Stocks rest in June after the biggest quarterly return of the last 10 years
The S&P 500 gained 0.2% in May and is now up 3.2% on the year. Stocks gained 15.9% in Q2, the best quarterly result since 1998. From the low on March 9th through quarter end, stocks generated gains of 36.9%, one of the steepest rallies of the last 80 years.
As volatility continues to drop, now below the level of September 12th right before the banking system seized up, we have some time to pause and reflect about how the financial system will evolve to prevent futures crises, or at least until bankers and investors forget the lessons learned from this crisis, typically in half a generation.
We have observed over time that accidents never happen because just one thing goes wrong. Instead a number of things have to go wrong simultaneously, often confounding received wisdom about how things should be. One of the most famous "accidents" of all time was the sinking of the Titanic, the supposedly "unsinkable" ocean liner that was destroyed on her maiden voyage. A little tour through history will shed some guidance on current events.
Long story short: ship hit an iceberg and sank
Edwardian England (1901-1910) represented the apex of power and confidence of the British Empire. Medicine and technology advanced at a break neck pace; the horrors of World War I and II were still in the future. By 1912, it was possible for the White Star Line to conceive of the concept of an "unsinkable" vessel. Of course, anything made of iron will sink, but the architects thought that their design was sufficiently advanced to keep the liner afloat under any circumstance. Specifically, the ship was divided into 16 compartments connected by water tight doors, which could be closed in 25 seconds by automatic controls. So with great confidence, the ship departed Southampton, England, and, after two short stops in France and Ireland, set out into the open ocean on April 11th.
Ocean crossing in the early part of the 20th century was highly competitive. To draw passengers from competing lines, not only was Titanic furnished with the finest accommodations, but was even fitted out with the latest in communications technology - wireless telegraphy - which enabled passengers to deliver and receive messages while in transit. The Captain was under orders to make the crossing in record time to further enhance the marketing of the new ship.
Under most circumstances, this order would have not caused problems, except that: that spring, sea ice flowed much further south than usual for April in the North Atlantic.
The captain knew of the sea ice from messages from other ships and posted lookouts who could have given sufficient warnings except that: The White Star line forgot to order binoculars for the lookouts.
Even so, the lookouts would have easily seen icebergs in daylight except that: Titanic was moving near maximum speed in the middle of the night. Other ships in the area had already halted sailing, waiting until daybreak. This information might have been radioed to Titanic, except that: the nearby Californian was swamped forwarding commercial messages and the final ice warning was not transmitted.
The lookouts might have seen icebergs anyway, except that: there was no moon that night. Icebergs can often be recognized at a distance by waves splashing at their base except that: the ocean was unusually calm that night.
By 11PM on April 14th, Titanic entered an ice field 80 miles wide and was guaranteed to hit iceberg sometime during the night.
At 11:40 PM, the two lookouts spotted a large iceberg dead ahead and frantically telephoned the bridge about the danger. The bridge crew spun the wheel hard over turning the boat to the left. This might have been just enough change in direction to let Titanic escape, except that: the engines were simultaneously ordered in reverse, which not only slowed the ship, but critically, slowed the rate of turn.
Had Titanic hit the iceberg dead on, the first, second, even third compartments might have been crushed, but the "4 compartments flooded out of 16" design would have kept the ship afloat. Instead, Titanic grazed her right side along the length of the iceberg. In a modern ship designed with welded plates, this contact probably would not have been fatal. However, early 20th century ships were built with riveted plates. This design might have been sufficient except that: the building order called for lower quality (high sulfur) iron rivets, which become brittle when cold. These rivets might have held in warmer water, but immersed in the 30 degree waters of the North Atlantic, failed.
As a result of the impact, a seam opened up from the prow to the first quarter of the ship. The overall length of Titanic was 883 feet, the length of the seam was about 150 feet, and the width was at most 6 inches and might have averaged 3 inches. The size of the entire gap was equivalent to an opening 6 feet by 6 feet, so water moved in at a brisk clip. Titanic still could have stayed afloat except that about 6 to 12 feet of the seam extended into the 5th compartment. Furthermore, because Titanic was settling bow first, soon the hawse holes for the anchor chains would submerge, followed by the main forward hatch. So Titanic would actually fill faster over time.
At that point in time, the ship was guaranteed to sink, but would remain afloat for the next two hours. The rate of fill might have been much slower except that: the waterproof compartments did not extend through upper decks. Like compartments in an ice cube tray, as one compartment filled water would flow into the next compartments; soon water flowed into the 6th, 7th and 8th compartments.
Two hours should have been sufficient time to move passengers into life boats, especially in calm seas, except that: though Titanic had been designed to carry two rows of life boats and twin davits were installed, the White Star Line only installed one row of lifeboats to save money. Thus, a ship with a maximum capacity of 3,295 passengers and crew, carrying 2,261 people, only had lifeboat capacity of 1,178.
At least that many passengers should have been saved except that: neither passengers nor most crew had any training in "abandon ship." Passengers were reluctant to enter onto lifeboats in the frigid water because they believed that the ship was unsinkable. Thus the early lifeboats cast off filled only one third to one half of capacity.
The crew of the Titanic frantically telegraphed to ships in the surrounding area. The lights of the Californian could be seen at the edge of the horizon 10 miles away - stationary in the ice field. Californian could have reached Titanic in about half an hour except that: ships' captains were not obliged to maintain 24 hour watches in their telegraph offices. Titanic's messages were received by the Carpathia, 3 ½ hours away, which made all speed to Titanic's location. The crew of the Californian could see signal flares being launched from Titanic, but were afraid to wake Californian's captain (reputed to have a nasty temper) and did not think to wake their telegraph operator.
Titanic gradually upended. At 2:17 AM, the ship broke in half,with the bow section plunging 2 ½ miles to the ocean floor. The stern section settled back briefly, then rose vertically and sank for good at 2:20 AM. Carpathia arrived on scene at 4:10 AM. By next day, 710 survivors were rescued, but 1,491 passengers and crew had perished.
An interesting story, but what does Titanic teach us about finance?
The core belief of the designers, builders, owners, officers, crew and passengers of Titanic was that the vessel was unsinkable. This assumption drove other decisions, for example, the failure to provide sufficient life boats, and the order to press on at high speed despite iceberg warnings.
An American board of inquiry convened in Washington DC one day after passengers disembarked from Carpathia in New York and proceeded for 5 weeks. The British Board of Trade Inquiry commenced May 2nd and lasted two months. From these inquiries, new laws were implementing including the requirement that all commercial vessels maintain 24 hour telegraph (later radio) watches; that life boats be installed sufficient to hold all passengers and crew; that passengers and crew conduct mandatory evacuation drills on every voyage. Most importantly the illusion that any ship could be unsinkable was shattered.
The illusion of the last decade in finance was that, with sufficient application of computers, statisticians and economists, investment risk could be hedged away. The US economy's quick recovery from the Latin American debt crisis of the early 1980's, 1987 stock market crash, the savings and loan crisis of the late 1980's, the Asian Financial crisis of 1997, the Long Term Capital Management hedge fund meltdown of the 1998, and the "tech wreck" of 2000-2002 supported this illusion - the Federal Reserve would always step in to "make things better." Paradoxically, surviving these events made banks ever bigger risk takers ("Sure we're steaming through a field of icebergs, but so far they're just bouncing off the hull.")
Meanwhile, starting under the Clinton administration and accelerating under the Bush administration, safeguards that had been in place since the 1930's (separation of investment and commercial banks, the "up-tick" rule, limits on short selling, responsible regulation by the SEC and Federal Reserve, limits on how much leverage banks could employ) were systematically dismantled (the equivalent of eliminating the second row of lifeboats. Furthermore, new "products" such as credit default swaps and leveraged exchanged traded funds were permitted even though these "products" allow aggressive investors to profit by collapsing a company's stock price.
On May 20th, President Obama signed in the law the "Financial Crisis Inquiry Commission," which will empanel 10 members to study "how fraud, regulatory lapses, monetary policy, accounting, lending practices and executive pay contributed to the worst U.S. financial crisis since the Great Depression." Unlike the American Titanic inquiry, which began interviewing survivors one day after Carpathia docked in New York, the Financial Crisis Inquiry is curiously slow to staff up (could it be that the Federal government is reluctant to reveal its own contribution to the crisis?) By comparison, the Brady Commission or "Presidential Task Force on Market Mechanisms" commenced November 5th, 1987 to review the events leading up to the October 19th crash and delivered a preliminary report with recommendations by January 8th, 1988.
Risk cannot be eliminated, only transferred
Like "portfolio insurance" from the 1980's, credit default swaps were sold to bond investors as a means of eliminating investment risk. If a bond issuer defaulted, the seller of the credit default swap would make good on the bonds at par (i.e. pay back 100 cents on the dollar.) Bond investors got out of the habit of doing credit analysis. But the risk wasn't truly eliminated; it was merely concentrated, primarily in the hands of the AIG Financial Products group, about 50 traders based in London. Over a decade, this group accumulated $2 trillion in notional exposure to fixed income instruments. In an environment of stable interest rates and solid economic growth, the London group reaped profits as much as 30% of AIG's total income. We call this a "picking up nickels in front of a steam roller strategy - good fun until your sleeve gets caught." So far the net loss on these derivatives, covered by the Federal Reserve and US Treasury through various programs, exceeds $225 billion. The peak market cap value of AIG was $185 billion (currently $9.3 billion.)
Although CDS's were marketed as "insurance" to bond fund managers and later as "put options" to hedge fund managers, the name of the product remained "swaps." In securities regulation, any product officially termed insurance is regulated in the United States by the 50 state insurance regulators, while any product officially termed an option is regulated by the SEC and options exchanges, and requires margin to back up the exposure (as a AAA credit, AIG was NOT required to post margin.)
Alan Greenspan, while Chairman of the Federal Reserve board in the 1990's through 2006, repeatedly opposed CDS regulation, stating that the banks were far better equipped to manage risk. However, in October 2008 during Congressional testimony, Greenspan commented that he was "'partially wrong for advising against more regulation of derivatives earlier this decade. Credit-default swaps, I think, have serious problems associated with them." In our opinion, Bear Stearns and Lehman Brothers would still be in business if the CDS market had NOT existed. Traders bought put options on and sold short the stock of those companies, while simultaneously bidding up the price of CDS on those companies. This created the "appearance" that the companies were in trouble, which then became self-reinforcing as panicked investors liquidated long positions. As the SEC had eliminated the "uptick" rule in July 2007, there was no market mechanism left to halt the slide.
Just as the sinking of the Titanic generated new laws and regulations, the financial meltdown of 2008 is also generating new laws and regulations. The Securities and Exchange Commission (SEC) has proposed to take over regulation of credit default swaps and other derivatives related to securities such as stocks and bonds, while the Commodities Futures Trading Commission (CFTC) has proposed to take over regulations of derivatives related to energy, commodities, metals and currencies. In our opinion, regulation can't come soon enough. Meanwhile, though some investments firms like Goldman Sachs and Paulson & Company made obscene amounts of money last year buying CDS, so many other firms got their eyeballs ripped out writing CDS that the pool of CDS is naturally shrinking.
Other learnings from the crisis include:
· Real estate CAN fall in value
· A conglomeration of low-grade securities is still a low grade security (no more AAA ratings for mortgage backed securities based on sub-prime loans)
· It's a fantasy to presume that financial models are robust or reliable
· Leverage kills!
Regardless of what government regulators come up with, you can be sure that the capital committees of banks and funds will be much more conservative going forward (OK, until they forget about this crisis.)
Strategy
Even with the massive gains of the second quarter, the S&P 500 is about unchanged on the year. Economic reports are generally less bad. Even though last week's jobs report disappointed, the rate of job losses is slowing (1.7 million in Q4 2008, 2.1 million in Q1 2009, 1.3 million in Q2 2009.) By August (data for June) we expect to see housing prices flattening month to month. GDP declined at a 6.3% annualized rate in Q4 2008, a 5.5% rate in Q1, and we expect a decline of about 2.5% in Q2, flat in Q3 rising to gains of 2% by Q4 2009. We're fully invested at this point in time and waiting for a recovering economy to lift stock prices further.
As always, please don't hesitate to call with questions and concerns.
Yours sincerely,
David Edwards
President
