Remembering 1994
07/31/07
July ended with a thud for stocks. The Dow Jones Industrial Average dropped 146 points Tuesday after earlier being up as many as 138 points. Much of the swing took place after the market learned of the latest casualty tied to the collapse of the subprime mortgage business, American Home Mortgage. American Home shares plunged 89% after the lender told investors it was seeking an orderly liquidation of its assets, following a series of margin calls that essentially put it out of business. American Home's plunge came a day after the implosion of a much bigger player, Sowood Capital Management. The hedge fund collapsed under the weight of different issues -- specifically a widening of credit spreads, or the difference between the yields on safe government debt and risky corporate securities. Rumors are already flying about more hedge funds meeting with huge declines for July, and bid lists circulating through the bond markets. With July having turned into an even worse month for the credit markets than June, investment managers may soon have to face the music. The Merrill Lynch High Yield Master II Index had dropped 3.86% in July through Monday's close. That made July its worst month of the year. July 2002 was the last time the high-yield market saw as big a loss.
The left chart shows the S&P investment grade and speculative grade spreads in basis points (hundredth of a percent) over T-Bonds. Junk bonds currently fetch 9% (4.25% over T-Bonds which fetch 4.75%). The right chart shows the price level (and the yield spread over LIBOR) of the LCDX index tied to high-yield, high-risk loans of 100 U.S. companies. The spreads on these loans have quadrupled within the past two months. That seems overdone and is likely to revert a little bit, but the credit crunch that had been predicted by many is now upon us. I have to admit that I did not believe in this kind of scenario. I thought that in a world of international diversification, risks of markets and credits would spread more easily over more and sturdier shoulders, better able to withstand systemic shocks. I was clearly wrong. The more things change the more they stay the same. Lenders are pulling back, liquidity is drying up and lending standards will be tightened. Easy credit will no longer drive the speculative juices around the globe that seems to be certain. The first victims of this new environment are those investors, who demanded low volatility and stable “predictable” returns. They chose hedge funds that invested in mortgage and asset backed pools of credit, using in turn credit themselves to enhance returns. In 1994 investors and the pension fund of Orange County found out that Bond Mutual Funds were not the same as simply holding the bonds themselves. Although the funds were labeled “government bond funds” and therefore implied safety, they were anything but safe. Just like investments in mortgage pools imply stable cash flow but may produce anything but stability or cash flow. It just depends how your money is used and if leverage is applied or not.
The difference was that those government bonds funds not only bought government bonds. A fund could not shine with that. They also invested in interest only bonds (IO bonds) and other esoteric instruments, which gave them a higher yield as long as interest rates stayed stable or were falling. To further enhance the yield they did all that with borrowed money, too. When Greenspan raised the Fed Funds rate from 3% to 6%, all those instruments declined in price. The ensuing massacre in the fixed income markets wiped out Orange County’s entire pension system. The bond funds fell in value because they had to trade around their positions a lot, especially to meet redemptions. Had investors bought the government bond outright, they would have survived the price decline by simply holding the bond to maturity. That was 1994. Today, investors are facing the same dilemma. They often do not know what positions their hedge funds are holding, how liquid they are and how prices are being determined. The “mark to model” approach used by most hedge funds in the asset backed securitization business, which was supposed to imitate reality closely enough, is now being replaced by the “mark to market” approach. This approach is damaging portfolios all over the world since it is based on real world transactions. The value of a portfolio is determined by the price of the last transaction of each day. Portfolio values drop, margin calls are being issued and investors sell first and ask questions later. In this kind of environment, investors are pulling money out as fast as they can. The trouble is that in order to pull money out, you need to be able to sell some of those artificial cash flow conduits that look like bonds (some of them, with AAA rating) but behave like penny stocks. They are highly speculative and trade by appointment. In other words, money managers who need fast cash to meet redemptions are forced to sell what they can, not what they should. In all likelihood this meant stocks were sold before mortgage bonds even received a bid. In addition to that, the SEC has eliminated the up tick rule, which means that investors can short into a falling market. The combination of redemptions and the ability to short into a falling market caused wild swings in the stock market over the last two weeks. These swings are also known as increased volatility.
VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge”. The left chart above shows the weekly VIX which has reached a new 3 year high of anxiety. The chart to the right, however, shows that this recent high is really quite low when we look at the past 10 years. Up until 2002, our volatility measure used to be always above 20. Only after 2003 did we experience a new era of low volatility. The first reason for this subdued volatility is that the markets have spent 4 years now without a 10% correction. The second reason is that many hedge funds figured out that selling VIX-Options meant a nice steady stream of income. This kind of selling subdued the index further, until the spring of 2007. The current volatility is probably going to stay with us for the rest of this year. This means increased risk but thankfully also increased opportunity.
At the moment this market is as washed out as it usually was at major market bottoms over the past three years. This does not mean that the risky phase is behind us, but that flexible investors should look for opportunities next week.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
