Friday, May 7, 2010

Leverage as Liquidity isn't liquidity at all.

Over time there are ideas, as those ideas gain acceptance they become policy, and eventually policies become truths due to self-reinforcement.  That is, until their validity gets tested.  It is not until the final stage, where the truth in the policy is tested, that the "real" truth is uncovered.

Recent examples include:
  • Housing prices, on average, will always appreciate;
  • An EU sovereign can never default;
  • An AAA rating is as safe as it gets;
  • The US Dollar as a reserve currency will always be a safe-haven ...
You get the idea.  What is the true value of a stock, especially one that pays no dividend?

What occurred yesterday was a loss of leverage.  It was an Event, not a sign of what "loss of liquidity" will do to the markets.  Leverage as liquidity isn't liquidity at all because leverage can be called/pulled all at once, and the distributed loss of liquidity resulting therefrom results in a snowball of defensive posturing by institutions who have too much skin in the game if they can't cover the calls without having to punch market orders as fast as their fat fingers can move.

If liquidity loss due to leverage loss, even if caused by high frequency trading, is to blame for yesterday, then there exists in the market another leverage bubble whose hollow core equity valuations temporarily fell into.  If there exists a leverage bubble then, indeed, we are in an equity valuation bubble.

This rube doesn't expect the bubble to pop.  I expect the next phase of the market to be generally horizontal, but with specific (under/)performance as the stretched valuations of some of these pigs are tested with a few quarters of results.  Alternatively, some of the tougher to DD names locally and abroad will be examined more closely in the search for appropriate valuation and the alpha resulting therefrom.  I also expect institutional equity deleveraging as retirement account suckers load up on the "counseling" of their advisors at Douchenozzle Capital, plying them with group sessions and charts, and begging them not to "miss the rest of the rally."

If yesterday was an attempt to Shock and Awe elected officials against cracking down on I-Banking practices it will probably work.  Most elected officials are culturally sophisticated dopes without the ability to free think, rather relying on inciting their contingencies with headlines and obscure stats.  If yesterday was an experiment, the outcome was rigged not because of the action, but because of the unexpected jarring to the system.  Again, yesterday was an Event.  It would be like instituting the uptick rule without telling anyone instead of giving the market 9 months to institute the policy after 18 months of consideration and panel meetings.  If yesterday was a carry trade collapse as is widely suspected then we see highlighted once more the disproportionate weight individuals have over what is supposedly the world's preeminent economic model.

From last March the idea has been that America would not fail, that the global economy would recover in time.  Over the last 13 months this notion has been reinforced by strengthening equity prices, moderating new unemployment, and increased consumer spending.  The policy has been to buy all dips as present earnings ratios are still undervalued relative to historical means.  The validity test will be whether broad market pricing can support the past averages.  There are good deals and there are pigs.  As Zachary Karabel said, "I am a buyer and a seller here."