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The Key Is “One By One”


Charles McKay said it 170 years ago, and until now it appeared to be true:

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one. (Extraordinary Popular Delusions and the Madness of Crowds)

That is, it seemed that way until today. Inexplicably, the stock market jumped overnight and on the open today. I say “inexplicably,” but there was no shortage of attempts to explain it. My favorite was the list on “reasons for a market rebound” given by one CNBC guest, who clearly was up all night trying to think of reasons to be bullish.  Reason number 1: “The European debt crisis is unlikely to get much worse.” Well, that’s the question, isn’t it? I guess if you know that, you’re already well ahead of me.

Unfortunately, the current indications are that the crisis is indeed getting worse. In a Wall Street Journal article today, it was reported that “Spain’s Banco Bilbao Vizcaya Argentaria, or BBVA, has been unable to renew roughly $1 billion of short-term funding in the U.S. commercial-paper market since the beginning of the month, according to people familiar with the matter.” This fact is made worse by the fact that (also noted in the article) new SEC regulations for money funds go into effect this Friday; these regulations are supposedly designed to forestall another credit crisis by…if I follow the reasoning…decreasing the supply of term credit:

Money-market fund managers try to buy relatively safe assets and hold them for a short time. A money-market panic in 2008 contributed to the broader squeeze in corporate credit.

In an effort to prevent another such crisis, the Securities and Exchange Commission is requiring money funds to hold more-liquid and higher-quality assets, effective Friday.

The new rules will shorten the maximum weighted average maturity of a fund’s portfolio to 60 days from 90 days. Funds also will have to maintain a minimum of 10% of assets in securities that mature in one day and 30% in securities that mature in one week.

Perhaps the critical piece of the argument is that by making it more difficult for money funds to lend to unregulated “Shadow Banking” institutions (as Paul McCulley coined the term, for example see his comment here) such as off-balance sheet asset-backed commercial paper conduits, hedge funds, etc, the SEC is forcing them to reduce their scale. It doesn’t seem like a bad idea, but preventing money funds from investing my cash in anything but T-Bills seems a rather circuitous route to get to that conclusion, if that is in fact the reasoning.

In addition to the news out of Spain came word (see for example the Financial Times article here) that the UK and France are rejecting the “bank tax” plan that was championed by Germany. This is just one small example of the fact that the various EU governments are enjoying something less than complete unanimity when it comes to addressing the crisis. Compare this to our own banking crisis, in which the bickering of Connecticut and New York would not have been relevant since the federal government was in charge overall. The patchwork of political economies in Europe are greatly complicating the issue, and although the VIX dropped briefly below 25 today on the notion that the crisis is nearly over (it did, however, finish at 35 when stocks turned south; the S&P ended -0.6% and just a smidge above the lows for the year), the underlying issues are not only unsolved, they may well be intractable. For a humorous analysis of the problem, follow this link (I love the Aussies!).

None of the above should be taken to imply that there was not some good news today. Indeed, in a rare show of comprehension (it must be pure chance) Rep. Barney Frank said that the requirement in financial regulation legislation that banks separate from their swaps desks “goes too far.” I clearly need to reconsider my own position if by some chance I happen to be on the same side as Mr. Frank, but I think I still agree. Now, I don’t know what his alternative is. My alternative is to regulate leverage and risk – which the regulators already have the authority to do, not to mention the “independent” rating agencies – and then leave them alone. I would pay special attention to funding risk; the notion that banks should finance their complex long-term derivatives books with substantial amounts of commercial paper that can vanish in an instant – especially if the SEC has its way (see above) – is crazy and it should be a red flag risk for bank managements and regulators. Companies, and especially banks, don’t generally die from losses; they die from an inability to get funding, and when that is short-term funding there is a regular potential for crisis. Most of a bank’s funding, if it is involved in complex endeavors, should be long-term (many hedge funds, for example Citadel, have gone about securing against this key risk themselves by issuing bonds).

Also in the good news category was the huge leap in New Home Sales. While Durable Goods was somewhat weak, -1.0% ex-transportation, that was counterbalanced by an upward revision to last month. New Home Sales, however, were just plain strong. Sales came in at 504k, versus 425k expected. The next couple of months, as the tax incentives expire, will be key. Another positive sign, apparently, was the fact that the inventory of new homes for sale is actually at a multi-decade low (see Chart, Source Bloomberg). However, that is partly because the shadow inventory of existing homes are starting to come onto the market, and this is crowding out the market for new homes (see second Chart below, Source Bloomberg).

First the good news: New Home inventory at an all-time low.

...And the bad news: Existing Homes for sale still swamp the market

One final piece of good news for the New York area, although this probably did not affect the market, concerned the awarding of the 2014 Super Bowl to New Jersey. This will be the first Super Bowl played outdoors in a cold-weather city in many years, but that will not stop fans here from going. New York/New Jersey is a great place to be a sports fan. Even funnier, to Giants fans, was Jerry Jones’ comment about whether he’d mind playing in a cold-weather Super Bowl:

“Oh, I will take that any day,” Jones said. “I’ll go up and play with the lights out … when the moon is on the wrong side of the sun.”

I have news for Mr. Jones – if the moon is on the other side of the Sun from the Earth, we are in very very deep trouble.

The smattering of good news, and the new-found willingness to mostly ignore the bad news again, at least for most of the day, helped push bonds lower. The 10y Note contract fell 16.5/32nds and the 10y yield rose to 3.20%. The Treasury’s sale of 5y notes helped keep a lid on things as well. Inflation markets recovered marginally.

On Thursday, the key release will not be the GDP revision of Q1 data (Consensus: 3.4% revision from 3.2%) but rather Initial Claims (Consensus: 455k from 471k). Recall the surprise last week when Claims jumped; one week does not a trend make, but with two points you can start to draw a line…if Claims refuses to drop back down, some economists will begin to get nervous.

It is a little surprising to me that stocks weren’t able to sustain even a modest overnight gain given the news, and we are shaping up for a trade potentially much lower if the February lows fail to support prices. I think that a retracement like this, with people regaining their sanity “one by one,” is the best outcome at the moment. What we have to be wary of is if investors suddenly become sane in herds.

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