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THE U.S. STOCK MARKET AVOIDED A MELTDOWN FRIDAY after a scary opening as investors worldwide start to anticipate one of the most severe global economic downturns since the Great Depression.
While not massive, the losses Friday were hardly encouraging as the Dow Jones industrial average finished with a decline of 312 points to 8378 after pre-market indications that the benchmark average could open with a loss of 500 to 600 points. The Dow industrials finished at a new closing low for 2008, as did the Standard & Poor's 500 index. The Dow and S&P 500 fell 5.3% and 6.8%, respectively, in the five sessions, reversing big gains registered in the prior week. The Dow now is down 37% so far this year while the S&P 500 has lost 40% and the Nasdaq 41%.
[pic]
Scott Pollack for Barron's
Forced selling by hedge funds, among many others, has given the bear the upper hand.
The losses are massive on a global scale, with the major markets down at least 40% this year. In the U.K., the FTSE 100 is off 40% as the British economy slides into recession, the French CAC 40 is down 43% and the German DAX 47%. European markets are at five-year lows while the Dow and S&P are holding above their 2003 lows. In Asia, the Nikkei 225 has dropped 50% to 7,649. Emerging markets have suffered huge declines, with Russian stocks down 76%, Brazil off 50% and China down 65%.
Wall Street seems resigned to a recession in 2009 and the debate has shifted to whether the global economy will slip into depression, a scary prospect.
Ray Dalio, who heads Bridgewater Associates, a Westport Conn. global investment firm that manages $150 billion in assets and is known as a currency and bond specialist, has been warning clients that the world is entering a depression caused by an irreversible deleveraging spiral in which super-low interest rates will have little economic impact. "We're in for a multi-year period of pain and the degree of pain will depend on policy responses," Dalio has told confidantes and clients. Dalio, who was last interviewed by Barron's in May 2007, has been reluctant to talk publicly for fear of exacerbating the worries of already nervous investors.
Companies ranging from American Express to UPS to Daimler are warning of weakening business conditions as consumers and businesses pull back worldwide. The U.S. jobless rate, now 6.1%, could hit 10%.
The good news is that governments around the world recognize the problems and are responding in unprecedented fashion to prop up banks and other financial institutions. Sharp declines in commodity prices, including oil, which is down over 50% from its summer peak of $147 a barrel to $64, will help both individuals and businesses, mitigating some of the economic weakness.
It's important that Warren Buffett has turned bullish, writing recently in the New York Times that he's buying American stocks. "I haven't the faintest idea as to whether stocks will be higher or lower a month -- or a year -- from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over," Buffett wrote.
There were some bright spots in financial markets last week, notably municipal bonds, which had one of their biggest one-week rallies ever as long-term yields fell roughly a percentage point to around 5%. Barron's highlighted the allure of munis last week.
Talk to professional investors and they say some of the best opportunities lie outside stocks in such areas as convertibles, leveraged loans and interest-rate swaps. These markets have been swamped by massive sales by leveraged hedge funds.
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Strategist Ed Yardeni called selling by the $1.7 trillion hedge-fund industry the "greatest margin call of all time." The impact is apparent in the strength of the Japanese yen, which surged 3% Friday to 94 yen to the dollar, capping a month-long rally of 12%. Many hedge funds borrowed in yen to finance their leveraged trades because yen rates have been below 1%. Now that these trades are being unwound, the hedge funds have to buy back the borrowed yen at a big loss. European hedge funds are being hit even harder because the yen is up 23% against the euro in the last month.
Convertibles, featured in the article, Convertibles: the Chicken Way to Play, have never looked so attractive after declining a record 36% this year (measured by total return). Investors now can get double-digit yields and equity exposure via converts. The junk bond market also is suffering its worst year in its history with a drop of 25%, according to Merrill Lynch. The result is that the average junk bond yields a stunning 19%, versus about 8% a year ago.
Bank loans to highly leveraged companies also have come under severe pressure this year as hedge funds and others that bought them with leverage of three to one or higher have been forced to sell. Many leveraged loans are selling at 60 to 80 cents on the dollar, down from around 100 in early 2008. Leveraged loans are yielding 10% to 20% and benefit from seniority in corporate capital structures. Debt from the likes of Neiman Marcus, Realogy and Harrah's Entertainment trades for 60 to 70 cents on the dollar, allowing investors to buy into these companies at a fraction of the price paid by private-equity firms in the past year. Individuals can't play directly in leverage loans, but there are a few closed-end funds, including the Van Kampen Senior Income (VVR) that focus on the sector.
Takeover arbitrage situations also offer rich returns because investors fear that companies won't get financing for all-cash deals. Anheuser-Busch (BUD), for instance, fell six to 57 last week, ending considerably below the $70 takeover price from Europe's InBev (INBVF). The $52 billion deal for the Budweiser brewer, which is expected to close by year-end, doesn't look so smart now for InBev, whose stock is down 33% to 28 euros in the past month.
As Wall Street firms like Goldman Sachs and Morgan Stanley have pulled back from the markets, seeking to preserve capital and reduce leverage, many anomalies have cropped up. One is in the derivatives market, where 15-year Treasury debt yields more than similar-maturity interest-rate swaps, which are bank obligations. The 15-year Treasuries yield nearly a half percentage point more than swaps, while typically they yield one-half percentage point less.
This is hard for swap participants to fathom because risk-free Treasuries ought to yield more than swaps. Why such a weird situation? Trading desks on Wall Street don't want to take proprietary positions, hedge funds are reeling, and banks seem loath to bulk up on what appears to be a virtually risk-free trade for an investor with staying power. "Until recently, those levels would have been dismissed as inconceivable, based on the cash-flow analysis of an asset swap that is held to maturity," wrote RBS Greenwich Capital derivatives strategist Fidelio Tata last week. Such a dislocation, he calculated, theoretically is a "seven-sigma" event, which means it should happen once every 14 billion years, which is roughly the age of the universe.
The Bottom Line
Based on Friday's big losses, global stock markets seem to have accepted that a recession is underway. The magnitude of the decline even raised the prospect of something worse.
Obviously, derivative market participants have understated the odds that illiquid markets will produce unprecedented developments. Stocks and other asset classes, like convertibles and junk bonds, may not represent a once-in-a-14 billion-year buying opportunity, but patient investors who heed Buffett's advice should do well
THE U.S. STOCK MARKET AVOIDED A MELTDOWN FRIDAY after a scary opening as investors worldwide start to anticipate one of the most severe global economic downturns since the Great Depression.
While not massive, the losses Friday were hardly encouraging as the Dow Jones industrial average finished with a decline of 312 points to 8378 after pre-market indications that the benchmark average could open with a loss of 500 to 600 points. The Dow industrials finished at a new closing low for 2008, as did the Standard & Poor's 500 index. The Dow and S&P 500 fell 5.3% and 6.8%, respectively, in the five sessions, reversing big gains registered in the prior week. The Dow now is down 37% so far this year while the S&P 500 has lost 40% and the Nasdaq 41%.
[pic]
Scott Pollack for Barron's
Forced selling by hedge funds, among many others, has given the bear the upper hand.
The losses are massive on a global scale, with the major markets down at least 40% this year. In the U.K., the FTSE 100 is off 40% as the British economy slides into recession, the French CAC 40 is down 43% and the German DAX 47%. European markets are at five-year lows while the Dow and S&P are holding above their 2003 lows. In Asia, the Nikkei 225 has dropped 50% to 7,649. Emerging markets have suffered huge declines, with Russian stocks down 76%, Brazil off 50% and China down 65%.
Wall Street seems resigned to a recession in 2009 and the debate has shifted to whether the global economy will slip into depression, a scary prospect.
Ray Dalio, who heads Bridgewater Associates, a Westport Conn. global investment firm that manages $150 billion in assets and is known as a currency and bond specialist, has been warning clients that the world is entering a depression caused by an irreversible deleveraging spiral in which super-low interest rates will have little economic impact. "We're in for a multi-year period of pain and the degree of pain will depend on policy responses," Dalio has told confidantes and clients. Dalio, who was last interviewed by Barron's in May 2007, has been reluctant to talk publicly for fear of exacerbating the worries of already nervous investors.
Companies ranging from American Express to UPS to Daimler are warning of weakening business conditions as consumers and businesses pull back worldwide. The U.S. jobless rate, now 6.1%, could hit 10%.
The good news is that governments around the world recognize the problems and are responding in unprecedented fashion to prop up banks and other financial institutions. Sharp declines in commodity prices, including oil, which is down over 50% from its summer peak of $147 a barrel to $64, will help both individuals and businesses, mitigating some of the economic weakness.
It's important that Warren Buffett has turned bullish, writing recently in the New York Times that he's buying American stocks. "I haven't the faintest idea as to whether stocks will be higher or lower a month -- or a year -- from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over," Buffett wrote.
There were some bright spots in financial markets last week, notably municipal bonds, which had one of their biggest one-week rallies ever as long-term yields fell roughly a percentage point to around 5%. Barron's highlighted the allure of munis last week.
Talk to professional investors and they say some of the best opportunities lie outside stocks in such areas as convertibles, leveraged loans and interest-rate swaps. These markets have been swamped by massive sales by leveraged hedge funds.
[hide]
Strategist Ed Yardeni called selling by the $1.7 trillion hedge-fund industry the "greatest margin call of all time." The impact is apparent in the strength of the Japanese yen, which surged 3% Friday to 94 yen to the dollar, capping a month-long rally of 12%. Many hedge funds borrowed in yen to finance their leveraged trades because yen rates have been below 1%. Now that these trades are being unwound, the hedge funds have to buy back the borrowed yen at a big loss. European hedge funds are being hit even harder because the yen is up 23% against the euro in the last month.
Convertibles, featured in the article, Convertibles: the Chicken Way to Play, have never looked so attractive after declining a record 36% this year (measured by total return). Investors now can get double-digit yields and equity exposure via converts. The junk bond market also is suffering its worst year in its history with a drop of 25%, according to Merrill Lynch. The result is that the average junk bond yields a stunning 19%, versus about 8% a year ago.
Bank loans to highly leveraged companies also have come under severe pressure this year as hedge funds and others that bought them with leverage of three to one or higher have been forced to sell. Many leveraged loans are selling at 60 to 80 cents on the dollar, down from around 100 in early 2008. Leveraged loans are yielding 10% to 20% and benefit from seniority in corporate capital structures. Debt from the likes of Neiman Marcus, Realogy and Harrah's Entertainment trades for 60 to 70 cents on the dollar, allowing investors to buy into these companies at a fraction of the price paid by private-equity firms in the past year. Individuals can't play directly in leverage loans, but there are a few closed-end funds, including the Van Kampen Senior Income (VVR) that focus on the sector.
Takeover arbitrage situations also offer rich returns because investors fear that companies won't get financing for all-cash deals. Anheuser-Busch (BUD), for instance, fell six to 57 last week, ending considerably below the $70 takeover price from Europe's InBev (INBVF). The $52 billion deal for the Budweiser brewer, which is expected to close by year-end, doesn't look so smart now for InBev, whose stock is down 33% to 28 euros in the past month.
As Wall Street firms like Goldman Sachs and Morgan Stanley have pulled back from the markets, seeking to preserve capital and reduce leverage, many anomalies have cropped up. One is in the derivatives market, where 15-year Treasury debt yields more than similar-maturity interest-rate swaps, which are bank obligations. The 15-year Treasuries yield nearly a half percentage point more than swaps, while typically they yield one-half percentage point less.
This is hard for swap participants to fathom because risk-free Treasuries ought to yield more than swaps. Why such a weird situation? Trading desks on Wall Street don't want to take proprietary positions, hedge funds are reeling, and banks seem loath to bulk up on what appears to be a virtually risk-free trade for an investor with staying power. "Until recently, those levels would have been dismissed as inconceivable, based on the cash-flow analysis of an asset swap that is held to maturity," wrote RBS Greenwich Capital derivatives strategist Fidelio Tata last week. Such a dislocation, he calculated, theoretically is a "seven-sigma" event, which means it should happen once every 14 billion years, which is roughly the age of the universe.
The Bottom Line
Based on Friday's big losses, global stock markets seem to have accepted that a recession is underway. The magnitude of the decline even raised the prospect of something worse.
Obviously, derivative market participants have understated the odds that illiquid markets will produce unprecedented developments. Stocks and other asset classes, like convertibles and junk bonds, may not represent a once-in-a-14 billion-year buying opportunity, but patient investors who heed Buffett's advice should do well
