Did we Escape the Rumblings of the Next Crash?
Was the Financial Times headline: "Traders lost bet blows hole in post-crisis safety net" the announcement of the Arch Duke's murder? The loss results from a more than $160 million default on margined futures trades at the NASDAQ (*) clearing house facility. Morgan Stanley(*) (NYSE:MS), UBS(*) and Norway's State Oil Company will have less than 48 hours to cover their defaulting counterparty. We think they will, but the size of their risks may give the professional market cause for concern as to the general risk in the marketplace. The implications of this default may take a while to be grasped fully. It took about six months from the Arch Duke's death before the armies started to move and begin World War I. Earlier this week I was asked by a group of retired, semi-retired, and active portfolio managers and analysts to give a top-down view of the market. My first point was that we should all prepare for a coming bear market. I hope my timing was not too prescient.
(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both
Current Odds Favor Upside
A very good friend gave me a book this week titled "Financial Market Bubbles and Crashes" by Harold L. Vogel. In the book the author lists 12 characteristics of a bubble, some are present, but not the complete list. As bubbles are much more an expression of extreme sentiment than financial and economic data, I pay attention as others do to measures of investment sentiment. As I mentioned in the past, I look at a sample survey of the American Association of Individual Investors (AAII). Three weeks ago the most popular choice was bullish at 43.5%, by this week the bulls represent only 32.1%.
The Growing Risk Side
One of the traditional causes of bubbles is that there is too much borrowing. Too often this borrowing is used to buy or leverage financial assets, not operating assets. We have that set of conditions today, where major corporations are borrowing to buy their stock. While there has for a long time been borrowing for home and auto financing outside of the bank and bond markets, it has recently grown much faster. Almost every major financial institution is utilizing the credit market and/or raising money for it. We are seeing a good number of these companies raising money on easier terms than in the past. This week the spin-off of Thomson Reuters (*) to a joint venture with a number of private equity funds led by Blackstone (NYSE:BX) was able to sell paper which allowed the equity owners to receive dividends without the permission of the credit holders. This is a global phenomenon. BYD (*) (OTCPK:BYDDF), a Chinese car and battery manufacturer asked its equity shareholders to allow their company to guaranty the debt of their auto finance subsidiary.
One of the other points I made to my fellow members of this investment discussion group was to build cash. At current short-term interest rates, one is much closer to breaking even with inflation than in the recent past. There are other advocates of the value of cash. Charlie Munger and Warren Buffett at Berkshire Hathaway (*) (NYSE:BRK.A) (NYSE:BRK.B), while still buying a few companies and stocks, have built up over $100 billion in short-term investments. They have a very promising record of getting very high returns by coming to the rescue of very large, generally quality companies, in periods of distress. Reviews of Howard Marks' new book speak about the optionality of cash. This means that he can deploy it to a quick advantage.
Two Other Points Made
With the Chinese stock market falling, it would make sense to buy some of their better companies, or well managed mutual funds specializing in Chinese stocks as hedges against existing US and European stocks. If they go down further in value, the odds are favorable that the other holdings will go up in relative value.
The second point, in opposition to the focus almost exclusively on current prices of stocks and derivatives, is to practice some time span diversification. Only for example, one could take some of the asterisk names as being appropriate for middle age children without a great interest in investing. One of the mentioned stocks might also be appropriate for grandchildren in the hope that they will live in a less polluted world.