Thursday, June 10, 2010

Markets Without Guardrails

Two significant changes are pushing markets towards a shakeout.

First, the bond markets are showing strains. For instance, both investment-grade and junk-rated companies are finding it more difficult to issue bonds. To put this in today's context, the momentum money that has pushed asset prices up since the spring of 2009 assumes, or believes, that governments will do whatever is necessary to sustain the upward march. Now there are doubts.

It looks as though institutions may be withdrawing funds from the global banking system as worries of European bank solvency rise. Recent spikes of interbank lending rates (such as LIBOR) suggest this.

The so-called recovery has been artificial. Pete Briger of Fortress Investment Group "poured cold water" on a recent private equity meeting in Boston, the SuperReturn U.S. conference. According to the Wall Street Journal, "the private-equity princes" basked until Briger spoke, when he stated what everyone in the room knew. He "said the improved environment is, in effect a charade, with everyone from central banks to large financial institutions 'in cahoots' to boost lending markets and consumer confidence." [The Journal's quotation marks, my italics.]

The second change is the rising volatility across markets, from currencies to stocks. To some degree, the greater frequency of stock markets rising or falling 2% or 3% in a day is attached to tighter credit market conditions.

A shakeout does not require a reduction of funding. "Charades," also known as bubbles, need ever greater amounts of funding to stay in place. If the pace of funding slows (for example, from a 10% to a 5% rate), the markets are apt to snap.

Prices in the stock market, for instance, flap around as computers decide whether the institution should be a buyer or seller at a certain level. This has led us into the unknown, as explained by the Financial Times: "An explosion in trading propelled by computers is raising fears that trading platforms could be knocked out by rogue trades triggered by systems running out of control."

This is a great worry, but nothing so nefarious is needed to ally a stock market crash. The buy-and-hold investor is in a lonely position. Only 3% of trading was by retail investors in U.S. equity markets during 2009. (For more on our perverted markets, see "blog" Should Investors Boycott the Stock Market?)

We have on our hands a deep-sea oil rig with the safety features for skimming oil off the water's surface. The technology for trading, such as described by the Financial Times, has not been matched by new technology to slay the monster, if necessary. There were such checks-and-balances in the days when stocks were traded on the floors of the exchanges.

At a Grant's Interest Rate Observer conference in November 1999, one speaker was not concerned about the stock market. (For those who were still in school, the Nasdaq had risen 150% over the previous 13 months.) One reason this speaker cited was "strong central bank leadership." Another speaker, Michael Steinhardt, did not think the Fed's leadership would be worth much when it was needed most. Steinhardt had started on Wall Street in the 1960s, the "Go-Go Years." Few investors had gone-and-got as profitably over the prior three-and-one-half decades as Steinhardt. He spoke about Wall Street's abandonment of controls, leadership and responsibility:

"The liquidity safeguards, historically, were the specialists' books, the retail system, and the institutional liquidity providers in the major brokerage firms. They were the mechanisms that the stock exchange itself had provided, and they were all structured for a system where trading was a very, very small fraction of what we're seeing today. Now there are no specialists' books; there is no serious liquidity provided by brokerage firms; and the trading mechanisms of the exchange are hardly relevant to the sorts of volumes that exist today. So yes, the Federal Reserve, if you define that broad context of liquidity in a financial sense, does still exist, but in a securities market sense, none of the former ones do."

The average buy-and-hold investor probably did not realize how the institutional framework was constructed to generate a harmonious flow of buy-and-sell orders and to protect the market from abuses. Now the institutions perpetrate the abuses and the guardrails no longer exist.

The "strong central bank leadership" was absent once the Nasdaq commenced its 78% collapse in March 2000, when the bubble had reached a level that no liquidity safeguards could have prevented. During the plunge, central bank leadership layered the world with paper in an effort to pump economies back up.

Now, that paper cannot be paid back. Since 2007, the world financial system has suffered periodic waves of deleveraging, during which times central bank leadership could not compensate for the discarded institutional mechanisms that had contained disruptions.

As Pete Briger of Fortress Investment Group said, the central banks and large financial institutions are "in cahoots." Their objective, "to boost lending markets and consumer confidence" is to draw the unsuspecting into markets. Beyond that, the institutions trade now to make money for themselves. Such notions as leadership and responsibility are gone with the wind.

Chances are good that volatility will keep rising until we reach a sharp market break. In simpler days, receding liquidity and less stable markets under bubble conditions meant "crash." This is still the likely course, but governments know asset prices are the hedgerows that shield fallow economies from view. Governments want to preserve the fa├žade. They will do what they can to push prices up. Speculators who see governments re-open vast credit lines (as they did in 2008) will probably reverse course in a fit of panic buying.

It looks, though, that central banks will respond after the fact rather than act preemptively. The Federal Reserve has reinstituted swap lines, but even that decision was in reaction to a problem the markets had already identified. Government will inflate, but probably after steep declines across markets.