The Latest Crisis Now Unfolding On Wall Street

by: Eric Parnell, CFA

"It's hard when you're always afraid

You just recover when another belief is betrayed"

--A Matter of Trust, Billy Joel

An entirely different type of crisis continues to fester and grow for capital markets. And unlike the financial crisis that has loomed over investors for the last several years, this other condition is subtle but far more chronic, as it threatens to compel many market participants to walk away from the markets altogether.

What is this latest calamity? It is a crisis of confidence and a mounting lack of trust in investment markets.

The latest round in this rotting situation came with the news that Barclays (NYSE:BCS), a systemically important UK-based financial institution, was fined for reportedly attempting to manipulate the daily fixing of LIBOR. This is not only the interest rate at which the bank could supposedly borrow funds from other banks on any given day, but far more importantly it is a critical benchmark that is used to set the interest rate for those that have collectively borrowed over $350 trillion worldwide. Needless to say, this latest development is one that has potentially far reaching implications, and one gets the sense that we are only at the beginning of the episode.

The attempted manipulation of LIBOR is bad enough. But the real impact on investment markets is far more profound, as it represents another damaging blow to investor trust.

The reaction by some in the financial media to the LIBOR situation was surprising. Several commentators, some of which I respect, seemed generally dismissive of the situation as not a big deal. After all, it's been widely known and understood that daily LIBOR reporting has been subject to being "managed" over the years. Heck, one does not have to look far on the web to find news articles dating as far back as 2008 stating that Barclays and others were openly misstating their borrowing costs for LIBOR. And if these banks have known for the last several years that they have been under investigation by regulators, then they probably have been less inclined to massage the number in recent years. For these reasons they say, this latest scandal surrounding LIBOR is not a big deal.

But this conclusion misses the much bigger point. That is that it is yet another incident among a growing list of events that betrays the trust of investors. It's not necessarily what those responsible for reporting LIBOR rates at Barclays were lying about. Instead, it was the fact that they were lying. And it was the reasons why they were lying. They weren't acting unethically for any seemingly noble reasons. Instead, they were lying to protect their own daily derivative bets. And during the depths of the financial crisis, they were lying in an attempt to make the markets think that Barclays as a firm was in better financial shape then it actually was. Perhaps most importantly, it seems that Barclays was not at all alone in lying for their own self-interests and at the expense of everyone else.

"I'm not upset that you lied to me, I'm upset that from now on I can't believe you"

--Friedrich Nietzsche

Such is the critical problem that is only compounded by the LIBOR scandal. Here we have a systemically important financial institution in Barclays that is reporting a borrowing cost to construct a global benchmark interest rate each and every day. Thus, one could reasonably assume that this would be a fairly reliable and transparent number. Of course, Barclays was found to have been manipulating and misstating this daily number. And it sounds like many other systemically important financial institutions including several in the United States were allegedly doing the same including JP Morgan Chase (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) among others. This raises some critically important questions. If we cannot trust the banks to accurately report a number such as daily borrowing costs to construct LIBOR, how exactly can we trust anything they say? And given the fact that mark-to-market accounting has been suspended for over three years, how can we reliably trust how banks report their more obscure assets when they have been found to be lying about the most basic and transparent of information like daily borrowing costs? In short, they simply cannot be trusted.

Given this crisis of confidence in the banking system, the easy conclusion from an investment standpoint would reasonably be the following: forget the financial sector (NYSEARCA:XLF) and just invest elsewhere. As a matter of fact, I have done exactly that having been zero weight to the financial sector in stock portfolios since January 2007 save a small short-term trade position in Goldman Sachs (NYSE:GS) from November 2010 to February 2011.

Unfortunately, it is not that simple for investors. This is due to the fact that the influence of financial sector is vastly different than the other nine sectors that make up the stock market. For example, if health care (NYSEARCA:XLV) was shocked due to an event such as new health care regulations, or if the technology (NYSEARCA:XLK) inflated a bubble that subsequently bursts, the outcome may serve as a drag but does not threaten to destabilize the global market system. However, if the financial sector crashes as it did a few years ago, it quickly threatens to suck the global economy down a black hole. And how does the stock market as measured by the S&P 500 (NYSEARCA:SPY) decline by -23% in just seven trading days in October 2008? Or drop by -18% over twelve trading days in July-August 2011? When major systemically important financial institutions across the globe start liquidating every asset in sight on their books in order to try and save themselves from collapse. Given the fact that many of the problems that sparked the crisis several years ago remain unaddressed, it is unlikely we have seen the last such episode. And somehow I do not expect we will receive an advance call the next time the banks decide they need to scramble and liquidate. Instead, the only thing we do know is that we are less likely to have an inaccurate LIBOR number than we might have had in the past. Not much to rebuild investor trust to be certain.

"The hell with the rules. If it sounds right, then it is"

--Eddie Van Halen

Investor trust issues do not end with the banks. Unfortunately, they also extend to those that are supposedly enforcing the rules.

Before going any further, I feel compelled to mention that I am not a conspiracy theorist. I am instead someone that believes in the proper functioning of markets and the rule of law. But when one is left to examine the events surrounding the unfolding LIBOR scandal, it is only prudent to reevaluate the confidence in these principles.

Revelations that members of the Bank of England may have encouraged Barclays to misstate LIBOR borrowing costs escalates the situation to an entirely new level. For it is one thing when a market player such as Barclays is reported to be acting unethically. And it is also disturbing when Marcus Agius is both the Chairman of Barclays since 2007 and also the Honorary Chairman of the British Bankers Association to which Barclays was reporting the allegedly misstated LIBOR numbers. But it is another thing altogether when a market referee such as the Bank of England is potentially involved in encouraging the activity to make the market think that Barclays was in better shape than reality. When playing a game, one hopes that the referees are taking the necessary steps to prevent the rules from being broken. So when we learn that a market referee like the Bank of England was potentially involved in encouraging the rules to be broken, this is a staggering blow to investor confidence. For while the idea of breaking the rules may have some application when it comes to playing the electric guitar, it does not at all apply to capital markets.

The implications stretch well beyond the Barclays matter, as it forces investors to question how much influence the public sector might be trying to exert on other areas of the private sector. For example, was the Fed providing similar advice to U.S. banks? What other publicly reported numbers are being "managed" in order to potentially influence market behavior one way or another? And might upcoming releases of economic data be tweaked to make certain policy responses more or less palatable? While I continue to believe in the integrity of the reported data, if nothing else the events surrounding LIBOR necessitate evaluating this additional layer of risk more closely going forward.

So what are the direct implications on stocks from this mounting crisis of confidence going forward? It implies lower stock valuations going forward. For if investors have less confidence in the integrity of each dollar of earnings reported by companies in the market, they will be willing to pay less for it. And if investors feel that the actions by those trying to deceive may ultimately lead to a result that might shock the market once again, they will demand to own fewer shares and will be willing to pay less for those shares. Lastly and perhaps more importantly, if investors feel as though regulators assigned to oversee the market may not be enforcing the rules and may actually be encouraging participants to bend if not break the rules, then investors will simply walk away from the markets altogether. For any marketplace that is not governed by a predictable set of rules in which all participants can have full confidence, then it is potentially fated to eventually decay into nothing more than a random game of chance.

How then can investors position to protect themselves against this crisis of confidence? Two key strategies are instrumental. The first is to remain hedged and to hold short-term allocations to cash when necessary depending on market events. The second is to identify asset classes and investments that you can know and trust to concentrate your allocations. This includes identifying asset classes that are performing consistently and predictably given underlying market fundamentals, even if this includes the influence of seemingly endless monetary policy intervention. This includes categories such as Agency MBS (NYSEARCA:MBB), U.S. TIPS (NYSEARCA:TIP), Build America Bonds (NYSEARCA:BAB) and National Municipal Bonds (NYSEARCA:MUB). Recognizing that the stock market could descend into crisis at any moment, maintaining allocations to negatively correlated asset classes such as Long-Term U.S. Treasuries (NYSEARCA:TLT) remains prudent. And positions in stores of value such as gold and ssilver are also sensible for protection against both crisis as well as further balance sheet expansion by global central banks. In keeping with this theme of trust, I will be revisiting my allocations to both Gold and Silver in more detail in an upcoming Seeking Alpha article.

Of course, maintaining an allocation to the stock market is also prudent in an overall hedged approach. Investors are best served by emphasizing those securities that rank among the highest quality and lowest price volatility, as these stocks have demonstrated the ability to outperform by a healthy margin over the course of the financial crisis with less risk. Representative names include Microsoft (NASDAQ:MSFT), ExxonMobil (NYSE:XOM), IBM (NYSE:IBM), McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG) and Hormel Foods (NYSE:HRL). Nike (NYSE:NKE) is another name worth considering in this context, particularly following its recent sharp sell off.

Markets must be cleansed to bring the current financial crisis to an end. And this cleansing is not limited to allowing stock prices to find equilibrium without extraordinary policy support. It also requires persistent and dedicated efforts to restore investor trust and confidence in the markets. Until then, market volatility and uncertainty is only likely to continue.

Disclosure: I am long TLT, MCD, PG, HRL, NKE, TIP, MBB, BAB, MUB.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.