The Priceless Parable of Price Discovery

The Priceless Parable of Price Discovery, Danielle DiMartino Booth, Money Strong LLC“Gentlemen prefer bonds.” So quipped Andrew Mellon in 1929 as stocks fell and investors rushed into bonds, pushing their yields down and prices up. Historians recount that the flight to safety had anything but a smooth landing. Within two years, almost all of the sovereign bonds of foreign nations had defaulted, triggering massive losses for American investors and a stream of bank runs that would mark the darkest days of the Great Depression.

What cometh from this despair? Why hope, of course.

Picture the backdrop 85 years ago: Shanty towns that would come to be called ‘Hoovervilles’ had sprung up across the nation as the Clutch Plague took hold. The largest was located in New York’s Central Park. Suffice it to say, the men laboring a handful of city blocks south did anything but take their good fortune for granted. They knew penury was but a paycheck away. In response, they did as we all must during this season – they gave of what they had.

On Christmas Eve, 1931, workers at the Rockefeller Center Construction site pooled their money together to buy a 20-foot balsam fir tree. Erected at the work site, it was decorated with, “strings of cranberries, garlands of paper and even a few tin cans.” Today, a half a million people from all over the world will gaze with wonder at this humble tree’s successor. Another half million will follow in their footsteps tomorrow as will be the case every day it stands, shining as a beacon of hope in its purest form.

To mark the occasion of this holiday season, please accept all I can humbly offer you, week in and week out – my words. For those of you who have read these missives for some time or ever heard me speak, you’ll recognize what follows. For newer readers, settle back. You’re in for not one, but two, real treats, one of which is wrapped in an iconic robin’s egg blue box.

It will come as no surprise to any who have met him that the giver of the gifts you’re about to receive is Arthur Cashin, one of the greatest storytellers of all time. For over a decade, I’ve had the honor to call him friend. Readers of Cashin’s Comments, a daily offering that delights his followers the world round, would agree that it’s hard to pin down the very best story he has told over the years. These are my two favorites.

You may note that 2017 marks the 30-year anniversary of a momentous day in stock market history. It is Cashin’s recollection of the day that followed the 1987 crash that is among my favorites. On the Tuesday, October the 20th, the Dow initially opened up 200 points. But trading quickly turned negative. Adding fuel to the panicked fire, banks were in the process of cutting off lines of credit to the specialists on the floor. What would have followed, had the banks stood firm, could have been catastrophic.

At the moment bad was turning to worse, Alan Greenspan was on an airplane headed back to Washington DC. The freshly appointed Federal Reserve chairman had landed in Dallas on Black Monday just in time to learn that while he had been in flight, the Dow had fallen by 22 percent. This shocking news prompted Greenspan’s cancelling his Dallas engagement and heading back to DC. Unfortunately, for the markets, he was once again in the air, just as another historic sell-off ensued.

As Cashin wrote on the 25th anniversary of the crash, news that Greenspan couldn’t be reached was of little comfort to NYSE Chairman John Phelan: Desperate, Phelan called the President of the New York Fed, Gerry Corrigan. He sensed the danger immediately and began calling the banks to reopen the credit lines. They were reluctant but Corrigan ultimately cajoled them. The credit lines were reopened and the halted stocks were reopened. Best of all, the market started to rally and closed higher on the day.

I hope you agree the story of the day the NYSE didn’t crash harder is a classic. But it doesn’t resonate as much as it once did. Since October 19, 1987, the stock market has operated in an increasingly contained vacuum thanks in large part to overly-easy monetary policy. That makes the following story, generously gifted to me in its unabridged form by Cashin, the most relevant of the day as we look to the new year with stocks at record highs. The two main characters of this timeless tale are Charles Lewis Tiffany and John Pierpont Morgan.

Being the astute jeweler that he was, Mr. Tiffany knew that Mr. Morgan had an acute affinity for diamond stickpins. One day, Tiffany came across a particularly unusual and extraordinarily beautiful stickpin. As was the custom of the day, he sent a man around to Morgan’s office with the stickpin elegantly wrapped in a robin’s egg blue gift box with the following note:

“My dear Mr. Morgan. Knowing your exceptional taste in stickpins, I have sent this rare and exquisite piece for your consideration. Due to its rarity, it is priced at $5,000. If you choose to accept it, please send a man to my offices tomorrow with your check for $5,000. If you choose not to accept, you may send your man back with the pin.”

The next day, the Morgan man arrived at Tiffany’s with the same box in new wrapping and a different envelope. In that envelope was a note which read:

“Dear Mr. Tiffany. The pin is truly magnificent. The price of $5,000 may be a bit rich. I have enclosed a check for $4,000. If you choose to accept, send my man back with the box. If not, send back the check and he will leave the box with you.”

Tiffany stared at the check for several minutes. It was indeed a great deal of money. Yet he was sure the pin was worth $5,000. Finally, he said to the man: “You may return the check to Mr. Morgan. My price was firm.”

And so, the man took the check and placed the gift-wrapped box on Tiffany’s desk. Tiffany sat for a minute thinking of the check he had returned. Then he unwrapped the box to remove the stickpin.

When he opened the box he found – not the stickpin – but rather a check from Morgan for $5,000 and a note with a single sentence – “JUST CHECKING THE PRICE.” 

Please share this timeless legend of price discovery far and wide. Do your part to make sure this priceless parable keeps giving the greatest gift of all — hope.

Creative Indestruction

Night of the Living Dead movie posterGeorge A. Romero knew how to make an entrance onto the Hollywood stage.

Night of the Living Dead, his 1968 directorial debut, set the ‘A’ standard for horror flicks. Though the special effects may seem unsophisticated to today’s moviegoers, the movie still terrifies modern day audiences.

The premise of the film has stood the test of time and been the subject of numerous sequels: The recently deceased find no peace in their graveyard slumber; they rise from the dead hungry to feast upon living human flesh. The film, produced on a shoestring budget of $114,000, follows a group of seven unlucky souls trapped in a rural Pennsylvania farmhouse, desperate to escape the fate that has befallen others who’ve succumbed to the grasp of the ravenous zombies.

It’s plausible that Romero had come across the work of Joseph Schumpeter before entering filmmaking. The phrase ‘creative destruction’ was coined by the Austrian American economist in 1942 and refers to what W. Michael Cox describes as “free market’s messy way of delivering progress.” Something new and innovative necessarily kills off the methodology it replaces, freeing an economic pathway to advancement. The absence of creative destruction, therefore, invites zombie industries to languish, feeding off healthy and more efficient new entrants and dragging down economic growth.

Think Eli Whitney’s cotton gin, which removed seeds from cotton in a fraction of the time it had taken to do so by hand. Imagine a world before the rise of railroads, in which horse drawn wagons were primarily responsible for transporting goods. Dare we go there? Close your eyes and picture what it would take to get through any given day with a rotary phone.

Feeling immeasurably more productive with that iPhone in hand? Then you understand creative destruction, what Schumpeter himself called, “The essential fact about capitalism.”

I suppose that makes quantitative easing and other central banking magic tricks like negative interest rates the essential executioner of capitalism. Look no further than the amount of U.S. industrial capacity that is up and running, or better put, fallow. At 76.5 percent, the rate of capacity utilization remains 3.6 percentage points below its average dating back to 1972.

A friendly reminder – the U.S. economy is technically 80 months into ‘recovery.’ Imagine how much better off we’d be if a little creative destruction would have been allowed to take hold.

It could be worse. We could be as overcapacitized as China’s industrial sector. Consider that cutbacks to production in the Chinese steel industry alone will result in some 400,000 layoffs. Tack on planned capacity reductions in China’s coal, aluminum and copper industries and you’re talking about reducing the Chinese workforce by the equivalent of Wyoming’s or Vermont’s entire population. Debt-fueled growth stories all tend to end the same, though China’s case is arguably one for the history books.

Many years ago, when my friend Oleg Melentyev was still at Bank of America Merrill Lynch, he wrote a report that haunts me to this day. In what I now realize was a channeling of Romero’s spirit, Melentyev warned that there would be repercussions for the default rate cycle of the Great Financial Crisis being cut short by the Fed’s extraordinary measures.

You will recall that step one on the road to ‘extraordinary’ entailed reducing interest rates to the zero bound, which the Fed did in December 2008. By then, there were multiple horror shows playing out in the financial markets. While the stock market bottomed in March 2009, with the Standard & Poor’s 500 hitting a devilish 666-level before rebounding, the bloodbath in the bond market continued through year end.

Companies were meeting their makers right and left. The default rate, which tracks the percentage of issuers reneging on their promised interest payments, was careening skywards and would eventually top out at 13.1 percent, according to Moody’s Investors Service. The rate was a barely discernible one percent two years earlier. Looked at through a slightly different prism, the dollar volume of defaults ended 2009 at 16.8 percent.

The what-happens-next is what so troubled Melentyev at the time. The default rate tumbled 10 percentage points, ending 2010 at 3.2 percent, while the dollar-volume rate crashed to 1.6 percent. (No, Virginia, that is NOT normal.)

For all of the analyst communities’ concerns about the inability to refinance all of this junky debt over the past few years, cheap money has managed to tear down each and every so-called ‘wall of maturity.’ Such is the reality of a world without yield in safe places.

A glance at issuance volumes doesn’t begin to suggest there was a recession underway, much less one that was ‘Great.’ Though growth slowed for a moment between 2007 and 2008, the siren call of zero interest rates that led off 2009 all but commanded investors back into the bond market.

The high yield bond market has doubled in size not once, but twice, since the start of this young century, hence the tendency for it to implode under its own weight. Outstandings doubled from 2000’s $334 billion to end 2007 at $674 billion. Then came the pause. The high yield market ended 2008 at $675 billion, up a mere billion over the prior 12 months.

Then it was off to the races. Issuance has since redoubled the size of the junk bond market to $1.5 trillion, with a capital ‘T.’ If you include all of the debt on high risk borrower balance sheets, including institutional facilities, term loans and credit lines outstanding, you’re talking about an additional $2 trillion.

“The high yield market and leveraged loan market has continued to grow,” worries Moody’s Tiina Siilaberg, “and the covenants are much looser now than they were in 2007. The default cycle this time around will be much different.”

As things stand, investors are being reminded in rude form how closely linked the behavior of risky debt and the stock market are. According to Melentyev’s latest tally, the spread, or the extra compensation investors receive for holding junk bonds vis-à-vis Treasury bonds, is nearly eight percentage points, the most since the fall of 2011.

“All-in high yield spreads today…are at their widest point since the depths of the Great Financial Crisis in 2009,” Melentyev cautions.

To his credit, Melentyev has never been one to buy into the dire need to net out energy borrowers to get the true underlying health of the bond market. After all, no analyst was doing this when oil issuance was going haywire and benefitting investors. If you must, junk spreads ex-energy have another percentage point to go in terms of widening and worsening before reaching their 2011 wides.

By the looks of things, investors won’t have to wait too long. Six of the ten issuers Moody’s downgraded in January to the category least-likely-to-be-able-to-refinance-their-debts were companies outside the atrophied energy sector. Overall stress, as gauged by the credit rating agency’s Liquidity Stress Index, spiked to 7.9 percent from 6.8 percent in December, the highest since December 2009 and the biggest one-month leap since March 2009.

Where’s the real worry? If you do play the neat netting game, but in a fair manner, removing financial issuers, which were a massive drag on the market, AND energy borrowers, which flattered the figures, investment grade is trading at its widest since 2011.

In other words, on a relative basis, junk is actually outperforming its hoity-toity investment grade big brother. It’s tomorrow’s fallen angels, or downgrades to junkland, that should give investors fright. At $5.3 trillion, it’s over three times the size of the high yield market. But that’s such a big story on its own, it merits its own sequel.

Of course, the Fed could truly be on the path to normalizing interest rates, which would give investors license to pull the plug on zombie companies once and for all, and allow Schumpeter to finally slumber peacefully in his ***own*** grave. What are the odds of that happening?

Investors would do well to listen to one of Wall Street’s most experienced voices, UBS’ Art Cashin, on those prospects. Cashin is sticking by his call that we’ll see zero before we see one percent interest rates care of a frightened Fed that backtracks on its ill-fated and two-years-overdue initial interest rate hike.

The next stop? That would be negative interest rates according to the dangerous theorists running the world economy.

Japan certainly seems to have bought into the notion that negative interest rates will prove to be the palliative they’re in desperate need of after 25 years of failed monetary policy. Japan’s inauguration to this sad group brings the total amount of global sovereign debt trading at negative yields to $5.5 trillion. Punctuating the implications for future countries dragged down the same path to negativity: The Japanese government has just canceled its next 10-year sovereign debt auction.

Can you imagine Uncle Sam going that same route – cancelling a Treasury auction because the 10-year was trading with a negative yield? If you answered ‘yes,’ you’re clearly comfortable co-existing with the corporate zombies in our collective midst.