10 Notes on Current Market Risks

1) You hear me talk about this more than most, but liquidity risk needs more emphasis. This is true whether you are a retail or institutional investor. As the old saying goes, “Only invest what you can afford to lose.” The basic operations of life require liquidity.

That even applies to the abstract mathematicians who developed much of modern finance. The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets. I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.

My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research. Once markets do not trade continuously, the math gets tough.

2) Insiders are selling, should you worry? Perhaps a little, but I would wait until the price momentum starts to fail. Like value investors, insiders tend to be early.

3) What works in a time of rising leverage will not work well when leverage is decreasing. Or, a strategy that requires liquid markets does not so well in a time of deleveraging. Consider Citadel, then. The period from 1991-2007 was pretty care-free. What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap. In 2008, the trap was sprung and Citadel had a lousy year. Amid the carnage, they were forced to sell into a falling market. Now they are running at reduced leverage, and planning products that would have been smart eight months ago.

4) Average retail investors don’t understand regulated investments well enough to invest in them. It would be stupid to allow them to invest in hedge funds, then. If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.

I can’t see that happening in my lifetime. The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much. (The culture abhors little investors being fleeced by bigger institutions.)

5) Auction rate preferred securities — when I was younger, I wondered how they worked. By the time I figured that out, the market failed. Now the lawsuits fly. Yes, they were marketed as money market equivalents, but none of them made it into money market funds. Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance. Few believed them because it had worked so well for so long. My view is this — investors needed to read the “risk factors,” and did not. ARPS were designed to be investment vehicles that could survive a storm, but not a tornado. Tornadoes do happen, and those that assumed that such volatility would never happen lost.

6) My, but the high yield market and lower investment-grade corporate markets have moved higher. What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog. Systemic risk is still high.

7) Spreads have fallen for high yield; I have previously suggested to lose the overweight in credit. I now suggest that credit be underweighted. This is not a time to stretch for yield.

8) After many other crises, junior debt gets grabbed when seniors have rallied a great deal. The need for yield is significant, much as I think it is premature to buy those junior debts.

9) The same is true for high yield. When does the rally end? Now? Typically near a market peak, there is confusion, and a diminution in volume. I think we are close to the end, but as I usually say, honor the momentum. If it is still going up, hold it.

10) This article is a little unusual for me, but it points out something that I often talk about in different terms. Trees don’t grow to the sky. In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless. Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve. So it is with business, and much of finance.

Comments

[markfl:]

David Merkel wrote:

"2) Insiders are selling, should you worry? Perhaps a little, but I would wait until the price momentum starts to fail. Like value investors, insiders tend to be early."

At least in terms of insiders, on the aggregate they aren't always that astute. Yes, there has been a 30-1 ratio of insider sellers to buyers (TrimTabs), but, looking at a chart of the S&P vs. the insider sell/buy, the former has moved inversely with the latter: although very volatile, sell (bearish) interest has gone up while the S&P has gone UP.

Sep 20 04:27 PM

[Mark Bern:]

"9) The same is true for high yield. When does the rally end? Now? Typically near a market peak, there is confusion, and a diminution in volume. I think we are close to the end, but as I usually say, honor the momentum. If it is still going up, hold it."

Perhaps I am overly cautious, but I like to sell into the rise, taking a portion of profits on good up days when I have met my target for a particular trade or when I sense that the market is losing steam. I prefer to sell on the way up as opposed to one the way down. I feel there is less risk in this approach. Waiting for the top, IMO, increases risk exposure. Maybe I am not greedy enough, but I sleep well.

Sep 20 05:18 PM

[axelrod608:]

Re "insider selling", the assumption is always that they know something that will take the price down. Which may be valid in normal times, but may be way off target today.

Let's face it, just about everybody lost a chunk in the past couple years. And over half of everybody is holding assets that are underwater. Where I live there has been a big increase in garage and yard sales, cars, trucks and motorcycles on the lawn with "for sale" signs. I would assume that some portion of those "insider sales" are nothing more than a way to raise liquidity to cover the effects of what occurred in the greater economy.

These are extraordinary times and the ordinary assumptions may not be valid now.

Sep 21 11:49 AM

[Buckoux:]

"Trees don’t grow to the sky."
This obviously simple, yet profoundly obvious statement should be on the entrance to Congress, the Fed in Wash.D.C. and engraved on our money. The corollary is that trees do bear fruit. However, Wall St. has investors watching the tops of the trees as they have been busy stealing the fruit near the ground. As does Congress. Specifically, when will Congress reform the tax on the interest of after tax savings? The fruit of one's own money tree and a source of capital for other tree farms. Right now, there are a multitude of "pests" in the orchard.

Sep 21 02:35 PM

[Econ 101:]

On your point 4 - It is exactly that small investors have been fleeced, the whole country has beeen fleeced by wall street and the big banks like Goldman Sachs, BAC, C, and AIG. Where have you been? Sure they dont like it but all the sheeple do is grumble about it. Then the leadership of the country (ie. Speaker pelosi) derides them by calling the sheeple Nazi's or unamerican for disent. Even fromer Prez Carter jumped in and exposed those disenters for what they were - racists! Racist for not bowing at the feet of BHO (as he did to the King of Saudo Arabia) and praizing cap and trade for saving the environment or the health care bill for its reform.

Americans dont understand investments? They dont understand how badly they have been scr*w*d by the government for the past twenty years. Check that, 50 years, or more.

Sep 21 03:08 PM

[metaforge:]

Same old same old... don't see much change coming out of Washington at all. Piss money away fighting useless unending wars, and funnel it to the fat cats on WS & big defense co. Give some lip service to climate change and health care, but nothing will get done - nothing that really matters anyway. The locusts have been here for 20+ years.

Sep 23 02:06 PM