This blog post originally appeared on RealMoney Silver on Oct. 22. EDT.
Permit me the opportunity to give you my perspective and to reflect on the intermediate-term prospects I see for the capital markets.
We live in a brave new investment world. With the explosion of hedge funds -- the newest and most aggressive and dominant investor -- riches beyond the highest degree of avarice can be only a year away.
Industrialization of America business icons (Ford, Carnegie, Rockefeller, etc.) are no longer the leaders, nor are the kids of the dot-com boom (Bezos, Yang, Case, etc.); today, the masters of the universe are hedge fund managers (Ed Lampert, Stevie Cohen, Paul Tudor Jones, etc.).
And there are many hedgies who are, understandably, wannabes -- and who sometimes (arguably) misuse other people's money by worshiping at the altar of momentum in the pursuit of happiness. In the process, negatives are also sometimes ignored or, even worse, dismissed.
As such, in the pursuit of George Soros-like riches, momentum has taken a peculiarly more important role than ever. It has been almost unbridled as investors have often taken abnormal risks for normal returns in the low-interest world of 2000-07. This is true not only in the equity markets but especially true in the credit markets.
And, as a result, over the last five to seven years, following the stock market bubble of the late 1990s and the easing in monetary policy around the world in the 2000s, we entered a period in which a surplus of cash led to a shortage of good sense in the capital markets. Investors prospered in the ensuing synchronized advance in almost every asset class -- equities, private equity, fixed-income, commodities, gold and real estate.
As a consequence of the broad-based financial and economic prosperity, another new paradigm emerged -- the notion that a long and uninterrupted economic boom was believed by many to lie ahead. That promise, abetted by the low cost of capital and interest rates, stimulated the straw that stirred the drink of growth and speculation -- namely, the financial derivatives markets.
That market mushroomed, in an unquestioning atmosphere in which T's were not crossed and I's were not dotted, to the point where the derivative market eclipsed the actual size of the markets it served. (In a generally unregulated market, this was an easy do.)
The appetite for derivative products creation grew almost boundlessly and was brought to us by that wonderful brokerage community that brought us the dot-com IPOs and biased research, stoking all asset classes and revving up the real estate market in particular.
Layers of different sorts of assets were securitized by the Street and packaged into one, and the generally unregulated asset-backed securities, collateralized debt obligations, special interest vehicles and so on were given their birth. The new securities gave way to their cousins; levered hedge fund pools of capital emerged to take advantage of the availability of borrowed money ("the carry trade") supporting those ABC and XYZ assets. They could, in theory, produce alpha (or excess returns).
In time, the need for speed had as its outgrowth the loss of common sense, particularly in lending. Subprime and no-/low-documentation lending gained share of the total mortgage market, and speculators/investors, drawn to those riches of flipping and daytrading homes, began to stretch home prices to levels well beyond affordability and reason.
In time, the unintended consequence was literally a very shaky foundation to the residential real estate market and to the derivative products into which the subprime loans were dumped.
Over in equities, a new breed of stocks (energy, infrastructure, metals, emerging markets, etc.) flourished and took center stage during the synchronized worldwide economic growth boom and personal consumption binge -- and these sectors were capable of making the sort of broad and parabolic moves that rivaled the AOLs and
of the last decade.
As an aside, and for good measure, we can add the anointed ones --
Research In Motion
-- which prospered by taking share from less innovative and less thoughtful competitors.
Meanwhile, other secondary deleterious influences were "emerging," too. Although, prima facie, these influences were positive for the markets -- that is, as investors easily marginalized the U.S.' loss of its competitive edge in producing goods for worldwide consumption -- they were destined to hold some negative consequences down the road.
The most important was the emergence of India and China as world economic powers and the concomitant dive in the U.S. economy's currency and economic standing, which buoyed the demand for basic materials as those countries' infrastructure developments began to take hold.
That rising demand served to have the adverse consequence of raising commodity prices around the world -- and with it, attendant inflation and higher costs for manufacturers. Other influences during this period, such as the U.S.' reliance on imported oil, sowed the seeds for higher noncore inflation.
In summary, the momentum of asset-price appreciation and the rewards that were a byproduct of those gains have been intoxicating and virtually unquestioned, even as headwinds mounted, in a world in which the dominant investors (hedge fund managers) get a carried participation in their growth.
And so was the cocktail of derivatives, leverage and credit creation, which buoyed consumption in both the industrialized and emerging economies. What has recently intensified the problem is recognition that the derivative markets have bypassed the traditional conduit -- namely, the commercial banking system (governed by capital and reserve requirements and audits).
In the absence of oversight, accountability has been weakened and, at times, eliminated. And then, almost overnight, conduits worth tens of billions of dollars are revealed. And so are tens of billions of dollars of debt securities and loans the market is unable to value.
Surprise, surprise. It was especially a surprise to the money center banks, which are in the forefront of the dance of write-offs -- a marathon, not a two-minute fast step.
The problem with the aforementioned momentum and the overexuberance that follows is that it is does not last forever. Equally important (and often enigmatic) is that you never know what should end it -- nor what will end it.
Over the past several years, I have chronicled the seeds of what I believed would be the market's (self-) destruction -- in housing, in risk-taking and in the derivative markets. For a time, I am sure that many subscribers (and contributors) probably viewed my preoccupation with a housing downturn and the subprime problem with skepticism bordering on ridicule and even annoyance. I tried to demonstrate the logic of the developing contagion, but common sense was ignored.
While the market has dismissed my warnings -- most of which have come, or are coming, to pass -- I suspect that tolerance as well as the unquestioned momentum stimulated by the strength (or madness) of crowds are eroding. Today there are a number of obvious problems/casualties that suggest that a more problematic and uneven stock market might be surfacing.
Unlike Cassandra, I am not saying the end of the world is near. (Bulls tend to dismiss bears with this one phrase.) Indeed, there is no reason to believe that Friday was the Big One. (Quite frankly, it has not paid to bet on the Big One, and probably won't for a while longer.)
It appears, however, that there are solid reasons to be increasingly concerned.
Most of my concerns, which I shall discuss below, are fundamental, not technical. I would add, however, that the negativity bubble you read about could not be further from the truth; just look at the
sentiment studies, the high level of margin debt and/or the consistent raft of uninterrupted bullishness in the media.
Importantly, a confluence of a number of events is occurring at or near the conclusion of a mature economy in the U.S., Japan and Europe.
Without further ado, here are some (but not all) of my concerns:
- The pile of levered pools of capital that hold the extraordinary (in size and quality) amount of derivative assets are now in disarray. Mark-to-market issues and an acceleration in nonearning assets run deep and are endangering large bodies of market participants and their capital bases. This includes the domestic money center banks, investment brokerage firms and, importantly, the unregulated and monstrous special interests vehicles, collateralized debt obligations and levered hedge funds that play in that water.The destabilizing effect of the impaired financial institutions cannot be understated or underestimated; just ask those investors who have overweighted financials (20% of the S&P) on the basis of "value," only to see the sector drop on a daily basis. Banking problems tend to have a long tail and historically are not resolved in a quarter or two (e.g., the less-developed-country debacle, the junk bond fiasco and the early 1990s housing depression, all of which crippled the banking community for years).Arguably, the problems in housing and leveraged derivatives in 2007 run deeper than the prior adverse cyclical issues. Finally, we should not lose sight of the fact that the money center banks, which are this cycle's (and nearly every cycle's) dolt, entered 2007 ill-equipped to deal with losses. (They were at a historically low level of reserves as a percentage of earning assets.) The banks, too, were momentum players, believing in the new paradigm and believing (incorrectly) in their own credit standards and (lack of?) analysis.Recognizing that the level of credit losses virtually hit an all-time low in 2006, only to be reversed markedly through the first three quarters of 2007, a likely mean reversion-of-loss experience augurs poorly for a capital-depleted and off-balance-sheet-dependent U.S. commercial banking system that has experienced a two-decade drop in loan-loss reserves just as the economy matures and the consumer falters.
- To an important degree, the Fed has lost control of the capital markets. These are situations that cannot be arrested by somewhat lower interest rates. Many problems reside abroad outside of the Fed's influence. And much that is domestic lies in unregulated territory.
- Capital-weakened financial intermediaries spell an important retardant to the financing of growth. The era of unbridled lending is over. Just try to get a mortgage for a second home. Just try to get a jumbo mortgage. Just try to borrow with little or nothing down -- on anything. Or just try to get a nondocumented mortgage loan, motorcycle loan, furniture loan or automobile loan today.
- The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.
- The domestic, nonexport economy is in recession. If you don't believe me, read last week's conference calls at Schlumberger (SLB) - Get Report, Caterpillar (CAT) - Get Report, etc. The Federal Reserve gets it and will likely lower interest rates by another 50 basis points next week. But the adoption of a Japanese solution of supporting bad debts will have, as an adverse consequence, further drops in our currency and competitiveness -- and higher prices for consumer products.
- Based on my recent trip, I can assure you all that the Western European economies are falling faster than is generally realized for many of the same influences behind the U.S. weakness.
- The dual impact of a higher real rate of inflation and climbing oil prices are a tax on the consumer and will weigh on corporate profit margins, which will be hurt by slowing top-line growth. Importantly, these are occurring at a time in which the consumer's debt load has never been higher based on nearly any measure. As I mentioned earlier, with declining home prices, the burden on maintaining financial net worth has never been more on the shoulders of stock prices, and that's a slippery slope. One might prefer to listen to some of the bullish managers interviewed on CNBC and Bloomberg (and now Fox Business News), who repeatedly defer to dogma in their general statement that "it has never paid to underestimate the American consumer."I prefer to look at some of the more tangible measures regarding the consumer's rocky fundamental position -- for instance, an all-time high in debt service and in the debt load of the consumer and, importantly, the message of the market from the Retail HOLDRs' (RTH) - Get Report steady demise and the equally steady drop in bond yields -- as a precursor to the obvious slowdown.
- The excess capacity in housing holds far-greater economic import than the excess capacity in technology six years ago. Ben Stein wrote yesterday in The New York Times that "there is still a long waiting list for Bentleys in Beverly Hills."Unfortunately, there is no waiting list for low-end Fords or Chevrolets. That's the reason the Democratic Party's message of populism struck a chord in 2006 and is likely to influence the presidential election in 2008.Meager job and income growth and the squeeze on the lower- and middle-income classes at the tail end of a maturing economic cycle bodes especially poorly as the consumer's dependency on asset appreciation (stocks and houses) remains elevated. In the aforementioned Times article titled "The Gloomsayers Should Look Up," my email buddy, Ben Stein, further suggests that the ursine crowd should look up to see that the sky is not falling. By contrast, bears, like myself, suggest that when we look up to the sky, we will see dark clouds and headwinds. (Memo to Ben: $200 billion here, $200 billion there and soon we are talking about a lot of money!)
The next five years in the capital markets seem destined to be unlike the last five years. The most significant difference is that the egregious use, generation and packaging of debt will not be repeated -- and the consequences of that leverage will be adversely seen in areas of the world economies that we had never contemplated.
From my perch, the bulls continue to think very linearly and seem to be missing how significant the role of credit was to past growth and how significant a pullback in credit will be on future growth. Significantly, the markets continue to underestimate the consequences of leverage and are overestimating the prospects for corporate profit growth.
There will always be winners in the markets, just as there are always losers in the markets, and a number of contributors have brought up some beauties over the years. The winners appear to be narrowing in scope, however, representing a classic sign of a maturing equity market. And, in more difficult markets, those babies are often taken out with the bath water.
At time of publication, Kass and/or his funds were short the Retail HOLDRs, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.