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Today's issue again focuses on derivative
exposures and the collapse that has occurred as a result. Although
we have been far too bullish on the potential for stocks in 2008, we can
only repeat that we clearly and correctly stressed systemic financial problems
and most importantly, we have stated on numerous occasions that the
derivative crisis was overdue and had to happen!
Previous reports as far back as February
2001 have been archived and paid subscribers have access to all Crosscurrents
newsletters published since December 2002. In our last issue of Pictures
of a Stock Market Mania in August, we wrote "Write offs for financial
companies now exceed $500 billion and we believe at least another $500
billion is likely to vanish." We have already been proved
correct on that score.
Writeoffs now exceed $1 trillion....
The echo of the mania that ended in March of 2000
was in many ways, even more excessive than the mania itself. Probably
the only way in which the bubble echo of 2003-2007 did not match the prior
bubble was Nasdaq's relative underperformance. Once burned, twice
shy. However, the slew of so-called "investment" products created
in recent years were all the impetus required for a huge expansion in total
Dollar Trading Volume (DTV). In fact, almost all of the "products"
created in recent years were not directed at investors, but were fashioned
for speculators. The August 2008 issue of Pictures of a Stock Market
Mania covered this subject in depth.
As we have noted in previous commentaries, a stock
market ruled by speculators tends to reach far more grossly overvalued
levels than a market dominated by investors, and reaches overvalued levels
far more rapidly as well. At the bottom in 2002, prices had been
cut in half and most of those participating were investors. By the
time the index highs were achieved in 2008, DTV was running at a rate triple
that of the lows of 2002 and speculators were clearly in control.
The chart below should provide clear and irrefutable
evidence that stock trading relative to gross domestic product had grown
to unsustainable levels. Even if we include the totals generated
in the mania and its echo, DTV still only averaged less than 62% of GDP
in the 82 years from 1926-2008. And this year, if December plays
out like the months preceding it, DTV will set a new all-time record, over
345% of GDP.
Frankly, after the collapse from 2000-2002, we
never thought that this measure would equal or exceed the 2000 level again,
thus activity last year and this year were truly astonishing. It
is somewhat sobering to comprehend that for every dollar of business transacted
in the economy, $3.45 is transacted in the stock market.
Nothing exceeds the importance
of the stock market.
It is clear why the economy
is now in recession.
DTV has soared versus total stock market capitalization
as capitalization has rapidly contracted. From the peak, more than
$8 trillion is now by the wayside and at the lows, it was close to $10
trillion. We believe this updated chart puts the 1929 spike into
a better perspective, since that spike came also as a result of a contraction
in market capitalization as prices declined 36% from the September highs
into the end of the year.
Relative to total market
capitalization, DTV is now double what it was at the end of 1929.
The spike in 2008 is evidence
of the most amazing lunacy ever.
The collapse in prices was
The following article is reprinted
from the September 29, 2008 issue of Crosscurrents.
The Inevitable Dénouement
On Thursday, September 18th, the U.S. Treasury
and the SEC took extraordinary measures to stem a tide that threatened
to engulf world markets, already poised on the brink of a financial collapse.
A bailout of giant AIG was drawn up and short sales were temporarily banned
in 799 financial issues. This was not the first time we have seen
extraordinary measures brought to bear. We remember quite well how
close we came to a complete meltdown in 1987 and then again in 1998, with
the Long Term Capital Management (LTCM) crisis. In each case, the
stock market became “too big to fail.” Subsequently, the Treasury
cobbled together a $700 billion plan to save the industry, and presumably,
the stock market, from a total collapse.
Immediately after the crash of 1987, your Editor
began writing about the impact of derivatives and their peculiar capacity
to actually increase systemic risks. These commentaries predated
the publication of Crosscurrents and their popularity were one of the principal
factors that actually led to the creation and subsequent maintenance of
this newsletter. Over the last two decades, very few observers have
taken on Wall Street's penchant for devising their many new spurious methods
to deal with risk, and indeed, the former Chairman of the Federal Reserve
Board embraced them for their ability to widen the scope of the markets,
provide liquidity and reduce systemic risk. Alan Greenspan was wrong.
We can't recall just how many times we have ranted
and raved about the inevitability of crisis. Our Pictures of a Stock Market
Mania archives (see http://www.cross-currents.net/archives.htm)
includes at least a dozen reports dating back to August 21, 2001, dealing
with derivatives and their effect upon our financial markets. Click
here for a partial list. Paid subscribers have access to all
of our newsletter derivative commentary dating from March 10, 2003 (for
instance, anyone can click
here see to see the Match 10, 2003 issue). Commentaries
previous to then were either published under the aegis of another company
or have yet to be permanently archived.
The most striking aspect of the Office of the Comptroller
of the Currency's (OCC) first quarter report on derivatives (see below)
is the first decline in notional values since the stats were first reported
in 1991, more evidence that the era of paper is undergoing a radical transformation.
Through last year, annualized growth in notional values came to over 21%.
Since it is very difficult to imagine what 21% for 16 years means, if the
Dow Industrial averages had risen by a like amount, the index would have
ended last year at nearly 68,300.
Growth in derivatives has dwarfed growth
in both GDP and stock market capitalization to such an extent
that it should be easy to understand why
the current financial crisis has developed.
Approximately 62% of the $150 trillion in notional
values of derivatives is in the form of "swaps," in which two counterparties
agree to exchange one stream of cash flows and their associated risks against
another stream. They can be used to hedge or transfer certain risks such
as interest rate risk, or to speculate on changes in the underlying prices.
Options constitute 16% of the overall picture, futures and forwards are
12% and credit derivatives are 9%. The extraordinarily rapid growth
in derivatives was heartily embraced by the Federal Reserve under the aegis
of Alan Greenspan, and the Fed chairman was a huge fan, claiming the subsequent
creation of liquidity and ability to transfer risk would lead to a golden
age of growth. However, as portfolio insurance painfully proved in
1987, although risks can certainly be transferred from one party to another,
risks can never be removed from the system. Overall, systemic risks
must remain constant. From a standpoint of physics, the principle
is precisely the same as the conservation of matter (see http://tinyurl.com/9gyxj).
But the enormous growth of derivatives incorrectly afforded participants
a sense of security they were not entitled to. For instance, Bank
X might be a party to $100 billion in notional swaps, with only $1 billion
in actual credit exposure. Factoring in normal activity (which includes
market extremes) for the life of the contract appeared to indicate near
zero risk, but in the final analysis, assumptions are only assumptions
and not guarantees. As Nassim Taleb brilliantly showed in Fooled
By Randomness (see http://tinyurl.com/4l2nr4)
and The Black Swan (http://tinyurl.com/47cf65),
markets are only normal until they are not. What can become extreme
can become more extreme. The assumptions that allowed LTCM to create
a daisy chain of exposures $2 trillion long, more than 100 times their
capital, were valid until they were not. In 2007 and 2008, assumptions
of “normal” behavior proved disastrous, as the net capital rules requiring
broker dealers to limit their debt-to-net capital ratio to 12-to-1, were
instead circumvented for certain parties, who increased their debt-to-net-capital
ratios to as high as 40-1 (e.g., Merrill Lynch). Julie Satow reported
in the NY Sun that we can thank the SEC for their largesse; to wit, "the
SEC justified the less stringent capital requirements by arguing it was
now able to manage the consolidated entity of the broker dealer and the
holding company, which would ensure it could better manage the risk" (see
Whoops. The inevitability of the Black Swan was roundly ignored.
In our early commentaries on derivatives, we insisted
that a worst case scenario would likely result in losses equal to 1% to
2% of total notional values. In recent years, we have toned down
the possibility of a worst case to 1%, but such a cataclysm would still
equate to a $1.5 trillion “hit.” Bear in mind, worldwide banking
system losses have already well exceeded $500 billion. And worldwide,
the Bank of International Settlements estimates that OTC derivatives encompass
a total of $415 trillion in notional values, an amount equal to 8.5 times
the entire planets GDP, not just the $150 trillion for the U.S. banks we
show in our front page chart. Worldwide, the magnitude of a worst
case disaster is incomprehensible. The good news is that our expectations
for a worst case scenario to unfold are rather small. The bad news
is that exposures to Black Swans remain enormous.
Below, check out this chart versus the one presented
in our April 21st issue. Bank America's credit exposure as a percentage
of risk based capital has nearly doubled and has risen over 65% for HSBC.
Although we are not especially negative on either company, we can only
stress that today's exposures for all those pictured are ludicrous.
No matter how you package and re-package bonds, securities or other entities,
risk cannot be removed from the system and remains constant throughout
the system. Typically, constructed financial products perform as
forecast. And because they do, reliance on the formulae or models
increases to infinite.
Since there is no credible
method to forecast the inevitable Black Swan
nor any safe way of factoring
such an event into conclusions,
the system of reliance on
counterparty performance is actually designed to eventually fail.
At right below, another perspective of exposures
in place today. If only 1% of the larger bars equate to a worst case
scenario, it becomes patently clear just how much risk remains in the financial
system. In the April 21st issue, we wrote, “no wonder the Fed is
doing everything they can to buttress the banking system.” And look
what has transpired in the five months since then!
Until there is a widespread comprehension
that risk transference cannot possibly work for all participants,
the threat of the Black Swan will be the
only constant we can count on.
The sum of all risks
in all markets will always and forever
equal the sum of all
risks in all markets.
The collapse of derivatives
The following article is also
reprinted from the September 29, 2008 issue of Crosscurrents.
publication affords more powerful commentary, nor more unique perspectives.
Our September 29th issue commentaries
ran close to 3800 words (most issues typically run 3000 words).
The Headsman's Axe
It is Thursday evening as your Editor writes this.
The story below was already written and was ready to print. Our headline
ran, “WAMU NEXT IN LINE FOR HEADSMAN'S AXE.” Oops. Wamu was
just taken over by the FDIC. You cant make this stuff up. Both
Wamu and Merrill remain part of the data to make our point.
The featured table above is repeated and updated
from the version shown in the August 18th issue. Missing, of course,
is Lehman Bros., now trading at a few pennies, and we have added both Morgan
Stanley (MS) and ex-Dow ex-giant AIG for further comparison. We also
featured Lehman Bros. as a possible short idea in the Three Weeks Ahead
section of the August 18th issue but unfortunately, did not elect to include
it in our Trading Stance. For all intents and purposes, Lehman Bros.
was gone within a month.
The point the previous table made was as clear
as day; the number of shares these companies had authorized to trade had
become a statistical casualty of a broken short sale mechanism. Martin
J. Whitman is one the savviest investors around and runs the Third Avenue
Value Fund. He recently wrote shareholders, “One of the important lessons
from the Bear Stearns debacle...is to avoid owning common stocks of companies
where the businesses need to have relatively continuous access to capital
markets to survive as going concerns.” Now you may understand why
share capitalization is such a huge matter. One method of raising
capital is to sell shares from the corporate treasury. MER raised
$8.5 billion in this way on July 29th. The question begs to be answered,
would Merrill have been able to sell even more shares or sell shares at
a higher price if there were no more shares in play than those actually
authorized by the company? Of course. Less supply is the equivalent
of more demand.
We have explained the broken short sale mechanism
in vivid detail too many times to recall, but at the core of the problem
is that in theory, the same share of stock can be sold short many times
over to different buyers. In practice, the situation occurs often
enough so that large block “owners” may hold shares in excess of what a
company has authorized to trade in total (see table above for evidence).
And now another question begs to be answered. Exactly what did the
recent move by GS to sell $5 billion in common mean to share capitalization?
The math indicates a sales of 40.65 million shares. Add the 428 million
shares already authorized and it appears GS is selling 8.7% of itself.
Trouble is, if we just tally the holdings of large block “owners,” 601
million shares are already in play and GS is selling just 6.3% of itself.
This not mere slippage nor the devil in the details. This is a significant
development that ensures a much harder sell for financial issues down the
If you're still not getting it, think about
while Washington Mutual (WM)
had 1.7 billion shares authorized to trade,
2.9 billion existed in just
the accounts of large block owners.
The question of what Wamu was worth per share had
to be clearly very much in doubt, since there was no way to accurately
determine the share capitalization. Was it 1.7 billion shares?
Was it 2.9 billion shares? Was it some number between the two or
was it even higher than the 2.9 billion listed by CNBC? Most importantly,
given this circumstance, was there any chance for Wamu to raise cash through
the sale of shares? For the first time in stock market history, it
is no longer possible to accurately gauge what a company may be worth,
because no one can get a handle on how many shares or entitlements are
in the system. Given that financial companies have a constant need
for new capital, corrupted share capitalization should be a death knell
for the group. Why should anyone buy these companies? If there
can be 40% or 50% more shares trading than are authorized by the company,
who wants to guess what they're worth?
If giant pension funds are going to lend
shares to shorts to take their pound of flesh on the downside or for ETFs
to work their inverse magic, what in heavens name can the point be for
None. Step aside.
Avoid like the plague.
Doubtless, there will be a rally in these
issues at some point
and the bear market for financial issues
will be declared at an end.
Instead, it will likely endure
for years to come.
In our last issue of Pictures of a Stock Market
Mania, we presented both a 10-year and 20-year view of rolling average
returns (ex-dividends) for the Dow Industrials and to show how dire the
situation was, we offered several scenarios for the future. Today,
we reveal a 30-year perspective to again illustrate just what stocks are
Over the last eight decades, the Dow (ex-dividends)
has returned an average of 4.66% annually over all 30-year rolling periods.
As we see below, some periods are better than other and quite obviously,
the trend has been towards higher 30-year returns, which is for most of
us, an investment lifetime.
While there is no reliable way to accurately forecast
what will occur in the next 20 to 30 years, we can nevertheless, make reasonable
assumptions. For instance, if we suppose 30-year rolling returns
will eventually subside to higher than the historical average
- say 5% - it would take another eight years of mind numbing patience at
the Dow's December 5th close of 8635. If we use Dow 10,000 as our
benchmark, it would take take an additional two years, ten years in all,
to achieve the 5% level of average returns. If we use the Dow's all
time weekly closing high above 14,000, then be prepared to wait yet another
3 years, 13 years in all from today!
Investors are going to have
to be patient.
We must pay the price for the
greatest stock mania of all time.
We have shown the chart below on many occasions
since we commenced this feature and we boldly forecast that the Dow had
to return to the regression line. In fact, the Dow touched
the regression line exactly at the exact low in October of
2002. The surge back above the line was embodiment of the
echo of the mania and again, there was no doubt.... the Dow had to return
to the line which history has conclusively proved is a sustainable growth
in prices. Note that the Industrials have been under the line 80%
since 1897, a period measuring 111 years.
The 5% regression line now
stands at Dow 9775.
On October 7, 2008, the Dow
broke below the line.
It rallied nominally above
the line on October 14th
and then after correcting
again, rallied to just below the line on November 4th.
Having provided support in
the regression line is expected
to exert resistance
for a very long time to come.
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Maximum upside potential
through April 2009 - odds 15%
10,400-10,900 /// SPX 1040-1090 /// Nasdaq Composite 1800-1900
the highs are likely to occur in late March/early April.
risk through April 2009 - odds 25%
6700 /// SPX 670 /// Nasdaq Composite 1165
Most likely scenario
through April 2009 - odds 60%
trades in range from no lower than 7500 to no higher than 10,300
the bear market will not end until the fall of 2010.
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Alan M. Newman, December 9, 2008
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by us, and is not considered to be all inclusive. Any stocks, sectors
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