Leverage and Divergences Getting Red Hot

By: Henry To | Mon, Feb 20, 2006
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Dear Subscribers,

I have just gone through Barton Biggs' new book "Hedge Hogging" and it is a book that I highly recommend for individual investors or just anyone who are interested in the financial markets (and history). Mr. Biggs was formerly the Chairman of Morgan Stanley Asset Management, and was ranked as number one global strategist by "Institutional Investor" from 1996 to 2003. He left MWD in June 2003 to form his own hedge fund (with two other partners), Traxis Partners. This book does jump from one topic to another (I realize that not many "mainstream folks" have kind words to say about this book), but the general financial insights and history that the book provides is definitely very valuable. For example, there is a good snippet about "Gibson's Paradox and the Gold Standard" for the gold bugs, and lest we ever need to concern ourselves with a societal breakdown, Biggs conjectures that it may be a much better option to be holding fine jewelry, instead of gold or silver coins. The fact that not many "mainstream investors" have kind words to say about this book makes me more confident in his insights. By the way, anyone that has access to the latest research by Sun Valley Gold LLC - please do somehow try to get me a copy!

For readers who are currently still long on individual stocks, I highly recommend reading the latest two-part interview of Paul Desmond on TheStreet.com - President of Lowry's Reports. In the latest interview, Desmond discusses the art of picking stock market tops - which as this author has mentioned before - is inherently much more difficult than picking bottoms. In the two-part interview, Desmond discusses that we may be on the verge of a major top, and that the next few weeks of stock market action will be crucial for the bulls. To get a copy of Lowry's original report (cost $10), one can do so by surfing over to the Lowry's research studies page. Note that this author does not have any personal or business relationships with Lowry's reports at this time. The conclusion of the latest Lowry's research confirms with the divergences that we have been seeing and that we have been discussing over the last few weeks.

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,115.32), our position is 245.32 points in the red - but again, given all the weakening fundamental and technical indicators that this author is currently witnessing, I believe that this short position will ultimately work out well.

In our February 9th commentary ("The Bank of England Financial Stability Review"), this author discussed the extreme complacency as experienced currently by most financial players - and along with that extreme complacency - the use of leverage to heights we have never witnessed before. I discussed the LBO market, as well as the explosive use of derivatives and leveraged loans. I argued that this in fact can be regarded as a "new era" but just like with other "new eras," what started out as a structural story may ultimately turn out be just another cyclical story:

In other words, the hedge funds and the pension funds have no choice. In a world of historically low actual and implied volatility, returns have significantly declined and one can only generate "excess alpha" by investing in more risky assets or buying more of the same assets by utilizing leverage. This is dictated by the Capital Asset Pricing Model (and especially by the models that the hedge funds utilize) as well as the modern concept of finance and investments.

Just as with other cycles, what started out as a structural story may ultimately turn out to be just another cyclical story. No doubt, the advent of the internet, globalization, and securitization may have resulted in more sophisticated deals being done - and given the latter two, one could also have found more willing participants than ever before. This has the fortunate result of spreading the systematic risks among a greater number of investors than ever before - creating a more liquid marketplace - which is a God-send in times of great financial distress. However, the effects of such structural changes in the financial system are not infinite. For example, total assets as held by hedge funds rose from $600 billion to over $1 trillion over the last two years. At the same time, American investors have grown more sophisticated, and globalization in recent years has brought in a number of new investors from both China and India. But can such structural changes "handle" the continuing exponential explosion in derivative products and leveraged loans, such as the 55% increase in options volume on the CBOE or the 71% increase in futures volume on the Intercontinental Exchange? The more sturdy the car, the faster I drive. At some point, the pool of new, willing participants will be exhausted - which brings us back to square one unless such volumes and transactions are curbed. And judging by the numbers and complacency that this author is witnessing (and given that hedge fund inflows actually turned negative for the first time in a decade in the fourth quarter of 2005), we may be coming to such a breaking point.

Further evidence of a highly leveraged, worldwide financial system is outlined in the latest quarterly review published by the Bank for International Settlements ("the BIS"). Chapter 4 discusses the widespread use and proliferation of derivatives, starting with the observation that total derivative trading volume on all international exchanges during 3Q 2005 experienced "year-on-year rate of growth... [of] 23%, after 21% in the preceding quarter." As stated by the report, total trading volume in fixed income, currency, and equity contracts totaled $357 trillion during the third quarter of 2005, or approximately six times the world's annual GDP. Note that this trading does not take into account trading in the over-the-counter markets. Make no mistake: The financial industry is now by far the biggest industry in today's globalized world. Following is a chart from the BIS report showing the trading volumes of exchange-traded derivatives from 1Q 2002 to 3Q 2005. Please note that trading volume as late as the first quarter of 2002 only stood at $150 trillion - representing an increase of over 135% in just fewer than four years:

Turnover of exchange-traded futures and options

The problem for the financial market analyst is always this: How to differentiate the above volume into either hedging volume or speculative volume? In other words, which contracts add to the systematic risk of a financial meltdown and which contracts contribute to the integrity of the system? Even for folks who have good intentions, it is not clear how these contracts will function in a period of financial distress. E.g. Assume you have default insurance on certain GM debt obligations. Should there be a period of financial distress (coinciding with GM entering into Chapter 11, for example), there is no certainty that this insurance will ever be paid, given that some insurance companies out there may also be experiencing financial distress at the same time. Moreover - in an age of securitization, the counter-party that is on the other side of the insurance contract may very well be a hedge fund, and not any type of insurance company. Given that the popularity of hedge funds is now on the wane, there is a high likelihood that we will see some kind of shake-out in the hedge fund industry in the months ahead. Taking a page from "Hedge Hogging," Barton Biggs noted that during the bear market in the 1970s: "Although the hedge funds in the 1970s never reached anywhere near the size and influence they have today, they crashed and burned in the secular bear market. Most failed to preserve their investors' capital in a bear market by having substantial short positions, as they had advertised. In reality, they were just leveraged long funds; in other words, they had borrowed money to buy stocks but had not hedged by selling other stocks short."

So you can bet that this author is worried - but the BIS quarterly review does provide some additional insights, such as:

The increase in activity was particularly strong on Asian derivatives exchanges. Turnover surged by 71% in Korea to $12 trillion, overtaking the United States as the world's busiest market for stock index derivatives ... Individual investors [in Korea] account for approximately two thirds of trading in options and one half of trading in futures on the KOSPI 200, far higher than in other markets ... Korean pension funds were not permitted to hold equities, let alone equity derivatives, until early 2004, after which this outright prohibition was replaced by ceilings on their holdings of equity instruments.

While many of the Asian markets are still undervalued compared to the markets in the United States or Europe (and with promise of higher growth going forward), such a development (the huge increase in retail investor speculative volume on the derivative markets) in the Korean market is definitely troubling. From both a U.S. standpoint and from a local standpoint, speculation in emerging markets is now highly rampant. From a contrarian standpoint, pension funds entering the equity markets aren't a good sign either. Make no mistake: Pension funds - no matter which part of the world you are in - are usually a contrarian indicator when it comes to making investment decisions.

As an aside, further confirmation of the highly speculative sentiment in emerging markets can also be witnessed in the premium/discount rates of the India Fund - a closed-end fund that specializes in investing in Indian equities. Following is a chart showing the historical premium/discount of the fund relative to its NAV since inception, courtesy of Nuveen Investments:

India Fund - historical premium/discount of the fund relative to its NAV since inception, courtesy of Nuveen Investments

As one can see, the premium of the India Fund relative to its NAV is now at nearly 30% - an all-time high (if I recall correctly, the highest premium that a closed-end fund achieved in recent times was the China Fund when it traded at an amazing 55% premium over its NAV in December 2003). Note that the India Fund has been trading at a discount for most of its life since inception - and was trading at a discount as recently as June 2005. Folks - such bullish sentiment does not bode well for emerging markets for the foreseeable future, especially since both the Fed and the ECB are now done with hiking rates just yet. For folks who are invested in the India fund, I suggest putting a tight stop loss under your position, especially given that the presence of Bird Flu has now been detected in India as well.

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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