Inverted Reasoning and Market Reversals & Bottoms

The market action last week was very encouraging and optimistic. The fact that it moved up ignoring all critical bad news has given a lot of hope to market players. Many believe that a reversal has happened and that we are on our way with a recovery rally – a rally that signifies that the bottom made in November ( in October in some markets like India) is now a significant long term bottom and that we shall now be moving on with a higher bottom kind of market movement.

I have here tried to think through this process of a market rally in the wake of significant bad news and, its interpretation that all major players who were to sell have done so. The bears therefore are now exhausted giving opportunity to the bulls to come out show their valor. But is there a case for inverted reasoning here? Let’s explore.

As the market tanks in value in a bear situation, after significant fall the scope for bears making money becomes lesser and lesser as the buyers become scarce and bids for reasonable volumes come at much lower prices than in normal situations. This increases the risk for bears and the expected risk- adjusted returns may not justify further activity. The bears at this time start to withdraw and start to give bulls a sort of psychological advantage. In the current situation, if we assume that the forced selling is more or less done then the bears have more reason to hold back as the risk-return equation is distorted even more. This means that the bears now need some reasonable up move for the risk-reward to shift in their favor.

But the question is if the forced selling is almost done what will give them the ammunition to fire? Just a technical position – overbought situations or is there something else? If the play for them till now was forced selling or deleveraging and if it has been done (which I’ am still not too comfortable assuming) then where will their deliverance come from? Well to me it is the economy! the global economy. As I see it even if the forced selling is discounted in the market, the state of emerging global economy is not. While one may argue that it was economic news that was overridden, the prime reason for its neglect appears more technical - the bears wanting better and more blood.

This is also because I believe the forced selling is happening in different markets. For example it is reported that the sell-off in the leveraged loans market over the past month has been particularly bad.

“The primary draw of leveraged loans for the pros: When a company defaults on its debt, holders of bank loans, which have certain of the borrowers' assets and/or stock pledged as collateral, are higher up in the capital structure and generally get paid before holders of unsecured debt and equity holders. And these loans can be bought at sharply discounted prices, around 65 cents on the dollar on average, say fund managers.

That's the main reason for the dramatic drop in prices for bank loans, which are down 20% to 25% in the last 120 days, loss rates not seen in 25 years, he says. "It is not reality-based in terms of what I focus on," which is mostly companies' ability to repay their debt and, if they can't, what the reasonable chances are of the fund recouping most of its investment.

"If 100% of the companies in our portfolio went bankrupt tomorrow, our historic recovery would be 70%, which is above where they're currently trading," about 65¢ on the dollar, he says. There's nothing about the companies in his portfolio that warrants their trading 25% down from where they were last summer, he adds

One indication of the high level of risk involved in leveraged-loan investments: the growing possibility that a number of firms that go bankrupt will be liquidated instead of reorganized. (Emphasis added)

Hedge funds, which now hold more secured loans than banks, have less incentive to see a company whose debt they hold restructured, and are more likely to push a company that defaults on its debt into liquidation, says Martin Fridson, chief executive of New York-based Fridson Investment Advisors. Those odds are even greater if hedge funds have shorted the subordinated debt and stand to make more money from liquidation. Liquidations require the approval of all classes of shareholders and creditors, however, and unsecured bond holders could vote to block it, he adds.

But Standard & Poor's said in an Oct. 23 report that "liquidation is becoming more likely in default and recovery scenarios, with market conditions making the financing needed for companies to emerge from bankruptcy as going concerns increasingly scarce." S&P drew special attention to constraints on debtor-in-possession, or DIP, loans, which typically are used to pay vendors and cover a company's ongoing operating costs.”

Apart from the forced sales angle - this is really scary from an economic point of view – see the emphasized part of the excerpt above.

The current situation and the responses are unprecedented and much of what is theory is being tried out. I believe it is far too early for the market as a whole to be able to fathom the depth and possibility of outcomes of a series of measures being taken by various national governments/central banks and how these measures will interact to bring about global systemic changes. And there are quite a few pointers to this.

1. Given the enormity of global problems that the failure of the big 3 can be bring, more than the economic arguments it was the partisan north-south US politics played a greater role. This also brings out the uncertainty of the current political process to address other critical issues in a timely, focused and result oriented manner. And imagine this political behavior across all the countries!

2. This is further buttressed by the way the much touted US bail out package (TARP) is being handled. The incendiary report to congress has a lot to say.

“Is the Strategy Helping to Reduce Foreclosures? What steps has Treasury taken to reduce foreclosures? Have those steps been effective? Why has Treasury not generally required financial institutions to engage in specific mortgage foreclosure mitigation plans as a condition of receiving taxpayer funds? Why has Treasury required Citigroup to enact the FDIC mortgage modification program, but not required any other bank receiving TARP funds to do so? Is there a need for additional industry reporting on delinquency data, foreclosures, and loss mitigations efforts in a standard format, with appropriate analysis? Should Treasury be considering others models and more innovative uses of its new authority under the Act to avoid unnecessary foreclosures?”

The point being made is that people handling the bail out seem to have very little idea or strategy and are ad-hoc at best. How will the results be? Again imagine so many packages being executed all over the world!

And it is not easy to execute packages with so much moral dilemma. As Jim Roger says:

"What is outrageous economically and is outrageous morally is that normally in times like this, people who are competent and who saw it coming and who kept their powder dry go and take over the assets from the incompetent," he said. "What's happening this time is that the government is taking the assets from the competent people and giving them to the incompetent people and saying, now you can compete with the competent people? It is horrible economics."

3. Now coming to the issue that mothered the current crises – the US housing sector. According to a Reality Trac report:

“Foreclosure activity in November hit the lowest level we’ve seen since June thanks in part to recently enacted laws that have extended the foreclosure process in some states, along with more aggressive loan modification programs and self-imposed holiday foreclosure moratoriums introduced by some lenders,” said James J. Saccacio, chief executive officer of RealtyTrac. “There are several indications, however, that this lower activity is simply a temporary lull before another foreclosure storm hits in the coming months.

“Delinquencies on loans not yet in the foreclosure process jumped to nearly 7 percent in the third quarter, a record high, according to the Mortgage Bankers Association,” Saccacio continued. ”And more than half of the homeowners who received loan modifications to reduce monthly mortgage payments in the first half of 2008 are already delinquent on their loans again, according to the U.S. Office of Thrift Supervision. Many of these delinquencies could turn into foreclosures next year.”

Why so many re-defaults? The questions being asked are:

“Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?”

That question “has important ramifications for the foreclosure crisis and how policymakers should address loan modifications, as they surely will in the coming weeks and months….”

4. Further it looks like the beach communities are likely to join the party soon with Jumbo Defaults. To quote:

”Jumbo Prime are high-leverage programs that allowed borrowers to buy much more home than they should have. Because Jumbo Prime borrowers had better credit overall, banks were very easy on the qualifying.

…It goes hand in hand with the Moody’s downgrade of many Bank of America Jumbo Prime deals citing a 13% delinquency rate. This represents a total meltdown in the sector happening right now that nobody is reporting.

…..Now that the raters are reporting such massive default rates, I am going to officially say that the ‘Jumbo Implosion’ is upon us. The sad part is (ex-Countrywide) BofA was one of the better lenders during the bubble years. In my opinion, it was much more conservative than Wells Fargo, Citi, Chase, Wachovia or WaMu.

These programs offered by most of our nations largest banks allowed a considerable amount of leverage when purchasing or refinancing. These are the ultimate ‘walk away’ loan, as a household income of $85k per year could legitimately buy a $650k home with 5% down during the bubble years. With stated, no ratio and no doc available at a slightly higher rate, many didn’t even need $85k. Now that home is worth 25-70% less and borrowers are making the wise decision to walk away given most their after-tax income is going towards this massively depreciating asset.

Analysts are not taking into consideration how much trouble the American economy will be in across the nation when those middle to upper class home owners all over the nation see their prices fall as much as the lower end has. This will happen - it has to.”

Looks like the key problem still remains and if these have been discounted today’s prices is anybody’s guess.

5. Talking about collateral damages I don’t know how many have figured this out. Says one report:

“In its quarterly report, the BIS warned the US Federal Reserve, the Bank of England and other central banks that near-zero interest rates and emergency monetary stimulus may come at a cost.

By opening the cash spigot, the authorities risk displacing the money markets and may "discourage banks from lending to other banks".

The money markets are a crucial lubricant for the financial system, but they cannot function if rates fall too low. The sector can wither away, as Japan discovered during its "Lost Decade".
…worldwide issuance of bonds and securities has also gone into freefall, plummeting 77pc from over a trillion dollars to $247bn in the third quarter…

The collapse in bond issuance reflects the near-total closure of the capital markets in the late summer as credit spreads surged. Bonds issued in Euros dropped by 94pc from $466bn to $28bn over the quarter."

6. The fact that Fed is likely to issue its own bonds has its own collateral ramifications. Would the price start reflecting the way Fed is performing? Would it be a call on its policies, execution capabilities and the risk in the assets it purchases using the proceeds? If this happens and if the past track record of Fed performance is any indication it would be a grand stage to watch.

Government backing may help but as seen now the yield on government backed issues of banks are higher than the Treasury securities.

7. China is emerging as bigger joker in the pack than was previously imagined. According to this informed article:

“But veteran Hong Kong economist Jim Walker, the director of the Asianomics research firm, believes investment cycles don't slow -- they disintegrate. Although Beijing will try to keep building public infrastructure, Walker's research indicates that a steep decline in private-sector demand from Europe and the U.S. will lop 7.5 percentage points off gross domestic product growth in 2009.

Walker thinks a crash in domestic consumption will lop an additional 2.5 percentage points off GDP growth. Thus Walker's best-case scenario is in the 0%-to-4.5% range, and he puts 30% odds on a contraction. "There has been an outrageous over-investment in property and factories, and much will be unwound," he says. The economist also believes that the growth in Chinese domestic consumption has been overblown and that despite a 50% decline this year, the Chinese stock market remains grossly overvalued. “

Russia too is hearing the D word according a Business Week report. According to it “In comments cited in The Moscow Times, leading Russian economist Evgeny Gavrilenkov warns that if the latest government figures are accurate, they mean that Russia is now heading into a “severe depression”.

8. Are we looking at the death of OPEC. Many of the governments in these countries and those like Russia had national budgets at oil prices well above the current levels and are in deep trouble. It can only balance its current accounts and budget at around $70, according to its finance minister’s own estimates. Further highlights:

“Politicians in oil-producing countries have gotten used to oil revenue providing the bulk of the national budget, enabling them to keep taxes low and expand services. In Iran, for example, oil revenue provides between 40% and 80% of the national budget, depending on which oil industry analyst you believe. In Nigeria, oil and natural-gas revenues account for 85% of government revenue.

According to PFC Energy a consulting firm the United Arab Emirates, Algeria and Qatar would be the only OPEC nations able to balance their accounts in 2009 with oil below $50. Saudi Arabia would need oil prices just over $30 a barrel, according to Merrill Lynch, or slightly more than $50 a barrel, according to PFC Energy.

In contrast, Iran needs a price of $90 to $100 a barrel to break even in 2009. And because of President Hugo Chavez’s soaring spending on social programs, Venezuela needs an oil price somewhere between $60 and $120 a barrel; the consensus seems to be somewhere around $90. On Nov. 24, Chavez told a news conference that $80 to $100 a barrel would be a fair price.”

Makes you wonder if in the current economic turmoil if the countries concerned will be able to reduce or cut expenditure when the call of the day is to increase it like never before. So the question then is how long before oil prices catch up for these countries to balance budgets - a 2mn. barrel per day cut could not help stem the prices (It is well known that the compliance of these cuts by OPEC members is low). Or will middle-east countries see taxation become an important tool? The internal dynamics of OPEC is changing rapidly.

And as far oil demand and off take is concerned, Bloomberg reports that storage of oil in land is very tight and that producers are hiring tankers to store them.

9. As a fall out of the economic crisis and the mistrust the financial system and its guardians have created, Nassim Taleb the celebrated author of the book Black Swan talks of Capitalism 2 in which societies will not depend upon asset values any more!! As one commentator to this talk points out:

“Mr. Taleb has his mind around this present market morality play presented by the usual cast of self proclaimed financial charlatans... This tragedy Taleb correctly points out is another in a series of blow ups brought to us since he first experienced the 1987 incarnation of financial magical thinking in London...The Salmon Bros blow up that Warren Buffett helped mitigate at great personal risk seemed to be a remake or at least a knock off of 87 ... a ludicrous estimation of risk by people with PhD’s and fuzzy models... This same group of mathematical elves marched Hi Ho Hi Ho right into LTCM with the same lame theories Greek lettered disastrous result... Now a recent set of variants of that same sort of magical thinking has produced CDO's CDS's and a host of other alphabet soup sows ears... These seem have the potential of marching us all toward living in caves and bartering with loaves and fishes...”

The import I believe is that the in future risk will be profiled giving a lot of weight to distrust on corporate reporting, assets and cash flow values which when factored-in through PE multiples or discount rates are not going to be very comparable to historical averages.

Disclosure: No stocks discussed - No Positions


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