Sunday, August 12, 2007

Note to Financial Wizards: There is No Free Lunch

Well, you're all an optimistic bunch. 80% believe that the stock market is in correction mode. 20% of you are bracing for the worst. It looks like Hedge Funds are bracing themselves, too:

One hedge fund manager estimated that statistical arbitrage funds with more than $100bn (€73bn, £49bn) in assets had on average borrowed four times their actual assets. These borrowings magnify significantly any moves they may make in the market.

It is these more heavily indebted statistical arbitrage funds that have proved most attractive for pension funds seeking supposedly lower risk hedge fund strategies.

It is also these funds that ran into problems at the end of July when volatility began to rock the market.

As volatility rose, they began to cut back their risk. They did this by selling out of their positions to reduce leverage.

But the wave of selling only exacerbated the problem by pushing down prices. As asset values fell, the ratio of debt to assets rose. This forced them to sell yet more assets.

One hedge fund manager said: “Nobody is happy with their credit position and everyone wants to de-risk and de-leverage. And it is global. The market has gone freaky”.

Analysts at Lehman Brothers said the problem was that investors’ models, its own included, were behaving in the opposite way to tried and tested predictions.
Gah! MaxedOutMama gives this advice, if like me, you're concerned with the market:
Howard at Oraculations wrote about the perils of black-box investment models and buying stocks held mostly institutionally. But in general, if you have a good stock with strong management that has not been loading up with debt, I would hold that stock. Even if stock prices go down, over a few years you are likely to make a good gain on the stock, because it probably will grow its business in a difficult environment whereas weaker competitors will lose.

So how do you know the stock is a good one? There is no substitute for reading financials for stocks you buy or hold. None. If you are not willing to do this, you probably will be better off having a professional manage your money, with the proviso that you still must check their logic.

The stock market is a place to invest for long term gains. At any given time, stock prices could be up or down. What matters is not the stock's price today, but the long term performance of the stock. So if you like a company, pay attention to what the company is doing, and see the stock falling because of causes that do not seem intrinsic to its basic business or its management, a period of falling stock prices is the time to buy more. No guts, no glory, but do your homework. This is one reason for selling out before the top - then you have more money to buy later when things go down. Over decades this maximizes your returns.
Good advice. It's actually advice I took on Friday...which was too late to make a difference in the last week. So I called our financial guy on Friday and thoroughly pissed him off, I believe. But since I'm no stock expert and don't read the individual companies' financials and do trust stock fund managers (mutual funds), I asked him essentially what Mama said to ask yourself as an individual, What do the guts of the funds look like? How sound are they? How exposed to this bad debt and credit mess are they?

His answer,"We don't know. We'll know with more information." Well, I hate being told "I don't know". Shouldn't a financial guy know this? I also asked the financial guy about this phenomenon:
As for defaults, if a person has a non-resetting mortgage and has been paying on it for a few years, that person's risk of of default is not that high, but then you have to adjust for the possibility that a person loses so much money in the home from property devaluation that the person will walk away from it. This is already happening in some markets.
I am seeing lots more lower priced homes sitting and waiting for renters, too. This was not the case six months ago. While Houston has not seen sky-rocketing gains, just steady-eddy improvement, there are more homes available in the lower range. I've written about it before. It's strange. The homes that are over $500K are moving and the less expensive ones are sitting. Of course, like James Lileks says, ugly homes sit. But it's more than that. The houses aren't being rented either. So I mention this to the Financial guy and he sounded just like your local medical doctor, "Well, that's anecdotal." Well, true. But it's also factual and there is data to support it. Homes are sitting and the people who would buy them can't. And they can't afford to rent them either. I can only guess that they are moving in with parents or other relatives.

And there is another possibility, too. Could it be that that the market for lower-income homes is drying up because the pool of people buying them is drying up--namely "foreign guest workers"? I don't know the answer to that, but Mama has a theory:
I have been wondering if the Bush administration hasn't finally woken up to the facts. The move to actually follow up on the SS discrepancy files makes me think that they are trying to produce a lower unemployment rate by clearing out 20 - 30% of illegals.

We are in a recession, no doubt about it. We've lost too much forward impetus to recover.
Wow, if that's the case, it's hard core. I wrote before that the administration seems to view the Mexican workers in purely economic terms:
But for economic and social reasons, Congress and the President have no intention of creating a secure border. The United States electorate would experience inflation again with a tight border. It's simple, really. Less workers, higher wages, businesses struggle to keep costs down, prices passed on to the consumer, rinse, repeat.
This will happen if the illegals go back to Mexico. So in the midst of a credit crunch, a reduced worker pool would drive up employer costs. It would, however, keep Americans employed for a while longer until businesses start losing revenue because the voracious consuming American machine stops buying. That's the double whammy. Credit dries up, companies stop hiring, coupled with a family who has lost their home and living beyond their means in other ways......economic Armageddon.

And then, people will stop buying "luxuries" and non-necessities like, say, Chiropractic. Or, they'll buy whatever they need when they're in crisis. This happened after 9/11 for about six months and again after Katrina and Rita for about six months.

The fundamentals of the market seem worse now, though. And the market is freaking out. It's simple really: Debt is bad. Lots of debt is really bad. The American economy might soon pay for it's stolen "borrowed" lunch.

There is no free lunch.


Anonymous said...

That's the double whammy. Credit dries up, companies stop hiring, coupled with a family who has lost their home and living beyond their means in other ways......economic Armageddon.

No coincedence the Real Estate Pimps are screaming "BUY NOW OR BE PRICED OUT FOREVER! DON'T BE LEFT BEHIND!"

MaxedOutMama said...

Dr. M., regarding the vacancies, household formation has plummeted over the last year. So your observations are more than "anecdotal", or even regional....

This is exactly what I meant by checking logic. The investment guys are genuinely sitting on their hands and saying "I don't know", and that is causing a lot of people to sell, quite reasonably.

We are in a recession. It doesn't show well in any currency-denominated measures because of high inflation, but we are in a classic consumer-led recession. Business investment will follow as sure as night follows day.

Melissa Clouthier said...

Yes, well, the question is "where to move the money?" Is there a safe haven? Are all mutual funds exposed to this mess?

Or is it a matter that even if they aren't, the economy is sliding and everything will be affected?

People still need food, water and diapers, right?