Wall Street SAT Exam Question
Louis Rukeyser is to Jim Cramer like:
(A) A healthy head of hair is to bald
(B) Uptown Manhattan is to Brooklyn
(C) The Pony Express is to e-mail
(D) All of the above
OK, if you picked (D), you scored 800 on this part of the exam. Despite their being polar opposites though, I must tell you I was a fan of Lous and Im a fan of Jims even if they occupy(d) the investment stage of public opinion with entirely different personalities and a broadband disparity of decibel levels. Rukeysers Wall $treet Week was a monologue scripted, spontaneous pun inflicted, Friday night quipp-ded diatribe, concluding in part that analysts and portfolio managers would better serve the world by joining the military. Cramerica is a daily light show, a smite-the-idiots show, a battle between the clueless and smart money, with the ultimate conclusion that those who know nothing know nothing would be better off teaching as opposed to doing. Both Rukeyser and Cramer were probably correct and that is why I guess I sort of like(d) them both.
When it comes to Cramer, you may be wondering why one would bother with a late afternoon lightning round conclusion to a busy investment day. Well, hes entertaining, first of all, and I never get tired of the multiple booyahs! that listeners come up with. I find, though, that there are more than appetizers on Cramers menu. He has the instincts of a money manager (because he was one), but the unequivocating courage of convictions that not many of us have. To take on the Fed in the moment of the markets deepest despair took guts. It would be like a passenger rushing from the dining room of the Titanic and heading straight for the bridge: Get your hands off that wheel, Captain, theres icebergs ahead! Indeed there were. Yet aside from the entertainment and courage, theres a commonsensical lesson plan that pops up almost every day. To be sure, the lightning round is intentionally prefab as opposed to lath and plaster, but interspersed and intertwined around all of it are entreaties to diversify and to be aware that markets dont always go up. Rukeyser, in fact, was a perpetual bull. Cramer is a cat with one eye on the mouse hole and the other on a side door that just might usher in a roaring predator. If you can filter the schmaltz from the chicken you just might learn something. Thats what I tell myself, anyway, on many Monday – Friday afternoons. Booyah, Jim!
The reason I bring up Mr. Cramer and his ascension to at least a portion of the investment media throne is to discuss one of his oft-quoted phrases: Remember, theres always a bull market somewhere! In its simplicity thats hard to dispute. There are always some stocks that go up in bear markets and some bonds as well. The bond market long ago, for instance, split mortgages into what are known as POs and IOs, where you could take your pick between principal repayment or the interest component of the mortgage. One was effectively a bet on yields going down, the other on rates going up. Currencies are probably the purest form of the Cramer thesis because one could easily argue that if the dollar is in a bear market, then there have to be multiple currencies that will be going the other way. Taken one step further, Jim Grant of Grants Interest Rate Observer would surely acknowledge the idiosyncratic movement of individual currencies but argue that they all were deflating versus gold. Voila! Even in Mr. Grants world theres a bull market somewhere.
So the lesson must be to go forth and find the bull market, wherever it is. Almost always – but not now because in a global financial marketplace in the process of delevering, assets that go up in price are rare diamonds as opposed to grains of sand. For the past several months our PIMCO Investment Committee blackboard has continued to display the following lesson plan:
What Happens During Delevering
1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.
The above might seem simplistic to us at PIMCO but it is not necessarily clear to all readers. Term premiums? Risk spreads? Volatility? What do they have to do with bull or bear markets? Well, what Step 1 really says is that as GSEs, banks, investment banks, global hedge funds and even individual households delever their balance sheets by shedding assets, they lower the prices of not just what they are selling, but other securities that are arbitrageable within the marketplace. The past 12 months, for instance, have focused on subprime and alt-A mortgages and their drastically lowered prices. Stocks of companies that own them are of course marked down, but so are other assets of impeccable quality. Because junk mortgages now in some cases yield 15%, money at the margin is pulled out of the agency mortgage market where implicit guarantees and explicit Treasury promises to provide standby capital lead to bona fide AAA quality ratings. We estimate that the process of delevering has lowered the price on FNMA and FHLMC mortgages by as much as 3-4% and raised the yield on their 30-year fixed paper by as much as 75 basis points.
Similarly, the volatility associated with asset liquidation as well as the observable lack of liquidity adds additional risk spread premia, which in turn lower the price of almost any stock, bond or piece of real estate that you or anyone else owns. In combination, the current delevering has managed to sink all three primary asset classes in aggregate, as shown in Chart 1. At first, one might wonder why all the fuss. As the chart demonstrates, there have been prior periods when this trio has not done well and the U.S. economy has hardly blinked. However, the current year-over-year decline of over 10% has never really been witnessed since the Great Depression. That, in and of itself, is a potential red flag. Yet a 10% aggregate asset price decline does more than make us all 10% less wealthy. Because many of these assets are leveraged and margined, the more they decline, the more frequent and frenzied the margin calls, and if the additional cash flow is not provided, not only an asset liquidation but a debt liquidation follows. It is the debt liquidation that potentially turns a stagnant/recessionary economy into something much worse. In the housing market for instance, it is one thing to observe a 15% national decline in home prices. It is much more serious however, when margin calls in the form of monthly mortgage payments (many of which are in-creasing due to adjustable or option-related contractual provisions) lead to foreclosures, which in turn cause a debt liquidation. The bank in this case, takes possession of the home and dumps it back on the market, lowering the price even further, which leads to more foreclosures, which leads to .