Easy Money, Stock Buybacks, and the Wall of Worry

In September 1998 Long-Term Capital Management (LTCM) hedge fund lost $4.6 billion. From 1993 until 1998 LTCM was amazingly profitable, generating annual returns in excess of 40%. The core of its success was a sophisticated mathematical trading model created by Myron Scholes and Robert Merton, the 1997 Nobel Prize Winners in Economics, using borrowed money to leverage. At the beginning of 1998 LTCM had equity of $4.72 billion plus borrowed funds of $124.5 billion.

 Unfortunately, the model did not anticipate the Russian government’s default on its bonds. LTCM’s failure was large enough to have spooked the Fed into a swift $3.4 billion bailout accompanied by interest cuts. Investors in LTCM were more than grateful for the rescue and the stock market responded with a rally that eventually ended in one of the all-time speculative manias in 2000.

 Fast forward to September 2006 and the $6 billion plus loss taken by Amaranth hedge fund. What it lacked in sophistication it more than made up for by taking huge risks to generate $2.7 billion gains in the first eight months of 2006. The market it bet on big- time was the natural gas market.

 Unconfirmed reports suggest that more than 50% of fund assets were invested in spreads between the natural gas futures of two different months in anticipation the spreads would increase with the onset of heating season. Instead, the spreads suddenly narrowed during September 2006. For example the December 2006 versus November 2006 spread went from $2.02 in August 25, 2006 to $1.25 in September 22, 2006. Unfortunately for institutions that placed their money with Amaranth the only action or help they got from government agencies was an investigation by the SEC.

 Thanks to excess global liquidity and smaller assets of Amaranth involved, the financial markets did not need the Fed to come to the rescue. Liquidation of hedges held by Amaranth and other funds only hit an already depressed natural gas market. The record high storage levels, the result of an unusually warm winter during 2005 and 2006 and the moderate summer of 2006 were bad enough for natural gas producer. The last thing they needed was a bunch of gunslingers playing their market.

 Increasingly clear signs of a slowing economy have yet to diminish optimistic expectations for a soft landing, circa 1994 to 1995. Unfortunately, out of the last 16 monetary-tightening cycles by the Fed, that was the only one that was not followed by a recession. The decline in yield of 10-year T-Notes from 5.2% to 4.5%, since July 2006 is an indication bond traders are going with the high odds that the landing will not be a very soft one.

 Stock market investors who still remember the five-year bull market that followed the end of that tightening cycle appear to have a more upbeat expectation for the economy and earnings growth. That, at least, is the first impression one may get from the market gains of 9% to 10%, from their June to July 2006 lows.

 However, with the benefit of hindsight, it is apparent that the slow, but steady, market climb of the last two years owes a lot to the excess liquidity created by the Fed and the Japan Central Bank in their efforts to halt the deflationary threat in 2001 to 2003. The consequence has been an accelerating growth in mergers and acquisitions (M&A), with many privately leveraged buy-outs (LBO).

 According to Thompson Financial (www.thompson.com), in the first half of 2006 the Worldwide value of M&A rose to $US 1.8 trillion, up by 44% from the first half of 2005. In the U.S. the M&A hit $702 billion in the first half of 2006, up by 22% from a year ago. That included the U$26.5 billion LBO of Kinder Morgan. The second factor helping the market climb the “walls of recession worry” has been stock buybacks. Using record high cash reserves the S&P 500 companies alone repurchased $367 billion worth of shares in the year ending March 31, 2006. At the same time, the supply of stocks from new equity underwritings has been well below the volume of M&A. In the first half of 2006 the total value of global equity underwriting was $321.8 billion, up by 46% from 2005. In the U.S., equity offerings totaled $111.5 billion, up by 63%, for the same period in 2005. There are always other factors moving markets, but for the long-term nothing is more important than demand and supply imbalances.