"You want 'flation with that?"

In the past few decades, with all the talk about the neither-too-hot-nor-too-cold-but-just-right “Goldilocks Economy,” one has not had to think a great deal (in the United States) about inflation. In my earlier career, which involved Brazil, Argentina, and other historically inflation-prone economies, one could not even have a discussion about business, finance, politics, or any economic matter without at least considering an analysis of inflation expectations. One knew, however, that too much printing of money (typically to finance public sector needs) would almost certainly exacerbate inflation and - if you lived in one of those economies - the optimal solution would be to send one’s assets out of the country or into hard assets that might plausibly track the coming inflation.

In 2005 and 2006 as we watched the United States keep interest rates historically low, pursue an expensive war in Iraq, and maintain a large current accounts deficit, I became convinced that the lessons of countries like Brazil were about to be learned in the United States (an analysis I still largely believe), and positioned myself for increases in inflation. Over the long term, I still believe this is the right position, but my positions (gold, commodities, TIPS, but not - for obvious reasons - real estate) did get hurt by the collapse of the commodity bubble and the expectations for DEflation.

My analysis had gone wrong because my inflation/disinflation/deflation analysis had centered too much on watching the actions of fiscal and monetary authorities, and had missed the deflationary impact of across-the-board collapses of asset prices caused by deleveraging and panicked selling. Simply put, when people have bought assets at inflated prices (caused this time by easy credit/liquidity), and those assets are suddenly worth 20-40% less than they were, that money has essentially vanished - POOF! - from the money supply. Even if this only happens with publicly traded assets like stocks and commodities, the reduced money supply filters back into the rest of the economy, and brings on deflation. There is less money to go around, and therefore things simply need to cost less if they are going to be sold.

Dangers of Deflation

If people and businesses suddenly feel poorer because of paper-losses and thus slow down their spending (reducing the velocity of money), then this situation can perpetuate itself, leading to a depression. Businesses have to lower their prices and may have to sell so low that revenues cannot cover costs, creating bankruptcies, grater unemployment, more fear, less spending, and so forth. For the moment, this is certainly the great deflation worry about the economy, and it is a fair description of how the 1929 stock market crash contributed to the collapse of the economy in the Great Depression.

At first, deflation might sound appealing, since it means that most things will start to cost less over time. The biggest problem with deflation is that it removes the incentive to invest, because cash will buy more assets over time without requiring making risky investments in debt or equity. As a result, firms cannot get capital for expansion, so all but the most profitable businesses begin to shrivel and die. That exacerbates unemployment, hurting remaining businesses, and perpetuating the depression in a vicious circle.

Rescue Helicopters

Federal Reserve Chairman Ben “Helicopter” Bernanke earned his nickname by suggesting that deflation could potentially be solved by dumping money out of a helicopter as a “money gift” so that consumers have enough spending power to keep businesses and employment afloat. This philosophy informs a great deal of the Fed’s and Treasury’s current actions to prop up banks and bail out key industries. Estimates of total infusions to date rise as high as $8.5 Trillion, or just over half of annual US GDP.

In traditional political economy, a central bank that infuses such large quantities of money is risking inflation and possibly hyperinflation. It is a dangerous game with potentially disastrous consequences. But is also a game that is typically played only when the alternatives are just as dire. If a deflationary spiral is the fear, than the proper policy is to try to inflate the currency deliberately, and a policy that is seemingly irresponsible in normal times suddenly turns sensible in extraordinary times.

Crisis, Response, and Possible Results

So what we are observing today is a massive collapse in the money supply caused by the crash of stock, bond, commodity, real estate, and other prices. In the equity markets alone, the 40% decline in the Wilshire 5000 since January 2008 has eliminated almost $7 Trillion in US market capitalization, $5T of that since the beginning of September. This is money that has simply vanished from the system. Consider the real estate and bond markets, and the losses are even higher. One estimate of real estate losses comes to around $6 Trillion between 2006 and June 2008. Although the exact figures can be debated, the net effect is that remaining assets, goods, and services need to be priced lower to reflect vanished purchasing power, roughly in proportion to the contraction in circulating money and available credit.

As a result, the creation of money through Federal Reserve purchases, Fed lending, treasury expenditures, and new government spending suddenly does not look as dramatic compared to the monetary losses that the economy has already incurred. Fiscal and monetary policy may need to inject capital and funds at the same order of magnitude as the losses in order to avoid the deflationary spiral, and this means that the economy may be able to absorb substantial inputs before we reach a point where inflation or hyperinflation become major risks.

It is probably not necessary (or even a good idea) to provide enough money to “top off” assets to where they were at the market’s peak, but it might make some sense to use - as a rough guide - a desire to bring asset prices to the level they would be after a two standard-deviation loss, given historical norms. It is clear that assets were overvalued because of easy credit and the urge to speculate on risky assets, but if the loss is on the order of a once every 20 year loss, this should be the kind of event that most reasonably responsible organizations should have some kind of contingency plan for.

Relative price distortions, or “up is not the opposite of down”

One problem with deflated asset prices is that the relative prices of goods, services, and assets get distorted. For example, the relative value of diamonds versus bread can get highly distorted when money and credit is flush, since one does not need to eat substantially more bread, but one might be buying substantially more diamonds. When there is a sudden deflationary shock, one challenge is that ordinary consumers and businesses start to lose the ability to plan and budget accordingly, because prices may change in unanticipated ways, making business and living intrinsically more risky. One reason to try to “top off” the money supply would be to reduce these distortions, because people are typically better able to adjust to small changes in relative prices than they are to very large shifts.

Both monetary policy and increased fiscal spending can increase the money supply and therefore help combat deflation, but the two policies will have different effects, and these effects will shape the kind of price distortions that businesses and consumers will experience. Increased fiscal spending, such as the infrastructure investments and other spending proposed by the incoming Obama administration, has the advantage of increasing the money supply, which will combat deflation, and also target specific areas that are consistent with a long-term industrial strategy, but these policies will tend to increase interest rates because the United States will need to pay higher rates to convince investors to lend more money.

Compared to fiscal expansionary policy, monetary expansion is relatively untargeted, and will tend to inflate prices across the board as banks access the Fed’s credit facilities and (hopefully) spread liquidity through the financial system. Monetary expansion will still have some price distortions due to the fact that only certain types of institutions are able to access loosened credit from the Fed, and indeed a major problem of the present situation is that the types of banks that most liquidity from the Fed have not traditionally been allowed to access it. However, the Fed appears to be making its policies more flexible in terms of what it will purchase on the market (and from whom) in order to address these needs.

Traditional economic analysis sees “distortions” as bad things for the economy, but in this case, distortions may not be entirely bad or undesirable. The truth is that some investments in the past 10 years were clearly bad investments, or investments that dramatically understated the risks, and many investors took on levels of risk that were unsustainable. The goal of policy -- fiscal or monetary -- should not be to make responsible investors whole, but to protect the parts of the economic and financial system that have been affected by this crisis and which, if allowed to fail, will bring the entire economy to a halt.

Policy and market implications

What this means, practically, is that policymakers will need to come up with a set of principles that can separate what assets or businesses are entitled to government assistance/bailouts and what assets or businesses should be left for the process of “creative destruction” to purge from the system. This is vital so that businesses and investors can plan appropriately for the emerging environment. At the level of firms, the chief argument is that the firms receiving help will form of vital part of the economic system and that letting them fail will create such an enormous hole in the fabric of the economy that the economy may not recover for half a decade at least. Another key factor is that firms which made substantial profits during good times should have some kind of reserve for lean times, whereas companies who did not make major profits and did not contribute to the creation of the systemic problem have more of an argument or government assistance.

The point of fiscal and monetary stimulus is not simply to hand out money in order to make people feel as wealthy as they did before the crisis -- this would be irresponsible -- but rather, to avoid the hoarding of money that can lead to a deflationary spiral and a long-term depression, and to enable investments in genuinely productive activities that can form the basis for a future economy and future employment for citizenry. The American economy has major challenges ahead of it, the largest one being the quest to find what the average American can produce that has sufficient value to buyers around the world so that it can support a middle-class lifestyle in the United States. The creation of this economy, or the structural foundation for it is where the opportunity lies. One of the key policies may well be to provide small business loans in strategic areas.

Summing up, the sudden deflation of asset prices in the stock market and real estate crashes provides an opportunity to make new injections of capital serve complementary purposes. In the short term, both monetary and fiscal policy can soften the effects of deflation to avoid the deflationary spiral that caused the Great Depression. These policies should not aim to bring prices back to their levels at the peak, but they should bring prices to a level that might be considered a “major correction,” as opposed to a “crash.” At the same time, it is not necessary to pump all prices back to earlier levels, there is an opportunity to shift investments to the infrastructure, knowledge, and incentives required for a newly productive American economy. Some major parts of this policy should include:

• Putting spending power back in the hands of consumers


• Bailing out critical sectors of the economy (sectors with dense linkages to other areas of the economy)


• Small business loans (and potentially preferred equity) to entrepreneurs in strategically important sectors


• Assistance for existing industries to develop strategies to become globally competitive


• Flexible workforce retraining programs, potentially with scholarships/stipends for structurally dying industries

What is ironic about these policies is that while the current crisis has come from excesses of spending, borrowing, risk, and greed, the solutions appear to be helping to perpetuate all of these problems. It is counterintuitive to think that if the present pain is somehow “punishment” for past sins, the most sensible policy in some way allows some of these excesses to continue. The main issue is that, although many past financial habits should not be continued, it is not possible to go “cold turkey” without the cure being worse than the disease. If we think of ourselves as to highly leveraged as a country, the trick is to enable us to come down slowly rather than crash to the ground.

Risk of inflation and stagflation

While deflation is the current bogeyman to be avoided, this excess liquidity does present a danger of producing inflation or hyperinflation down the line. There is even a danger of stagflation if fiscal policy is unable to create the conditions for sustainable growth. Indeed, close coordination between the Treasury Department and the Fed will be critical because the combination of those expansions will determine the degree to which interest rates rise or fall as both policy tools are utilized. If monetary policy is too lax, excess credit will simply perpetuate the financial habits which created this crisis, because money will be too cheap. If fiscal policy is too ambitious, it will drive up interest rates and make it difficult for the non-targeted parts of the private sector to obtain the capital necessary for resumed growth and productivity. It will therefore be a balancing of both policies which has the best chance of seeing us through this crisis.

Perhaps most importantly for the new administration and Congress is the need to develop clearly articulated principles for federal spending and fiscal policies. One danger of the current situation is that many industries will line up for handouts with the simple argument that “I’m hurting.” Funds should be available for moving this country onto a newly productive tract, and families that have been caught between the gears of a structural shift or globalization should have resources available from the government to help them cope, but everybody needs to have an image in their mind of what we want the United States economy, businesses, and labor force to look like five or ten years from now so that we can identify what activities will be supported and rewarded. Fortunately, the President-elect appears to be someone uniquely able to accomplish this; there is no guarantee that he will be able to, but he is more likely than anyone we have seen in a long time to be able to create the kind of consensus that is required to ensure that fiscal and monetary expansion is accomplished in a responsible manner.

How Deleveraging Makes for Market Craziness

Virtually every presentation, conference, or discussion these days opens with the statement “These are challenging times for markets,” or some equivalent. Part of the challenge, of course, is that it is simply difficult to make money from investments in down markets. This is especially true if there are long-only restrictions on one’s portfolio or mindset, but even when short positions are possible, a non-deriviative or margined short will at most double one’s investment, and this happens only when an investment goes all the way to zero.

It turns out that the fact that today’s crisis started as a credit crunch and evolved quickly into a leverage crisis adds an extra layer of confusion into markets that has many participants throwing up their hands and wondering if there is any logic left to markets. Bill Miller, the legendary CEO/CIO of Legg Mason Capital Mangement, noted in his second quarter letter to shareholders of the Legg Mason Value Trust :

“A point [John Rogers of Ariel Investments] made that I have likewise noted to our staff is that this is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it’s in the papers, it’s in the price -- which used to be correct. Indeed, it borders on cliche in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn’t need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).”

What Miller is complaining about is how many of the standard tenets of professional investment knowledge - that markets are relatively information-efficient, excess returns come from reacting differently than the crowd, etc. - have recently flown out the window. And Miller is not the only one. Quantitative funds, celebrated for their mechanical ability to de-emotionalize investment decisions have also been hammered as the rules-for-investing-success have essentially changed underneath them.

The craziness is because of deleveraging. As simple as that.

Superficially, this might seem self-evident. This is a deleveraging crisis, and the crisis is driving things down unpredictably, and so, naturally, deleveraging is the reason that things seem crazy. But what I’m trying to say here is that the fact that portfolio investors are trying to roll back their leverage ratios has specific effects that are different from a simple liquidity freeze or from earnings contractions in the real economy.

Why deleveraging confuses traditional market logic

To understand how deleveraging creates confusion, it helps to think about how investment decisions are made in normal market environments, and then think about how the availability and/or loss of leverage affects these decisions and the market as a whole.

Markets in “normal times”

The market portfolio (assume no leverage for now) represents the collective valuation of all assets at a moment in time by all potential investors in the market. It is essentially a weighted average of individual valuations, where the weight of any given investor’s valuation is proportional their total portfolio size. Given that the largest portfolios tend to be run by professional investors whose job is to be informed about markets as a whole and what they invest in, it is reasonable to assume that market prices and the weights of assets in the market portfolio usually incorporate a more-or-less sensible analysis of available information at any point in time. This is why the risk adjusted performance of passively replicating the market is generally difficult to beat: numerous very-large players with rapid access to the best information and analysis have already weighed in with their valuations. If one assumes that the average professional is fairly informed and has a sensible analysis of the majority of issues, then it is understandably difficult to outperform their average.

One can potentially outperform with an actively managed portfolio, but it requires the investor to have realistic knowledge of their comparative advantage. A manager could have access to better data, better analysis, a unique perspective or model, faster analysis and execution, or some other quality that offers some investment advantage. To maximize that advantage, it helps if at least some large-scale investors lack it, because a high-weight laggard will create a larger deviation between the current market valuation and one’s (presumably superior) valuation, and therefore a profit opportunity.

In normal times, active investors are placing their investments according to their valuation estimates, and passive investors are basically “piggybacking” and reinforcing those valuation decisions when they choose to use a passive index. Although there is some diversity in specific active strategies, a large body of financial and economic knowledge informs these investment allocations, much of it follows the received wisdom of what are “sound” investment strategies and the logic of how markets operate. Whether they think consistent outperformance is possible or not, most managers agree that outperformance is difficult, because the most common insights into valuation are likely already embedded in prices.

Cheap credit, low volatility, and creeping leverage

Interest rates and credit spreads have been quite low for the last decade, in part because of Fed policy to keep base rates low, and in part because of loan securitization that (rightly or wrongly) reduced premia for credit risk. Low credit spreads have two major effects on investment portfolios. First, low returns to risk-free investments decrease the attractiveness of saving and shift theoretically optimal portfolio allocations to hold a higher proportion of risky investments (defined as any asset that has the potential to lose value and therefore pays a premium for taking on risk). Second, easy credit actually enables portfolios to leverage themselves up inexpensively, increasing exposure to risky events. For many fund managers and allocators, the low-volatility environment of the last 5 years also made this look like a sensible strategy. On the whole, risky assets were returning substantially more than low-risk and risk-free assets, volatility was low, and it looked sensible to increase exposure to risky assets in general. Moreover, when nearly everyone had access to easy credit, cheap borrowing increased the demand for virtually all risky assets, sending the prices (and thus total returns) even higher year after year.

What this meant, on average, was that relative sector and security weightings were being determined based on defensible financial and economic principles, but taken as a whole, society was buying too much of them because easy credit and low volatility understated the risks. The fact that so many investors overallocated their portfolios to risky assets drove asset prices up and made these investment decisions look brilliant, when in fact these were simply unsustainable gains that had yet to correct. The more money made available through borrowing, the more ended up invested in risky assets. Within risky assets, these investments may have been placed based on rational economic insights about relative growth, competitive advantage, and so forth, but the total amount allocated to these assets was unsound.

Credit flows dry up; hello deleveraging

Eventually, the credit faucet had to turn off, as lenders found it harder and harder to find borrowers that could pay back their loans. This happened first in the mortgage sector, but also involved auto loans, credit cards, and credit more generally. The securitization that in part enabled this cheap credit is not inherently a bad idea, but as in earlier posts, it did make it difficult to do appropriate due diligence on one’s borrowers, and the loan originators had few if any incentives to select good borrowers.

When sub-prime and no-documentation loans entered the bundling stream, lenders were taking on borrowers for whom there was little or no historical data on which to create rational pricing and risk models. As a result, lenders took on far more risk than they realized. Many may simply have had no clue about the risks they were taking; others may have hoped to exit their positions before the house came falling down.

As defaults began to accelerate, lenders started panicking, sending credit premiums to new highs. The result was that the days of cheap credit were over. Portfolio managers who had leveraged up to buy more risky assets suddenly needed to sell those assets to reduce their debt and interest expense.

Here is where the seeming craziness begins.

Deleveraging makes markets look crazy

Deleveraging makes for crazy markets because, when an investor is forced to delever, they reverse (“unwind,” in industry jargon) previous positions in order to turn assets into cash and reduce debt/leverage levels. If the investor and/or the quantity of leverage is large, then these changes are likely to have an impact on market prices. Moreover, the need to deleverage does not typically come from a re-evaluation of the market’s prospects, but usually from changes in the borrower’s credit position or liquidity needs.

If we assume that investors’ portfolio compositions are created by a mostly rational and realistic evaluation of company and market prospects, what this means is that investments are placed in logical allocations when there is no need for leverage or leverage is freely available. When enough investors deleverage, the market impact of large-scale unwinding simply reverses these sensible allocations sending prices in exactly the opposite direction that you would expect, given a logical analysis of the macro-economy.

For example, suppose large investors conclude that defensive companies with stable earnings and consistent dividends are logical investments for the current environment and start tilting their portfolio allocations to take advantage of that. When one or more of these large investors are forced to delever, these “favored” companies are sold, rather than bought, sending prices in the opposite direction, even if the macro-, sector, or company data suggests that one should be buying.

Therefore, as investors deleverage, financial markets will lurch forward and back, causing market observers to scratch their heads - perhaps worriedly - wondering “why did that price collapse, while this other price rose?” During a large deleverage, a number of seemingly attractive securities will move in counterintuitive ways precisely because they seem attractive.

The price fluctuations have a second-order effect as well: it makes even experienced and competent investors less sure of their analysis and more likely to second guess themselves. This actually exacerbates the effect, since the appropriate response to increased model uncertainty is to reduce the quantity of funds that are managed with that model.

Implications

To think about the future, it will help to have some idea of how the deleveraging process will play out. Deleveraging is a painful process for everyone involved, particularly because it typically entails recognizing net losses as one exits positions. Existing leverage starts to more and more excessive as asset prices fall, which forces selling at a loss.

As a result, companies and investors will generally try to deleverage as slowly as possible, but also in sudden jumps, when they realize there is no longer any choice. At these moments, there may be pressure to take a “big bath” loss to avoid needing to deleverage again in the future. This big bath method may or may not work in any one case, but the result is that markets will have sudden drawdowns as different investors realize they can no longer hold on. Like a scared child trying to slide down a long pole, companies and investors will deleverage in rapid unpredictable jumps until they reach the ground, and every time we encounter a deleveraging slip downwards, markets will jump in the opposite direction that the fundamentals seem to warrant.

From a portfolio manager’s perspective, one possible solution would be to deleverage by choosing portfolio assets to liquidate at random. This is hard to ask a portfolio manager to do, because so much of a portfolio manager’s job is about applying knowledge and information and reducing the effects of randomness, but by randomizing the choice of assets to liquidate, one might reduce the connection between deleveraging needs and the mal-performance of otherwise economically sensible assets.

It is hard to know exactly when the mass-deleveraging dynamic will end, but one clue will be that volatility has declined as a result of large-scale moves in either direction becoming less frequent. Whether volatility will return to the low levels of the pre-crisis years is difficult to say - I think it is unlikely to return to those levels any time in the foreseeable future - but the immediate implication is that we will simply need to get used to an environment with higher levels of volatility than we have in the recent past. In fact, if one simply accepts that volatility will be high for a while and creep downwards as deleveraging needs are flushed from the system, this may be enough to guide portfolio strategy for a while.

A major part of this argument is that the need for deleveraging has made market action seem to detach entirely from company and economic fundamentals. Part of this can be attributed to a lasting increase in volatility over the levels of the past few years, and part of this is because large financial and economic changes will themselves impact company fundamentals in non-linear ways. One implication is that technical analysis methods may turn out to be more useful than normal in this market environment. Certainly, Bill Miller’s above reflects that markets are exceptionally information-inefficient at the moment, which is one of the pre-requisites for effective technical analysis. The other reason is that as fundamentals themselves become more difficult to measure and predict, the psychological element becomes a more important aspect of investment decision making, and capturing the psychological element is where well-designed technical analysis really can add value.

How Deleveraging Makes for Market Craziness

Virtually every presentation, conference, or discussion these days opens with the statement “These are challenging times for markets,” or some equivalent. Part of the challenge, of course, is that it is simply difficult to make money from investments in down markets. This is especially true if there are long-only restrictions on one’s portfolio or mindset, but even when short positions are possible, a non-deriviative or margined short will at most double one’s investment, and this happens only when an investment goes all the way to zero.

It turns out that the fact that today’s crisis started as a credit crunch and evolved quickly into a leverage crisis adds an extra layer of confusion into markets that has many participants throwing up their hands and wondering if there is any logic left to markets. Bill Miller, the legendary CEO/CIO of Legg Mason Capital Mangement, noted in his second quarter letter to shareholders of the Legg Mason Value Trust :

“A point [John Rogers of Ariel Investments] made that I have likewise noted to our staff is that this is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it’s in the papers, it’s in the price -- which used to be correct. Indeed, it borders on cliche in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn’t need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).”

What Miller is complaining about is how many of the standard tenets of professional investment knowledge - that markets are relatively information-efficient, excess returns come from reacting differently than the crowd, etc. - have recently flown out the window. And Miller is not the only one. Quantitative funds, celebrated for their mechanical ability to de-emotionalize investment decisions have also been hammered as the rules-for-investing-success have essentially changed underneath them.

The craziness is because of deleveraging. As simple as that.

Superficially, this might seem self-evident. This is a deleveraging crisis, and the crisis is driving things down unpredictably, and so, naturally, deleveraging is the reason that things seem crazy. But what I’m trying to say here is that the fact that portfolio investors are trying to roll back their leverage ratios has specific effects that are different from a simple liquidity freeze or from earnings contractions in the real economy.

Why deleveraging confuses traditional market logic

To understand how deleveraging creates confusion, it helps to think about how investment decisions are made in normal market environments, and then think about how the availability and/or loss of leverage affects these decisions and the market as a whole.

Markets in “normal times”

The market portfolio (assume no leverage for now) represents the collective valuation of all assets at a moment in time by all potential investors in the market. It is essentially a weighted average of individual valuations, where the weight of any given investor’s valuation is proportional their total portfolio size. Given that the largest portfolios tend to be run by professional investors whose job is to be informed about markets as a whole and what they invest in, it is reasonable to assume that market prices and the weights of assets in the market portfolio usually incorporate a more-or-less sensible analysis of available information at any point in time. This is why the risk adjusted performance of passively replicating the market is generally difficult to beat: numerous very-large players with rapid access to the best information and analysis have already weighed in with their valuations. If one assumes that the average professional is fairly informed and has a sensible analysis of the majority of issues, then it is understandably difficult to outperform their average.

One can potentially outperform with an actively managed portfolio, but it requires the investor to have realistic knowledge of their comparative advantage. A manager could have access to better data, better analysis, a unique perspective or model, faster analysis and execution, or some other quality that offers some investment advantage. To maximize that advantage, it helps if at least some large-scale investors lack it, because a high-weight laggard will create a larger deviation between the current market valuation and one’s (presumably superior) valuation, and therefore a profit opportunity.

In normal times, active investors are placing their investments according to their valuation estimates, and passive investors are basically “piggybacking” and reinforcing those valuation decisions when they choose to use a passive index. Although there is some diversity in specific active strategies, a large body of financial and economic knowledge informs these investment allocations, much of it follows the received wisdom of what are “sound” investment strategies and the logic of how markets operate. Whether they think consistent outperformance is possible or not, most managers agree that outperformance is difficult, because the most common insights into valuation are likely already embedded in prices.

Cheap credit, low volatility, and creeping leverage

Interest rates and credit spreads have been quite low for the last decade, in part because of Fed policy to keep base rates low, and in part because of loan securitization that (rightly or wrongly) reduced premia for credit risk. Low credit spreads have two major effects on investment portfolios. First, low returns to risk-free investments decrease the attractiveness of saving and shift theoretically optimal portfolio allocations to hold a higher proportion of risky investments (defined as any asset that has the potential to lose value and therefore pays a premium for taking on risk). Second, easy credit actually enables portfolios to leverage themselves up inexpensively, increasing exposure to risky events. For many fund managers and allocators, the low-volatility environment of the last 5 years also made this look like a sensible strategy. On the whole, risky assets were returning substantially more than low-risk and risk-free assets, volatility was low, and it looked sensible to increase exposure to risky assets in general. Moreover, when nearly everyone had access to easy credit, cheap borrowing increased the demand for virtually all risky assets, sending the prices (and thus total returns) even higher year after year.

What this meant, on average, was that relative sector and security weightings were being determined based on defensible financial and economic principles, but taken as a whole, society was buying too much of them because easy credit and low volatility understated the risks. The fact that so many investors overallocated their portfolios to risky assets drove asset prices up and made these investment decisions look brilliant, when in fact these were simply unsustainable gains that had yet to correct. The more money made available through borrowing, the more ended up invested in risky assets. Within risky assets, these investments may have been placed based on rational economic insights about relative growth, competitive advantage, and so forth, but the total amount allocated to these assets was unsound.

Credit flows dry up; hello deleveraging

Eventually, the credit faucet had to turn off, as lenders found it harder and harder to find borrowers that could pay back their loans. This happened first in the mortgage sector, but also involved auto loans, credit cards, and credit more generally. The securitization that in part enabled this cheap credit is not inherently a bad idea, but as in earlier posts, it did make it difficult to do appropriate due diligence on one’s borrowers, and the loan originators had few if any incentives to select good borrowers.

When sub-prime and no-documentation loans entered the bundling stream, lenders were taking on borrowers for whom there was little or no historical data on which to create rational pricing and risk models. As a result, lenders took on far more risk than they realized. Many may simply have had no clue about the risks they were taking; others may have hoped to exit their positions before the house came falling down.

As defaults began to accelerate, lenders started panicking, sending credit premiums to new highs. The result was that the days of cheap credit were over. Portfolio managers who had leveraged up to buy more risky assets suddenly needed to sell those assets to reduce their debt and interest expense.

Here is where the seeming craziness begins.

Deleveraging makes markets look crazy

Deleveraging makes for crazy markets because, when an investor is forced to delever, they reverse (“unwind,” in industry jargon) previous positions in order to turn assets into cash and reduce debt/leverage levels. If the investor and/or the quantity of leverage is large, then these changes are likely to have an impact on market prices. Moreover, the need to deleverage does not typically come from a re-evaluation of the market’s prospects, but usually from changes in the borrower’s credit position or liquidity needs.

If we assume that investors’ portfolio compositions are created by a mostly rational and realistic evaluation of company and market prospects, what this means is that investments are placed in logical allocations when there is no need for leverage or leverage is freely available. When enough investors deleverage, the market impact of large-scale unwinding simply reverses these sensible allocations sending prices in exactly the opposite direction that you would expect, given a logical analysis of the macro-economy.

For example, suppose large investors conclude that defensive companies with stable earnings and consistent dividends are logical investments for the current environment and start tilting their portfolio allocations to take advantage of that. When one or more of these large investors are forced to delever, these “favored” companies are sold, rather than bought, sending prices in the opposite direction, even if the macro-, sector, or company data suggests that one should be buying.

Therefore, as investors deleverage, financial markets will lurch forward and back, causing market observers to scratch their heads - perhaps worriedly - wondering “why did that price collapse, while this other price rose?” During a large deleverage, a number of seemingly attractive securities will move in counterintuitive ways precisely because they seem attractive.

The price fluctuations have a second-order effect as well: it makes even experienced and competent investors less sure of their analysis and more likely to second guess themselves. This actually exacerbates the effect, since the appropriate response to increased model uncertainty is to reduce the quantity of funds that are managed with that model.

Implications

To think about the future, it will help to have some idea of how the deleveraging process will play out. Deleveraging is a painful process for everyone involved, particularly because it typically entails recognizing net losses as one exits positions. Existing leverage starts to more and more excessive as asset prices fall, which forces selling at a loss.

As a result, companies and investors will generally try to deleverage as slowly as possible, but also in sudden jumps, when they realize there is no longer any choice. At these moments, there may be pressure to take a “big bath” loss to avoid needing to deleverage again in the future. This big bath method may or may not work in any one case, but the result is that markets will have sudden drawdowns as different investors realize they can no longer hold on. Like a scared child trying to slide down a long pole, companies and investors will deleverage in rapid unpredictable jumps until they reach the ground, and every time we encounter a deleveraging slip downwards, markets will jump in the opposite direction that the fundamentals seem to warrant.

From a portfolio manager’s perspective, one possible solution would be to deleverage by choosing portfolio assets to liquidate at random. This is hard to ask a portfolio manager to do, because so much of a portfolio manager’s job is about applying knowledge and information and reducing the effects of randomness, but by randomizing the choice of assets to liquidate, one might reduce the connection between deleveraging needs and the mal-performance of otherwise economically sensible assets.

It is hard to know exactly when the mass-deleveraging dynamic will end, but one clue will be that volatility has declined as a result of large-scale moves in either direction becoming less frequent. Whether volatility will return to the low levels of the pre-crisis years is difficult to say - I think it is unlikely to return to those levels any time in the foreseeable future - but the immediate implication is that we will simply need to get used to an environment with higher levels of volatility than we have in the recent past. In fact, if one simply accepts that volatility will be high for a while and creep downwards as deleveraging needs are flushed from the system, this may be enough to guide portfolio strategy for a while.

A major part of this argument is that the need for deleveraging has made market action seem to detach entirely from company and economic fundamentals. Part of this can be attributed to a lasting increase in volatility over the levels of the past few years, and part of this is because large financial and economic changes will themselves impact company fundamentals in non-linear ways. One implication is that technical analysis methods may turn out to be more useful than normal in this market environment. Certainly, Bill Miller’s above reflects that markets are exceptionally information-inefficient at the moment, which is one of the pre-requisites for effective technical analysis. The other reason is that as fundamentals themselves become more difficult to measure and predict, the psychological element becomes a more important aspect of investment decision making, and capturing the psychological element is where well-designed technical analysis really can add value.