September 30, 2016
By Steve Blumenthal
“It’s like déjà vu all over again.”
— Yogi Berra
Something just doesn’t feel right to me. In March 2008, Bear Stearns executives made a shocking discovery: They were nearly out of cash. They faced a barrage of withdrawals from worried clients. In a blink, confidence was lost. In what seemed like a blink, Bear was gone. They were the first casualty of the great financial crisis.
Now, as was the case back then, we are walking on thin ice. What do I mean? How do I explain this in an understandable way to my team, my wife Susan and our children? We are near a Bear Stearns moment but this time in Europe. What is happening there right now matters to you, me and to all investors everywhere.
In the next few paragraphs I’ll do my best to share what I’m seeing in a way that I hope makes sense. I’ll try my best to keep it simple.
Deutsche Bank is in trouble. Really big trouble. What is needed is a bailout by the German government, but that may or may not happen. The political environment both pre- and post-Brexit adds to the drama. The point is that if DB goes down, it affects banks here, there and everywhere. Why? Read on.
But first, get in the mindset of how humans tend to respond. Recall how the CEOs from Bear and Lehman went to exceptional lengths to profess the strength in their balance sheets. How much did they really know? Think about the recent problems at Wells Fargo. How could Chairman and CEO John Stumpf not know about the practice of setting up phony accounts to meet sales goals? He seems like an honest and straightforward guy.
I think he is being honest and I believe that perhaps he did not know. Regardless, his employees had, over the course of several years, opened as many as 1.5 million bank accounts and 565,000 credit card accounts that may not have been approved by customers.
I’ll bet my pay that there were some pretty good bonuses tied to reaching certain metrics. Doing right isn’t front of mind for some people. Bad behavior happens. Certain policies, conceived with good intentions, may actually stimulate bad behavior. It happened with no-doc mortgages, subprime lending and the seemingly small (at the time) mortgage risk exposure that sat on the books of some of our biggest banks (again, Bear and Lehman come to mind).
The point is that these are really big institutions with many moving parts. When you mix leverage into the equation and losses mount, there is little room for error. Keep that in the back of your mind.
Deutsche Bank is one of today’s great systemic risks. Yesterday, Bloomberg reported that 10 large hedge funds are withdrawing their capital from the bank. Predictably, DB Chief Executive Officer John Cryan rushed to shore up confidence as the stock price dropped to record lows.
“The bank’s balance sheet is safer than at any point in the past two decades,” Cryan told staff in a memo Friday. “Trust is the foundation of banking. Some forces in the markets are currently trying to damage this trust,” he said. (Source)
The bank’s balance sheet the best in two decades? Some forces trying to damage trust. Personally, that doesn’t sound so good. Recall the same kind of rhetoric prior to Bear Stearns and Lehman Brothers hitting the mat.
Let’s look at some simple math.
JP Morgan’s equity capital is about $250 million. Their balance sheet is about $2.5 trillion. Think of the balance sheet as all of the loans they have made and capital set aside to support trading, derivative exposures and other bank functions. Here is the skinny: U.S. banks are currently leveraged approximately 10 to 1. Under the Third Basel Accord (“Basel III”) and the controls the Fed wants, banks can lever up 10 times. U.S. banks are in that range today.
Think of it this way. If you were a bank and you had $1 million in capital, you can loan out as much as $10 million. If a few of the businesses you loaned money to get into trouble, you might not get paid back. If 10% of the loans you made default, then you lose $1 million. Subtract that from your original $1 million in capital and your bank is bust. You have to be really good with the loans you make.
DB’s equity capital is $15 billion. Their balance sheet is about $2.5 trillion. That puts them at over 100 times leveraged. If you are down ¼% (0.25%) and you are leveraged 100 times, you lose $25 billion in equity capital. Subtract that from $15 billion and you are more than knocked out. That means the bank has to do perfect banking, everyday all the time.
Did Jimmy Cayne, the CEO of Bear Stearns, have a handle on the mortgage risk exposure before or after it was signaled when one of their mortgage hedge funds sparked warning of what was to come? Did John Stumpf know about the fake accounts? Did the president of that particular unit know about the fake accounts?
Do we trust the DB CEO when he says “the bank’s balance sheet is safer than at any point in the last two decades.” Not sure.
It is impossible to be safe when you are leveraged 100-1. Oh, by the way, they are loaded up on exposures to Italian, Portuguese, Spanish and Greek sovereign bonds. There is no room for error. This could call “checkmate” on the entire European sovereign debt mess. Will Draghi do “whatever it takes?”
My Susan might look at me and say, “So what? They are way over there. What does this have to do with us?” Well, one of the big problems is that major banks across the world all trade with each other. This is where it gets messy for our banks. We are interconnected by a highly complex web of what is called counterparty risk.
What that means is that if I bought a structured note to hedge my currency exposure, or to hedge my exposure to a bond I bought, or to place a bet against the decline or gain in a particular credit facility or to buy a structured mortgage instrument; I have to post my collateral at the bank and if the bank goes bust, I won’t get my money back. If the bet or hedge I put in place is tied to a bank-created structured note moves in my favor, I will not only lose the collateral I had to post, but I won’t get paid off on my win. So I have risk to the bet I made and risk to the bank who is the counterparty to my trade.
If DB goes bust, you can see in the next graph all of the exposures other banks have to DB being on the other side of the trade. This is when leverage and highly leveraged structured products can become what Warren Buffet described as “financial weapons of mass destruction.”
In a picture it looks like this:
Source: International Monetary Fund, Germany – Financial System Stability Assessment, IMF Country Report No. 16/189 (June 2016).
At the height of the Bear Stearns and Lehman problems, those two banks were each leveraged something like 30 to 1.
100 to 1. Come on! How in the world does a bank not risk losing one quarter of 1%?
It is important to understand that DB is the main financial clearing house for trades in Europe. So far, Angela Merkel is adhering to the policy of a “bail in.” That means the investors and the depositors take the hit. Recall Cyprus. But Germany is no Cyprus. That means the names next to the big blot circles in the chart above take the hit.
Behind closed doors, I’m sure the calls are being made. 100 to 1 leverage, I believe, means the world will be looking to Angela Merkel and the German government for help. The hope, for those caught in the crosshairs, is she blinks.
This is the Lehman-like moment in Europe.
It is important to note that there is a provision under EU regulations that would allow Merkel to bail out DB, provided it is only to “remedy a serious disturbance in the economy of a member state and preserve financial stability.” However, EU state aid rules require junior creditors and shareholders to share losses. Therein lies the problem of a global contagion.
This becomes what we in the business call a clearing issue. I trade with you, you trade with me, but I have no idea if I trade with you that you will pay me. If DB is out of business, who will step in to clear the trades. In crisis, it is likely that the EU banks may need to concede clearing to the British banks. Oh, but the anger and indigestion that remains over Brexit.
Very large hedge fund customers are running for the exit. This is getting dicey.
Confidence lost, then crisis. Keep a keen eye on this. It has the potential to trigger the next global recession and hurt our wealth. Some strategies will do well. A flight to safety will help bonds gain. High yield debt will get hurt and so will equities, so be mindful that risk is elevated. Hedge that equity exposure.
My two cents (and I could be wrong): I think Merkel will blink. If not, the bank run will continue. Look again at the web of counterparty exposure. I think she blinks. If not, international chaos will follow and that great big buying opportunity I’ve been waiting for will present.
I hope I explained this in a way that makes sense. I realize it is a complex discussion. I am truly an optimistic kind of guy. It was tech in 1999 and the “this time is different” bubble mindset. I wrote about crazy valuations and cab drivers making money trading stocks on their hand-held QuoTrek devices.
It was mortgages in 2006, 2007 and 2008. I wrote about Fannie and Freddie, subprime and CDOs, Greenspan and his “there is no irrational exuberance” and “housing has never collapsed, nor will it” comments. At the time, I received a lot of feedback that I was too bearish. Turns out I wasn’t bearish enough.
It sure feels like “déjà vu all over again.” Remain patient, stay tactical, hedge your equity exposure and build that equity shopping list and be mentally prepared to take advantage of the opportunities that the next bear market will present.
Notwithstanding the challenging issues I’ve shared, our CMG strategies have performed well in the most recent quarter and are currently positioned risk on. The CMG Opportunistic All Asset ETF Strategy is allocated 82% to equities and 18% to fixed income. We continue to see strong relative price leadership in emerging markets, utilities, technology and biotech. Because of our rules-based investment process, we have the ability to position defensively and move to cash if cash is performing best. Our High Yield trend following strategy is positioned risk on.
I was in NYC this week to attend the Bloomberg Markets Most Influential Summit. I took a few notes and share them with you below, along with links to select video interviews. Hedge fund great Julian Robertson kicked things off on Tuesday evening. He sees opportunity in technology and biotech stocks and pain ahead for investors not properly positioned due to the bubble created by Janet Yellen and the global central banks.
I particularly enjoyed interviews with Howard Marks of Oaktree Capital Management and Marc Lasry of Avenue Capital Group – managers who made me good money some years ago. And what a treat it was to see and listen to Julian Robertson.
Today, I share with you some of the high level notes from the Bloomberg conference. You’ll find a few links to the video recordings.
Also, here are the audio recordings from the Morningstar ETF Conference I previously promised you:
- Beyond the 60/40 Portfolio (this is the panel that I was on)
- Best Ideas Panel: Yusko, Bernstein and West
Included in this week’s On My Radar:
- Bloomberg Markets Most Influential Summit – Howard Marks
- Bloomberg Markets Most Influential Summit – Marc Lasry
- Bloomberg Markets Most Influential Summit – Julian Robertson
- Trade Signals – Cyclical Bull Equity Trend Positive, Bond Trend Bullish (Again), Sentiment Supports Bullish Trend (9-28-2016)
Bloomberg Markets Most Influential Summit – Howard Marks
My notes presented in bullet point format.
- On monetary policy: He believes that the free market is the best allocator of resources in the long run. It is the essence of capitalism. It is a large part of the success of the United States.
- We don’t have a free market of money all around the world and we haven’t had one for five, six or seven years. And that’s unfortunate.
- He likes the Keynesian approach. Which is, when the economy is in the soup, you run a deficit and spend more than you bring in and that stimulates the economy and brings it back. And when your economy is doing well, you run a surplus, you spend less than you make and you pay off the debt. Everybody has forgotten about that latter part.
- “And now the Fed and the central banks think they can manage their way to prosperity” and “I don’t believe they can.”
- “I don’t believe CBs can create growth nor should they be in the business of controlling the money market.”
- Marks is a micro investor. He invests in one company at a time where they are paired well to take the risk and where they believe the outcomes are probable.
- You can name on two fingers the number of macro thinkers who have gotten it right. Most can’t get the timing right. It is not something they do.
- Returns are extremely skimpy thanks to the CBs lowering the risk-free rate of return – so we have low prospective forward returns at the same time we have great macro uncertainty.
- He rejects the idea of getting out of the market. Clients need returns. He says he can’t take the risk that he’s sitting in cash for two years or his clients will fire him and he’ll be out of business.
- Asked if there is a moment when it is right to get out of the market, he answered, “when there is a demonstrable bubble, when psychology is crazy bullish and when risks are extremely high and valuations are high. Implicitly, I’m saying I don’t think there is.”
- “I think things are elevated and you have to proceed with caution but I do not think we are in a dangerous bubble.” “Bubbles are noted by extremely high valuations and by bubble thinking.”
- He sees this as a time for caution but not a time of maximum risk.
- A big worry is the path that automation technologies are on and what that will do to displace workers.
- The U.S. is in better shape than Europe and Japan. But everything is slowing down. Everything is complicated by globalization and automation.
- He is a little more optimistic on forward returns than I am. Pensions need 7.5% and historically that was a realistic target. He said, “The first thing I’m pretty sure of is that 5.5% yielding high yield bonds are not going to deliver 8.6. And 2% treasuries are not going to deliver 5%. And the biggest mistake you can make, in my opinion, is buying a 5% bond expecting to make 7%. So today, high yield pays 5.5%, most people expect stocks to deliver 5 or 6, high grade bonds pay 3-4, treasuries pay 1-2. You average those together and throw in alternative investments, I think you can do 5½. This is the most reasonable expectation for long-term returns.
- This is a big problem because most endowments need 8%. Charities need 8%. Pension funds need 7.5%-ish.
- He noted that he meets with a lot of pension fund managers who ask for his opinion and he tells them to expect 5.5%. They say, well our actuarial assumptions tell us we need 7.5% to meet our obligations and ask what he recommends they do. He tells them to change their actuarial assumptions.
- But the problem is that the actuarial assumption that I think is supposed to be the return you think you can make has morphed into the return you need to turn today’s assets and predictable cash flows into the amounts you’ll need in the future to pay to meet your needs.
- That thinking doesn’t have anything to do with what a prudent investor can make.
I liked this quote: One of Marks’ favorite sayings is, “What the wise man does in the beginning the fool does in the end.”
Kind of feels that way when I think of the chase into high yield bonds and the chase into high dividend payers today. Bubble? Expensive, but missing is the speculative fever type behavior that tends to come at market tops. The trend, as you’ll see in the Trade Signals section below, remains positive for both stocks and bonds at the time of this writing.
You can watch the 22-minute Howard Marks Bloomberg interview – here.
Bloomberg Markets Most Influential Summit – Marc Lasry
Marc begins the interview talking about the state of the hedge fund business. Move to the six minute mark where the discussion turns to investment ideas.
He sees return opportunities in niche industries and particularly likes energy company debt.
- He likes some oil companies and he is investing in their senior debt.
- It’s a great market because everyone is running from energy
- It is about $3 billion of his $11 billion fund.
- Distressed debt in the energy sector has grown from $120 billion to over $300 billion in the last two years. It is the only sector where the amount of distressed debt has increased. And this in an environment where there has been positive GDP growth.
SB here: it increases because more companies get into trouble. Lasry seeks to invest in distressed companies he believes he can make money on. Kind of a buy when everyone else is selling strategy
- Energy is the single most attractive opportunity he sees
- The next big opportunity is European sovereign debt
- Think about what is happening there. The European Central Bank is forcing banks to de-lever. Why? Because they are massively overleveraged. So they force the banks to keep selling loans. Non-performing loans. Or as the loans come due, don’t roll it. They are forcing them to de-lever.
SB: In this way, Lasry buys the senior loans at discounted prices and looks to earn in the mid-teens. He is a distressed debt buyer.
- Most of these companies are companies that nobody has heard of because there are so many middle market companies in Europe.
He was asked, what about Deutsche Bank (skip to the 16 minute mark). Note that I shared a number of the stats he talked about in the intro of today’s On My Radar. You may find it helpful to watch and listen to Marc explain the situation.
- DB needs to be fully hedged, they need to be perfectly hedged and then they need to make money on what’s on their books.
- So what do you think the ECB is doing? They are pressuring them to de-lever, de-lever, de-lever.
- And that’s what’s going on in Europe and DB is the classic leverage.
- When you are 100 times leveraged and you look at all the rules that you should be no more than 6 times or 10 times leveraged, it is a bit illogical.
- So I think there will be problems. It’s hard for people to be that much leveraged and not have shocks.
Marc’s not calling for a crisis. I think things are a bit more dire and absent a German government backstop, sparks will fly. In any event, that’d be good news for Marc’s strategy as he’ll look to pick up some more bargains at distressed prices.
You can watch the Marc Lasry interview here.
Bloomberg Markets Most Influential Summit – Julian Robertson
I remember my first due diligence trip to Julian’s office. It was sometime in 2000 or 2001. I was excited to sit in on the session.
Following are a few notes:
- Bloomberg broke the interview down into a number of short video clips (that helps them sell ad time): Here is the one about Yellen creating serious bubbles.
- Higher interest rates are going to encourage savings and I think we need to encourage savings. People don’t know what to do with the money.
- They can only go into stocks. It creates the bubble.
- Tom Keene asked who is to blame for this mess. Janet Yellen is unwilling to see the American public take any pain at all and because of that I think she is creating a serious bubble that will create serious pain. People are going to get hurt.
- Keene asked how he’d be exposed into the rest of the year, Julian answered that the only game in town are equities so we have to play in that theater. Here is the clip on how stocks are the only game in town.
- He’d tell people that there will eventually be chaos created by the negative and low interest rates and that a conservative attitude has to be taken.
- He believes biotech stocks are cheap. Clip is here. This is because the fear of Clinton on the drug industry has created real value in biotech.
- He added that Google and Microsoft are available at really good multiples.
Robertson founded Tiger Management in 1980 and turned it into one of the world’s largest hedge funds.
- On the hedge fund industry, Julian said ultra-low interest rates and swollen stock market valuations are crimping returns for the managers, whose portfolios are designed to outperform during a downturn. Hedge funds have underperformed the S&P 500 since 2008. But remember that many go long and short stocks and it has been a risk on Fed-driven environment since then. Video clip here.
I’ll conclude notes on this section with the following:
Fed Chair Janet Yellen “is just unwilling to see the American public take any pain at all and because of that I think she’s creating a serious bubble where serious pain is coming,” he said. “If we have that bubble burst, you’re not going to make any money in the stock market unless you’re short and unless you’re in some sort of hedge fund.”
Trade Signals – Cyclical Bull Equity Trend Positive, Bond Trend Bullish (Again), Sentiment Supports Bullish Trend (9-28-2016)
S&P 500 Index — 2,170
Posted each Wednesday, Trade Signals looks at several of my favorite stock, investor sentiment and bond market indicators. It is my weekly risk management dashboard, designed to keep me better in sync with the major technical trends. I hope you find the information helpful in your work.
Click here for the most recent Trade Signals blog.
I had dinner at a great Greek restaurant on Wednesday night with my daughter Brianna. She’s working for a 15-year-old investment startup. I say startup because there are zero revenues, but oh, their financial technology. They should be coming to market with their product soon and it will be worth our attention. But what I love most, outside of who she is, is our discussions about finance.
She funded her first investment account, a Roth IRA, earlier this year and has the money parked in cash. “What should I buy?” she asked. My advice is for her to create a shopping list. There will be another 50% decline and you want to be ready to buy when the panic ensues. That’s when you get the best value. That is when risk is least. I gave her a few ideas.
She can sit it out and dollar cost average over many years. But we baby boomers, who will personally control nearly 75% of all investable assets by 2020, don’t have the luxury of all that valuable time.
To that end, prior to dinner with Brie, I met with one of my OMR readers for a drink. In his early sixties, he and the rest of us baby boomers can set aside some home run money but we don’t have the necessary time to overcome the next one or two market dislocations. He can’t afford to take the hit.
The goal is to get across the bridge with capital intact and hopefully gains. There is potential for gain along the way, but it depends on how you are positioned. In my view, traditional 60/40 is going to get run over.
If you favor 60/40, hang on and expect -2% to +2% annualized per year for stocks over the coming 10 years. Not a bad way to go if you have time and can dollar cost average in over many years. The question is need for income and just how many years for you.
I keep writing that Jeremy Grantham is predicting -3.2% real annualized returns for the next seven years. He’s been amazingly accurate over the years. No guarantees but I personally wouldn’t bet against him.
Expect 1.58% for bonds. That’s the yield on the 10-year Treasury. There is no way that 1.58% can earn 5%.
The probable outcome is that 60/40 gives you 2% before inflation and 0% real (assuming 2% inflation). Where is the needed retirement income going to come from? 60/40 is not going to do it.
Of course, much depends on your personal financial position, your wealth and your age. For most of us, I believe it is a must to think differently. Yes, seek growth but do it in a way that allows you to get defensive. Get across the bridge in a way that allows you to take advantage that the next recession or crisis or both create.
The Ryder Cup starts today and I’ve hit the record button so I can catch what I’m going to miss live. My sister Amy and her husband are in town and a big family dinner is planned. There is much to do around the house, some writing to catch up on and with rain in the weekend forecast, it looks like some time with my boys watching the Ryder Cup – that will be fun. Go USA!
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Have a terrific weekend!
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman and CEO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
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