation of debts, the sale of collateral depresses collateral values, unleashing a self-reinforcing process that is much more compressed in time than the expansionary phase. This holds true whether the credit was provided by the banks or the financial markets and whether the borrowing was against securities or physical assets.”
In respect to Mr. Soros’ theory of reflexivity and how credit plays a central role in boom and bust cycles, two specific areas deserve particular attention. First, leveraged lending to the telecommunications/Internet sectors. We see great similarities between the 1970’s/80’s boom and bust in LDC lending and the more recent spectacular telecom/Internet lending and speculative bubble. Indeed, the prosperity of the borrowing company/industry is dependent on its ability to borrow. The illusion of wealth creation from a multitude of companies that will never generate profits or positive cashflow holds only as long as new credit and capital are forthcoming. Clearly, the perception of incredible wealth opportunities fostered massive speculative and credit excesses that manifested into an historic boom. Overpriced stock and manic speculation created strong positive feedback, as did unprecedented credit excess. Bust will now follow boom.
However, nowhere has perception and reflexivity played such a profound role in fostering unprecedented excesses than with the explosion of derivatives. Before we dive into this discussion, another Soros quote. “Reflexivity is absent from natural science, where the connection between scientists’ explanations and the phenomena they are trying to explain runs only one way. If a statement corresponds to the facts, it is true; if not, it is false. In this way, scientists can establish knowledge. But market participants do not have the luxury of basing their decisions on knowledge. They must make judgments about the future and the bias they bring to bear influences the outcome. These outcomes, in turn, reinforce or weaken the bias with which the market participants began.”
During this long bull market, there has been a belief that derivatives strategies and sophisticated risk management models are a “natural science.” Instead, the unappreciated fact is that Soros’ theory of reflexivity has played a momentous role in the dangerous proliferation of derivatives. Participants’ perceptions that derivative “insurance” was an effective vehicle for reducing/mitigating risk, actually only exacerbated the growing proclivity for risk-taking. The availability of derivatives changed behavior and risk perceptions. This has particularly been the case with the endemic use of derivatives by the leveraged speculating community throughout the credit but also the equity markets. These derivative strategies have played a major role fostering massive leveraged speculation that has provided, to this point, insatiable demand for the debt securities and credit instruments that have been the fuel for a protracted financial and economic boom. Certainly, there is a perception in academia, the marketplace, as well as within the Fed, that derivatives and contemporary risk management techniques have been a positive factor in unprecedented “wealth creation.” This bias has only strengthened over the long life of this boom. However, the “science” behind derivatives is flawed, specifically as it relates to “efficient” markets and liquidity (to be discussed another day.) All the same, the proliferation of derivatives during this long bull market created a strong feedback mechanism, where greater volumes of derivatives have fostered more egregious credit excess that fueled higher asset prices, only to engender additional derivatives and credit excess. Indeed, derivatives have not reduced risk all. Instead, through the enormous increase in underlying leverage, derivatives have dangerously accentuated the inherent instability of financial markets and the boom/bust cycle.
This week’s Economist had a very interesting quote related to derivatives. “Regulators might still be interested to hear what Mr. Druckenmiller has to say about risk management models, especially the ubiquitous value-at-risk (VAR) models, which purport to show how much an institution might lose. Quantum was forced by its bankers to use such models after their near-death experience with LTCM. ‘VAR is extremely dangerous. People look at their computer models and think they are safe. Much better to have no models and watch your own net worth every day.’ Watching it crumble is what told him to get out.”
The Economist also quoted Mr. Soros’ as saying “I AM very happy to pull my money out of the market.” The same article quoted Mr. Druckenmiller as stating “The stock market is now crazy-insane, unbelievably dangerous.” The most telling quote, however, came earlier in the week from Mr. Soros: “Markets are extremely risky, and in some ways I think the music has stopped – only most people are still dancing.” We think Mr. Soros was referring to the credit market as much as he was the stock market bubble. As a student of markets, economics, credit and booms and busts, as well a master of macro “bets”, Mr. Soros has, as much as anyone, a keen understanding of all facets of the present environment. Clearly, Mr. Soros is well aware of the enormous leverage in the US financial system, and the acute vulnerability of the credit-induced US financial and economic boom to an inevitable bust. At the same time, it is an extraordinary enigma to us that the vast majority of individuals within the fields of finance and economics can remain incredibly oblivious to the unfolding environment.
