ICEBERGS DEAD AHEAD!
On April 10th, 1912, the cruise ship Titanic owned by The White Star Line, which was owned by J.P. Morgan, set sail for New York City from Southampton. The cost to travel ranged from Third Class at 7£ (676£ today) to First Class suites at 870£ (75,156£ today). The number of exact passengers was not known since the national coal strike in the United Kingdom, disrupting shipping, created many last minute cancellations which has caused debate about the actual number onboard. The most notable cancellation being J.P. Morgan himself on the morning of embarkation. The approximate number of passengers has been placed, however, at 1,317: 324 in First Class, 284 in Second Class and 709 in Third Class. This number was less than half of what the Titanic could actually accommodate.
The passenger list was a Who’s Who of American nobility: Millionaire John Jacob Astor (in today’s terms that would be with a B), Industrialist Benjamin Guggenheim, Macy’s owner Isidor Straus, Denver Millionairess Margaret “Molly” Brown, Journalist William Thomas Stead, Author Jacques Futrelle and silent film actress Dorothy Gibson, among others.
First Class names were recorded for posterity; however, the passengers’ names for both Second and Third Class were lost to eternity. One could say in contemporary terms the Titanic contained the 1%, the middle class and those who found day to day existence a challenge. The travelers were young and old, rich and poor, either returning to America or looking for a new beginning.
The confidence placed in both the construction of the ship and the skill of the crew made the passengers unusually complacent about their safety.
As stocks rose the width of participation by all sectors such as retail, corporate, institutional and banking gave rationale for the continued direction upward. Removing one or two of these elements is dangerous enough. Unfortunately, when only one sector, corporate, has been participating, then danger can be expected on the horizon. When the final sector ultimately decides to withdraw then it will be obvious that the path of least resistance will be down.
In the second quarter share buy backs have actually declined dramatically on a quarter over quarter and a year over year basis.
If it has been so successful then why not just continue the practice? Unfortunately, this pro-cyclical event, like others has a habit of stopping and not by the influence of the corporations themselves. If they had their way trees would grow to the sky forever and they would never cease buying back their own shares. Recessions and closing of the credit markets can be credited for the stopping of what, for a few people, has been a very lucrative enterprise. Now that QE has ended so too will the buy back program and that which has been the supporting feature will only be a cold icy distant memory.
Ignoring geopolitical risks, worldwide slowdowns and daily central bank machinations has become an accepted practice not only by Wall Street, mainstream media but also retail investors themselves. Complacency makes one feel invincible no matter how many icebergs are dead ahead. So what are the factors that are contributing to this, perhaps, most unique period in history?
First, the buy back programs which we mentioned above. Higher stock prices create the perception that all is well.
Next, comes the VIX (a measurement of future volatility) which is historically low, but reasons for its low level has turned it into a misleading fear gauge. Janet Yellen, like her predecessor, implicitly provides the market with protective putts. “Furthermore” the Fed’s ZIRP (Zero Interest Rate Policy) makes investors so starved for any yield enhancement strategies that they are incentivized to go far beyond their risk tolerance.
Finally, the ECB’s (European Central Banks) LTRO Plan (Long Term Refinancing Operations) offered “free money” to banks to buy back high yielding debt of their own countries’. The program helped to collapse sovereign debt spreads and create the illusion that once again all is well in Europe.
The Pro’s, so called, have even come out and stated that the S&P will never again experience another 10% correction. Expectations for the next several years have created such levels that the word arrogance is used by novices of the retail public and even many veterans, disregarding the fundamentals in favor of “what they know” will happen.
Who buys stocks without clearly checking fundamentals? Who buys junk bonds from companies whose future is so precarious they can’t afford to pay a penny of interest let alone the retirement of debt? Who buys shares of a company that has one employee, no assets, no earnings, no revenue and has fraud written all over it?
Who keeps buying houses on the premise of quick flip in spite of the lowest loan originations in history?
The answer to, the who, is the one who is mired in complacency. Whether they are a 40 year veteran who handles other people’s money or a brand new investor managing his first dollar. Complacency will be the death of them all.
However, for the time being batten down the hatches, full speed ahead and icebergs be damned.
As complacency becomes the rule of the day it must be clearly understood that there is a definite bias, as a matter of fact there is an outright extreme opinion in bulls vs. bears. The Investor’s Intelligence Advisors Survey shows that bullish advisors outnumber bearish advisors by a better than 4 to 1 margin yet you have to go back 27 years to find a higher bull/bear ratio.
Cognitive dissonance is clearly the order of the day.
Could the market go down? All agree anything is possible but most believe it is not probable and if there happened to be a “slight adjustment” most are of the mind that they are smart enough to steer around it.
The same thought pattern occurred at 11:40 pm on April 14th 1912. An iceberg was spotted immediately ahead. The First Officer ordered the ship to be steered around the obstacle and the engines put in reverse but it was too late “the starboard side of Titanic struck the iceberg creating a series of holes below the water line. Five of the ship’s watertight compartments were breached. It soon became clear that the ship was doomed as she could not survive more than four compartments being flooded. Titanic began sinking bow first with water spilling from compartment to compartment as her angle in the water became steeper”.
And thus the success of being able to “steer around”.
Has this worldwide economic ship already struck the proverbial iceberg? Next we’ll look at Junk Bonds and how the watertight chambers of indebtedness seem to have sprung a leak.
The Titanic, in 1912, was the largest ship afloat at the time it entered service. It had advanced safety features such as watertight compartments and remotely activated watertight doors. These features, among others, gave the passengers of all classes a sense of comfort and protection.
THE SMARTEST FOLK IN THE ROOM??
In 1998 there was a firm called Long Term Capital (LTCM). It was formed for the express purpose to give vent to the mathematical ideas conceived by some of the best bond traders on Wall Street, two of which would become Nobel Laureates. “LTCM boasted of its use of complex models that were supposed to generate outsized returns while operating with a risk-minimizing portfolio. That, mathematically, was only supposed to experience severe losses so infrequently that the periods between them would be measured in the thousands of years.” Like the Titanic, LTCM was unsinkable – theoretically.
Unfortunately, LTCM struck an iceberg in the form of models badly understanding real risk. The original one billion dollars of capital turned into total losses of 4.6 billion in a little over 4 years. The miscue almost dragged down the entire financial system process. Put your thinking caps on-it’s worth it.
Here is where our tale diverges.
On that fateful evening when the unsinkable sank, two hours later the RMS Carpathia arrived on the scene, to save an estimated 705 survivors but not before more than 1500 had perished, two hours too late.
When LTCM broke apart and foundered no such delay was experienced. The Federal Reserve swooped in and saved all hands on board. In this instance was born the terms “Too Big Too Fail” and “Moral Hazard”.
If those building ocean liners learned from the catastrophe of the Titanic so too did those learn from the LTCM debacle “Go big or go home. Take on as much risk as possible secure in the knowledge that if things go bad enough the Fed will simply print up what was necessary to make all the players whole again, with perhaps one minor player or institution thrown under the bus for the sake of appearances.”
In 2008, the lessons of the past had been learned well.
Wall Street’s perception that it is best rewarded by chasing big risks and big returns. In the event an iceberg got in the way the Federal Reserve rescue ship would cruise to the rescue.
Consider no one of consequence went to jail after fraud and excesses were revealed in housing. In addition not one penny of ill gotten profit had to be given back. A few fines, a slap on the wrist and back to what they all do well. They took taxpayer funds, continued to pay themselves gigantic bonuses, and after the dust settled began taking huge new risks.
Thus, today, financial risks instead of being reduced loom larger than ever. The iceberg that was supposed to be melting due to Al Gore’s global warming has grown in size. Nothing has been learned! Nothing has changed!
The same Federal Reserve that could not and did not see the housing bubble.
They encouraged risk taking to a level where CCC rated corporate bonds, one step from default, are mainstays in seniors’ retirement accounts. The bond market is the 800lb. gorilla. It dwarfs the equity market by 2 to 1 or 3 to 1 if you include non-securitized loans. More important, the yields to worst, junk, hit lows never before seen in history. The idea that the worst of the worst credit risks in the corporate world are now yielding less than 6% is absurd. Factor in the Sovereign European debt debacle and the 800lb. gorilla has put on a lot more weight.
Like the Titanic passengers’ confidence of steering and structural soundness, so too do many believe that the Fed has all of this under control. It is believed the Fed can steer the consequences of the entire world of investment and speculation decisions to a normal and graceful ending.
However, perchance the ship is not as sound as most believe and many have been heading for the lifeboats.
For 22 consecutive days the outflow from high yield retail funds has been flying another warning. 16.9 billion dollars in assets. A pittance to the trillion dollar market could be the first sign of a hole which has been breached.
The major players all knew that buyers aren’t readily available at such low yields and, therefore crying fire in a crowded theater does no one any good.
However, Nash’s Gains Theory about the “first mover” seems to have convinced a few that getting out with something is far better than being the last man standing. The ship of junk, all be it slowly, seems to have sprung a leak.
Why is this so important to the overall market and, in my opinion, the ship killing iceberg? First of all, understand that stock prices, in the most recent past, have appreciated for one reason and one reason only, share buy backs.
“This financial engineering-for even the worst of the worst credit-has been enabled by massive inflows into high yields and leveraged loan funds, lowering funding costs and allowing CFOs to buy/re-leverage their firms all in the goal of raising share prices”.
Without the support of high yield credit markets the equity game is over.
As the trickle out of junk becomes a full blown flood the values will go to zero. More important, the so called watertight compartments will give way to the surging pressure. The vessel, it will ultimately be discovered, was not designed to withstand this kind of leveraged pressure and will force the Captain to declare “abandon ship”.
The warnings have been given, the iceberg struck and water is flooding in. It is time to go to the lifeboats.
One never knows what will be the straw that breaks the camel’s back or the iceberg that sinks the ship.
The most recent non-farm payroll report stunned everyone with the lowest print in 2014 at 142,000 jobs. Perhaps more important was the announcement that the labor participation pool had dropped to its lowest number since 1978. Imagine 92.3 million people not being counted as unemployed.
Numbers are fine but a picture paints a thousand words.
Perhaps the most visual remembrance of the Great Depression was the black and white images of thousands of people around the country waiting in line to be fed.
The need is far greater today, in numbers, however, because of food stamps (plastic cards) and direct social payments the need for lines and the pictures there of have been greatly reduced.
As the street corner panhandler multiplies, so too the lines at the food banks.
These images may not be in black and white but they will be just as impactful in living digital color.
92.3 million Americans guarantee it so.
Just another iceberg.