Thursday, September 4, 2008

Bill Gross talks his book, while the hedgies liquidate

And the market tanks! What a day. Stocks were puked up everywhere! To understand today, you have to go back to July 24. That was when Bill Gross gave his August letter. Here was a snippet of it:

An asset deflation in turn becomes a debt deflation, as subprimes, alt-As, and finally prime mortgages surrender to the seemingly inevitable tide. PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

That day the financials were smacked 7%, and the oil stocks rallied. Anyone that stayed short the financials and long oil from that day got killed!

Today Bill Gross had this to say:

Similarly, the volatility associated with asset liquidation as well as the observable lack of liquidity adds additional risk spread premia, which in turn lower the price of almost any stock, bond or piece of real estate that you or anyone else owns. In combination, the current delevering has managed to sink all three primary asset classes in aggregate, as shown in Chart 1. At first, one might wonder why all the fuss. As the chart demonstrates, there have been prior periods when this trio has not done well and the U.S. economy has hardly blinked. However, the current year-over-year decline of over 10% has never really been witnessed since the Great Depression. That, in and of itself, is a potential red flag. Yet a 10% aggregate asset price decline does more than make us all 10% less wealthy. Because many of these assets are leveraged and margined, the more they decline, the more frequent and frenzied the margin calls, and if the additional cash flow is not provided, not only an asset liquidation but a debt liquidation follows. It is the debt liquidation that potentially turns a stagnant/recessionary economy into something much worse. In the housing market for instance, it is one thing to observe a 15% national decline in home prices. It is much more serious however, when margin calls in the form of monthly mortgage payments (many of which are in-creasing due to adjustable or option-related contractual provisions) lead to foreclosures, which in turn cause a debt liquidation. The bank in this case, takes possession of the home and dumps it back on the market, lowering the price even further, which leads to more foreclosures, which leads to….

This rarely observed systematic debt liquidation is what confronts the U.S. and perhaps even the global financial system at the current time. Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami.

Bill also went on CNBC and said he was no longer buying any more "bank deals." Since PIMCO manages almost $900 billion, that means something. So he begged the Treasury to do something! After all, PIMCO is loaded with GSE paper. Just six weeks ago, they were crowing about all the paper they were buying. Today he cried uncle! You can see the interview here:

Today reminded me of July 14. That day the market gapped up, and, as an example BAC opened at 22.80, and then sold off. The next day, July 15, it closed at 18.52. But it hit 33 a week later on the Treasury's short sale rules. I think the steel, material and coal stocks could have a playable trading rally as the financials did back then.

Tomorrow morning, we get the unemployment numbers. Who knows how these will be fixed! But if you believe in Armageddon, and don't want to play the opportunities this market is presenting then take a look at Vulcan Materials (VMC 74.52) from the short side. This went from 80 in June to 50 a month later, and then up to 77, and is just now starting to break. Oil is a big input cost, so the decrease in oil supposedly will help margins, but if we are in a recessionary environment with hedge fund liquidations why play this number?

It's also controlled by a tight group of funds, and it looks to me that the "keirutsu" holding this stock up on the margin is starting to break. Short it!

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