Bear with me here, as I can't import an Excel Spreadsheet directly.
All prices are The London Fix Silver/oz. in USD.
Open and Closing Dates are the First and Last trading days of each respective month.
1984 1985 1986 1987 1988 1989 1990
May Open $8.93 $6.15 $5.11 $7.94 $6.36 $5.65 $4.95
May Close $9.12 $6.09 $5.20 $7.69 $6.60 $5.22 $5.07
Difference $0.19 ($0.06) $0.09 ($0.25) $0.24 ($0.43) $0.12
June Close $8.39 $6.11 $5.05 $7.14 $6.65 $5.17 $4.84
Difference ($0.73) $0.02 ($0.15) ($0.55) $0.05 ($0.05) ($0.23)
July Close $7.11 $6.34 $5.05 $8.32 $6.80 $5.15 $4.85
Difference ($1.28) $0.23 $0.00 $1.18 $0.15 ($0.02) $0.01
Aug Close $7.45 $6.25 $5.17 $7.55 $6.46 $5.07 $4.83
Difference $0.34 ($0.09) $0.12 ($0.77) ($0.34) ($0.08) ($0.02)
Sept Close $7.44 $6.05 $5.52 $7.64 $6.17 $5.28 $4.79
Difference ($0.01) ($0.20) $0.35 $0.09 ($0.29) $0.21 ($0.04)
Gain/Loss ($1.49) ($0.10) $0.41 ($0.30) ($0.19) ($0.37) ($0.16)
% -16.69% -1.63% 8.02% -3.78% -2.99% -6.55% -3.23%
1991 1992 1993 1994 1995 1996 1997
$3.97 $4.01 $4.27 $5.29 5.7 5.33 4.68
$4.13 $4.06 $4.71 $5.50 5.3 5.34 4.86
$0.16 $0.05 $0.44 $0.21 ($0.40) $0.01 $0.18
$4.45 $4.03 $4.48 5.25 5.33 5.03 4.72
$0.32 ($0.03) ($0.23) ($0.25) $0.03 ($0.31) ($0.14)
$4.06 $3.95 $5.30 $5.29 5.1 5.11 4.38
($0.39) ($0.08) $0.82 $0.04 ($0.23) $0.08 ($0.34)
$3.81 $3.72 $4.84 $5.36 5.32 5.2 4.73
($0.25) ($0.23) ($0.46) $0.07 $0.22 $0.09 $0.35
$4.13 $3.77 $4.03 $5.62 5.53 4.88 5.17
$0.32 $0.05 ($0.81) $0.26 $0.21 ($0.32) $0.44
$0.16 ($0.24) ($0.24) $0.33 ($0.17) ($0.45) $0.49
4.03% -5.99% -5.62% 6.24% -2.98% -8.44% 10.47%
1998 1999 2000 2001 2002 2003 2004
6.17 5.33 5.01 4.34 4.54 4.66 6.1
4.97 4.94 4.9 4.43 5.05 4.56 6.17
($1.20) ($0.39) ($0.11) $0.09 $0.51 ($0.10) $0.07
5.36 5.22 5.02 4.34 4.87 4.51 5.91
$0.39 $0.28 $0.12 ($0.09) ($0.18) ($0.05) ($0.26)
5.53 5.45 4.95 4.22 4.66 5.08 6.32
$0.17 $0.23 ($0.07) ($0.12) ($0.21) $0.57 $0.41
4.79 5.08 4.91 4.2 4.57 5.11 6.74
($0.74) ($0.37) ($0.04) ($0.02) ($0.09) $0.03 $0.42
5.39 5.58 4.89 4.59 4.53 5.12 6.67
$0.60 $0.50 ($0.02) $0.39 ($0.04) $0.01 ($0.07)
($0.78) $0.25 ($0.12) $0.25 ($0.01) $0.46 $0.57
-12.64% 4.69% -2.40% 5.76% -0.22% 9.87% 9.34%
2005 2006 2007 2008 2009
6.85 13.92 13.45 16.64 12.15
7.13 12.9 13.25 16.85 15.52
$0.28 ($1.02) ($0.20) $0.21 $3.37
7.1 10.7 12.54 17.65 13.94
($0.03) ($2.20) ($0.71) $0.80 ($1.58)
7.15 11.34 12.93 17.48 13.63
$0.05 $0.64 $0.39 ($0.17) ($0.31)
6.74 12.6 11.95 13.76 14.54
($0.41) $1.26 ($0.98) ($3.72) $0.91
7.53 11.55 13.65 12.96 16.45
$0.79 ($1.05) $1.70 ($0.80) $1.91
$0.68 ($2.37) $0.20 ($3.68) $4.30
9.93% -17.03% 1.49% -22.12% 35.39%
Average Loss: -7.49% Median: -5.62%
Average Overall: -0.27%
Average Gain: 9.57% Median: 8.02%
Since 2003: Average Loss: -19.57%
Average Gain: 13.20% Median: 9.87%
Average Overall: 3.84%
w/o 2008/09: 2.72%
Monthly Performance:
1984 1985 1986 1987 1988
May %'s 2.13% -0.98% 1.76% -3.15% 3.77%
June %'s -8.00% 0.33% -2.88% -7.15% 0.76%
July %'s -15.26% 3.76% 0.00% 16.53% 2.26%
Aug %'s 4.78% -1.42% 2.38% -9.25% -5.00%
Sept. %'s -0.13% -3.20% 6.77% 1.19% -4.49%
1989 1990 1991 1992 1993 1994
-7.61% 2.42% 4.03% 1.25% 10.30% 3.97%
-0.96% -4.54% 7.75% -0.74% -4.88% -4.55%
-0.39% 0.21% -8.76% -1.99% 18.30% 0.76%
-1.55% -0.41% -6.16% -5.82% -8.68% 1.32%
4.14% -0.83% 8.40% 1.34% -16.74% 4.85%
1995 1996 1997 1998 1999 2000
-7.02% 0.19% 3.85% -19.45% -7.32% -2.20%
0.57% -5.81% -2.88% 7.85% 5.67% 2.45%
-4.32% 1.59% -7.20% 3.17% 4.41% -1.39%
4.31% 1.76% 7.99% -13.38% -6.79% -0.81%
3.95% -6.15% 9.30% 12.53% 9.84% -0.41%
2001 2002 2003 2004 2005 2006
2.07% 11.23% -2.15% 1.15% 4.09% -7.33%
-2.03% -3.56% -1.10% -4.21% -0.42% -17.05%
-2.76% -4.31% 12.64% 6.94% 0.70% 5.98%
-0.47% -1.93% 0.59% 6.65% -5.73% 11.11%
9.29% -0.88% 0.20% -1.04% 11.72% -8.33%
2007 2008 2009
-1.49% 1.26% 27.74%
-5.36% 4.75% -10.18%
3.11% -0.96% -2.22%
-7.58% -21.28% 6.68%
14.23% -5.81% 13.14%
Average: May %'s 0.87%
June %'s -2.16%
July %'s 1.18%
Aug %'s -1.87%
Sept. %'s 2.42%
Since 2003: May %'s 3.32%
June %'s -4.80%
July %'s 3.74%
Aug %'s -1.37%
Sept. %'s 3.44%
Up Down
May 62% 38%
June 31% 69%
July 58% 42%
August 38% 62%
Sept 58% 42%
Wednesday, June 30, 2010
Friday, June 18, 2010
Issue XVI - Mergers 2010
Dear Readers,
After Mergers and Acquisitions activity picked up in the second half of 2009, commentators, economists, and bankers alike were divided with regard to what 2010 held in store. The divide was vast, ranging from predictions of a “perfect storm” for M&A by Goldman Sachs to expectations of another downturn. While predictions of a robust comeback have yet to pass, after what has transpired the past few years M&A is doing better than expected. After a steep drop in 2008 and again in 2009, the value of overall deals has leveled out so far in 2010. When history is considered, even a breakeven year in the wake of such an economic contraction is something to feel good about. In the grand scheme of things, 2010 is currently on pace to transpire as a lukewarm year for M&A.
As I covered in January, M&A activity through the first half of 2009 was dominated by a few mega-healthcare deals (Wyeth/Pfizer and Schering/Merck), and a great percentage of investment banking revenue came via assignments to help companies of all sizes shore up their balance sheets. Activity on both the traditional M&A and Private Equity sides began to pick up at the end of the summer. The final three months of 2009 featured activity from industries across the board. Highlights included Exxon buying XTO energy, Warren Buffett buying Burlington Northern Santa Fe, and Comcast buying NBC Universal.
Looking back on M&A activity during the past three recessions, the cycle has been about two or three years from peak to nadir. This has been the trend regardless of the downturn’s severity. M&A experienced three down years during and after the 1990-91 recession, and two years after the 2001 dot-com bust. The latter was a particularly tough period, as bulge bracket firms were also reeling from the loss of revenue from underwriting tech IPO’s. Based on current numbers, this year could be shaping up to follow this pattern yet again. As of last week, total deal volume so far in 2010 is merely 1% off last year’s pace. After peaking in 2007, M&A saw year-over-year drops of 41% in 2008 and 22% in 2009, according to Bloomberg. While things are still touch and go, given the two-year cycle and this year’s pace, the M&A market appears to be holding up nicely while not getting ahead of itself.
Additionally, as we all know, the most recent recession has been deeper than the previous two in both its severity and longevity. According to data from the Bureau of Economic Analysis, the 1990 recession saw three consecutive quarters of negative GDP growth from Q3 1990 to Q1 1991. The 2001 recession saw two non-consecutive quarters of negative growth, in Q1 and Q3 of that year. Compare that to five out of six quarters of negative growth from Q1 2008 to Q2 2009, the one exception being Q2 2008 when the government’s stimulus checks helped out. ThomsonReuters columnist Rolfe Winkler wrote last week that, “considering the depth of the latest recession compared to the prior two, one might think dealmakers would still be in hibernation.” That said, it is all the more remarkable that M&A appears to be resilient, sticking to its two-to-three year cycle (refer to Chart 1).
Chart 1 – Annual M&A Volume 1988-2008
Partly in response to the pickup in late 2009, many were quick to predict that 2010 would be a robust year for M&A. A report endorsing this viewpoint was produced by Goldman Sachs in late 2009. Goldman’s view was based on the fact that companies have lots of cash on their balance sheets, with levels rising through and after the recession. In addition to rising cash levels (refer to Chart 2), the report pointed to the environment of low interest rates and the search for non-organic growth potentially leading to what was described as a “perfect storm for M&A.” Thus far, this has not come to pass. That is not to say that the report was completely inaccurate in its predictions, however. While the activity in late 2009 was promising, the momentum seems to have stalled somewhat in the first months of 2010. There are several reasons for this.
Chart 2 – Corporate Cash Balances September 2004 - 2009
First, the reduced activity during the first quarter of 2010 was partially the result of continued volatility in the equity markets. The Dow Jones Industrial Average ranged from just below 10,000 to above 11,200 within the first few months of the year. Heavy volatility is not conducive to M&A activity because buyers and sellers want to have a fairly stable equity environment before they act/make an offer. But that is not to say that big deals did not take place. Energy and Utilities led the way early in the year, with Schlumberger acquiring Smith International and FirstEnergy acquiring Allegheny Energy. As volatility lowered in April, activity saw an uptick, accelerating into May after the so called “flash crash” on May 6. Companies have taken advantage of the lower stock prices since then to make moves. A few all-cash examples of this include Hewlett-Packard’s acquisition of Palm on April 28 and SAP’s acquisition of Sybase on May 12.
Second, despite the largesse of cash on balance sheets, this in and of itself does not mean that companies will be going on buying sprees. While large cash positions increase the potential for activity, in the aftermath of 2008 companies have been treading carefully with regard to using cash for acquisitions, and especially for buybacks of stock. However, after going through an aggressive cost-cutting cycle through the recession, it is possible that companies will be looking in the near future for potential acquisitions where they can cut costs while creating growth, which is inherently difficult to do in a low-growth economy. A few recent examples are the aforementioned FirstEnergy/Allegheny Energy merger, the United/Continental merger, and Century Link’s acquisition of Qwest Communications. Although the latter transaction is all-stock, it is one of the best examples of a synergy-based deal so far this year. While both companies have been cutting costs, they are hoping the synergies from their merger, announced on April 26, will provide more than $500 million in new cost savings, according to ThomsonReuters.
Finally, another sector within M&A that could see a pickup in 2010 is one of its main engines: Private Equity. The reason is that not only do PE firms have lots of cash sitting on the sidelines, they are also potentially racing the clock with regard to investor’s funds. Private equity has largely been on the sidelines since 2007-08 due to the lack of credit, which provides the leverage needed to generate promised returns for investors. Obviously, this is a far cry from the over $1 trillion in buyout deals that were consummated in 2006-07 (refer to Chart 3). An editorial last week in Investor’s Business Daily reported that PE firms have $445 billion sitting on the sidelines that was raised during what is rapidly becoming known as the Second Golden Age of Private Equity (the first was during the 1980s). To have such a sum in one’s coffers doesn’t sound bad at all, but it’s more complicated than that. In short, when a PE firm raises a new fund, it usually has a pre-set time frame in which it can put those funds to work. Most funds have a five to seven year window in which they can legally invest capital, after which investors can start pulling their capital out to look for returns elsewhere. There is a popular saying within the industry that goes, “use it or lose it.”
Chart 3 – Total LBO Deal Volume 2006-2010
Indeed, there is a great amount of capital that will be lost if it is not put to work. Therefore, many firms may accept the reality of lower returns and start investing once again. Of course, this carries the risk that some bad deals may take place. That said, we have seen an uptick in PE deals so far in 2010 compared to 2009. A few of the bigger deals have included the acquisition of Interactive Data by Silver Lake Partners and Warburg Pincus, as well as the acquisition of Dyncorp by Cerberus Capital Management.
For the remainder of the year, there are two main factors that could set the tone for how the M&A sector plays out. First, as always, the equity markets. The events of May 6 sent the VIX to nearly 40, but it has since fallen back to the level it was at just before that day. However, with many market observers pointing to tepid economic data and expecting a pullback, this could change. Volatility could reassert itself, and that could potentially inhibit activity for the rest of the year. Second, as mentioned, private equity will have to continue negotiating with lenders to take advantage of the low-interest rate environment to make use of their investor’s funds. Their success or lack thereof in this will be a major determinant for M&A the rest of this year. Finally, another factor that could make a difference is the situation in the Gulf, which could lead to a few consolidations within the petroleum industry and the associated sectors. Already, the volume of M&A activity in the energy sector has doubled to date this year compared to the same time frame in 2009, according to ThomsonReuters. Total deal volume in the sector stands at $128.5 billion as of last week, compared to $57 billion in the same period in 2009, which also outpaces the volume of $122 billion during same period in 2007. With a robust second half, M&A in the energy sector could surpass the 2007 high-water mark.
In summary, it is reasonable at this time to assert that M&A will have a reasonably good year, possibly breaking the downtrend, but not great compared to some of the boom years. Deal volumes continue to recover and we continue to see companies across with board with cash-rich balance sheets, the same situation existing in private equity. Therefore, the real question should be how much potential activity is built up, and whether or not that potential can be unleashed within the current economic environment. The surest way for this to happen would be an improved economy that leads to increased lending by the banks. It adds a reason to hope the economic recovery continues through the remainder of the year.
Respectfully Yours,
Matthew R. Green
June 18, 2010
After Mergers and Acquisitions activity picked up in the second half of 2009, commentators, economists, and bankers alike were divided with regard to what 2010 held in store. The divide was vast, ranging from predictions of a “perfect storm” for M&A by Goldman Sachs to expectations of another downturn. While predictions of a robust comeback have yet to pass, after what has transpired the past few years M&A is doing better than expected. After a steep drop in 2008 and again in 2009, the value of overall deals has leveled out so far in 2010. When history is considered, even a breakeven year in the wake of such an economic contraction is something to feel good about. In the grand scheme of things, 2010 is currently on pace to transpire as a lukewarm year for M&A.
As I covered in January, M&A activity through the first half of 2009 was dominated by a few mega-healthcare deals (Wyeth/Pfizer and Schering/Merck), and a great percentage of investment banking revenue came via assignments to help companies of all sizes shore up their balance sheets. Activity on both the traditional M&A and Private Equity sides began to pick up at the end of the summer. The final three months of 2009 featured activity from industries across the board. Highlights included Exxon buying XTO energy, Warren Buffett buying Burlington Northern Santa Fe, and Comcast buying NBC Universal.
Looking back on M&A activity during the past three recessions, the cycle has been about two or three years from peak to nadir. This has been the trend regardless of the downturn’s severity. M&A experienced three down years during and after the 1990-91 recession, and two years after the 2001 dot-com bust. The latter was a particularly tough period, as bulge bracket firms were also reeling from the loss of revenue from underwriting tech IPO’s. Based on current numbers, this year could be shaping up to follow this pattern yet again. As of last week, total deal volume so far in 2010 is merely 1% off last year’s pace. After peaking in 2007, M&A saw year-over-year drops of 41% in 2008 and 22% in 2009, according to Bloomberg. While things are still touch and go, given the two-year cycle and this year’s pace, the M&A market appears to be holding up nicely while not getting ahead of itself.
Additionally, as we all know, the most recent recession has been deeper than the previous two in both its severity and longevity. According to data from the Bureau of Economic Analysis, the 1990 recession saw three consecutive quarters of negative GDP growth from Q3 1990 to Q1 1991. The 2001 recession saw two non-consecutive quarters of negative growth, in Q1 and Q3 of that year. Compare that to five out of six quarters of negative growth from Q1 2008 to Q2 2009, the one exception being Q2 2008 when the government’s stimulus checks helped out. ThomsonReuters columnist Rolfe Winkler wrote last week that, “considering the depth of the latest recession compared to the prior two, one might think dealmakers would still be in hibernation.” That said, it is all the more remarkable that M&A appears to be resilient, sticking to its two-to-three year cycle (refer to Chart 1).
Chart 1 – Annual M&A Volume 1988-2008
Partly in response to the pickup in late 2009, many were quick to predict that 2010 would be a robust year for M&A. A report endorsing this viewpoint was produced by Goldman Sachs in late 2009. Goldman’s view was based on the fact that companies have lots of cash on their balance sheets, with levels rising through and after the recession. In addition to rising cash levels (refer to Chart 2), the report pointed to the environment of low interest rates and the search for non-organic growth potentially leading to what was described as a “perfect storm for M&A.” Thus far, this has not come to pass. That is not to say that the report was completely inaccurate in its predictions, however. While the activity in late 2009 was promising, the momentum seems to have stalled somewhat in the first months of 2010. There are several reasons for this.
Chart 2 – Corporate Cash Balances September 2004 - 2009
First, the reduced activity during the first quarter of 2010 was partially the result of continued volatility in the equity markets. The Dow Jones Industrial Average ranged from just below 10,000 to above 11,200 within the first few months of the year. Heavy volatility is not conducive to M&A activity because buyers and sellers want to have a fairly stable equity environment before they act/make an offer. But that is not to say that big deals did not take place. Energy and Utilities led the way early in the year, with Schlumberger acquiring Smith International and FirstEnergy acquiring Allegheny Energy. As volatility lowered in April, activity saw an uptick, accelerating into May after the so called “flash crash” on May 6. Companies have taken advantage of the lower stock prices since then to make moves. A few all-cash examples of this include Hewlett-Packard’s acquisition of Palm on April 28 and SAP’s acquisition of Sybase on May 12.
Second, despite the largesse of cash on balance sheets, this in and of itself does not mean that companies will be going on buying sprees. While large cash positions increase the potential for activity, in the aftermath of 2008 companies have been treading carefully with regard to using cash for acquisitions, and especially for buybacks of stock. However, after going through an aggressive cost-cutting cycle through the recession, it is possible that companies will be looking in the near future for potential acquisitions where they can cut costs while creating growth, which is inherently difficult to do in a low-growth economy. A few recent examples are the aforementioned FirstEnergy/Allegheny Energy merger, the United/Continental merger, and Century Link’s acquisition of Qwest Communications. Although the latter transaction is all-stock, it is one of the best examples of a synergy-based deal so far this year. While both companies have been cutting costs, they are hoping the synergies from their merger, announced on April 26, will provide more than $500 million in new cost savings, according to ThomsonReuters.
Finally, another sector within M&A that could see a pickup in 2010 is one of its main engines: Private Equity. The reason is that not only do PE firms have lots of cash sitting on the sidelines, they are also potentially racing the clock with regard to investor’s funds. Private equity has largely been on the sidelines since 2007-08 due to the lack of credit, which provides the leverage needed to generate promised returns for investors. Obviously, this is a far cry from the over $1 trillion in buyout deals that were consummated in 2006-07 (refer to Chart 3). An editorial last week in Investor’s Business Daily reported that PE firms have $445 billion sitting on the sidelines that was raised during what is rapidly becoming known as the Second Golden Age of Private Equity (the first was during the 1980s). To have such a sum in one’s coffers doesn’t sound bad at all, but it’s more complicated than that. In short, when a PE firm raises a new fund, it usually has a pre-set time frame in which it can put those funds to work. Most funds have a five to seven year window in which they can legally invest capital, after which investors can start pulling their capital out to look for returns elsewhere. There is a popular saying within the industry that goes, “use it or lose it.”
Chart 3 – Total LBO Deal Volume 2006-2010
Indeed, there is a great amount of capital that will be lost if it is not put to work. Therefore, many firms may accept the reality of lower returns and start investing once again. Of course, this carries the risk that some bad deals may take place. That said, we have seen an uptick in PE deals so far in 2010 compared to 2009. A few of the bigger deals have included the acquisition of Interactive Data by Silver Lake Partners and Warburg Pincus, as well as the acquisition of Dyncorp by Cerberus Capital Management.
For the remainder of the year, there are two main factors that could set the tone for how the M&A sector plays out. First, as always, the equity markets. The events of May 6 sent the VIX to nearly 40, but it has since fallen back to the level it was at just before that day. However, with many market observers pointing to tepid economic data and expecting a pullback, this could change. Volatility could reassert itself, and that could potentially inhibit activity for the rest of the year. Second, as mentioned, private equity will have to continue negotiating with lenders to take advantage of the low-interest rate environment to make use of their investor’s funds. Their success or lack thereof in this will be a major determinant for M&A the rest of this year. Finally, another factor that could make a difference is the situation in the Gulf, which could lead to a few consolidations within the petroleum industry and the associated sectors. Already, the volume of M&A activity in the energy sector has doubled to date this year compared to the same time frame in 2009, according to ThomsonReuters. Total deal volume in the sector stands at $128.5 billion as of last week, compared to $57 billion in the same period in 2009, which also outpaces the volume of $122 billion during same period in 2007. With a robust second half, M&A in the energy sector could surpass the 2007 high-water mark.
In summary, it is reasonable at this time to assert that M&A will have a reasonably good year, possibly breaking the downtrend, but not great compared to some of the boom years. Deal volumes continue to recover and we continue to see companies across with board with cash-rich balance sheets, the same situation existing in private equity. Therefore, the real question should be how much potential activity is built up, and whether or not that potential can be unleashed within the current economic environment. The surest way for this to happen would be an improved economy that leads to increased lending by the banks. It adds a reason to hope the economic recovery continues through the remainder of the year.
Respectfully Yours,
Matthew R. Green
June 18, 2010
Friday, June 4, 2010
Issue XV - Correlations
Dear Readers,
Although many date the start of the current economic crisis to the July 2007 collapse of two Bear Stearns internal hedge funds that were heavily invested in fixed-income mortgage securities, to me, the first event that was a “snap out of it” moment came in late February 2007. On February 27 of that year, the Shanghai Composite Index fell 9% in one trading session. This would be followed shortly by the collapse of Irvine, California, based New Century Financial, the first major mortgage originator to fail.
In the wake of the events since, much has been written and said about what warning signs existed, if any, prior to the crash of the US housing market. Of the warning signs, most pundits have pointed to the overheated housing market and other symptoms of excess liquidity (i.e., banks lending for leveraged buyouts at 8-10 times cash flow, with relatively few covenants). From following and studying the precious metals market during the past few years, I have noticed that a few unusual correlations existed prior to the first signs of trouble in early 2007. I am seeking to take a look at what the big picture was, what available data indicated at the time, and what, if any, warning signs can be deduced.
By early 2007, everything from equities to real estate was up. This occurrence can be attributed to several things. First and foremost, the capital unleashed by Greenspan’s interest rate cuts needed to find a home somewhere. That alone contributed to all asset classes being pushed up. Second, China’s role in the global economy contributed to subdued US inflation, rather than the level of inflation that might have been expected due to then-historically low interest rates. Finally, the modern measure of volatility, the VIX, was at all-time lows. This did not allow for proper risk management, allowing dangerous levels of leverage to be built up. As such, all asset classes were held up, and this paved the way for a swift decline when it all ended.
A mass of liquidity was unleashed in the early 2000s by central banks around the world, led by Greenspan’s Fed. This was due to the economic slowdown in 2000-2002 and the shock of 9/11. This global flood of capital saturated everything from emerging markets to equities around the world, but especially the US housing market. By early 2007, while banks were still making lots of money, uncertainty was creeping into the economy from the stalled housing market. No one was really sure what the effects would be, and around this time economists increasingly found themselves at odds with each other with respect to their predictions. However, there was a feeling that at the very least, the Federal Reserve would be able to engineer a soft landing for the economy, as Greenspan had been credited with doing five years earlier. For the time being, an air of euphoria prevailed in late 2006 and into 2007.
This giddiness was not only caused by the billions that had been made in real estate, but across all markets. The correlations that existed in late 2006 were unlike any that had ever been seen before. Gold, equities, and bonds, government and corporate, were all up. Such an across-the-board correlation, particularly between US government debt and gold, is rare. Gold finished 2006 up at a then-eye-popping $637 per ounce, up more than 20% for the year. The S&P 500 was up 14% on the year, rising after two relatively tepid years in 2004 and 2005, when it was largely range-bound. Finally, US government bond futures finished the year up 6%. As such, yields between the 5, 10 and 30-year bonds had not only risen but converged as well.
While the full faith and credit of the United States government was alive and well, an increase in gold implies uncertainty in the monetary system and, more often, the perception that inflation is going to rise. After all, inflation was significantly up in 2006 and 2007. The rise of emerging markets, such as Brazil, China, and India, and the resulting increases in demand for oil and food staples had helped to steadily push inflation up during the 2000s. However, in that case fixed-income investments would not be expected to do as well. The inverse correlation between Uncle Sam’s debt and gold was mentioned by a few commentators at that time. Dennis Gartman, the Virginia-based economic commentator and author of The Gartman Letter, wrote in December 2006 that, “one would expect gold and the debt market to move in contravention, for strong gold means rising inflation which is, of course, an anathema to debt investments. The only reason we can ascertain to push both higher is weakening economic environs, deflation and serious economic dislocations” (refer to Charts 1 and 2).
Chart 1 – Price of Gold, January-December 2006
Chart 2 – US Government Debt Yields, 2000-2010
In addition to contributing to the increases in the price of commodities, China’s role in the global economy allowed interest rates to stay low without immediately generating inflation due to the lower prices for its goods. It also contributed to lower rates and the property boom by, as I have previously written about, a voracious appetite for US debt. By early 2007, as Greenspan was enjoying the close of his first year of retirement, he was the most celebrated central banker in history (in all reality his legacy will be as such, no matter how much we know that he made mistakes). What was the perhaps the first tremor of what would become the Great Recession arrived in late February while Greenspan was addressing a large European fixed income conference in London. There, he advised the attendees that there was a chance the US could fall into recession in late 2007. The next day, a tremor came out of China that reverberated around the world.
On February 27, it became known that the Chinese government was creating a task force to explore ways to curb speculation on the Shanghai Composite Index (SSE). Investors panicked at the prospect of the Chinese government suddenly curbing their access to its capital markets. The SSE, which had doubled in 2006, fell by 9% in one trading session, to 4000. Suddenly, the markets were on edge. Although the SSE recovered along with US and European markets to post all-time highs in October 2007, it served to illustrate the newfound importance of China, even at a time when its importance was not completely understood by those who had the most at stake.
The rise of China and its role as a factory for the world created economic conditions that served to mask the true situation. This had many ripple effects on the global economy, some more obvious than others. The “money loop” that was established enabled goods to be produced at lower prices, contributing to subdued inflation at the point of sale in the US and Europe. Another effect was that the resultant, ballooning trade deficit left the Chinese flush with cash. As was the case with the US, this capital had to find a home somewhere. The Chinese ramped up their buying of treasuries throughout the 2000s. Indeed, it was one reason that US government debt prices went up with the market in 2006. China’s purchases of US government debt increased from $72 billion in 2000 to $420 billion in 2007. China bought other, higher-yielding debt implicitly guaranteed by the US government (translation: Fannie Mae and Freddie Mac debt) in large numbers, further contributing to the property bubble. Of course, to political leaders in the US and Europe, this was a win-win situation. Subdued inflation was a key ingredient in maintaining economic stability despite low interest rates. The juiced housing market created construction and real estate jobs (these sectors created over 1/3 of the new jobs created from 2003-06, according to official Dept. of Labor data). In this manner, China’s role of helping to pay for the American Dream was crucial to keeping the American machine running, which in turn had to run in order to keep China’s factory machine running, and so on.
By early 2007, economists and central banks across the globe found themselves increasingly divided about the future prospects for the US economy. Residential real estate prices across the nation had stopped appreciating or were in swift decline, particularly on the coasts and across the Sun Belt. At the same time, as we know, there was still plenty to smile about. One month before the first signs of trouble, the mood was jovial at the 2007 World Economic Forum in Davos, Switzerland. As mentioned, prices for most assets were still at relative highs, and there was emerging talk of a secular “Great Moderation” among a growing cadre of academics. One central tenet of this theory was that modern banking systems and risk management had brought volatility to new, permanent lows. Thus, the implication was that we were in an age of lessened, if any, financial shocks. Since the early 1990s, the primary measure of volatility has been the VIX index. In late 2006, the VIX was at multi-decade lows.
The VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index. Briefly, it has been disseminated since 1993, and is constructed by formulas that measure the fluctuations of S&P 500 futures activity. Although there are now derivatives that trade based on its fluctuations, the VIX itself is not backed by anything. It is solely for the purpose of measuring volatility in the market. The VIX measured in the 40’s after the tech bubble burst, and fell steadily from the upper 20’s in 2001-02 before dropping below 10 for the first time in late 2006 (refer to Chart 3). The driving up of asset prices across the board had led to lower profits and returns on investment. However, this also served to drive down volatility. Although I have generally disagreed with Nouriel Roubini’s economic predictions since the beginning of 2009, his initial prediction about the US real estate market and the derivative-led shock waves across the banking system proved to be spot-on. While he was predicting the ripple effects of the real estate downturn, he was also noting that the excess of liquidity was resulting in diminished returns as well as less volatility. In turn, this caused rates of leverage to grow at alarming rates (after all, traders thrive on volatility, no matter which way the market goes). At Davos in January 2007, while part of a panel discussion, Roubini prophetically noted that, due to leverage more than anything, “the risk of something systemic happening is rising.”
Chart 3 VIX Index 1993-Present
By late 2006, nearly every widely-used measure of market risk did not point to heightened volatility in 2007, let alone a sharp downturn, and much less than what would eventually transpire. One of the reasons that I point to the SSE fall in February 2007 is that on that day, the VIX posted its largest one-day jump ever up to that point, and this sent global markets ineluctably on the path to heightened volatility that would define the next two years. Prior to that day, however, volatility was low across the global markets, and yields continued to flatten across the atlas of credit. Money managers found themselves needing to take on more risk to achieve the returns demanded by clients, or to merely replicate/exceed past performance.
Lower volatility, to a trader, meant it was theoretically safer to take risk. That directly translated into more leverage. In particular, a key driver of the hedge fund industry’s growth from 2000-2007 was the fact that many institutional investors had fallen behind when the tech bubble burst. This was particularly true within the realm of pension funds. To get back on track, more robust returns were sought. Hedge funds, ready to use leverage via the environment of readily available credit, were the perfect candidates to accept this assignment. Money managers would lose clients if returns were not high enough to meet or exceed investor expectations, so the vast majority of them used leverage. The first hedge fund tremor came five months before February 2007, in September 2006. A trader at Amaranth Advisors, one of the many hedge funds that opened up in Greenwich, CT, in the 2000s, had wagered with 9-1 leverage that the value of the March and April 2007 natural gas futures contracts would converge. When the spreads instead widened, Amaranth was forced to liquidate after losing more than $5 billion in one week.
According to Michael Lewis’s Bloomberg column from January 11, 2007, the Amaranth debacle was the most widely-read story on Bloomberg since 9/11 when it broke on Monday, September 18, 2006. Additionally, several of the follow-up stories were in that year’s Top 20. That speaks volumes about what Wall Street was concerned about in the months that led up to February 2007. Besides the obvious reasons (cutthroat competition, firms wanting to know who the winners in the trade were, wanting to know who would buy the portfolio, etc.) it is also indicative of what may have been shared concerns. What I mean is that other Wall Streeters appear to have been concerned about the use of leverage and risk. They could conceive of their own firms having the same problems. However, the conclusion by way of the prevailing market measurements at the time was that all was well. Indeed, in spite of Amaranth, the VIX continued to fall for several more months afterward.
In the end, this lack of preparedness for the events of 2007-2009 was an issue of unprecedented historical market correlations brought on by the excess of liquidity. Because it had never happened on a global scale, and therefore had no historical precedent, the effects and outcomes were nearly impossible to predict. Therefore, it should serve as a reminder that this was not completely a matter of the financial and political crème de la crème being asleep at the wheel, as countless pundits have asserted in the three years since.
Respectfully Yours,
Matthew R. Green
June 4, 2010
Although many date the start of the current economic crisis to the July 2007 collapse of two Bear Stearns internal hedge funds that were heavily invested in fixed-income mortgage securities, to me, the first event that was a “snap out of it” moment came in late February 2007. On February 27 of that year, the Shanghai Composite Index fell 9% in one trading session. This would be followed shortly by the collapse of Irvine, California, based New Century Financial, the first major mortgage originator to fail.
In the wake of the events since, much has been written and said about what warning signs existed, if any, prior to the crash of the US housing market. Of the warning signs, most pundits have pointed to the overheated housing market and other symptoms of excess liquidity (i.e., banks lending for leveraged buyouts at 8-10 times cash flow, with relatively few covenants). From following and studying the precious metals market during the past few years, I have noticed that a few unusual correlations existed prior to the first signs of trouble in early 2007. I am seeking to take a look at what the big picture was, what available data indicated at the time, and what, if any, warning signs can be deduced.
By early 2007, everything from equities to real estate was up. This occurrence can be attributed to several things. First and foremost, the capital unleashed by Greenspan’s interest rate cuts needed to find a home somewhere. That alone contributed to all asset classes being pushed up. Second, China’s role in the global economy contributed to subdued US inflation, rather than the level of inflation that might have been expected due to then-historically low interest rates. Finally, the modern measure of volatility, the VIX, was at all-time lows. This did not allow for proper risk management, allowing dangerous levels of leverage to be built up. As such, all asset classes were held up, and this paved the way for a swift decline when it all ended.
A mass of liquidity was unleashed in the early 2000s by central banks around the world, led by Greenspan’s Fed. This was due to the economic slowdown in 2000-2002 and the shock of 9/11. This global flood of capital saturated everything from emerging markets to equities around the world, but especially the US housing market. By early 2007, while banks were still making lots of money, uncertainty was creeping into the economy from the stalled housing market. No one was really sure what the effects would be, and around this time economists increasingly found themselves at odds with each other with respect to their predictions. However, there was a feeling that at the very least, the Federal Reserve would be able to engineer a soft landing for the economy, as Greenspan had been credited with doing five years earlier. For the time being, an air of euphoria prevailed in late 2006 and into 2007.
This giddiness was not only caused by the billions that had been made in real estate, but across all markets. The correlations that existed in late 2006 were unlike any that had ever been seen before. Gold, equities, and bonds, government and corporate, were all up. Such an across-the-board correlation, particularly between US government debt and gold, is rare. Gold finished 2006 up at a then-eye-popping $637 per ounce, up more than 20% for the year. The S&P 500 was up 14% on the year, rising after two relatively tepid years in 2004 and 2005, when it was largely range-bound. Finally, US government bond futures finished the year up 6%. As such, yields between the 5, 10 and 30-year bonds had not only risen but converged as well.
While the full faith and credit of the United States government was alive and well, an increase in gold implies uncertainty in the monetary system and, more often, the perception that inflation is going to rise. After all, inflation was significantly up in 2006 and 2007. The rise of emerging markets, such as Brazil, China, and India, and the resulting increases in demand for oil and food staples had helped to steadily push inflation up during the 2000s. However, in that case fixed-income investments would not be expected to do as well. The inverse correlation between Uncle Sam’s debt and gold was mentioned by a few commentators at that time. Dennis Gartman, the Virginia-based economic commentator and author of The Gartman Letter, wrote in December 2006 that, “one would expect gold and the debt market to move in contravention, for strong gold means rising inflation which is, of course, an anathema to debt investments. The only reason we can ascertain to push both higher is weakening economic environs, deflation and serious economic dislocations” (refer to Charts 1 and 2).
Chart 1 – Price of Gold, January-December 2006
Chart 2 – US Government Debt Yields, 2000-2010
In addition to contributing to the increases in the price of commodities, China’s role in the global economy allowed interest rates to stay low without immediately generating inflation due to the lower prices for its goods. It also contributed to lower rates and the property boom by, as I have previously written about, a voracious appetite for US debt. By early 2007, as Greenspan was enjoying the close of his first year of retirement, he was the most celebrated central banker in history (in all reality his legacy will be as such, no matter how much we know that he made mistakes). What was the perhaps the first tremor of what would become the Great Recession arrived in late February while Greenspan was addressing a large European fixed income conference in London. There, he advised the attendees that there was a chance the US could fall into recession in late 2007. The next day, a tremor came out of China that reverberated around the world.
On February 27, it became known that the Chinese government was creating a task force to explore ways to curb speculation on the Shanghai Composite Index (SSE). Investors panicked at the prospect of the Chinese government suddenly curbing their access to its capital markets. The SSE, which had doubled in 2006, fell by 9% in one trading session, to 4000. Suddenly, the markets were on edge. Although the SSE recovered along with US and European markets to post all-time highs in October 2007, it served to illustrate the newfound importance of China, even at a time when its importance was not completely understood by those who had the most at stake.
The rise of China and its role as a factory for the world created economic conditions that served to mask the true situation. This had many ripple effects on the global economy, some more obvious than others. The “money loop” that was established enabled goods to be produced at lower prices, contributing to subdued inflation at the point of sale in the US and Europe. Another effect was that the resultant, ballooning trade deficit left the Chinese flush with cash. As was the case with the US, this capital had to find a home somewhere. The Chinese ramped up their buying of treasuries throughout the 2000s. Indeed, it was one reason that US government debt prices went up with the market in 2006. China’s purchases of US government debt increased from $72 billion in 2000 to $420 billion in 2007. China bought other, higher-yielding debt implicitly guaranteed by the US government (translation: Fannie Mae and Freddie Mac debt) in large numbers, further contributing to the property bubble. Of course, to political leaders in the US and Europe, this was a win-win situation. Subdued inflation was a key ingredient in maintaining economic stability despite low interest rates. The juiced housing market created construction and real estate jobs (these sectors created over 1/3 of the new jobs created from 2003-06, according to official Dept. of Labor data). In this manner, China’s role of helping to pay for the American Dream was crucial to keeping the American machine running, which in turn had to run in order to keep China’s factory machine running, and so on.
By early 2007, economists and central banks across the globe found themselves increasingly divided about the future prospects for the US economy. Residential real estate prices across the nation had stopped appreciating or were in swift decline, particularly on the coasts and across the Sun Belt. At the same time, as we know, there was still plenty to smile about. One month before the first signs of trouble, the mood was jovial at the 2007 World Economic Forum in Davos, Switzerland. As mentioned, prices for most assets were still at relative highs, and there was emerging talk of a secular “Great Moderation” among a growing cadre of academics. One central tenet of this theory was that modern banking systems and risk management had brought volatility to new, permanent lows. Thus, the implication was that we were in an age of lessened, if any, financial shocks. Since the early 1990s, the primary measure of volatility has been the VIX index. In late 2006, the VIX was at multi-decade lows.
The VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index. Briefly, it has been disseminated since 1993, and is constructed by formulas that measure the fluctuations of S&P 500 futures activity. Although there are now derivatives that trade based on its fluctuations, the VIX itself is not backed by anything. It is solely for the purpose of measuring volatility in the market. The VIX measured in the 40’s after the tech bubble burst, and fell steadily from the upper 20’s in 2001-02 before dropping below 10 for the first time in late 2006 (refer to Chart 3). The driving up of asset prices across the board had led to lower profits and returns on investment. However, this also served to drive down volatility. Although I have generally disagreed with Nouriel Roubini’s economic predictions since the beginning of 2009, his initial prediction about the US real estate market and the derivative-led shock waves across the banking system proved to be spot-on. While he was predicting the ripple effects of the real estate downturn, he was also noting that the excess of liquidity was resulting in diminished returns as well as less volatility. In turn, this caused rates of leverage to grow at alarming rates (after all, traders thrive on volatility, no matter which way the market goes). At Davos in January 2007, while part of a panel discussion, Roubini prophetically noted that, due to leverage more than anything, “the risk of something systemic happening is rising.”
Chart 3 VIX Index 1993-Present
By late 2006, nearly every widely-used measure of market risk did not point to heightened volatility in 2007, let alone a sharp downturn, and much less than what would eventually transpire. One of the reasons that I point to the SSE fall in February 2007 is that on that day, the VIX posted its largest one-day jump ever up to that point, and this sent global markets ineluctably on the path to heightened volatility that would define the next two years. Prior to that day, however, volatility was low across the global markets, and yields continued to flatten across the atlas of credit. Money managers found themselves needing to take on more risk to achieve the returns demanded by clients, or to merely replicate/exceed past performance.
Lower volatility, to a trader, meant it was theoretically safer to take risk. That directly translated into more leverage. In particular, a key driver of the hedge fund industry’s growth from 2000-2007 was the fact that many institutional investors had fallen behind when the tech bubble burst. This was particularly true within the realm of pension funds. To get back on track, more robust returns were sought. Hedge funds, ready to use leverage via the environment of readily available credit, were the perfect candidates to accept this assignment. Money managers would lose clients if returns were not high enough to meet or exceed investor expectations, so the vast majority of them used leverage. The first hedge fund tremor came five months before February 2007, in September 2006. A trader at Amaranth Advisors, one of the many hedge funds that opened up in Greenwich, CT, in the 2000s, had wagered with 9-1 leverage that the value of the March and April 2007 natural gas futures contracts would converge. When the spreads instead widened, Amaranth was forced to liquidate after losing more than $5 billion in one week.
According to Michael Lewis’s Bloomberg column from January 11, 2007, the Amaranth debacle was the most widely-read story on Bloomberg since 9/11 when it broke on Monday, September 18, 2006. Additionally, several of the follow-up stories were in that year’s Top 20. That speaks volumes about what Wall Street was concerned about in the months that led up to February 2007. Besides the obvious reasons (cutthroat competition, firms wanting to know who the winners in the trade were, wanting to know who would buy the portfolio, etc.) it is also indicative of what may have been shared concerns. What I mean is that other Wall Streeters appear to have been concerned about the use of leverage and risk. They could conceive of their own firms having the same problems. However, the conclusion by way of the prevailing market measurements at the time was that all was well. Indeed, in spite of Amaranth, the VIX continued to fall for several more months afterward.
In the end, this lack of preparedness for the events of 2007-2009 was an issue of unprecedented historical market correlations brought on by the excess of liquidity. Because it had never happened on a global scale, and therefore had no historical precedent, the effects and outcomes were nearly impossible to predict. Therefore, it should serve as a reminder that this was not completely a matter of the financial and political crème de la crème being asleep at the wheel, as countless pundits have asserted in the three years since.
Respectfully Yours,
Matthew R. Green
June 4, 2010
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