January 2006

The Many Faces Of Liquidity

I Really Wanna Care.  I Wanna Feel Somethin’.  Let Me Dig A Little Deeper.  Nope, Nothin’.  My Give A Damn’s Busted…If there’s one issue that probably all market participants, whether bull or bear, can agree upon, it's that the global economy and financial markets have been very big beneficiaries of significant liquidity creation since the turn of the millennium at the very least.  As we look back over the events of 2005 and ponder just how the financial markets seem to have so easily shook off the real world implications of crude above $60, natural gas prices in double digits, the economic ramifications of the destruction left in the paths of Katrina and Rita,  the almost out of nowhere bankruptcy of one of the largest futures trading outfits in the country, and what appears to be the all but impending financial implosion of the US auto industry, we can only come up with one answer as to why - market participant perceptions of liquidity.  We thought we’d kick off 2006 with a bit of varied look at the many faces of liquidity.  After all, we believe it’s undeniable that the greater force of liquidity will continue to exert an important influence on the markets in 2006, as it has really in a very meaningful manner since the equity market lows of late 2002/early 2003.  Is there really going to be any hard driving conclusion to this discussion?  Not really.  What we hope is important is to get a feel for the character of what we’re dealing with in terms of how liquidity conditions can shape economic and financial market outcomes, as well as try to develop a sense of what to watch for in terms of ultimate change in the nature of global liquidity somewhere ahead.  After all, as Ray DeVoe opined many years ago, in the endgame "liquidity is a coward, there's always too much when it's least needed and it's nowhere to be found when needed the most".  

It also seems a bit fitting to have a quick look at the greater concept of liquidity now that we’re a month away from Bernanke assuming the position of grand poobah at the Fed.  As you know, Bernanke is the academician who appears convinced that the Holy Grail of real world financial and economic cycle longevity is the L word itself – liquidity.  And more of it, baby.  In the much broader sense, we’re convinced that the financial markets have very importantly convinced themselves over the past few years that liquidity, per se, will always and everywhere be available and will always and everywhere be low cost.  In fact, from a longer-term contrarian standpoint, this is probably the most widespread and most important consensus viewpoint in the financial markets of the moment.  A viewpoint that we believe will ultimately be shattered.  But as always, the question is when and how?  As you’d imagine, we only wish we had the answers to those questions, as does everyone else.  Very quickly, we do have two guesses as to when and how.  We believe the “shattering”, so to speak, will occur when market expectations regarding the significant influence of monetary inflation change.  For now, those expectations are completely benign; soothed by heavily massaged government statistics that make current CPI numbers a good bit incomparable with data from prior periods.  We believe gold is hinting directly at this issue, but it's only the few that are listening for now.  Secondly, we expect the shattering to at some point be accompanied by the conceptual realization that ongoing liquidity expansion equals credit expansion.  Liquidity equals debt.  As hard as it may seem to comprehend, we’re not sure that has completely sunk in to both the domestic and global financial markets in the true sense.  We’re still living in the period where excess liquidity is a rush to the brain, a new high, if you will.  We’ve just needed more and more of it in the current cycle to continue the endorphin release or modification of the brain synapse messaging function.  For now, it appears to us that the markets have convinced themselves they have an infinitely renewable prescription courtesy of the monetary physicians at the Fed.  And this is how we enter 2006.

One of the most important aspects of excess liquidity is its influence on how we as a greater investment community and global economy perceive risk.  Or more correctly, how those perceptions influence the "price" of risk in a multiplicity of asset values.  For example, in the world of the moment, we are seeing cap rates (very simply rental cash flow relative to market values) on real estate of all types, commercial and residential, literally at the lows of our careers.  We’ve never seen anything like it.  It’s as if real estate investors are implicitly assuming vacancy rates will trend toward zero in short order and rent prices will exceed the general rate of inflation for many moons to come with complicit tenants absolutely more than happy to pay ever higher rental prices.  In our eyes, what global excess liquidity generation of the recent past has done is to distort the traditional concept of market risk across the broad spectrum of investment assets.  And when you get right down to the very heart and soul of it, what is the very reason for being of an efficient public/global financial marketplace other than to correctly price in investment risk?  Isn’t this the very basis for the efficient market hypothesis?  If not, then you can throw Bill Sharpe’s capital asset pricing model in the nearest trashcan.  From our vantage point, what the Fed and their global central bank compardes have done over the last half decade at least is to create a financial market, and in part real economy, whose traditional and very important sense of “give a damn” is busted.

And we suggest this lack of “give a damn” has only heightened over the last three years.  It’s not just seen in real estate cap rates; we can see it very simply and directly in generic fixed income risk premiums.  Have a quick look at the following chart.
       

We already know that in the world of today, yield spreads between many classes of fixed income assets and risk free yields, that are supposedly exemplified by US Treasuries, are tight.  Very tight.  A highly levered fixed income market, a low overall rate of return environment, and the significant growth of the hedge fund community since 9/11 are key rationales as to why at the moment.  Above is a look at the relationship between the Moody's Baa yield and the 10 year UST yield.  In the immediate post 9/11 financial marketplace, yield spreads widened meaningfully over a short number of months, prior to a subsequent bit of spread reversion on the back of a Fed that acted to open the flood gates of monetary accommodation in a split second.  We already know that at the market lows of late 2002-early 2003, many a yield spread hit their apex in what was a market pricing in meaningful real world investment risk.  But the Fed and Administration really swung into action in 2003 and brought the definition of accommodation to a whole new level.  Being quick learners, market participants from that point forward finally figured out that anything deleterious to the US economy for even a brief period would be accommodated away by the Fed and Administration.  Hence, yield spreads collapsed from late 2002 straight through to the present.  Moreover, and as you can see, financial market participants in 2005 have clearly learned to simply not "give a damn" in the wake events such as the significant GM and Ford financial deterioration (or the realization of just how big the problems really are), accounting scandals at FRE and FNM, Katrina, Rita and REFCO, as well a meaningful upward change in the commodity and energy markets .  Lesson well learned about the Fed and liquidity?  It sure looks that way.  For now, in the wake of what should have been eye-opening and market moving events in 2005, the risk premium being assigned in the example above is virtually non-existent.  It just confirms our thought that the markets are more than knee-deep in discounting the characteristics of modern day liquidity (continual availability and cheap cost)  well into the future, more so than perhaps at any time in the current cycle.  As we said above, this is how we enter 2006.

As a quick tangent to the timing in yield spread compression seen in the chart above, you can see below that the VIX also began its own most recent multi year collapse in late 2002, completely in directional coincidence with bond yield spreads seen in the example above.  We included the top part of the chart more as an FYI than not.  It compares the price level of the SPX with the VIX over the last decade and one half.  As you can see, we're now well above the peak put in during 2000.  In our eyes, this is a statement on price relative to risk.  Or should we more properly characterize the current environment as "what risk in light of an implicit liquidity promise?"  
       

By no means are tiny real estate cap rates, traditionally risky versus risk free bond yield spreads being very tight, and the VIX relative to the S&P exhaustive examples of current financial market complacency regarding financial/economic risk.  But we believe they are meaningful visual representations of a market that is basically saying, "I don't give a damn because I don’t have to.  I have Alan and, even better, will soon have Ben".  Reflective of a market that has learned not to give a damn in the wake of events potentially dangerous and significantly disruptive to the real US economy.  A market that has learned to place implicit faith in the Fed to heal all financial wounds, if not necessarily real world economic wounds.  We'll be continuing to watch our little versions of financial market risk premium assignment as we move forward for signs of change.  A market that might lose faith in the Fed or Administration will price in that loss of new age religion by assigning heightened financial asset risk premiums across the financial market scoreboard.  What we're discussing above is simply a representation of what we believe the markets currently expect, translated into price and risk premium experience of the here and now.  From our standpoint, good to know as we enter the new year.  Market participants have a definite sense of risk invincibility.  If the market gets what it expects it terms of forward liquidity accommodation, then the current price discounting has been correct.  If it does not get what it expects, then we would suggest a price adjustment lies in our future.  And perhaps a meaningful adjustment given the more than noticeable lack of risk premium currently embedded in many a financial asset price. Given that global capital flows, now more than ever, act to set financial asset prices across the planet, it's global capital's reaction to how liquidity conditions are influenced by the domestic monetary authorities that may be the most important watch point of all as we move forward.

"history has not dealt kindly with the aftermath of protracted periods of low risk premiums"

Of course Greenspan's above comment regarding risk premiums delivered at Jackson Hole last year is completely disingenuous in that the Fed has been the key provocateur in helping to remove risk premiums among major financial asset classes really since the aftermath of the 9/11 tragedy.  We at least would have expected some type of reaction in intermarket price relationships in US financial markets in the wake of GM/Ford, FNM, FRE, Katrina, Rita and REFCO but so far - nothin'.  And in reality, as you know, we have no one but the Fed to thank for that.

As a final comment, we've not discussed our view of risk premiums to necessarily suggest the markets are wrong.  They're never wrong.  Rather, we thought it useful to bring this up in terms of maintaining our own sense of awareness and our own comfort level with the investment risk we wish to accept in the financial marketplace set against how we perceive the market to be pricing in risk at the moment.  The lack of heightened financial asset risk premiums in the wake of 2005 events we mentioned isn't something terrible, it is what it is.  But from our standpoint, we believe that the important point is if the markets are pricing in very little forward "risk" relative to historical precedent, we need to adjust for that in our own investment and hedge related actions.  We just need to realize that the markets are currently giving themselves very little price cushion in case real events looking ahead unfold somehow less than very favorable to the US economy.  Alternatively, maybe we can suggest that the markets are moving into 2006 never more assured, as seems Bernanke, that excess liquidity indeed is the Holy Grail.  Onward to Camelot?    

The World I Love, The Tears I Drop, To Be Part Of The Wave, Can’t Stop.  Do You Ever Wonder If It’s All For You?…Let’s leave the philosophical for a bit and look at the faces of liquidity we see in the real world.  In the two tables below we’re looking at two faces of liquidity – total credit market debt and M3.  The credit market numbers are taken from the most recent 3Q Fed Flow of Funds report.  In our minds, quite simply, these tables show us accelerating real world economic dependence on increasing liquidity availability and the real economy increasingly drawing on that liquidity over time.  What’s a bit interesting is that in the current decade so far, we’ve about matched nominal dollar GDP growth for the entire decade of the 1980’s, but growth in total credit market debt so far into the current decade’s journey is already close to 60% greater than was the case for the entirety of the 1980’s.  Bringing it down to per dollar numbers makes the point.  Does this set of data tell us that we’ve needed an extraordinary amount of liquidity/debt growth to achieve what has really been one of the weakest economic recoveries of any cycle of the last half-century at least?  If that’s not the conclusion, then what do these numbers tell us?

We really see the same set of dynamics when looking at money supply growth (M3 being the broad proxy) relative to the real economy.  Nominal dollar M3 growth over the last six years has no precedent in US history, not that this is a big surprise. But, again, when we bring this down to per dollar values and compare this relative to GDP growth across the prior decades, the striking character of the current cycle stands out like a sore thumb.

Without trying to sound melodramatic or wildly over the top, but simply factual in looking at the real numbers you see above, do we have a current economy that certainly appears a bit addicted to cheap and easily available liquidity?  Sure we do.  It’s no wonder the markets have come to expect more of the same, as the alternative seems unthinkable at this point.  And the Fed up to this point has done absolutely nothing to discourage this viewpoint.  In fact, we probably have the ultimate cheerleader for this construct picking up the baton on February 1st.  At least in terms of financial risk premiums we discussed above, the market is clearly ignoring or assigning a zero probability to “the alternative”, so to speak.  Again, we see this as the most important financial market macro consensus viewpoint of the moment which to monitor for change, real world as well as psychological, as we move forward into 2006.

Hedging Our Bets...To ourselves, what the essence of the discussion up to this point would suggest is that making use of investment risk hedges in the current environment is probably a pretty smart thing to do, if not mandatory, especially given that the market sure does not seem to be implicitly doing this for us in so many asset price examples of the moment.  Give up a little something on the upside to essentially do what the market should be doing in terms of risk protection vis-à-vis current asset pricing.  But we want to end this discussion with a another look at hedging, so to speak.  And that's with a quick and overview review of the hedge and proprietary trading communities.  Why is this important?  We're convinced that the asset growth in both the hedge community and among the proprietary trading desks is responsible for a number of important changes in the texture and character of the financial markets over the last half decade at least.  And not that this is bad by any means.  It simply is what it is.  Our simple belief is that we need to stay on top of the magnitude of these changes in order to better understand the environment in which we work.  Same deal as trying to remain aware of the dynamics of liquidity.  We need to know both our teammates and opponents on the playing field at all times.  And the reason we home in on the hedge and proprietary trading desks is that it's these folks specifically who make the most use of financial market liquidity/credit availability, to which we've been referring, on a daily basis in the markets.  Clearly, in our minds, the hedge crowd has helped to accelerate individual sector price volatility and magnitude of shorter term sector movements over the last half decade, despite the apparent quiescence of the macro world of equity risk premiums according to the VIX.  As we've mentioned to you many a time, when short term equity rallies have lifted off since the equity market bottom in late 2002/early 2003, beta has led the charge.  We attribute this phenomenon to both the hedge players and momentum players closely following in their footsteps.  Hoping for a fast bang for the buck is what we've seen at the outset of virtually all of these short term rallies.  Likewise on sell offs, damage has been short and sharp as of late.  The homebuilders and energy sectors felt the swift wrath of the selling swords aplenty in September and October of last year.  We could go on and on with example after example of sharp and fast sector movements, but you get the picture.

As of the end of 3Q of last year, it's estimated that the hedge community has grown to just shy of $1.1 trillion in total assets under management.  It's just about a doubling since year end 2001 and a quadrupling since 1996.
       

But what is also clear is the fact that year over year growth in hedge asset accumulation has been slowing in recent years and  we believe it's for obvious performance reasons, or lack thereof to be more specific.  Secondly, institutional money has also "found" private equity funds in ever greater fashion over the recent past.  As you know, the large pension funds in this country had been loaded with large cap blue chips over time.  The exact sector that has been one of the most significant laggards over the past half decade.  Large institutional pension dough is chasing hedge and private equity investments out of sheer lack of alternative rate of return terror.  But this is important in that the private equity players are also big users of liquidity/leverage.  That's how the whole private equity game makes sense, to be honest.  So what you see below is not wildly surprising, because the decline in rate of change in hedge asset growth has largely transferred to the acceleration in private equity assets under "management".
       

Finally, just for a bit of perspective, what do hedge assets look like against some type of a macro benchmark?  Below is a look at hedge assets as a percentage of the market value of US equities in their entirety.  (We obtained the market value data from the Fed Flow of Funds report estimate for total market value of US equities at each calendar interval.)  Now clearly not all hedge outfits are playing the stock game.  There's plenty of fixed income, derivative, off shore, etc. assets and vehicles being used.  What you see below is just our trying to get a sense for magnitude.
       

Giving Props To The NYSE Member Firms...Although it's clear that the hedge community is helping to change the face of the financial markets as we know them today, perhaps not enough folks give proper respect to what many of the NYSE member firms are up to these days.  As you might know, proprietary trading has become a very big deal for many of the NYSE members.  And although the specialist firms are members and do trade for their own accounts, we're really talking here about the Merrill's, Goldman's, JP Morgan's, etc. of this world.  NYSE "members" with access to some serious capital/liquidity availability.  According to the wonderful folks at the NYSE, member firm proprietary trading now makes up over 20% of total trading volume on the Big Board.  As you can see below, this is up from less than 5% five short years ago.  To suggest that the large brokerage outfits have expanded their proprietary trading desk activities is an understatement.  Combine these stats with the hedge fund proliferation data and you are looking at the ingredients as to why daily trading activity in the equity markets today has a much different focus and character than it did even five short years ago.  And knowing that these players are some of the most prolific in terms of the application of liquidity/credit in leveraged financial investment/speculation, we think it's important to both realize and keep tabs on what's going on in this neck of the financial market woods.
        

One final look at structural market change over which to ponder.  It's simply an update of a picture we have shown you in the past.  It's the picture of program trading as a percentage of weekly NYSE volume.  From near 20% five years back, we're now looking at roughly 55% of weekly NYSE weekly volume being driven by program trading.  Again, neither good nor bad.  It's not just a sign of the times and a sign of the changed nature of market players and focus, which is clearly exemplified by the growth of the hedge and prop desk communities, but what you see below is certainly a function of ongoing technological change and the ever increasing concentration of investment assets in large institutions.  Again, this is not something evil, but a fact that acts to meaningfully shape the nature of the current financial markets.  Especially over the short term.
       

As you know, all of the above data paints a picture of very important change in terms of the character of market participants of the moment.  You know that both the hedge and prop desk communities are focused on the short term.  Intensely focused short term.  For them, this is much more a game of short term speculation as opposed to long term investment positioning.  Together they command a meaningful portion of shorter term actual market activity than literally ever before.  As opposed to pining for the "good old days", so to speak, we need to incorporate this information into our own thinking and attempt to use it to our own advantage.  One last comment we'll make is that much of the above data would lead us to believe that market volatility, all else being equal, would be much greater with a thriving hedge and prop desk community than not.  But, as you know, we see popular measures of volatility such as the VIX and VXN much nearer historic lows than not.  From our point of view, just maybe the VIX and VXN are low because of the intensity of short term focus of these two powerful forces, hedge and prop desk trading.  If you will, the excessive competition for short term basis point rate of return is keeping arbitrage opportunities to a bare minimum and macro environment excess liquidity is killing what have been historic financial asset risk premiums embedded in price.  And even though sector volatility is higher than not in our view of life, money sloshing between sectors as opposed to the macro tradeoff of cash versus stock exposure, has kept overall major index price volatility low.  In other words, we see less money "leaving the market" as opposed to simply shifting emphasis in an ever more furious fashion short term.

What can we learn from all of this?  We have just a few thoughts.  And maybe we're really talking to ourselves more than not.  First, we need to continue learning to use sector or individual security specific volatility to our own advantage over the short term, when longer term fundamental convictions regarding those sectors or securities are firmly grounded.  Secondly, although we believe the marriage of fundamental and technical analysis is very important for any investor to incorporate into decision making over time, from a short term perspective, technicals and quant models are driving a big piece of prop desk trading as well as many hedge management styles.  Again, it simply is what it is.  We find ourselves watching charts more and more these days.  If nothing else, timing the entry and exit of positions is clearly a multidisciplinary process.  As you know, we're just scratching the surface in terms of what these changes you see described above mean for the total of the investment community longer term.  We just hope that being attuned to the structural change we currently see is conquering half the battle in terms of ongoing awareness of our total surroundings, so to speak.  And finally, not only is the concept and reality of market perceptions of liquidity important in terms of trying to get a sense for current consensus thinking and action, and where that thinking may at some point encounter its proverbial Achilles Heel, but is crucially important in terms of how liquidity and leverage affect the current movers of the markets on a very short term basis at the margin - the hedge and prop desk communities, and to a much lesser extent the private equity funds.  Stepping back and looking at the broad macro of market liquidity and the increasing influence of the hedge and prop desk communities on the financial markets short term, we need to realize that there is a true symbiotic relationship between the Fed (as well as the Bank Of Japan and People's Bank Of China) and the hedge/prop desk crowd at the moment.  It's a story of the relationship between the provocateurs of excess liquidity and how that liquidity finds its way into financial asset prices.  In one sense, the character and texture of the current financial market, and the real economy, really is different this time.  But, let's face it, isn't it really different every time, so to speak?  We sure think so.  We hope that by being very aware of our total surroundings, we won't get lost.  This is how we enter 2006.