Financial crises, bank implosions and chaos generally don’t often inspire. But every debacle has a silver lining. One of those linings shows up these days in higher interest rate spreads. Investors willing to wade into the riskier realms of debt are being paid for their troubles, or so one could argue.
As our chart below shows, you get more for your money these days when buying high-yield bonds and Baa-rated corporates, the lowest tier of investment grade debt.

High-yield bonds (as per Citigroup High Yield Index) offered an 875-basis-point yield premium over a 10-year Treasury Note as of Monday’s close. Meanwhile, the yield on Baa bonds (represented by Moody’s Seasoned Baa Corporate Bond Index) closed at 378 basis points over the 10-year the same day. As the graph above relates, those are the highest risk premia in roughly six years.
But are they high enough? Do they fully compensate for the turbulence ahead? Since we don’t really know what degree or type of hazards await, we must remain agnostic when it comes to proclaiming definitive answers. Common sense, however, suggests that there’s still trouble afoot, and so one can’t be fully confident that the elevated risk premia noted above will suffice. But they might.
The potential for capital losses that exceed the received yield is an ever-present risk, and perhaps more so than usual in the early days of autumn in these United States. At the same time, it’s getting harder to ignore the rising spreads. It may be too early to make hefty bets about the future, but it’s not too early to begin dipping one’s investment toes into the riskier ranks of bonds. That’s especially true for those with an existing multi-asset class portfolio, a long-term perspective and an underweight position in lower-grade fixed-income allocations.
There are no guarantees with investing, but you can count on variations in risk premia. Ignoring the variations is imprudent, but so is diving in head first at the first uptick in yields. Finding a middle ground is the goal, and arguably that middle terrain begins with a toe in the water now.
Yes, spreads may be higher down the road. Or not. We don’t know, and neither does any one else. You can bet the farm one way or the other. Alternatively, you could make modest buys on occasion, when the odds seem at least moderately favorable. Might these be one of those times?

The dollar was crushed yesterday. The U.S. Dollar Index dropped more than 2%, reversing whatever gains were left from the now-evaporated summer rally.
The verdict, it would seem, is in. The forex market isn’t amused by the prospect of adding $700 billion-plus to the already bloated U.S. budget deficit. Jay Bryson, global economist at Wachovia Securities, summed it up neatly in a note to clients yesterday, explaining that “this weekend’s announcement that the U.S. government will buy up to $700 billion worth of bad debt from financial institutions is a short-term negative for the dollar. In order for investors to absorb the increased issuance of U.S. Treasury securities the returns on those securities will need to rise.”
Bryson adds that there are two ways for bond returns to rise from a foreign investor’s perspective. Yields can rise, which is to say that prices will drop. That seems plausible, given that $700 billion in new debt equates to roughly 15% of existing Treasury debt outstanding. The second way is a depreciation of the dollar.
Yesterday, we got both. The buck was slammed and the benchmark 10-year Treasury Note rose to 3.83%, the highest close in more than a month.
Why does this matter? Because foreigners will be ponying up a fair chunk of the $700 billion loan to fund the new bailout plan. As such, monitoring what foreigners think is more than a passing news story these days. One might wonder what might compel foreign central banks and offshore investors to further expand their already large holdings of Treasuries.

Continue reading →

The financial industry has been transformed to a degree that few thought possible only a few weeks before. But this is all a sideshow to the real story of change as it relates to the economy and deciding how Main Street will fare in the months and years ahead.
Still, it’s hard not to gawk at the spectacle that is Wall Street. First observation: Wall Street as it existed just a few weeks ago is gone. The news that Morgan Stanley and Goldman Sachs–the last two large, independent investment banks standing–will transform their businesses into bank holding companies, a decision that completes the decimation of the old investment banking model. The boys had a good run. Unfortunately, they blew up the industry and now all that’s left is a bunch of humbled Citigroup wannabes.
That’s not so bad, if only because Citigroup, sprawling and unwieldy as it is, didn’t self-destruct. Neither did J.P. Morgan or Bank of America. One reason: those three, as bank holding companies, operate under a tighter, more constricting regulatory framework, and so by law they were forced to operate more conservatively compared to the likes of Bear Stearns and Lehman Brothers. No problem: some of our favorite institutions are plain old banks and the world will probably survive just fine now that they’ve inherited the throne.
But let’s not get too giddy. Keep in mind that there are still a lot of little Lehmans and Bear Stearns in the world, otherwise known as hedge funds. Collectively, this gang runs a lot of money, much of it leveraged, and some of it–perhaps most of it–is managed unintelligently. We don’t really know, of course, but given what’s transpired in recent weeks we’re inclined to wonder.

Continue reading →

First it was Bear Stearns. Then the government bailed out Fannie Mae and Freddie Mac. Before the ink was dry on that deal, Uncle Sam loaned $85 billion to insurance giant AIG in exchange for an 80% stake in the company. Along the way, the Fed has been throwing money every which way, depending on the day.
But wait: there’s more. In the last 24 hours, a new round of government bailout efforts are underway. Yesterday, Congressional, Federal Reserve and Treasury officials were talking of launching a massive government fund to buy up the toxic securities from investment banks and other institutions. Meanwhile, the SEC announced a ban on short selling on nearly 800 financial stocks. And the Treasury is now insuring money market funds to shore up sentiment in the wake of news that the Reserve Fund—a money market portfolio—broke the buck this week, i.e., its net asset value fell below $1. The drop stoked fears that even cash equivalents might not be safe.
The government, in other words, is throwing everything but the kitchen sink at the bear market. There’s some logic to this, of course. Preventing bank runs and the like is just common sense. But how much is too much? Or too little? Alas, intervention is an art, not a science. Financial turmoil of the degree we’ve seen this week is rare, and so there’s not a lot of precedent. The early 1930s are an obvious era for study, but the relevance is limited, since two or three things have changed the days of FDR and “brother can you spare a dime.”
Meanwhile, asset prices want to fall, and interest rates want to rise (i.e., those rates that involve private parties that can’t print their own money). But the government is doing everything in its power to keep Mr. Market from having his way. This is reasonable, up to a point, although it’s a safe bet that it’ll take time before we know where reason ended and moral hazard began.

Continue reading →

Perspective may be the only true value left when fear runs amuck.
There’s a blizzard of reports swirling about and it’s easy to get confused. One need only review the headlines for a few minutes to feel dizzy. But while the red ink flows like rivers in a hurricane, the first step in assessing what’s happening is stepping back and looking at the big picture. With that in mind, here’s a whirlwind tour of where we stand as of last night:
First, demand for safety has surged–to extraordinary levels. One need only look at the collapsed yield on 3-month Treasury bills for evidence. It’s a rare event when money managers willingly accept a guarantee of no return, perhaps even a slight loss in exchange for assurance that principal will be returned. Welcome to the new age.
The annualized yield on the popular benchmark of a “risk-free” asset closed at 0.03% last night, a sea change from just three days earlier, when the security closed at a 1.49% yield. Reportedly, some investors yesterday at one point were gladly buying 3-month T-bills at negative nominal yields! The rush to safety was so strong that the hope of turning a profit could wait for another day (or year?). The same motivation drove up the price of gold by one of the biggest single-day gains ever for the precious metal. The rise had nothing to do with inflation worries, which are effectively dead for the moment. Rather, it’s all about finding a port that’s sure to weather the financial storm blowing through global markets. A few thousand years of encouraging history in the metal’s ability to preserve wealth aren’t easily ignored these days.

Where does that leave the major asset classes? Battered and bruised, to be sure. With the exception of commodities and bonds–short-term investment grade bonds–there was red ink everywhere yesterday. There’s no shortage of minus signs so far this month either. All the major asset classes are down in September through last night, with the exception of U.S. investment grade bonds as per the Lehman Aggregate Bond Index. As a result, our CS Global Market Portfolio Index (GMP) has slumped 8.5% so far this month, based on our preliminary estimates. That’s better than the S&P 500’s 9.9% drop this month through yesterday, although it’s cold comfort given what’s going on in the world. (We’ll analyze GMP and the implications for portfolio strategy in more detail in the coming days and weeks. As a preview, this isn’t entirely unexpected although it’s clearly painful.)
The biggest fear is now fear itself. Perhaps that’s rational, perhaps not. Lending has dried up, cash is king and everyone’s wondering where the next shoe will drop. That’s hardly a surprise, but strategic-minded investors must keep the big picture in perspective.

Continue reading →

A bit of good news on the real estate front would be ideal right about now. Alas, today’s update on the housing market is disappointing once again.
Housing starts for August posted another hefty decline, the Census Bureau reports. The 6.2% drop in annualized starts last month vs. July isn’t the biggest decline on record, but it’s still hefty. More troubling is the fact that the declines just keep coming, as our chart below shows. Starts are now at a 17-1/2-year low.

Investors have been looking for a bottom in starts, and the bounce in June gave hope to some, including this editor, who thought maybe, just maybe, the carnage was behind us. But the optimism was premature–again. Today’s numbers reconfirm the bearish tone in housing.

Continue reading →

The great sucking sound on Wall Street has few redeeming features with the possible exception that it’ll cleanse the economy of long-running financial excess and dampen, if not kill the former inflation for a time.
Today’s update on consumer prices for August offers a preview of things to come. The CPI dropped a seasonally adjusted 0.1% last month, the Bureau of Labor Statistics reported today. That’s a sea change from the surges of 1.1% in June and 0.8% in July. The last monthly decline was -0.4% in September 2006.
That still leaves CPI higher by 5.4% in August from 12 months previous, but the annual pace of CPI is likely to fall further in the months ahead. The reason, of course, is that demand generally is retreating. From commodities to large-screen TVs to the three-bedroom ranch in the suburbs, the marginal growth in buying overall has evaporated.
One need only read the newspapers in the past 24 hours to understand why. Deflation, in short, is the big risk at the moment. It may or may not pass quickly, but that’s the primary hazard hanging over the economy as we write. Rest assured that the Federal Reserve will continue to inject liquidity into the system as insurance to keep the blowback from Wall Street from infecting Main Street. In fact, the Fed yesterday “added $70 billion in reserves to the banking system yesterday, the most since the September 2001 terrorist attacks,” according to Bloomberg News. The helicopters are in the air and Captain Ben is releasing the proverbial bags of money.
We have no problem with the central bank going to extraordinary lengths to keep the system from seizing. That’s the only challenge today. The question is whether, and when the bank will commence a mopping up effort at the appropriate time down the road. Keep in mind that the government is accumulating lots of new debt as a result of the financial troubles. The recent bailout of Fannie Mae and Freddie Mac, for instance, will increase government’s red ink by a tidy $300 billion, estimates economist Nouriel Roubini in an interview via Advisor Perspectives. And it’s not clear how much more the government will have to spend before the crisis is over. Meanwhile, the ongoing expenses of modern government continue to roll on, i.e., the expanding price tags for Medicare, Social Security, the Iraq War, and on and on.
The path of least resistance is still printing more money. For now, however, no one really cares, given the turmoil of the moment. And rightly so. Focusing on whether AIG will be liquidated, for instance, is the priority, as today’s FOMC meeting will surely reflect. The long-term isn’t dead, but it’s taken a back seat to the events of the moment.
Nonetheless, for those who can still look out a year or more, inflation is still an issue, although the future of pricing pressure depends on what unfolds in the coming weeks and months. How bad will the economy be hurt? How steep will job losses be? How will foreign economies be affected? And on and on.
Monetary policy is fated to attack the virus du jour, which is a function of falling demand and the associated illness of deflation, either real or perceived. No wonder, then, that the stampede into Treasuries went up a few notches yesterday. And for good reason, since there are real and present deflation dangers afoot. The D risk may soon pass, and it may evade us entirely, but for the time being no one really knows and so the Fed will and must act on the side of assuming a rising D risk.
The Faustian bargain of central banking is on full display. Trading long-term price stability for short-term comfort is always lurking, although it’s rarely on such a stark display as it is now. The good news is that enlightened policy can navigate the two quite well by satisfying the immediate needs of liquidity without throwing away price stability over time. The bad news: human error hasn’t been banished.

If it keep on raining, the levee’s gonna break.
Some of these people gonna strip you of all they can take.
–Bob Dylan, “The Levee’s Gonna Break”
There’s a rumor going around that Wall Street’s troubles, which have become every investor’s troubles, reach back only a year or so. In fact, the genesis of the mess goes back much further. It’s true, of course, that most investors have only been paying attention for the last year or so, thus the rumor.
The unwinding of the great bull market is now unwinding faster, and with devastating consequences. But for those who claim that they didn’t see it coming, it’s obvious that they weren’t paying attention in the 21st century. Excess has been building for some time, and the trend must reverse, as all trends eventually do.
There are many lessons one can draw from the downfall that is now in full swing, but the most important one is the same one that every crisis imparts and that too many investors ignore until it’s too late: risk management is the only salvation over a full business cycle.
The bankruptcy of Lehman Brothers, the sale of Merrill Lynch and the precarious and perhaps fatal finances of AIG are nothing new in the grand scheme of economics and finance. Businesses have been collapsing and investors have been losing money since the ancients invented the money game. What’s changed in relatively recent history is our understanding of how we should play the game, as we’ve discussed many times, such as here.
Risk management, in short, is the first and last rule in money management. Easy to say, tough to do, but always and forever essential. Unfortunately, learning this lesson is very, very difficult, if not impossible at times–especially for those at the highest levels of the financial industry.
Risk management has been ignored, or at least manipulated and distorted by too many finance heads, and the price tag is now in full view. Identifying the motivation and rationalization for going off the deep end with inane behavior in managing assets is ultimately an exercise in reviewing the flaws of the human mind as it relates to greed and fear.

Continue reading →

How many times must this lesson be learned? Apparently there’s no limit when it comes to naïve and overconfident investors, which is to say that the need for tutoring is vast and unending. Sad and frustrating, but still true.
Two examples from today’s papers remind once more that diversification is too often ignored, assuming it’s recognized at all. Chalk it up to greed and fear, and perhaps ignorance of sound investment strategy. Good financial planning advice is widely available, but that doesn’t stop self-destructive behavior in finance, even in the center of the financial universe.
In today’s New York Times, for instance, a story about the fallout from the collapsing Lehman Brothers—a 157-year-old Wall Street investment bank—quotes a “rank and file employee” of the stressed company as it relates to the person’s investments. This former Lehman worker, who left the firm earlier this year, “lamented that he had put enough faith in the firm to retain shares — a decision he is paying for. ‘My children’s education fund is wiped out,’ said this person.”
One might imagine that working on Wall Street would provide some exposure to the lessons of sound portfolio strategy that have been honed over the last 50 years, but one can never assume when it comes to money.
Another sad item comes today via The Wall Street Journal, which relates the tale of a man who apparently invested all or at least most of his sons’ college money in Freddie Mac shares last week. The government has since taken over the battered mortgage institution and the shares have dropped sharply, leaving the investor’s college fund virtually wiped out.

Continue reading →

The U.S. stock market has been battered, twisted and otherwise assaulted over the past year or so. From the outside, the point requires no elaboration for those with equity positions of one type or another. But what has the havoc wrought on the internal sector allocations?
In search of some perspective, we crunched the numbers to see what’s changed over the past two years in large- and small-cap sectors for domestic stocks. Let’s start with the large-cap realm, as defined by the S&P 500 (all data comes from StandardandPoors.com).

As the above chart shows, information technology now occupies the top position in the S&P 500 as of yesterday, posting at 16% share of total market cap. Although that’s up only slightly from its share of two years previous, the rise was enough to dispatch the former leader—financials—to the number two slot.

Continue reading →