Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

THE PROS AND THE CONS

It has now become clear that the sudden bull that followed the sudden bear was primarily due to retail investors, first buying “cheap stocks”, then buying “momentum stocks”. What we have learned in recent days:

  • Online brokerages have seen a record number of new accounts opened this year, and the big four — E-Trade, TD Ameritrade, Charles Schwab and Interactive Brokers — executed as many trades in March and April as in the whole first half of last year, per public disclosures.
  • About 1.2 million retail clients started new brokerage accounts at Fidelity Investments between March and May, a 77% increase from the same period last year. TD Ameritrade Holding Corp. reported 608,000 new funded accounts in the three-month period ending March 31, a 249% increase from the year-earlier period. In March alone, new and existing retail clients opened 426,000 funded accounts, the company said.
  • TD Ameritrade said it is registering growth in customers younger than 35. Online broker Robinhood Markets Inc., which said the median age of clients is 31, has increased its customer base 30% through the first four months of the year.
  • The brokers are reporting more trading as well. TD Ameritrade is averaging 3.5 million client trades a day so far in June, for example, more than four times as many as in June 2019.
  • Public data from Robinhood has revealed a surge in the total number of positions held in customer accounts — doubling to 30+ million in early May  after the lockdowns began. Meanwhile, Charles Schwab and TD Ameritrade reported a record number of account openings in their latest earnings report. 

Dave Portnoy, founder of the popular website Barstool Sports, found a following doing pizza reviews but, because of the pandemic, flipflopped to day trading, sharing slices of his regular moves to his 1.5 million Twitter followers as he scans his portfolio.

In an interview with the WSJ, Mr. Portnoy said that in early June, when Warren Buffett said he sold his airline shares, Mr. Portnoy, who reportedly called Warren Buffett “an idiot”, bought those stocks, a move that has led to big profits for himself and, likely for some of his followers.

“I’m the new breed. I’m the new generation,” he crowed. “There’s nobody who can argue that Warren Buffett is better at the stock market than I am right now. I’m better than he is. That’s a fact.”

“I tell people there are two rules to investing: Stocks only go up, and if you have any problems, see rule No. 1.” (…)

“I do not necessarily miss sports that much because there are other things that entertain me far more, i.e. the stock market,” he said.

Funny that Mr. Buffett also claims there are only two rules to investing: rule #1: don’t lose money; rule #2, never forget rule #1. Funny also that George Soros once said that “Investing should not be entertaining. Good investing should be boring”.

Younger, inexperienced people seem to have taken this market over, pushing aside too cautious, “have been” billionaire investors as well as most other not so well known pros who have also proven very wrong per numerous surveys which revealed that these people, earning their living managing money, are very pessimistic on the economy, corporate profits and financial markets.

From my lens, only Lowry’s Research saw the trading tsunami coming as it smartly measured the rise in “buying power” in early April against waning supply pressure.

But how did that start? Some clues:

  • Professional investors have largely abandoned the stock market amid the coronavirus pandemic, but sports bettors and bored millennials have jumped into the retail stock trading market with both feet. (Axios)
  • Robinhood, whose easy-to-use app makes the transition between sports betting and trading seamless, boasts a similar customer base to most sportsbooks, notes Marc Rubinstein in his newsletter, Net Interest.
  • “43% of North American men aged 25-34 who watch sports also bet on sports at least once per week, and that’s the same group that has flocked to Robinhood,” Rubinstein writes.

Coincidentally:

Dayanis Valdivieso, who was laid off during the pandemic, is tapping an unlikely source of money for her first foray into stocks: the government’s $1,200 stimulus check. Ms. Valdivieso, a 22-year-old in Louisville, Ky., used a portion of her check to trade stocks, using a Robinhood account.

“It was basically free money, so, you know, I decided to play around with it,” she said. “You might lose some, you might win some. It’s like a gambling game.” (…)

She currently holds positions in United Airlines Holdings Inc. and the ProShares Ultra Bloomberg Crude Oil ETF, a leveraged product that seeks to track twice the daily return of an index of crude-oil futures. (WSJ)

Then there is this 29-year-old electrician in Seattle who, acknowledging Hertz is saddled with debt, faces intense competition and could have its shares delisted, rendering them worthless, figures “the Hertz brand name holds value and the company operates a huge fleet of cars. The stock was cheap enough to roll the dice”.

The trading surge pushed Hertz shares up nearly 500% after billionaire Carl Icahn dumped his stake in the company at 72 cents a share last month. (…)

However, “there can be no assurance that the NYSE will grant the company’s request for continued listing at the hearing and whether there will be equity value in the company’s common stock,” Hertz said. (WSJ)

So, Carl Icahn, who knows a thing or two about bankruptcy and equity valuation, but also fits right in with the “have beens”, bails out of Hertz at $0.72 only to watch illiterate newbies push the stock back to $5.00.

Yes, “the Hertz brand name holds value and the company operates a huge fleet of cars” but the above quoted electrician forgot the negative wire, the $17 billion debt load on its fleet of some 500,000 cars, a $34k average liability per car.

Hertz creditors would rather get more cash than cars, so they saw an opportunity to tap this un-hoped for demand for HTZ shares. From the U.S. Bankruptcy Court petition recently filed in Delaware last week:

The recent market prices of and the trading volumes in Hertz common stock could potentially present a unique opportunity for the Debtors to raise [up to $1 billion in] capital on terms that are far superior to any debtor-in-possession financing. (…) The Debtors bring this motion on an emergency basis given the volatile state of trading in Hertz’s stock and to ensure that the Debtors are in a position to capture the potential value of Hertz’s unissued shares.

Note that the petition comes from the debtors, not the company, the board or its shareholders. In plain English, this translate into a request to transfer speculators’ money directly into Hertz creditors’ bank accounts.

The senior unsecured, 6% notes due 2028 last changed hands at 40.5 cents on the dollar (though up from 15 cents on May 26) for a yield-to-worst of 22.65%, implying that the common stock is worthless. Yesterday, Hertz filed a motion to wiggle out of lease commitments on 144,000 vehicles, claiming that it cannot afford to pay them. 

According to data from Robintrack.net, 166,000 accounts on the Robin Hood trading platform held Hertz shares as of June 10, up from less than 2,000.

These 166,000 folks are obviously not aware of their odds. At around $40, the historical equity return is -85% according to Verdad’s director of credit Greg Obenshain:

Other zombies are benefitting from the free money sent to bored sports bettors and millenials.

  • Whiting Petroleum filed for Chapter 11 on April 1st and the stock price has soared 532% since that time, and reportedly 47,000 Robinhood investors are long.
  • Chesapeake Energy Corp., which said in May that it is considering a bankruptcy filing, rose more than 500% during that time frame.

Ms. Valdivieso, quoted earlier, has turned her attention to an even riskier form of investing: options trading. “You can make a pretty good amount of money in one day,” she told the WSJ.

She apparently has company in the option speculative arena:

Over the past few weeks, we’ve looked at the high and increasing amount of speculative activity among options traders, particularly the smallest of them that transact 10 contracts or less.

As stocks rose 3% or more each week, it was kinda-sorta understandable. But last week, stocks suffered high volatility and a big decline on Thursday, coupled with a mostly-failed rally attempt on Friday. That did not put off speculative traders – in fact, it emboldened them.

Last week, the net speculative activity (calls bought to open minus puts bought to open) of the smallest of traders was more than twice as extreme as it was at the peak in February. (SentimenTrader)

This is a truly amazing chart:

Using relative percentages, small traders spent 52% of their volume on buying call options to open. This is a record high, tied with the most extreme weeks in 2000. (…)

Among all traders, there were approximately 22 million more calls bought to open than puts. This is astounding. (…)

The Options Speculation Index, which is the most comprehensive look at how traders allocated their volume across speculative versus hedging activity, moved to the highest level since a few weeks in the year 2000. (…)

More likely, it’s a hoard of new traders stuck at home who have seen stocks only go up for months on end. This has never ended well and remains a large risk over the short- to medium-term.

Jason Zweig in last weekend WSJ:

(…) At the WallStreetBets community on Reddit, the online platform, users are encouraged to “show off a brutal, crushing loss.” When a user claimed to have lost roughly $750,000 trading options in just a few weeks last year, others posted such comments as “Goat” [greatest of all time] and “YOLO” [you only live once].

Jaime Rogozinski, who founded WallStreetBets in 2012, says the group has nearly 1.3 million members, up from 577,000 last June and 314,000 in June 2018.

“They don’t know what they’re doing,” he says, “and they don’t care that they don’t know what they’re doing.”

Where is Allan Greenspan when we really need him?

But don’t think the pros crowd is much more rational. Bank of America Fund Manager Surveys (FMS), a monthly poll of 212 investors managing $598 billion in AUM, reveals that 78% of respondents reckon that the stock market is “overvalued.” This is the most bearish they have been since at least 1998.

And yet, the June FMS cash level precipitously dropped from a high 5.9% in April to the 10-year average of 4.7%.

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The FMS hedge fund net equity exposure jumped to 52% from 34%. FOMO is clearly at play!

At least, the retail investor bets with his own money.

Richard Bernstein, president of Richard Bernstein Advisors LLC, has been one of the most astute investors during the last decade. Richard is a true fundamental investor who constantly ponders the pros and the cons:

We continue to manage our portfolios during this totally unprecedented period based on fundamentals, and not on market momentum or guessing. The US government has so far provided adequate cushioning of the economy, and economic data is starting to improve. As mentioned, this improvement argues for increasing cyclical exposure.

However, the US response to COVID-19 has been woefully inadequate when compared to other major economies’, and the risk of a reacceleration in cases is real. The risks argue portfolios should maintain some defensive exposure. (…)

Cornerstone Macro, a leading independent economic research firm, succinctly described the dilemma investors currently face. The US has led the world in fiscal and monetary stimulus, but it has lagged the world in COVID-19 response. Only some emerging markets now have infection rate trends worse than the US’s. The entire developed world has passed us in recovery trends. Chart 3 (Courtesy of Cornerstone Macro) shows the “curve” of COVID-19 cases in major economies. It is clear the US’s response has been quite poor relative to other G-7 economies.

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(…) As of this writing [June 14], 21 states (up from 14 two weeks ago) have increasing COVID-19 cases. The path to COVID-19 recovery still appears more challenging than is generally thought. The risk of a negative surprise seems meaningful to us. (…)

The extraordinary multi-black swan environment makes it difficult to be an ardent bull or ardent bear. Extreme positions seem based largely on guessing an outcome or market momentum rather than a thoughtful analysis of the fundamentals.

Fundamentals are improving from miserable levels and remain horribly depressed, but they are indeed improving. However, the reality of the US’s inept response to COVID-19 should temper investors’ enthusiasm at least to some degree. (…)

Believe it or not, we are only 5 months away from the U.S. elections. Odds are high that President Trump, whose approval rating has fallen from 47.8% in late January to 40.8% per FiveThirtyEight, will seek to boost the economy as hard as he can. That means strong pressures to re-open as much and as quickly as possible, potentially resisting any negative C-19 trends, right into flu season.

It also means intensified blaming on China and possibly new trade “initiatives”.

New polls from major polling organizations show a healthy 8-point lead average for Biden over Trump in the general election. A new CNN poll shows the biggest lead so far for Biden, with a 14-point lead over Trump, while the Hill/Harris poll shows a 10 percent lead and the IBD/TIPP shows a 3-point lead. (Statista)

But, Both Candidates Are Widely Disliked (Again). This Time, Biden Could Benefit.

It’s a truism of politics: When you’ve got an incumbent on the ballot, the race will be a referendum on her or his leadership — probably more than it’ll be about what the challenger is offering. So with President Trump’s approval rating stuck deep in the red, there’s little doubt that he is facing an uphill battle.

But there’s a wrinkle to this situation: His likely Democratic opponent, Joseph R. Biden Jr., also has a favorability problem. (…)

One key difference between this year and 2016 jumps out: In that election, people who saw both candidates unfavorably broke in favor of Mr. Trump, seeing him as the better of two bad options. This year, Mr. Biden holds an advantage — by a mile — among these ambivalent voters.

In a Monmouth University poll released last week, roughly one-fifth of voters did not express a positive view of either candidate (Mr. Trump’s net favorability rating was -19 in that poll; Mr. Biden’s was -7). Those voters broke hard for Mr. Biden, 59 percent to 18 percent. (…)

The latest Quinnipiac University poll contains evidence that Mr. Biden has room to grow. Unlike most, that survey offered respondents the option to say they hadn’t heard enough to make up their minds on whether they saw him favorably or unfavorably. Twelve percent of respondents said they needed more information about Mr. Biden before they decided. Just 3 percent said so about Mr. Trump.

Whether they will be voting or not, investors will need to start to focus on mundane things as David Rosenberg recently reminded us:

Here is what is at stake — from the current Biden platform:

  • The top personal income tax rate goes back to 39.6% from 37%
  • Capital gains tax rates go to a 28%-35% range from the current 23.8%
  • The top corporate rate goes to 28% from 20%
  • The tax on foreign income will double
  • The Biden plan calls for the Social Security payroll tax cap to be lifted from 15% of payroll tax to the 39.6% top rate
  • All in, the top marginal rate from all sources of income approaches to 50% — Canadian-style! — on incomes over $300,000

Finally, ponder the pros and the cons of a Democrat sweep.

Democrats are seeing a much better chance of retaking the Senate in 2020

(…) Democrats need to win back at least three seats to reclaim the majority, but they are also defending Sen. Doug Jones in deep-red Alabama — a state where President Donald Trump has a 28-point net approval rating. If Jones loses, that means Democrats need to win four seats and the White House (where their party’s vice president could vote to break ties in the Senate), or net five seats without the White House advantage.

Overall, Senate Republicans are defending more turf. Republicans have 23 seats (mostly in red states) to defend, compared to the 12 Senate Democrats who are up for reelection. (…)

“There’s no denying that the Senate is very much in play, and I think a lot of Republicans are in denial about taking that for granted at this point,” Tim Cameron, a Republican strategist and a former chief digital strategist at the National Republican Senatorial Committee in the 2014 and 2016 cycles, told Vox. (…)

If you don’t care much about fundamentals, you can ride with the many technicians who are bullish because of the “inherent strength” in numerous technical measures. Maybe a problem with many of these indicators is that they are being conned by all these retail speculators and their heavy trading with many pros chasing them to protect their relative performances.

In this tug of war between the people and the virus and between the pros and the cons, I tend to side with science and objective probabilities.

The Rule of 20 P/E is currently 21.3 at 3150 on trailing EPS of $158.70 which are on their way to $140 (23.9 R20 P/E) after Q2 and $125 (26.6) at the end of 2020.

The bullish thesis asserts that the world gets back to “normal” sometimes during the next 12 months so we should value equities based on normalized earnings. Sure thing…if one we can reasonably confidently project normality in 2021 or 2022.

This high-wire exercise involves predictions on crucial factors such as employment and consumer behavior in a deconfined world, corporate costs in a deglobalizing world and personal and corporate taxes in a deeply indebted world. The debates will go on until the fight against the virus ends and we can actually see life the day after (see my May 5 post THE DAY AFTER…).

The glass-half-full vision embeds profit estimates of $164 in 2021 (they were $162.93 in 2019) and $187 (+14%) in 2022. The S&P 500 Index is already at 19.2 and 16.8 times 2021 and 2022 estimates respectively. Valuation history remains unfavorable using conventional P/E ratios.

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Using the Rule of 20 which incorporates inflation in the valuation equation, the R20 P/E is 20.7 with EPS of $164 and inflation at its current 1.4%. Using 2022 “normal world” estimates of $187, the R20 P/E declines to 18.3. Buying currently at this level and assuming that the R20 P/E is at its 20.0 neutral level at the end of 2022 would return 9.3% over the next 30 months or +3.7% per year.

Considering the numerous heroic assumptions required in this likely best case scenario, such return does not strike me as attractive even with a riskless 3Y Treasury yield of 0.22%.

The charts below present the historical returns on the S&P 500 since 1927 at various R20 P/E levels:

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This chart shows the probability of losses 6 and 12 months out:

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In all, both the pros and the cons are scary.

If I have to choose between Dave Portnoy’s two-rules of investing (stocks only go up, and if you have any problems, see rule No. 1) and Warren Buffett’s (rule #1: don’t lose money; rule #2, never forget rule #1), I would go for the has been’s.

THE DAILY EDGE: 16 JUNE 2020

The surge in coronavirus cases in some states isn’t part of a ‘second wave’

(…) “We are seeing a notable uptick in identified cases in several states,” Raymond James analysts wrote in a June 15 note to investors. “We expected this uptick and anticipate other states will also see upticks as reopenings continue. This isn’t a second wave, this is another swell that is part of the ‘first wave’ of this virus.”

As states and local governments have eased stay-at-home restrictions over the last month, that may have led to the first significant wave of cases in regions that may not have already experienced large increases in case counts. “We’re now recognizing that we’re not going to see the summer break that we had hoped for,” Wen said. (…)

In May, when lockdown orders began to be lifted, the national daily infection rate was around 2.5%, J.P. Morgan analysts said. Most countries in Asia and Europe waited until daily infection rates were below 1.0%.

Daily infection rates are about 5.0% in Arizona and about 2.3% in Texas, “indicating that “state-specific issues may be in play rather than a generalized problem of community spread,” according to the analysts. (…) (MarketWatch)

R is at or above 1 in about a quarter of U.S. states

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PANDENOMICS
Trump Team Weighs $1 Trillion for Infrastructure to Spur Economy
Empire State Manufacturing Exhibits Unexpected Improvement in June

Economic activity in New York is strengthening. The Empire State Manufacturing Index of General Business Conditions rose sharply to -0.2 during June from -48.5 in May. The rebound far outpaced expectations for an increase to -31.3 in the Action Economics Forecast Survey. The percentage of respondents reporting an increase in business conditions rose to 36.1% from 14.5% in May. The percentage reporting a decline fell to 36.3% from 63.1%. The overall measure is a diffusion index which follows the breadth of change across the state.

Haver Analytics calculates an ISM-Adjusted Index which mimics the construction of the overall purchasing managers’ index. The figure surged upward to 50.0 in June from 40.5 in May. It was the highest level since February.

The subindexes of the report demonstrated uniform improvement. The new orders index rose to -0.6 from -42.5. Thirty-five percent of respondents reported higher orders in June, up from 18% in May, while 36% reported a decline versus 60% last month. The shipments measure rose to 3.3, its highest level since May. The unfilled orders, delivery times and inventories measures rose moderately.

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Employment indicators improved modestly and remained below the break-even level of 50. The number of employees index rose to -3.5 from -6.1, its best level in three months and far above April’s low. The percentage reporting improvement in employment rose 18% from 15% in May and the percentage reporting a decline was little changed at 22 %. The average workweek measure rose markedly to -12.0 this month from -21.6 in May.

The prices paid index surged m/m to 16.9 from 4.1, but remained well below earlier highs. Twenty-four percent of respondents reported higher prices while seven percent paid less. The prices received index rose to -0.6 from -7.4.

The Expected General Business Conditions index measure in the Empire State Survey surged to 56.5 from 29.1. It was the highest level in roughly ten years and occurred as expected new orders and shipments jumped. The gain reflected only moderate improvement in employment and a decline in the workweek. Expected prices also rose just slightly as did the capital spending figure.

What these diffusion indices are saying is that conditions are stabilizing at a low level.

US Restaurant Traffic Suddenly Craters Amid Second Wave Fears

After three months of slow but consistent improvement in restaurant dining data in the US and across the globe, in its latest update on “the state of the restaurant industry”, OpenTable today reported the biggest drop in seated restaurant diners (from online, phone and walk-in reservations) since the depth of the global shutdown in March. (…)

More charts from CalculatedRisk:

Cass Freight Index – Shipments

As a measure of economic activity, Cass Freight Index shipment volumes dropped 23.6% vs. year-ago levels (Chart 1), slightly worse than the -22.7% y/y change in April. But the absolute index reading nudged up 1.6% sequentially from 0.923 to 0.938.

May’s shipments index was barely higher than April and still at very poor levelsChart 1

U.S. rail traffic shows steady week-to-week improvement into June

Chart 4
US CFOs look to rebuild revenue amid worries of a second wave of COVID-19 infections

PwC surveyed 330 US CFOs and finance leaders between June 8-11, 2020.

  • Less than a quarter of leaders (24%) anticipate layoffs, down 7% from our last survey, while under a third (30%) expect to implement temporary furloughs—a drop of 6% since our last survey.
  • Facilities and general capital expenditures remain targeted — 78% of CFOs whose companies are considering deferring or canceling investments plan cuts here. Planned spending cuts to other areas are slowing somewhat, however: 48% now expect cuts to workforce efforts, down from 62% in March, and half are considering cuts to operations, down from 54%.
  • Nearly half (47%) of finance leaders expect revenue declines of more than 10% this year. In that grim forecast is a glimmer of optimism, however: Only 13% of US CFOs are now looking at declines of more than 25%, which is a drop from 20% expecting declines five weeks ago.
  • One-third (32%) of US CFOs are very confident in their company’s ability to identify new revenue opportunities.
  • 41% look to alter pricing, among other revenue strategies.
  • 54% of CFOs plan to make remote work a permanent option, up from 43% in our last survey. Only 26% of leaders are concerned about losing productivity due to remote work now, a significant drop from the beginning of the pandemic (63% in our March survey) — while 49% are trying to improve the remote work experience for their people.
  • As they reinvent their businesses, nearly one-third of CFOs (32%) look to tech-driven products and services.
  • Half of US consumers tried new brands or products while home during the pandemic, and 5% used telehealth for the first time.
Business Travel Won’t Be Taking Off Soon Amid Coronavirus After months of doing their jobs from home, many executives and employees say all those hours in the sky and nights away from home may not be necessary going forward.

(…) A major decline in corporate travel spending would have vast implications for the nation’s airlines, hotels and rental-car companies. (…) After 9/11, it took the airline industry six years to recover. (…)

“At the end of the day, if the customer says they need to see us, we’re going to go,” she said. “But we’re finding operating this way is considerably more efficient.” (…)

Ad Spending Will Drop 13% This Year, Ad-Buying Giant Says U.S. advertising spending is expected to plunge by 13% this year, GroupM, the world’s largest ad buyer said, but won’t fall as much as what occurred in 2009 following the financial crisis.

(…) One silver lining comes from the coming presidential election, traditionally a boon for ad spending. GroupM estimates that factoring in the effect of political dollars, overall ad spending is expected to fall by 8%. (…) Digital ad spending is expected to fall just 3%, a far cry from GroupM’s December forecast that expected a 13% increase.

Businesses to Slash Overseas Investment Amid Pandemic Risks New overseas investments will fall by 40% this year and as much as 10% next year, according to new United Nations forecasts, as disruptions from the coronavirus push multinationals to bring production closer to home.

(…) Unctad said profits among the 5,000 largest companies that operate internationally are expected to decline by 40% on average. Some industries anticipate losses.

The Geneva-based research body said FDI would only start to recover in 2022, but would remain subdued through the coming decade as businesses adopt a more cautious attitude to globalization—the process in which production has been split up and spread across the world since the 1980s. (…)

On top of those immediate pressures, Unctad said the growing potential of automation, rising economic nationalism and differences in carbon-emissions standards may also play a part in damping foreign investment flows.

That could hurt growth prospects in developing countries, which have relied on attracting foreign investment and the new technology it brings to drive growth and raise living standards for a low-paid workforce.

“The first rungs on the development ladder could become much harder to climb,” said Unctad Secretary-General Mukhisa Kituyi. “This may call for major policy rethink.” (…)

The World Bank warned earlier this month that developing economies entered the coronavirus pandemic in a more vulnerable position compared with the global financial crisis a decade ago. They have more debt, aging populations, weaker demand for commodities and trade tensions that weakened the international flow of goods and services even before the pandemic started, the World Banks said.

Housing Market Around New York City Is Booming Real-estate agents say more home shoppers are looking to buy outside the city, often because they are concerned about a second wave of pandemic-related restrictions.
China is recovering but far too slowly

We are keeping our China GDP forecasts
unchanged at -3.1% YoY for the second
quarter of 2020 and -1.5% for the full year.
Latest figures show that most sectors are still
in deep contraction territory, not least
manufacturing. ING’s Iris Pang says the
Chinese government appears to be wary of
spending more money to help the economy
for fear of racking up even more debt.

Fed Will Amass Corporate Bond Portfolio Using Index Approach The central bank announced a buying scheme to complement existing purchases in exchange-traded funds.

(…) The central bank has deployed a $250 billion lending program to buy outstanding corporate bonds. The central bank said Monday it plans to begin making those purchases on Tuesday by creating a portfolio based on a broad, diversified market index of corporate bonds.

The index will be made up of all the bonds in the $9.6 trillion corporate debt market from companies that satisfy the program’s criteria, including that companies were investment-grade-rated as of March 22 and that securities can be no more than five years in duration.

The Fed began purchasing debt through the program on May 12 by buying exchange-traded funds that invest in corporate debt. It has been buying those assets at a pace of around $300 million a day. (…)

Analysts at Bank of America estimated in April that the Fed could buy up to $419 billion of individual corporate bonds under the criteria it had established, many times more than it could buy by only purchasing exchange-traded funds.

Separately, the Fed announced Monday that a $600 billion effort to lend directly to small and midsize businesses had opened for business. Under that program, banks can sell up to 95% of loans that meet the Fed’s standards to an investment entity established by the Boston Fed. (…)

unnamed (12)

(via Grant’s)

Investors Are Sitting on the Biggest Pile of Cash Ever Grappling with the most economic uncertainty in decades and a head-spinning stretch of volatility in the U.S. stock market, many investors have rushed into money-market funds.

(…) Assets in the funds recently swelled to about $4.6 trillion, the highest level on record, according to data from Refinitiv Lipper going back to 1992. (…) Other measures, like bank deposits, are also at a high.

(…) overall stock positioning among investors remains among the lowest levels of the past decade, according to data from Deutsche Bank. (…)

Other positioning data shows traders have been pessimistic about the recent rally. As stocks rebounded, leveraged funds like hedge funds have accumulated the most bearish position on S&P 500 futures since 2016, according to Commodity Futures Trading Commission data.

CLOs Are Not CDOs, Not Even During a Pandemic The structured products have their problems but are hardly about to topple the banking system.

(…) I don’t want to spend an entire column on a rebuttal (others already have), so suffice it to say I was skeptical when the big reveal was that Wells Fargo & Co.’s exposure to high-rated CLOs was described this way: “The total is $29.7 billion. It is a massive number. And it is inside the bank.” Never trust absolute dollar figures, no matter how large they may seem. As a percentage of total assets, that’s a mere 1.5%. And, remember, triple-A rated CLOs have famously never defaulted.

The crucial question, then, is whether something is different this time. CLOs at their core are simply bundles of speculative-grade loans, sliced into different tranches, with the lower-rated portions suffering the first losses to protect payments to those invested in the top layer. One of the crucial assumptions behind CLOs is that because the debt is backed by companies of varying size and across disparate industries, the likelihood that all the securities would default at once is highly unlikely. That differentiates them from the CDOs of the past, which, in addition to being more complicated in structure, were exposed entirely to individual borrowers and just one part of the economy: the housing market. (…)

Make no mistake, CLOs are under pressure. Moody’s has placed 77.3% of all U.S. CLO tranches rated B or lower on review for downgrade, along with about 60% of those rated Baa or Ba. A handful of those with the most significant deterioration in their underlying loans could even see their Aa rated portions downgraded. To some, that might seem too close to the triple-A tranche for comfort, even if it’s just 0.8% of the notional amount of the Aa debt.

Still, a downgrade doesn’t equal a default. The fact that not a single top-rated slice is even at risk of a rating cut speaks volumes, considering they collectively make up more than 75% of the notional amount outstanding and are the portions sitting on banks’ balance sheets, both in the U.S. and elsewhere.

Moody’s also casts doubt on whether it will get worse in the coming months. “In recent weeks, the pace of negative corporate rating actions has slowed as our reassessment of ratings based on the shock of the coronavirus and low oil prices has progressed,” analysts led by Peter McNally wrote on June 11. “After the current credit shock materialized in March 2020, the number of global negative rating actions peaked in late March and early April. More recently, these have declined steadily.”

The worst-case scenario, as spelled out by Moody’s, isn’t as dire as it seems. The global 12-month trailing speculative-grade default rate will probably hit 9.5% by March 2021, up from 4.7% last month, and in its pessimistic forecast it’ll reach 16%, higher than at any point in the last 20 years. Drilling down deeper, Moody’s estimates the one-year default rate in the four industries most vulnerable to the coronavirus pandemic with the highest concentrations (on average 1% to 5%) in U.S. CLOs: hotel gaming and leisure, 17.5%; retail, 10.8%; automotive, 15.1%; and durable consumer goods, 15.1%.

Obviously, the next 12 months will be painful for individual holders of those leveraged loans. Moody’s has long predicted that recoveries in a downturn will be lower than the historical average, with first-lien loans recouping closer to 61%, compared with the long-term rate of 77%, and second-lien debt will get just 14% compared with 43%. And, as I wrote last month, funds investing in the riskiest portions of CLOs have suffered a wipeout and haven’t benefited from the rebound in risky assets over the past two months.

Whether speculators face losses is not the question at hand, however. It’s about financial giants like JPMorgan Chase & Co. and Citigroup Inc., two banks flagged as owning $35 billion and $20 billion of CLOs as of March 31, respectively. Setting aside that these are once again absolute numbers, even if Moody’s double-digit default rates over the next year come to pass, investment-grade tranches seem destined to come out unscathed. According to the credit-rating company’s analysis, the cumulative collateral default rate would have to reach 70% to 80% before double-A CLOs take losses, assuming a 60% recovery rate. DoubleLine Capital Chief Investment Officer Jeffrey Gundlach, for one, said on a webcast last week that middle-of-the-capital-structure CLOs were among his picks for most attractive assets, given that he sees a “significant march towards par in their future.”

Certainly, every loan and CLO has its own quirks. Barclays Plc strategists flagged the bankruptcy plans of Acosta Inc. and J.C. Penney Co., which gave CLOs a recovery rate 20 to 30 points lower than other first-lien holders. The problem, they found, was that an aggressive approach from a small group of distressed investors can put CLOs at a disadvantage, in part because many quickly bail on the loans when they’re downgraded, and also because stated investment criteria largely ban purchases of defaulted assets or bridge loans. If this relative lack of flexibility takes a bite out of recovery rates time and again, Moody’s and others may have to reconsider their loss scenarios.

Even still, it’s almost impossible given the evidence to extrapolate widespread losses to the biggest U.S. banks. The Atlantic’s hypothetical stipulates that “later this summer, leveraged-loan defaults will increase significantly,” which goes against the current outlook from Moody’s, and that “holders of leveraged loans will thus be fortunate to get pennies on the dollar as companies default.”

Yes, the equity portions and speculative-grade tranches will face losses. They might even be wiped out entirely. That may seem like a novel concept when the Federal Reserve has taken to backstopping just about all forms of debt, but as S&P Global Ratings has said, that’s just CLOs “working as intended during periods of economic stress.”

There are any number of reasons to fret about America’s recovery from the coronavirus crisis. A repeat financial collapse at the hands of a structured product with a similar sounding acronym isn’t one of them.

PANDEMONIUM

Following days of escalating tensions between the two nuclear-armed neighbors, Indian Army officials confirmed that three troops – an officer and two soldiers, to be more precise – had been gunned down by Chinese forces during a “violent faceoff” in Galwan Valley in the Ladakh region, which rests along the country’s border with China on Monday night.  (…)