Forced sales

My Take on This Very Risky Market

I have been working hard to keep the 120 or so RIA firms with which my firm works informed of what has been happening in the markets and why it is happening, so that they can communicate effectively with their clients. On Friday, I gave the third in a series of talks I have given over the last two weeks or so as the crisis has played out. Below are some notes from Friday's discussion.
We certainly live in interesting times. While I have witnessed events like this before, never have I seen so many at one time and with such a big impact---again, the lesson to remember is to never treat the unlikely as impossible and don't take more risk than you need to (at least without being fully prepared for the possible consequences). With that said, here is a short summary of what I believe is happening.

There are two main things going on now. The first is recognition that the economic crisis in the US is having a much greater impact around the globe on economies than almost anyone expected. So economies are likely to see slower growth (China) and/or steeper recessions (developed countries) than previously expected. In fact, the US housing and auto sectors were already in a Depression, not recession, type condition, with falls of production of more than 20%, and it is clearly going to get worse. So this is the bad beta showing up--economic cycle risks. The likely next step (my guess is that it will happen fairly quickly) is that you will see quick policy responses from Central Banks and governments. I would be surprised if we do not see coordinated rate cuts and fiscal stimulus programs from the developed countries very soon.
However, the emerging countries are another story, and this is compounding the problem. We are seeing here a likely repeat of the summer of '98, with currency crises spreading. It seems likely that the flight to quality will hit emerging markets hard--their currencies are getting hit hard, their debt, which had been rising in value, is getting crushed right now with EM bond prices collapsing. Risk capital is either fleeing on its own or being forced to flee by margin or collateral calls. For example, the Payden EM bond fund, which was up early in the year and down 7% at end of September, is now down 25%.

There are other "legs of the stool" being chopped off. Here is an example:

The commodity producing countries that rely on revenue from those sources to support the government/economy are getting hit hard, including countries like Venezuela, Argentina, Russia, Indonesia, etc. Argentina, on Thursday, basically confiscated (nationalized) the pension system to gain access to the dollars in the plans. There is going to be now risks of country defaults, like the summer of '98. And, of course, that can lead to geopolitical risks increasing.
Of course, the flip side is that the importing countries will benefit by lower costs, but they also will no longer be able to export as much to the commodity producing countries. And while the IMF will almost certainly try and help, there is simply not enough money around to bail all out the countries. As an example, we have seen Iceland basically go bankrupt as a country. Hungary, in the face of a global recession, had to raise interest rates 3% to help stem flight capital. I would not be surprised to see some countries' markets close, like Malaysia's market did in the summer of 1998.
So that is one of the things now hitting the market very hard: the continued flight to quality is accelerating.
But there is another major factor compounding the problem, leading to the kind of dramatic moves we are seeing. It is the forced selling caused by margin and collateral calls. The hedge fund world, which we have avoided, is basically being destroyed to a great degree. I would not be surprised if a third to a half of all hedge funds disappears within a year or two. You are seeing forced selling by margin calls on those that are leveraged and also forced selling even by those that are not leveraged as they have to prepare for return of capital calls which they know are coming at year end. They are selling at any price---price does not matter, they have to sell; and thus, with few buyers, prices will now simply collapse.

And another place that forced selling is coming from is corporate executives who used margin loans to exercise stock options and or simply buy stock they thought was undervalued. They are now being forced by margin calls to sell. Many examples of individual cases of forced sales in the hundreds of millions of dollars, with Sumner Redstone being just one such case in the news.

There is also a seeming amazing "anomaly" happening--but the anomaly is easily explained: The two countries with the lowest interest rates are rising at the fastest pace in history. Never have we seen moves like this. EVER. The dollar has gone from 160 to 126 in a few months and seems now certain to go higher as I will explain. And the yen, with even lower interest rates is rising much faster. (and that has another consequence which I will explain). Why is this happening?

Two reasons:
First, the dollar is benefiting from the flight to liquidity and quality
Second, the dollar and the yen are benefiting from the forced unwinding of the "carry trade." Those that borrowed "cheap" dollars and yen to invest in other higher yielding currencies have been caught on the wrong side of that trade now. And hedge funds typically heavily leverage this trade, so they are getting the double whammy of the currency bet going wrong, the banks demanding margin, leading to forced selling and their clients asking for money back as allowed and that leads to more selling and the yen and dollar rise in a vicious cycle of forced unwinding of the positions.

But there are other problems. The Japanese economy, one of the largest in the world and still trying to recover from the recession that started in 1990, is getting hit hard now by the rising yen. They are heavily dependent on exports for economic growth (high savings rate in the country keeps domestic spending down) and the global recession combined with the rising yen is hurting bad. That is why the Nikkei is getting hit so hard.

Unfortunately, we are now likely faced with the worst recession for the globe that we have seen in the post war era. We are likely to see steep falls in economic activity. You can see this for example in Friday's fall in oil prices of another $4 to about $64, despite OPEC announcing cutting production by 1.5 million barrels (by the way--I don't see how they can actually sustain a cut since the governments of producers like Venezuela are desperate for cash now that prices are down--that is why cartels never last). Note that we are already seeing major announcements of layoffs by even companies like Merck (MRK), let alone the financial services industry and the industrial sector.

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