A Potent and Combustible Combination

First 10 minutes of Wall Street Week episode from Friday October 16, 1987 just prior to the market crash on black Monday. 

I’m not the only bear in town of course. Most market professionals quietly agree that the market has been pumped up to unsustainable levels and most expect it to self-correct in the traditional way. The only disagreement is over the timing and amplitude of correction. I’m using the cluster of unusual turn dates during this current period to identify it as a period of vulnerability for equities but with valuations and sentiment stretched to historic extremes, a catalyst could come at any time and in any form from Q1 earnings, a Grexit scenario, conflagration in the Middle East with the Saudi’s being drawn into Yemen, a cyber event and so on. 

US investors are especially low on ammunition. The NYSE available cash figure has dropped to one of its lowest levels. The last time it was near this level shares struggled for the following two months. Also, the ratio of assets in equity mutual funds to assets in safe money market funds has reached a new high. Shares have struggled to make fresh headway when the ratio has previously been close to the current extreme. 

These cash levels have been abnormally low by historic standards for a while now, perhaps reflecting what the crowd has come to believe is a “new normal.” It’s clear that managers are not looked upon favourable either by investors or their own management when not fully invested. Nobody wants to be Tony Dye. The result is a heightened state of collective market complacency.

The comfort there is the belief that “if we fall we all fall together.” We can cut and slice this with a number of other measures such as money market holdings of mutual fund investors as a % of the S&P or the percentage of cash in mutual fund investors portfolios, (2.45%) but we come to the same conclusion.  

Sentiment surveys for investors, advisors and managers are all at extreme levels. The 52 week average of the Investors Intelligence bull/bear ratio hit 3.35 last week which exceeds every reading for 35 years. These readings can of course continue to reach even greater extremes but they are telling us that markets are on borrowed time.

Concurrent with that margin debt has been contracting since Feb 2014, (a traditional warning signal), when it reached an all time high of $466bn. Margin debt peaked in front of the four greatest corrections of the past 50 years, 1973, 1987, 2000 and 2007. Note too that the level of debt in February last year expressed as a percentage of US GDP is bang in line with ratio levels at those previous peaks.

The madness abounds in bond land too. You are now guaranteed to lose money on nearly €2tr of Europe’s sovereign bonds if you buy now and hold to maturity. Bloomberg noted that the German 30 year yielded just 0.66% and if that yield rose to 1% in the next year the price of the bond would drop by 10%. Time for investors to acquaint themselves with duration and convexity perhaps. The environment is so too-good-to-be-true that a growing number of US corporations are traversing the Atlantic to issue Euro denominated corporate bonds. In fact, its been the busiest start to the year for Euro bond issuance since the currency’s introduction.

Collectively, it all creates a potent and combustible combination to trigger a bear market. In fact, it’s difficult to think of how to improve it as a bear set up.

Technically, most equity indices are in the final stages of their respective rallies. Pullbacks to date have been quick and shallow. The “buying the dip,” mantra has become so rewarding its become an automatic reflex. Overall momentum however is declining while volatility spikes are becoming more frequent. Investors at this stage of bull market maturity should be treating each decline as if it is the start of a major correction. You may be wrong once, twice, five, ten times but you only have to be right once. That’s an oft quoted mantra of would be tech millionaires but actually, I think the tables have turned.

Hodge; Head Dementor of HSBC

Commons Public Accounts Committee - Head Dementor

The insipid performance of Rona Fairhead the other day in front of the Commons Public Accounts Committee was less than inspiring. She allowed herself to be bullied to the point of evisceration by its chair, Margaret Hodge. Rona Fairhead is a director of HSBC and heads the BBC Trust. Mrs Hodge suggested, or demanded, that “you should consider your position and you should think about resigning, and if not, I think the government should sack you.” Fair and even handed then.

HSBC is a global behemoth which is reaping the reward for the stupid Republic National Bank purchase in  1999, for that I suspect is the source of so much of the recent Swiss allegations. After the takeover all those years ago it only took two years for the first fines to appear, $606m in restitution for cheating Japanese customers. That was a $10bn purchase which is right up there in the stupid stakes with the $16bn purchase of Household International, a company that was a serial offender, a few years later. More fines are just inevitable, notwithstanding the growing reputation damage.   

Let’s face it, given the jaw dropping fees and mundane advice received from Swiss Private Banks there are only three reasons to have an account in one. First, to hide money, second, to avoid taxation or third, because you have lost confidence in your country of origins prudential management of its financial system and regard inherent risks as too high not to have a safe bolt hole. Perhaps, all three play a part. On that basis then, Rona Fairhead’s ability to do the “smell test,” of what is reasonable looks impaired and her and other executives excuse that “they didn’t know,” excuses nothing. 

The 2012 300 page Senate report on HSBC, which described its woeful money laundering controls, described the banks compliance culture as “pervasively polluted for a long time.” HSBC is a bank that the UK needs, not least of all because of its long standing Asian links but it is, like many banks, just too big to manage. The organisation badly needs an imaginative go-forward plan. It is unwieldy, inflexible and massively bureaucratic, (someone told me they have 1500 people in change management whatever the hell that is). The shares may be occasionally attractive to short duration traders but as an investment I’m not sure how one begins to attempt to fathom out the complexities of the investment case. There is more we don’t know than there is that we do. 

Mrs Fairhead is by all accounts a decent person but diligence and detail is everything when in a position of responsibility in banks, the personal compliance risks are simply too high for it to be otherwise which is why its becoming increasingly challenging to hire the right people, many of who only see potential reputational downside in accepting senior posts. Moreover, the blank refusal of the previous Labour administration to accept any responsibility for the GFC (Great Financial Crisis), is simply deluded. 

No matter, I’m here to help and Mrs Fairhead may wish to take advice from the brilliant Bird & Fortune in their handling of post crisis interviews.

Bonus Season Dawns

This year's bonus pool

This year's bonus pool

QE powered markets have been motoring to new highs with all the abandon of teenage lovers. I've been promulgating the view for some time that markets are not pricing in the risk of a demand shock, of any scale, but it has had little resonance until recently. Yet a growing number of commentators are beginning to echo the thought and with a deal more intellectual weight. Upside from here is totally dependent on increasing economic confidence and momentum. Without demand that’s not going to coalesce. The pace of human worker replacement by machines is accelerating, the US consumer is still on the rack even before interest rates move, a reduction in Chinese GDP is self evident, Europe remains the mother of all time bombs and the UK is being flattered by selective house price moves and the auto manufacturing business in the West Midlands. There is an end to all this but a deflationary disruption in demand along the way will eventually rock equities. 

So why are stock markets doing so well? One answer might be from a client who said, “I think governments everywhere are strangling their economies with regulation & taxes. It’s easier to put your money into the stock market than it is to build a business or a house on land that you own so equity markets go up and the real economy stagnates.”

Indeed, how many people do you know from the City or elsewhere  who have retired to invest and or trade under their own steam rather than drag themselves out of bed at 5am in the morning? As we roll into bonus season for the banks another challenge is facing managers on trading floors. The near doubling and more of basic salaries in investment banks, rolled out 4-5 years ago to circumvent an expected clamp down on bonus’s after the crisis, has created other unintended but quite predictable consequences.

Unallocated and allocated costs have soared, (especially as other headcount like compliance has mushroomed). One head of a desk told me the “per head,” number to have a member of staff on his trading floor and I nearly fell over; it was more than twice the number we used when last I worked in a bank and even then my bank was at the top end of peer group. Despite this, most operations have been profitable. However, with structural change being imposed on the bond market by Dodd-Frank and the underwriting of markets by QE on the wane, there will be some tough decisions to make when the tide goes out.

Moreover, the CEO of another operation said to me, “Bonuses’ are not what they were and anyway, only a modest percentage is paid out in year 1. That though is stifling ambition because they feel they just have to turn up and do a good job to bank the pay cheque.” Even at Goldman they are ramping up basics even more in response to EU bonus caps. These are the business economics of the madhouse. It won’t end well and yet again the City is lining itself up for another great reckoning.


rear view mirror.jpg

Talking of madhouse business principles, in these days of volatility suppression I’m reminded of another bugbear from my days in a bank. Trading books often have to take provisions against their positions. These provisions will be calculated against a number of metrics, mainly volatility but will include average daily volumes in the name, the average bid/offer spread and so on, and they are usually reweighted weekly. Unsurprisingly, when a bad thing happens volatility spikes and after a big fall for example, traders can expect risk control to wander over and say, “don’t forget, your provisions will rise on Friday.” Similarly, after a prolonged period of flatlining volatility, as we see now, provisions will be released back to the trading books and from their perspective, they’ve recovered hard earned P/L and can now walk the floor looking windswept and interesting rather than gaunt and persecuted.  We see then, that after a bad thing the risk geeks decide that it would be sensible to take out an insurance policy in the form of provisioning but when we’re at all time highs with stretched valuations and low volatility they chuck the insurance policy in the bin.

Is that smart?

Five Years On; Damage Report

Thus, it is crucial to identify the primary causes and implement effective policy to avoid future episodes whose magnitude could exceed even the staggering costs and consequences of the most recent financial crisis.
— Dallas Fed

All politicians, central bankers and regulators should read the above quote three times a day and ask themselves, "have we done everything we can do to prevent a re run of the crisis and to protect our citizens?"

Voters, who mostly know what the answer is, should be asking their politicians the same question. Perhaps though, voters should simply ask themselves "have we done everything we can to stop these idiots dropping the ball again?"

Markets; Headwinds Abound

The papers abound with upbeat copy about UK growth and politicians are scrambling over each other to claim participation and responsibility.  Growth though, is anemic and there are substantial headwinds out there for investors. Many of those investors are very probably, and rightly, just getting on with their lives. It's time though, to join the Wide Awake Club. 

Markets will ebb and flow but structurally, they are weakening. The equity bull is anyway, growing mature and is into the normal timing zone for a cyclical bear mark to take hold. The coming months will be very choppy and conservative investors, widows and orphans should be extremely cautious and focus on capital preservation, not media headlines.

One man who has a good handle on events is Grant Williams, the author of the newsletter "Things That Make You Go Hmmmm." In this well worth reading piece he takes a look at some of those September headwinds.

Any passing reader for whom the whole financial press reads like something written by a mad Aramaic monk may wish to brief themselves with this video, also by Grant which, although a few months old, represents a good briefing on what has gone wrong in the past and how financial recovery may be nothing more than a mirage with the crisis about to intensify, once again.


If it leaves you slightly concerned.... it should; I am.  We're not quite at Defcon 1, Tin Helmet time but it's closing in.

Kyle Bass on Europe


In every disaster movie there is one character who exudes calm and an air of common sense whilst all around him are losing theirs. In the rolling car crash that is the European financial crisis, one such beacon of rational thought is Kyle Bass of Hayman Capital Management. You may wonder, as I do on a daily basis, why it takes a fund manager all the way over in Dallas to articulate the massive issues at stake for Europe and the Global economy when so few of our leaders seem able to. Perhaps, some simply don't understand the enormity of the problems we face or more probably, lack the moral and political courage to face them.

In his latest newsletter, (linked with permission), Mr Bass lays out the challenge in simple and straight forward terms. For students of economics, taxpayers and market professionals alike it's well worth taking the trouble to read.

His blunt assessment that, "We are saddled with the largest accumulation of peacetime debts without any playbook for what happens next," ought to leave most people shifting restlessly in their chairs. Mr Bass, now getting into his stride moves on to say, with a bluntness that would have great resonance with most of our grandmothers, 

"Given the enormity of the debt burdens of the PIIIGSBF, (Portugal, Italy, Ireland, Iceland, Greece, Spain, Belgium and France) coupled with those of Japan (and at some point the US), lending schemes designed to lend more into an intractable debt problem are destined to fail miserably. There is no savior large enough with a magical pool of capital to stave off this unfortunate conclusion to the global debt super cycle. We think hard defaults are imminent."

"If we are correct regarding our hypothesis on the outcome of the debt crisis, the world will have it social fabric ruffled or even torn for a period of time. Be mindful that we are not talking about the end of the world as we know it; we are simply saying that it will be a different and slightly more difficult place to live in for those of us in the developed and indebted West."

Now, moving the family down to the basement with candles, tinned food and bottled water might be something of an over reaction but then again................. you can never be too prepared.



Housing & Students; Think Smart Not Stupid



It's a fact that our housing stock is in serious need of replenishment. The governments plans announced yesterday may or may not help first time buyers, I suppose we'll find out. 

I'm not so sure though that helping first time buyers is particularly the pressing issue. The people who need more affordable supply are young marrieds with children.

HMG is anyway, discovering some of the unintended consequences of other poorly thought out policies; in this instance the heinous rise in student fees without commensurate improvement in service levels at universities, (I know of students with no more than three hours of lectures a week). Wandering into this swamp, which is bare faced educational apartheid as far as English students are concerned,  with careless disregard for the individuals, it's obvious that no civil servant in his briefing to ministers thought to look at the American experience. I'll save them the time.

There is a clear pattern in the US of first time property buying being impacted by very high levels of student debt. For what it's worth, there is also a corresponding rise in the suicide rate amongst the young and an effect on relationships; "do I want to live with someone who has $150,000 of debt at 23 years of age?" Obviously, the cost of education has risen, some universities have become "for profit," institutions at taxpayer expense and the US national debt has increased. 

Back in April 2010 I offered this for inclusion in the manifesto to help the Tories win the election. I offer it again as a more elegant approach to getting the housing market moving;

"Match the requirement for the pension fund industry to meet it's long term liabilities with the chronic problems of housing affordablity for the lower paid and lack of housing stock.

Issue a 30 year 3% gilt and lend the money through state owned banks on 30 year fixed 4% terms."

I don't expect my low expectations to be met; you could hammer six inch nails into the foreheads of most of our politicians and it wouldn't make any difference to them so you won't be seeing it on the front pages any time soon. 

Oh and while we've mentioned students we might also bring up this post, "Bloody students," in which I put forward the idea of matching the assets of the retired to the liabilities of the young on a national scale. Unfortunately, as a concept it has all the advantages of being original, mutually supporting and apolitical so it therefore has absolutely no chance of seeing the light of day.

Incidentally, and unfortunately for the students in regard to all these matters, they have proved singularly unable to articulate their view successfully or indeed to put forward supporting evidence for their case and instead, wander through Trafalgar Square every three months blowing whistles and chucking dustbins around. If they switched on they could easily build traction with the public who I sense, by and large, support them being the fair and reasonable bunch we are.



UK Banks; Bad Loans


Just yesterday I described how the loan of nearly nationalised RBS to about-to-be-nationalised Bank of Ireland beggered belief. I'm left bemused and confounded, given businesses large and small and private customers in the UK can't get loans out of these people..

Our old friend Bank Vigilante, however, hoves into view and offers this explanation in mitigation. None of it though, it must be said, makes me feel any better, just more angry that what we've long suspected about their "mark-to-myth," concept of accounting is probably true. It is after all, what friends in the commercial property market have been saying for three years......... I'll let our Financial Jedi continue....

"On their sterling banking books Uk banks have 180bn of wholesale-funded CRE "investment" loans and 30bn of wholesale-funded CRE "development" loans - but non-bank funders don't want to fund this stuff on the banks' books as it is mostly wrongly marked. Irish and Spanish-style mis-marking of 50% could be the reality.

I hear the FSA and the BoE are on the case at last, scared partly by the Spanish banks scandalously being allowed to hide the true picture and the systemic risk then poses to the sovereign rating. This is especially the case in the UK as the two biggest culprits are Lloyds and RBS, 41% and 83% owned by the public sector, respectively.

Until this CRE stuff goes down, banks won't be able to lend more in this space.

"Real economy" manuf/service sector is more or less in balance re: deposits and loans. In any case, CRE is just financial/tax arbitrage and not proper banking.

If the unfunded (by deposits) CRE loans was the only problem then maybe not soooo bad. BUT there is also 1400bn of household loans (1200bn of mortgages and 200bn unsecured) against just 1000bn of household savings.

This is a 600bn "gap" (or deficit) for private sector UK plc. I temporarily forget the size of the public sector deficit the private sector is also ultimately responsible for.

Bottom line: deleveraging is painful (to some) but necessary.