Friday, November 21, 2008

What happened?

The stock market, and pretty much every other assets are plummeting due to hedge fund, mutual fund, and private equity firm redemptions. Investors are bailing out, so these funds have to sell assets--any good assets to raise cash. They can't sell the bad assets because no one wants them. So they are unloading good assets at low prices--that's why value players are salivating, but they keep getting burned because assets at cheap prices are getting hammered and getting even cheaper. This tug of war between bottom fishers and forced asset sellers is what's causing the high volatility. Overall, tho, the sellers are winning, as they are panic selling in droves, swamping any brave buyers. Eventually, these buyers lose out (at least in the short term), as even the savviest value buyers are seeing their entry points as being too early and too high, despite metrics that suggest they are good buys. Ultimately, over the long-term, these value buyers will be proven correct, but for now, guys like Buffett and Soros have seen their positions drop by more than 10-20%, despite buying assets that have already dropped more than 50% already.

For example, if a solid company's share price has already dropped 80%, it may seem cheap. It may be, but that doesn't preclude it from dropping another 50%. Let's say a stock is at $100 last year during its peak. It is now at $20. A Buffett buys at that price, thinking he's getting it at a bargain. He may be right (based on projected earnings growth, or more correctly, discounted cash flow), but that doesn't mean the stock won't drop to 10 before bottoming out, say next year. Ultimately, if the stock is worth $50 a share, Buffett may ultimately win out (he usually does), but only if he has a long-term view. While he may be annoyed, and since he's got plenty of cash, he can wait it out.

Realize that the fixed-income market dwarfs the equities (stock market)--that's why the subprime mortgage debt bomb obligerated everything around its wake. I wrote a quick email to some folks recently:

"That's not entirely correct. Derivatives allowed investment banks to transfer that risk to shareholders and get it off their books. When default rates on sub prime mortgages reached inevitably high rates, the credit default swaps (CDS) blew up, as they insured the sketchy collaterized debt obligations (CDO).

These CDS's are basically contracts which insured these mortgages against default--in this case, highly-risky subprime mortgages to marginal borrowers. The problem was that insurers like AIG didn't charge enough premium to insure these mortgages, as everybody assumed California real estate prices would always go up, and that few borrowers would actually default. With home prices/income ratios above 10, this assumption was unsustainable. And because these derivatives were highly-leveraged ($1 could control $40 or $100 due to Wall Steet's repackaging of said debt), if those assumptions turned sour just a little bit, whatever little equity put up as collateral disappeared. And once the selling of assets to unwind from those positions began, the vicious spiral just fed upon itself, as everybody had to de-leverage from their overly leveraged positions. It became a Category 5 game of hot potato, and the investors (hedge funds, pensions, institutional money) got burned, while chasing the high yields during good times.

Wall St. did a great job of selling this "AAA" paper as non-risky, when they were extremely speculative. The ratings agencies were unknowing perpetrators of this shell game. Wall St. repackaged these @#@% loans, and the ratings agencies gave it their blessing as low-risk, investment-grade securities. What compounded the problem is that some of this paper was created without even any mortgages to back them.

Derivatives by definition use leverage. It can be useful for hedging strategies, but hedge funds didn't use them as hedges--they used them as levers to squeeze out more returns. When the bets turned against them, they had to sell assets to raise cash as investors headed for the exits. This de-levering is causing markets to tumble.

I could go on ad nauseum, but I think you get the picture. I don't worry about what happened--I was able to avoid most of the roadkill, as I was out of the market in June. I am concerned about what's going to happen next, and I'm afraid the worst is ahead of us. We are going to see a carnage unseen since the Great Depression, as the unwinding of positions is not over yet--not even close. Thankfully, I've got a strategy in place for me and my clients which will enable us to not only survive this crisis, but also profit handsomely from it.

Without going into details, it does involve certain currency plays, financial institutions here and abroad, and various asset plays, including equities (surprisingly). More shoes will drop, and there will be bigger shocks and bank failures, some unfathomable only a few months ago. I predicted GM would be insolvent as far back as two years ago when people thought I was crazy (all documented in my blog). Last month, CNBC splashed it on their headlines, and now CNN has it on theirs.

I can send you a link to my blog, as well as what to Google. I will not do the research for you, but I will point you in the right direction. I will tell you the strategies will not be mainstream or conventional, but then again, conventional hasn't worked, has it?

I will give you this thought in case you think I am ringing alarm bells unnecessarily. Everybody is bitching and moaning about a $700 billion bail out (which is less than $1 trillion). Recall I mentioned CDS's as basically insurance--only they were labeled by Wall St. as "swaps" in order to avoid regulation (insurance contracts are heavily regulated, and you can't pile leverage on them). They were creating these insurance contracts with no regulation, and hence, no reserves to cover them. Guess how many swaps were written, and how big the derivatives market is? Some are predicting over $500 trillion! (A definitive number is difficult to calculate since these products were so complex, were sold so many times, and generally not transparent). In other words, there's no bailout that will mitigate this deleveraging. The current band aid will only prolong the process, but the perfect storm will come down upon us--soon."

As an edit: we've lost $10 trillion in equities market capitalization (net worth) in the last two months. That figure will seem minuscule when these derivatives blow up in our faces, and when Paulson et. al will no longer be able to hide it from the public. Read his past comments over the past year and a half. You will see he has hoodwinked us all along.

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