From Mark Grant, author of Out of the Box and Onto Wall Street
The Rout Will Decide The Route
“The ride is the thing; to sit out is to opt-out of the hand that you have been dealt. You were handed the cards at birth, you get to play them as you choose. Use all of the skill that you can master in their play and never, ever stop the shuffle!”
-The Wizard
This month marks my thirty-ninth year on Wall Street. What a ride it has been. Inflation and Deflation, a whole host of political shenanigans, fighting it out in the board rooms of four investment banks, hiring and firing people, playing Liar’s Poker in the trading room at Salomon Brothers, watching the stars of various luminaries rise and fall, helping to create the present day structure for corporate bonds tied to Inflation, a constant stream of re-inventions, almost twelve years of writing “Out of the Box” and still here; playing the Great Game. I have always said that experience is not replaceable by innate intelligence. There is no way to excel at the Great Game except by playing it. Age gives you the opportunity to acquire some wisdom as you head down the path and, if you do things right, you are better armed than the younger combatants.
So here I stand at three decades and nine and I will share with you what I have learned in the hopes that you may benefit from my musing. For the last four years the markets have been living off the mother’s milk of the Fed. The spigot has been open, money has been pouring out and equities have been buoyed by the flow while yields have come down because of it. The last Fed minutes marked a significant day in the market place that is not well understood and that is the day that the spigot was shut off. Now if there is great adversity it could be opened again but for now; no more Monetary Easing, no more Quantitative Easing and this is a game changing event; make no mistake about it.
Now there are those that will go on playing assuming that not much has happened and I will tell you that this is a losing hand. Many people in the markets will assume that the equity markets and the bond markets will just keep rolling along but the easy glide that had been facilitated by the flow of money is no longer there and so change is surely afoot. Within fifteen minutes after the Fed released their minutes I was on-line with commentary suggesting you take profits, raise cash and re-think just how the Game was going to be played. Equities are now going to turn down, long experience teaches you something and while I cannot predict how far down they will go; that is going to be the new heading. Also as a result of the lack of any more new money, and if there is some sort of normalcy, yields are going to rise especially in longer maturities and preparation is now the key to protecting what profits the Fed has helped you achieve. The days of compression are over and spreads are also going to begin to widen. Then Inflation is likely coming, the great killer of portfolios, and the adept will begin to switch strategies now. Injections of liquidity drive markets up and the end of liquidity injections drive markets down and do not be fooled into thinking otherwise.
A Projection based upon Normalcy
Now the current 10 year Treasury yields 2.18% and the average for the 10 year over the last ten years is approximately 3.86% so if the Treasury market goes back to its average condition then there will be a thirteen point loss from our present position. If the statistical deviation from where we are currently were to kick-in because of Inflation or politics or the forthcoming drop in monetary supply then the 10 year would yield 5.54% and the resultant loss from today’s price would be around twenty-five points. You wince, I wince but there you are. Now let us consider a shorter time horizon and use the date of the Lehman bankruptcy as the starting point which was 9/15/08 and when the Fed began injecting liquidity. The average yield for the ten year during that period of time was 3.00% so that a return to that average would result in a 7 point decline and if the statistical deviation were to come to pass then the loss would be about 13.25 points.
Then just for the fun of it let’s do the same exercise for equities. The Dow Jones average price over the last ten years was 10,714. This would mean that the Dow Jones would drop 18% if we returned to the ten year norm and a 33% loss if we use the derivation. Then using the Lehman date as the kick-off the average price for the Dow is 10,560 giving us a 19% loss or a 35% loss with the derivation.
A Projection based upon European Disruptions
The first scenario is built upon two sets of normal reactions when the Fed shuts off monetary easing. This projection is based upon the very serious fiscal and monetary problems in Europe causing quite different reactions. With our central bank finishing its easing and the ECB continuing in the pumping out of newly printed money then things will go in a quite different fashion. Treasuries will rise in price while risk assets will widen to Treasuries and the divergence between European equities and bonds and American equities and bonds will be quite pronounced. Equities will go down in both cases in America but the drop will be horrifying in Europe and none too pleasant in the United States as the Dollar will soar versus the Euro as America’s safe haven position takes on great credence. There will be a return to very wide spreads for Corporates and other credit risk bonds in the U.S. and Treasuries could head to all-time low yields if the Eurozone begins to break-up.
Liquidity never solves issues of solvency and the time that it buys is generally of a relatively short duration. After the $1.3 trillion loan by the ECB to the European banks which helped drive up the prices for European sovereigns what do we now find as the liquidity ebbs? Yesterday’s Spanish auction was abysmal and the French auction today did not go too well with rising yields and less demand. The austerity measures are driving Europe into a worsening recession and the financial positions of Spain and Italy are deteriorating even as new measures are put into place. In fact there are only two ways out of the European mess which are growth, not happening, and Inflation which may be the ultimate strategy employed by the EU and the ECB if the construct holds to the point of changing strategies which is surely no outlier event.
Please note, it is critical to note, that these are NOT opposing scenarios. The Dollar appreciates in either one, equities decline however it goes, risk assets widen to Treasuries in both cases and it is only the question of the yield on U.S. Treasuries that remains in doubt which is totally dependent upon how bad the situation becomes in Europe. On the Continent I foresee no way out; much lower equity prices, much higher yields for credit assets and sovereigns as succored by both the solvency issues and more liquidity which will only weaken the entire structure with the ECB already at a 4 trillion dollar debt and the quite real possibilities of Italy and/or Spain falling into the deep abyss of economic or political collapse.
The rout is not in question; only the severity of it.