Why the Market Continues to Drop
Oct 15, 2008
Posted by Jody Eisenman | Filed under crisis
There was a lot of euphoria after Monday’s rise of over 900 points on the Dow. Late in the day, I posted that I would still be very cautious until I saw movements in the credit markets. In the last 2 days, the credit markets have eased, but not by much. The TED spread has dropped from 457 basis point to 432. Remember, this number was around 110 about a month ago. Here is a link to a chart:
http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND
As you can see, the TED spread has traded below 1 (which signifies 100 basis points) for quite some time. In August of 2007, the credit crunch began as real estate began to fall. The first casualty of this on Wall Street were the problems with Auction Rate Preferred securities. At that point, the spread moved up on investor concerned, but generally traded in a range of between 1 and 2. Now we are much higher than we ever have been. Therefore, a drop from 457 to 432 doesn’t really signify much to me.
Now we have given back virtually all of Monday’s gains. I believe that we are going to see continued extreme volatility for awhile. Many people have asked me to explain why this is happening. The following are the major reasons for this in my opinion:
1. The credit markets
2. The economy. Here are some quotes by the head of the Federal Reserve taken from Bloomberg.com:
The U.S. faces “a very serious too-big-to-fail problem,” in which the insolvency of a large financial company could threaten a market collapse, Bernanke said in reply to an audience question. “There are too many firms that are in some sense systemically critical.”
No Imminent Rebound
Government efforts to calm financial markets and stem the credit crisis probably won’t result in an immediate economic rebound, Bernanke said.
“Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away,” Bernanke said in his speech. “Economic activity will fall short of potential for a time.”
If the head of the Fed feels this way, why should I feel any differently?
3. The Hedge Funds: Hedge Funds are generally large pools of capital, frequently heavily leveraged, that pursue certain strategies. Although originally named for “hedge strategies” (meaning that at least theoretically, they should be taking less risk), this has basically flown out the window in the pursuit of profits. Although each hedge fund is different, many pursue very high risk strategies.
Many of these funds are now failing. In addition, as investors get their statements and see their losses, they begin to demand their funds back. Here’s a hypothetical example: ABC Hedge Fund manages a billion dollars. They are leveraged 5/1, meaning that they actually have purchased 5 billion dollars worth of securities. For 2 years, their investment strategies produce annual returns of 15%/year. This year, with the market collapse, they lose 25%. Lets say DEF pension fund has 200MM invested. They decide they want out, and send the fund a notice of redemption. In order to meet this redemption, ABC must sell at least 5 times as much (or 1 Billion), and, they must to do it in a declining market. This, in turn, drops prices further. As you can see, this can lead to massive liquidations. As there are probably thousands of hedge funds out there with trillions in capital, you can see how even moderate amounts of redemptions can lead to massive selling of securities. Just today, one of the supposed “safer” funds, Citadel, announced that their largest fund has declined by 30% this year. This is a fund that invests in convertible bonds, which is generally considered to be less risky than common stock because of the dividends received from the bonds. An additional problem is that it is extremely difficult to sell most bonds today.
4. The economy continues to get weaker. Earnings are falling short of expectations, and stocks are declining on this news.
5. Consumer spending continues to decline. Americans have been seduced by expensive advertising that has convinced most of us that we must have 2 cars, an expensive home, flat screen tvs, personal computers, etc, etc..Unfortunately, the average American has little to no net worth. In this time of uncertainty, people are cutting back.
6. Unemployment is rising.
7. Real Estate. I have spoken about this many times
8. The major banks are still way too heavily leveraged to even consider making additional loans. Hopefully, the Fed’s new plan to own actual equity in these banks may help.
On a positive note, the state of California managed to sell almost $2 billion of short term bonds at rates between 3.75 and 4.5 pct. Last year, similar bonds sold for a yield of approximately 3.37. Gov.Schwarzenegger purchased $100,000 of these binds personally.
