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Weekly Market Commentary, February 19th 2008
Posted by Sean Hannon
February 19, 2008 at 5:00 pm
The direction of financial markets is determined by two distinct groups of people. On one side of the table are long-term investors who focus on the fundamentals of a business. On the other side are short-term investors who look at popular sentiment to derive their trading strategies. Their methods of determining value are complete opposites. Long term investors look at a stream of income that can come from a company’s earnings and dividends, a bond’s contractually obligated interest payments or a combination of multiple other factors. Short term traders care about what someone will pay them for their piece of paper in a matter of minutes, hours or days. Over many years, the long term adherence to fundamental value will always trump investor sentiment. However, the path that takes us from current prices to a projected value can be filled with many twists and turns.
As our economy and society have evolved, innovation occurs. Products that were never feasible become the norm and people’s tastes adapt to their new environment. Over the years, this has led to many investment fads where a new technology develops, stock prices levitate, the market for the product becomes oversaturated and then stock prices decline. From disk drive makers in the 1980s to various internet ideas in the late 1990s to mortgage lenders during the housing bubble, the pattern is the same. What I find interesting is as society evolves, irrationality does not change. When it comes to investment speculation, the mistakes that were made hundreds of years ago continue to be made today.
While the description of various asset bubbles and their aftermath are the subject of many books, the pattern can be summarized as follows. A new idea is created that promoters want to sell to the public. Initially, skeptical investors are wary and do not begin purchasing. This keeps the market small and inefficient. Within inefficient markets, select people reap tremendous profit and the news of their success spreads. Intrigued, people begin looking at this product and investor’s interest increases. As more buyers come into the market, liquidity blossoms and the product is created at a rapid pace. Constraints that were once thought to be prudent are pushed aside as people determine that extreme negative events will not occur. As caution is dismissed, underwriting standards slip, quality declines and investors are left with unpleasant surprises.
Anyone following the credit crisis knows where we are in this cycle. In the aftermath of the dot-com bubble, the Federal Reserve (Fed) reduced interest rates to a point that a credit bubble began inflating. As the bubble grew, the financial engineers on Wall Street churned out an array of complex debt instruments. The alphabet soup combination of MBS, CDOs and SIVs created financial instruments that appeared to have little risk yet also paid their investors higher returns. This combination of return without risk increased demand and the size of the market. As the market grew, underwriting standards declined and these instruments became more risky. Aggressive investors asked since there were no losses in the past how could there be losses in the future? Obviously they were wrong and losses have occurred. In fact, the credit losses have shaken the foundation of our financial services industry and led some to question the soundness of the banking system.
Looking at this disaster, it is easy to feel uneasy. Such a shock to our markets could lead to serious problems. However, there is always the chance to profit from short-term missteps. As an example, look at another acronym I did not mention - the auction rate security (ARS) markets.
Auction rate securities are long-term bonds offered by municipalities. Although the term of the bond may extend for over 20 years, the interest rate is determined by bidding that occurs every 7, 28 or 35 days. The intent of the security is to offer long term borrowers (the municipalities) the ability to issue long term bonds, but receive short term interest rates. Also, investors (the buyers of the bond) purchase long term bonds with the liquidity of short term instruments. While this sounds ideal, there is always a caveat. What happens if no one arrives at the scheduled auction to buy the new bonds? Rates at failed auctions are set at a level specified during the initial bond sale. However, everyone deemed the lack of buyers to be so remote that no attention was given to this contractual interest rate.
As could be expected, something eventually went wrong. As the credit crisis has spread, buyers of ARS have disappeared. As auctions have failed, solid borrowers have been forced to pay excessive interest rates on bonds with little chance of default. Two examples are the Port Authority of New York and New Jersey who received an interest of 20% following a failed auction on February 12th and the Pittsburgh Medical Center whose interest rate reset to 17% last week.
A quick glance at these events would lead most to say the credit crisis is worsening, spreading and will eventually destroy our economy. I take a different view. Within this crisis, opportunity exists. The chance to lend to solid borrowers with little chance of default and receive interest rates between 17-20% is ideal. A borrower with a sense of value and confidence in their ability to assess and price risk can profit while others panic.
While the ARS market is beyond the reach of most investors, the lessons of this episode can be appreciated by everyone. When things appear the worse, opportunities are often the greatest. By looking through short term investor sentiment, you can often profit when others panic. Develop a sense of what you think an asset is worth, continually assess whether your assumptions are valid and look for opportunities. When the market gives you a chance to profit, seize it. Those opportunities do not often last. By staying disciplined and acting when others are indecisive, you increase the likelihood of growing your wealth over time.
Awesome read Sean. I think a lot of investors delay and act when it is way too late. The ability to profit when the sentiment is at its, “worst” is definitely invaluable. I like your comment on confidence and staying disciplined at the end as well, it can be really though to buy when Wall Street media constantly screams sell.
Incredible and well thought out read, thank you, I had to re-read it a couple of times and mull it over.
It also made me think in context of the global market and the fact that many countries seem to lag behind the USA on innovation. So….that being said I’ve been looking to some ADRs currently, but still playing domestic for the most part at the current time in my investment strategy.
Regards, Ray