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The Bernanke put that underpinned stocks' climb to historic highs is dead--what comes next?
06/28/2013 8:30 am EST
I don’t think you need to invoke “feral hogs” or imagine conspiracies by the gnomes of wherever to explain the global sell off. It’s really quite simple.
Federal Reserve Chairman Ben Bernanke’s May 22 answer to a question after his Congressional testimony marked the end of the Bernanke put. That put, what the financial markets have seen as the guarantee that the Federal Reserve would support asset prices, has been a key to this rally that took the Standard & Poor’s 500 from 1131 in September 2011 to 1650 in May 2013.
Something, some guarantee from the world’s central banks and most importantly the Federal Reserve, has replaced it. It’s not like the Federal Reserve is about to abandon its support for the mortgage market, for example.
But right now nobody knows what’s in the fine print of that guarantee, how good the guarantee is, or how long it runs.
“When in doubt, get out” will rule huge hunks of global financial markets until the MBAs who crunch the numbers at the world’s big financial institutions feel they understand the new guarantee enough so they can plug it into their formulas.
How long will that take? More than the few days of this week’s bounce—especially because it’s clear that the bankers at the Federal Reserve aren’t certain themselves about the fine print on that guarantee.
I think it’s likely to take most of the summer, at least, to work out a new consensus on the central bank guarantee that will replace the Bernanke put. And until that consensus is in place, I think we’ll see levels of volatility high enough to keep markets on edge and high enough to turn minor disappointments, worries, and bits of bad news into major moves to the downside.
The key to understanding this drop is that pretty much everything has tumbled at the same time.
From the day, May 22, that Federal Reserve chairman Ben Bernanke off-handedly reminded everyone that the Fed would have to turn off the cash faucet at some point, U.S. stocks, as measured by the Standard & Poor’s 500, were down by 5.8% as of the close on June 24.
The damage to stocks didn’t stop at U.S. borders. Japan’s Nikkei 225 Index was down 16.4% in that same period of a little more than a month. China’s Shanghai Composite Index was down 14.7%. Brazil’s Bovespa was down 16.4%.
And it wasn’t limited to stocks. U.S. Treasuries, as measured by the Bloomberg U.S. Treasury Bond Index fell 3.3% from the May 8 high to the close on June 24. (Bonds, in general peaked slightly ahead of stocks.) U.S. Corporate High Yield bonds, known affectionately as “junk bonds,” were down 5.3% in the same period. Emerging market corporate bonds fell 8.3%.
That speaks to a worldwide, all asset classes re-evaluation of risk.
Assumptions about risk govern all the formulas that Wall Street uses to calculate the value of individual financial assets. A stock is worth what it is in Wall Street’s calculations because Wall Street can assume a company’s cost of capital, for example, and then plug that assumption into a valuation formula. A bond is worth what it is in Wall Street’s calculations because Wall Street can assume a rate of inflation and the appreciation/depreciation of the bond’s currency.
Assumptions about risk get more important as strategies get more complex. If you’re laying off the risk of the Japanese yen in order to go long Japanese stocks, for example, you need to make assumptions about the “riskiness” of each asset class and about the relationship of the risk of these asset classes.
Wall Street’s most successful thinkers remember that they’ve made these kinds of assumptions and they constantly check to see if the assumptions remain justified. When they no longer are, or when it’s not certain that the assumptions still make sense, the smartest course is to sell—and either figure out new assumptions from the sidelines or wait until the logic behind those assumptions is more convincing.
Let me use a current market puzzle as an example. The yield on AAA-rated general obligation municipal bonds has climbed to 4% from 3% a month ago. That means that a bond worth $1000 a month ago is worth $750 today.
Simply stunning. Here we have a 25% loss in the highest rated, lowest risk tax-exempt government bonds. Has there been a huge surge in default risk in the last month? Maybe in places like Illinois or Rhode Island where state and local governments are in deep, deep trouble after promising to pay out more than the budget can afford for years and years. But those aren’t the kind of bonds we’re talking about here. Illinois isn’t rated AAA.
So what’s going on?
The huge price drop in these least risky of municipal bonds is a result of the end of the Bernanke put and the new uncertainty about the price of U.S. Treasuries.
The muni bond market is exactly the kind of complex structure that takes a hit when investors and traders have to recalculate risk. Many munis are traded infrequently and don’t get priced every day. The big dealers in this market use the price of Treasury bonds to set prices for these infrequently traded municipal bonds. That’s the first place in this system where risk calculations pop up since to go from the price of a Treasury to the price of an AAA-rated muni requires making some assumptions about the risk of these two assets. Second, since big municipal dealers don’t want to get stuck if the price of an infrequently traded muni moves lower, they use Treasuries to hedge their portfolio risk. That’s risk assumption No. 2 since figuring out how many Treasuries to buy as a hedge demands an assumption about risk. (Dealers can’t hedge by going short since in a short the dealer would have to agree to pay tax-exempt interest to the party at the other end of the deal. But no one can pay tax-exempt interest but a government.) And finally, the big dealers have to make an assumption about the volatility of their muni portfolios. Since these portfolios can’t be shorted, if the Treasury hedge starts to look like iffy insurance, the best strategy for a dealer—or any other big owner of munis, even AAA-rated munis—is to sell.
Does that give you some sense of how uncertainty about risk in a post-Bernanke put world—turns into extreme volatility, in this case downside volatility—in a seemingly safe asset?
If “when in doubt, get out” is to rule markets for weeks or months, where do we look for the worst problems?
In leveraged bond funds. That, unfortunately, includes a lot of bond funds that use leverage to increase the potential returns from dull, boring, and safe assets. For example, the closed-end bond fund Pimco Dynamic Credit Income Fund (PCI) can use leverage of slightly more than 40%. (It had borrowed enough for leverage of 31.3% as of May 31, 2013.) The fund, as of the end of May, was 98% invested in high yield bonds with 90% in bonds of five- to ten-years maturity. For the month ended on June 26, the fund had lost 9.55%. That’s against a 3.76% loss for the Bloomberg U.S. Corporate High Yield Bond Index.
In the leveraged U.S. equity market. In March 2007, as U.S. stocks closed in on what would turn out to be the peak in that rally, margin debt on the New York Stock Exchange hit a record $380 billion. (Margin debt is money borrowed against the value of the shares in a portfolio in order to buy more stocks. Margin loans have to be repaid in a hurry if the value of the shares pledged as collateral falls. If an investor can’t meet a margin call with more money, the position is sold to cover the loan.) In April 2013 margin debt set a new record of $384 billion. Margin debt in absolute terms does rise when market values rise so it’s not surprising that with stocks at an all time high that borrowing against those stocks should also hit an all time high. I leave it to you to decide how comforting it is to know that margin debt now was in April just 2.56% of total market value versus 2.76% in 2007. (And, of course, these margin figures include only stock exchange margins loans. They don’t include leverage at hedge funds and other vehicles, for example.)
In emerging market positions supported by the carry trade. Buying yen, for example, in Japan or dollars in the United States where interest rates are low in order to invest in Australia or Mexico where interest rates are higher makes perfect sense as long as the yen or dollar is stable or declining since that means that you’ll get to pay back the loan in cheaper yen/dollars or, at worst, steady value yen/dollars. When the yen/dollar starts to rise, or indeed if its price simply becomes less predictable, then closing out the positions funded with cheap yen/dollars becomes the smart play. So a rising yen (or dollar or euro) becomes a reason to sell positions—debt and equity--in Australia, Mexico, and the Philippines.
In companies and industries that use hedges against uncertainty. There are two problems here. First, industries such as mining, airlines, oil and gas, and banks that routinely use hedges to reduce risk typically find that in volatile markets hedges are either more expensive or unavailable. That will make results in these sectors more volatile. Second, market volatility makes it more likely that a hedge will unexpectedly blow up and what was supposed to be insurance against volatility will wind up becoming a source of volatility.
In companies with complex, black-box business models. I think this pretty much describes the modern financial sector. Banks make a decent to large (depending on the bank) percentage of income and revenue by trading—but we don't know the contents or extent of those trades (and from recent testimony from officers at banks such as JPMorgan Chase frequently neither do the banks) until we see the quarterly financials—if then. We don’t know what are in portfolios until those end of quarter reports either. Right now one fear weighing on prices of bank shares is the potential for losses in bank portfolios as a result of drops in bond prices. Is that fear justified? It’s extremely hard to tell since we only know what a bank owned at the end of the March quarter and not what the bank owns now.
I grant you that these are extremely broad-brush characterizations of risk from the end of the Bernanke put. (And I’ve certainly left some risk situations out. For example, it looks like the end of the Bernanke put is putting pressure on the Draghi put in the EuroZone. Bond yields are climbing there, slowly but steadily, as bond markets question the value of the European Central Bank’s promise to do “whatever it takes” to defend the euro.)
One wrinkle on all this is that positions that are easier and cheaper to sell—such as big cap emerging market companies that trade in New York as ADRs (American Depositary Receipts) or that make up a big percentage of country or sector ETFs—are likely to take a hit first with harder to trade and more expensive to trade local assets holding up relatively better because they aren’t leveraged to global cash flows to the same degree. I’d expect that this relative safety will erode if the sell off in emerging markets drags on long enough to generate local selling.
The big question in all of this is how long it will take to put together a new consensus on risk and whatever is to follow the Bernanke put. If U.S. economic growth follows a Goldilocks trajectory with enough growth to support modest increases in jobs but not enough growth to raise worries that the Fed will taper off its asset purchases before the end of 2013, then I think we’ve got a good chance for a new consensus by September or October. The odds of that being the case will go up if Japan resumes its weak yen policy (and Japanese bond yields don’t spike) and if China’s growth doesn’t raise fears that the economy will slow to 6% or lower.
Shifting gears when the market has gotten so accustomed to the Bernanke put isn’t quick or easy, but it will happen.
The bad news is that this first shift is only one of many that global financial markets will have to make in the next few years.
Or as Pogo would say, “We have met the enemy and he is us.”
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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