The Deleveraging and Credit Hangover

It has been a while since my last post, in part because August is the month where many families (including mine) take holidays, and in part because I too have been digesting what to make of the market’s recent turmoil. I was both surprised and flattered by the response to my last posting and want to thank readers for your comments and reactions. Although I’d read to expect this, the Blogosphere is indeed bigger and farther reaching than I thought.

Today’s post mostly lists a number of questions going through my mind about how to interpret recent events. As a result it is a little less organized than usual. Still, I think the answers to these issues will tell us a lot about what to expect moving forward. I don’t actually have answers to these questions here, but I’m sure that knowing the answers will help to define strategies moving forward.

Question #1: is the worst over, or is there another shoe about to drop?

Question #2: although volatility has increased substantially, overall market prices have not suffered a large correction in (recent) historical terms; why is this?

Question #3: quantitatively driven funds were squeezed hard in the August turmoil; have fundamental funds been similarly affected, and if not, why?

Question #4: to what extent is the fund-of-funds community affected?

To keep the posting lengths manageable, I will address questions will stem over several posts. Here I address question #1.

1. Is the worst over, or is there another shoe about to drop?

My piano teacher used to point out that musical errors tend to come in pairs. First comes the initial, often unexpected mistake, and then comes a more predictable choppiness as one attempt to recover one’s place in the rhythm and melody. Because most classical music is set to measures of a fixed number of beats, the two-error pattern makes some sense. As a player unbalances one part of the measure, the line must be rebalanced somewhere else, precisely - and also differently from originally written - in order to continue with the piece in time.

Similarly, as a financial pressure comes from one unexpected event, accounts, portfolios, and trading strategies need to adjust to absorb them. If that adjustment is feasible, some return to normality is possible, even if a financial shock still has a noticeable effect.

Although my teacher did not elaborate further, I noticed that the real test is whether one truly recovers the musical line following that second glitch. After error two, the piece might continue, albeit with shaken confidence, but a third error would typically result in a harmonic death-spiral requiring one to stop and start over from scratch.

Technical traders often comment that markets have a kind of musical rhythm of their own, and I believe the three-error test - which I pose entirely as a hypothesis - has valid roots in human psychology. We are human beings and know that we can make mistakes and errors, sometimes big ones. When these mistakes happen, we enter a kind of “emergency mode” to try to resolve them, and these can lead to over-corrections that then themselves get more fine tuned corrections. If we are successful with this correction and the smaller fine-tuning that follows, we feel confident that we have been able largely to manage the situation and can therefore continue ahead. However, if a third large-scale calamity happens, many of us suddenly doubt whether we can truly understand or manage the situation and panic, flee, or massively overreact.

In 1929, this 3 pointed panic was clearly evident. Before the famous “Black Tuesday,” there was also a “Black Thursday” and a “Black Monday.” Black Thursday, October 24th 1929, was the first sudden drop in the US Equities market, which shocked observers so certain that prices could go nowhere but up. This drop produced stunned surprise, but the tide was turned on Thursday when Richard Whitney, vice president of the NYSE, ran across the floor, using funds his personal account to buy shares, push up prices, and turn the mood more positive. The technique worked that day: prices began to rise, and they rose further Friday as investors began to worry that they had missed a buying opportunity at the dip.

By the weekend, many thought that the trouble was over and clear skies lay ahead, but on Monday, October 28th, stocks fell again as investors reduced their exposure “just in case” and through the accumulated leverage, drove prices down again. No one stepped in to save the mood this time, and the result was the second worst percentage drop in US Stock history (the first was 1987’s Black Monday). This second event underscored that the previous intervention did not successfully salve the market, and people prepared to run for the doors. By Tuesday, word had spread and people began mass selling (the harmonic death-spiral) and a generation of Americans concluded to stay far far away from the stock market. As a result, US businesses found it extremely difficult to acquire capital and the following recession was exceedingly prolonged.

In 1987, however, we did not see this three-beat rhythm, and although traders were greatly hurt, the sudden crash did not result in an enormous crisis of confidence. The Fed stepped in the very next day, lowering interest rates substantially, which helped to provide a liquidity cushion and to increase the value of assets. This seemed to work, and prices picked up. Indeed, from a long term perspective, the overall market trend appeared to pick up right where it had left off, albeit at a lower level. On long term graphs of the Dow Jones Industrial Average (see a DJIA log graph and linear graph ), one has to look carefully even to locate the 1987 event. In this case, there was a shock and a recovery (though not a bounceback). If the proposal I am making is correct, a second shock in 1987 would have made a recovery substantially more difficult, because it would challenge the belief that the system could withstand a single shock.

So what does this mean for today? As funds have deleveraged, it appears that markets as a whole have returned to some kind of normal behavior. Every day that passes suggests that the system has absorbed this risk and found a way to pass around the pain of liquidity losses. Unfortunately for quantitative funds, even though markets have roughly returned to their absolute performance levels, what appears to have happened is that quantitative funds deleveraged on the way down to control risk, but then were insufficiently leveraged on the way back up to recover their losses in line with the larger market. The trading community would probably recognize this as one of the ironic behavioral quirks that all floor traders must come to grips with.

The fixed income market may have more adjusting to do than the equity markets. Fixed income portfolios actually have assets that have been written down, and trading strategies that depended on holding MBSs, CDOs, and CDSs for short periods may find that these items do have value, but only when they are held to maturity. Therefore, this might be a good time for buy-and-hold strategies in the fixed income to take advantage of low prices created by panic from higher frequency trading strategies.