Wednesday, July 29, 2009

Are ABX and CMBX Pointing to Economic Stabilization?

ABX.HE, or better known simply as ABX, is a collection of asset-backed securities indices administered by Markit. Without going into too many details, these indices basically track the price of residential mortgage backed securities and thus are an excellent barometer for the housing market. Our prediction is that these indices have to at stabilize for economic recovery to be possible. Let's take a look to see where we stand.

Below are a selection of ABX charts, from ratings AAA to BBB-, which began trading on July 19, 2007 (click on images for larger views):


The AAA index has turned up decisively in the preceding months.


The AA index looks to have stabilized, though at a remarkable 4 cents on the dollar.


The single A index has rebounded a whopping .4 cents, so let's call it stabilization anyway.



BBB and BBB- have stabilized as well, though glancing at the charts they may just not be trading at all anymore.

Like the ABX indices track residential mortgages, the CMBX indices track commercial mortgages. CMBX began trading on March 7, 2006. Below are a selection of CMBX charts, from ratings AAA to BB:

AAA has been trending up since March with no signs of trouble.



Double A and single A have been less steady than the AAA variety but still the trend is decisively up.


BBB does not look as strong as the other indexes but is still 4 cents off of its bottom.


Double B looks by far the weakest and while it has not made a new bottom, does not look like it has quite stabilized either.

What conclusions can we draw from examining the ABX and CMBX indices? It appears that most of the indices at the very least have stabilized. Looking at other price indicators, such as Case-Shiller, Residential housing prices look to have stabilized some while commercial prices are in free fall still. For the time being, the case can be made that the worst may be behind us as far as real estate goes. This is a far cry from a new bull market and strong economic recovery, but it is more than we had to cling to six months ago. Now what happens when monetary policy has to tighten again may be another story...

Tuesday, July 21, 2009

Fed Open Market Operations Update III

It's been almost two months since we last posted on the Federal Reserve open market operations so here is our long overdue update.

The Fed has purchased an additional $86.2 billion of treasury bonds since May 27th for a total to date of $216.7 billion:

The Fed has purchased $23 billion in agency debt since May 27th and a total of $116.4 billion since the program started:

The Fed has also purchased an additional $157 billion of agency mortgage backed securities (MBS) since May 27th for a total of $683.6 billion since the program's inception:

Here are the up to date totals for each open market operation type:

Back in May, we predicted that additional treasury bond purchases were likely. So far, this has not materialized. There could be a few reasons for this. First is that long term treasury bonds have rebounded. The 10 year bond now yields 3.49%, down substantially from over 4% only a few months ago. The second reason is that the certain economic indicators have also rebounded. The Fed's projection was to purchase $300 billion in treasury bonds through September. With current purchases already at $216 billion and September rapidly approaching, it will be interesting to see how the Fed proceeds from here. Is the program allowed to expire, will it be renewed or will it be expanded? If yields stay this low we are predicting that the program will be allowed to expire.

And what of the agency and MBS purchases? These programs might be allowed to expire as well but allow us to make a new prediction. We think this program will be rolled into a new program specifically for commercial real estate instead of the existing residential mortgage program. For those paying attention, commercial real estate is experiencing an epic free fall and has emerged as its own crisis in the making. Commercial real estate fell 8.6% in April from the prior month and 7.6% in May from April!

If the Fed is in the business of preventing epic market collapses then it has not choice but to make a move to attempt to stabilize commercial real estate and soon. It is either that or let the banks take massive losses and let the whole thing develop into a new Lehman style systematic banking collapse. Our view? The Fed will try to head off this new crisis before it develops. Whether they succeed is a topic for another day.

Sunday, July 12, 2009

Central Banks v. Markets - Who Will Win?

One of our favorite topics here at So? is the relationship between global trade, treasury bonds and the dollar. The geopolitical policies that drive these three concerns are one in the same. There were imbalances building in these relationships for many years but while the world economy was humming along nicely, everyone was content with the status quo. With the continuing economic collapse, however, market forces are ravaging economies and the wisdom of the prior policies is being questioned. Allow me to spend today's article summarizing the situation. It really is quite simple once you take the time to break it all down.

Here is the basic relationship: there is a trade imbalance between the United States and the rest of the world. The US simply imports more than it exports. This leaves the US with an abundance of foreign goods and foreign producers with an abundance of dollars. Foreign nations plow these excess dollars into US treasury bonds. They do this for two reasons. One is to artificially prop up the dollar's value and thus keep down their own currency. This is important for their exporters to remain competitive in the game of selling goods to US consumers. The second reason is because they simply have nothing better to do with these dollars. Some nations try to use their dollars to buy US companies, but these efforts are often rebuffed by the US government - see Chinese Drop Bid to Buy US Oil Company and The Dubai Ports World Controversy.

The relationship described above is now threatening to break apart. The catalyst is the US consumer's new frugality. See the personal savings rate as a percentage of disposable personal income courtesy of Calculated Risk:

The long decline from 12% to below zero for the savings rate has ended. Since the recession began the rate has now increased to 6.9%. I expect this rate to reach at least 8% by next year, which is the long term average savings rate. Since incomes are stagnant and savings are rising, this means that consumption must decline. Note that this is good news for the long term, despite what some political hacks and crooked economists might tell you.

Why have consumers stopped spending? There are many reasons. First, because of the economy, many people have lost or are afraid of losing their jobs. No jobs means less spending. Second, demographics. Older people tend to spend less money than middle aged people. As the US population ages, it will spend less in aggregate. Third, the level of credit available to US consumers is in decline. Home equity withdrawals, a key source of credit from 2002-2007, has declined precipitously. Credit card companies are tightening lending standards, lowering limits, increasing minimum payments and raising interest rates.

The US consumer is tapped out. This means that the US trade deficit is declining. See that the trade deficit declined in May courtesy of Calculated Risk:

The trade deficit has decreased. This means that foreign exporters are selling less goods to Americans and their manufacturing has collapsed. See global manufacturing has collapsed courtesy of the Federal Reserve of Dallas:

This means that foreign countries now have less excess dollars now than they had previously. This of course means that there are less dollars to buy US Treasury bonds. This means that Treasury bonds and the dollar must have collapsed, right? Well, not yet at least. Here is a one year dollar chart:

And here is a one year chart of the ten year treasury note:

The longer term charts are not as pretty but clearly there is no collapse yet. Why? One reason is that the dollar and treasury bonds are still seen as safe havens and because of the global recession, there has been increased demand for safe assets and thus dollars and treasury bonds. This is a tenuous psychological response that could give way at any time if market participants reassess their prior biases. Second, central banks have been intervening in the currency and bond markets. See the Swiss franc has depreciated because of the intervention of the Swiss central bank. Next see "Rambo" Fed buys treasuries.

What is going on here? Global trade has been imbalanced for a very long time. This was unsustainable and finally came apart in the past year. The markets want to weaken the dollar and weaken US Treasury bonds until the US trade deficit becomes balanced. This also entails a large decline in global manufacturing, which is too painful for policymakers to accept. The world's central banks are trying to prevent market forces from correcting these imbalances. For now, it is working in two respects: the dollar and treasury bonds have held their value. The intervention is failing in two respects: global trade and US consumer spending are not returning to their prior levels.

So who will win in the end - the central banks or the market forces? In the short run, we cannot know for sure. Global trade and US consumer spending could rebound in the short term. In the long run, however, the market always wins. Until next time...

Wednesday, July 1, 2009

Inverse and Levered ETFs

Over the last decade, Exchange Traded Funds (ETFs), have been one of the fastest growing segments in financial services. Within ETFs, inverse (bear) and levered funds have been gaining enormous popularity. Let's take a few minutes to examine the performance of certain funds then we will draw some conclusions.

To see how an ETF should work, let's compare the 10 year performance of the S&P 500 with SPY, the SPDR S&P 500 ETF (click on images for larger views):

In the past 10 years, the S&P 500 has returned -29.8% while SPY has returned -29.89%. This is about as good as performance gets.

Now let's compare SPY to SH, the ProShares Short S&P 500 ETF. Ideally, SH should return the inverse of SPY:

The one month return for SPY is -2.56% while for SH it is +1.73%. That is a degradation of .83%. That might not seem like much, but let's look at the returns over a longer time period:

Over a 6 month period, SPY returned +2.31% while SH returned -9.16%, for a degradation of 6.85%. Let's zoom out just a bit farther to one year:

Over a one year period, SPY returned -28.1% while SH returned -5.87%, for a degradation of 33.97%! In other words, in one of the worst one year returns in stock market history, holding an inverse stock fund resulted in a net loss!

If you think this was a fluke let's look at the one year return of QQQQ, the Nasdaq ETF, versus PSQ, the ProShares Nasdaq ETF, versus PSQ, the Short Nasdaq ETF:

Over a one year period, QQQQ returned -20.53% while PSQ returned -5.67%, for a degradation of 26.2%.

For good measure, let's compare the one year performance of EEM, the iShares Emerging Market ETF, versus EUM, the ProShares Short Emerging Market ETF:

Over a one year period, EEM returned -26.05% while EUM returned -33.14%, for a degradation of 59.19%.

Not all inverse ETFs are made equal. Let's compare USO, the United States Oil Fund ETF, with USL, an alternative oil ETF, and SZO, the PowerShares Inverse Oil Exchange Traded Note (ETN):

USO and USL returned +31.07% and 26.28% respectively while SZO returned -29.58%, about what one would expect from an inverse fund.

Let's look at the one year returns:

USO and USL returned -67.26% and -55.47% respectively while SZO returned +112.81%. Again, this is about what one would expect from an inverse fund. I will try to post an article in the future on why SZO performs so well compared to the other inverse funds. Moving on...

In addition to inverse ETFs, levered funds have also become quite popular. What many investors might not realize is that these funds are geared to return the DAILY specified leverage and not long term leverage. What this means is that if the index returns +1% today, a 2x leverage fund should return +2% today. Over a longer time frame, however, returns will degrade in a similar (or worse) manner than inverse funds.

Let's examine our earlier chart with SPY, the S&P 500 ETF, and SH, the inverse S&P 500 ETF, but then add the double long fund (SSO) and the double short fund (SDS):

SDS, the double short fund, returned -17.42% while SSO, the double long, returned an astounding -55.99%.

With all of the power that double daily leverage brings you, let's go one step further and use three times leverage! Below is an 8 month comparison between XLF, the SPDR Financial Sector ETF, and FAZ, the now notorious Direxion Financial Bear 3x ETF:

While XLF returned -14.9%, FAZ returned a remarkable -93.67%! Being that FAZ launched a mere 8 months ago at $74 and it now trades at $4.70, how much longer will it be before the fund literally trades at zero?

Direxion has a whole portfolio of ETFs with 3x leverage which you can view here. Of the 20 funds they offer, all were launched in the past 8 months and all have negative returns (their return results are outdated). Talk about a fly by night organization.

***UPDATE***Just after posting this article I saw this piece of news. "The Board of Trustees of Direxion Shares ETF Trust has approved reverse splits of the issued and outstanding shares of both the Direxion Daily Financial Bull 3X Shares (“Financial Bull Fund”) and Direxion Daily Financial Bear 3X Shares (“Financial Bear Fund”)." The reverse split will be five to one. Absolutely hilarious.***

What conclusions can we draw from this exercise? Be very careful when investing in inverse or levered ETFs. Both usually work in a similar manner in that their performance degrades over time. Holding them short term might be OK but long term they are usually suicide. Before you invest in a levered or inverse fund, make sure to check the fund performance against its index over a time period equal to your expected holding period. If the fund does not have a long enough track record to compare it is likely not worth the risk.