Thursday, July 26, 2007

Market Correction

Based on the number of phone calls I’ve received today, it would seem an appropriate time to make a few comments about the markets. Obviously, the last few days have not been nice, but it must be kept in context. At the time I’m writing this, all that has happened is that the gains we had achieved during July have been eliminated. Basically, the market is at about the same level as it was at the end of June. On June 29th, the DJIA closed at 13408.62. As I write this the DJIA is at 13423.01. The real damage has been done in areas to which we have little or no exposure. For instance, the high yield bond market is down about 5% this month and emerging market bonds have been hit as well. That’s why when we have bought bonds recently, they have been of the high quality variety (primarily government bonds). Our bond positions are up today as investors flee the risky high yield bonds for the safety of governments.

The cause of the selloff is the tightening of the credit markets. The subprime mortgage market got things rolling and it has now spread to other types of risky debt. Debt offerings that were intended to finance private equity takeovers are now being postponed. Three deals were postponed this week: Chrysler ($12 billion), Alliance Boots ($10.4 billion) and Allison Transmission ($3.10 billion). Some other smaller deals are also being postponed as the traditional buyers of these bonds have demanded better terms to compensate them for the risk they are taking.

Fear is returning to the market. The volatility index is over 22. This index rises when the market falls as investors pay ever higher prices (in the options market) to hedge their portfolios. Typically, the market makes a bottom when the cost of hedging hits its peak. The February correction saw the index peak at 21.25. The correction in June of last year caused a spike to 23.81. If this correction is similar to those, we are probably nearing some kind of bottom. I should mention however, that in the late nineties when volatility was generally higher, it usually took spikes into the 40s or 50s to find a bottom. The crash of ’87 caused a spike above 100, but I’m not looking for anything like that. Fear in the market is associated with bottoms; complacency or greed in the market is associated with tops.

Is this something long term investors should be worried about? I don’t think so – yet. If this mutates into a general credit crunch (like the late 80s/early 90s) it could cause a recession. Right now, I don’t think that is happening. Lending standards have been tightened – but they needed to be. A few years ago, all one needed to be approved for a mortgage was a pulse. Now the lenders actually want you to have the capacity to pay back the loan someday. So far, it appears that people (and companies) with good credit can still get financing. As long as that holds, the economy should be okay.

Another mitigating factor could be the Federal Reserve. If a hedge fund or other leveraged player gets in trouble, the Fed may be forced to cut rates. Could a hedge fund be in trouble now? Well, that may explain the high yield sell off and the yen rally we are seeing today. The carry trade, where funds borrow at low rates in yen and buy higher yielding investments in other currencies, appears to be unwinding a little bit today (high yield bonds are down and the yen is up). Consider that a fund that uses borrowed funds and buys high yield bonds may be leveraged as much as 10 to 1. That means that this months 5% drop in the high yield market is at least a 50% drop for any fund doing that trade. Another indicator is that the Brazilian Real, another favorite of the carry trade crowd, has dropped around 7% in the last two days. So if several of these funds really get in trouble and need to be bailed out, the Fed could come to the rescue. That’s what happened with the Asian crisis in ’98. Long Term Capital Management, a hedge fund with several Nobel laureates on the team (which may say something about the value of that award), made some bad bets and the banks who had loaned them money needed help. The Fed arranged financing and then cut rates to help the fund recover. Bernanke is not Greenspan of course, so I don’t know if he will react the same way, but my guess is that he would.

I’ll be watching things closely over the next few days. There may be a buying opportunity at hand or if this looks like it will turn into something worse, I’ll take the necessary actions.

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