There is no better example of “Early Means Wrong” than the subprime short in the 2008 crisis

By Peter Tchir of Academy Securities

Life In A Video Game

No, I’m not talking about virtual reality or our efforts to use and understand AI chatbots. I’m talking about markets.
Video games allow you to do things very quickly. You can conquer the world or play a single NFL season in a couple of days. Everything is possible and happens quickly so you can do it again and again.

This week we saw two examples:

We started with the recession the issue gained momentum and ended up believing in the “soft landing” scenario. WTI was the poster child for this fast-paced “game” that dropped from $77 to $68 (and finished at $71). Apparently, this week we had (and solved) a banking crisis. We did it in one week for the second time this year! While banking stocks ended the week lower, there were some surprising upside moves on Friday.

I’m not incredibly bearish. I’ve been moderately bearish, and despite Friday’s strength, the S&P 500 closed up nearly 1% and the Nasdaq 100 was marginally positive. I’m reluctant to bring up this next topic, but I feel compelled to do so.

I HATE the big short

This is ground we’ve covered before, but between what’s going on and my thoughts on mom, where bond losses come from, I felt it was time to reiterate some long-standing themes. The bond loss piece we posted on Thursday is worth a read if you missed it.

HATED the big short. I really like Michael Lewis. Liar’s Poker remains my number one recommendation for anyone considering a career on Wall Street (with the number of veterans coming to Academy Securities, we’ve probably increased sales). This has nothing to do with Michael Lewis, but everything to do with how the story was told.

It took me several years to even open the book. I lived through the CDS index trading crisis at the time (IG, HY, XO (what a beast) and LCDX). We traded a lot in the mortgage market as people traded ABX (of “flying the world” fame) in the other markets. Some of the major mortgage players were large components of the CDS indices (WAMU, Countrywide Financial, etc.). So tickers and trading were forever etched in my mind (not in a good way) and I was reluctant to read the book.

I finally fought through the book and I only have one complaint, but it’s a big complaint. The book made it sound like only a couple of people figured out the “problem”. For the record, I still can’t bring myself to watch the movie even though I’m told it’s really good.

Very few identified the problem, found the best way to execute the bet (AAA ABX), had the ability to stay in the trade when it started to break, I he had the conviction to stay in the trade during several powerful rallies.

The story took years to develop. Investors had been bearish on this market segment as early as 2005 and there was no better example of “early equals bad” in the financial markets than those businesses. 2006 saw more people get laid off. In early 2007, even more bones were created (and an inordinate number of Wall Street teachings about “why ABX is cheap”). So it wasn’t that just one or two people figured something out, many figured it out too soon, which I think is a useful lesson in this “video game” environment we’re dealing with!

The first major cracks in the mortgage market began in 2007. However, after serious intervention by the Fed, stocks hit new highs in October. Then things broke again, with CDX IG nearly breaking 200 in the days before Bear was bought by JPM. And yes, you guessed it, we went back to very credit-tight levels in the summer of 2008. Lehman was in the fall of 2008, and it was just one of many key events in the fall. The stock market didn’t bottom out until March 2009!

While “Lehman Moment” could be helpful (Lehman was NOT a moment), the process was long and created many opportunities to make and lose money in all directions.

The main advantage is this the market treated things as “solved” several times during those years, only to discover that they really weren’t (or that we had moved on to some other problem, often caused by one of the previous problems).

I’m not as bearish as the paragraph might sound

I’ve been sitting at a -4 (on a scale of -10 to 10) in equities for about a month (S&P 500 up 0.76% in that time, Nasdaq 100 up 1.5%) and just this week i downgraded my credit risk. from neutral to -4.

In any case, despite the previous section, I’m tempted to move my risk appetite closer to neutral (or even positive).

The two things I liked about this week:

The good news was good on Friday. Jobs’ data was “some good news” from an economic point of view, as noted on Friday. The 2-year yield rose 13bps (from 3.79% to 3.92%, which used to be a big move in 2-year yields). The market, rightly, believed the data could push the Fed to consider a hike in June rather than ending or cutting.
Earnings are almost done and discretionary buybacks are ramping up. Buybacks are a very powerful tool against QT headwinds. With many stocks well near their highs, there should be heavy use of buybacks, even in this higher yield environment.

I didn’t like the fact that the research talk of short trading in bank stocks on Thursday/Friday contributed to the strength. My experience through the GFC and the European debt crisis is that banning short films tended to have very limited impact and made things worse if and when there was another round of weakness (as there would be no supply of ” short cover”).

bottom line

I am being stubborn about not changing my equity/credit rating. I should probably move it closer to neutral, but I can’t get there.

Beyond that, a “vague notion” I have is seeping into something that could be a plausible tail risk event. I’m still playing with how it might work, but the “bond losses” due to the forced sale, the over-eagerness to claim victory over every crisis and the increasingly dismissive attitude towards the uber-bears (who have had some recent wins) are crystallizing into a tail risk of sorts.

This tail risk, while still nebulous, is lurking somewhere in the bond market. As discussed in “where bond losses come from”, the debt ceiling (however chaotic it becomes, including the risk of defaulting on some debt on time) has the potential to be a catalyst. We could see, for a number of reasons, bond selling outpace bond demand too quickly, which could spill over into other assets. Again, I haven’t latched onto that scenario, but it’s what I’m thinking about a lot right now. Also, at least so far, it hasn’t been identified by chatbots, so there might still be a need for human thought.

In terms of rates, we are limited at the moment. 3.55% in 10 seconds looks like a buy, while 3.30% looks like a sell. There may be some tail risk to either side, but it’s not obvious to me unless some geopolitical event occurs, which would likely create a flight to the security trade.

On the front, the market pulled ahead and remains overly optimistic that the Fed will go into cut mode. I don’t like the 2 year here as it should yield more and so I think 2 vs 10 will be invested more. However, that trade was crushed briefly this week (before the recession was averted on Friday).

With a high degree of certainty, I would advise issuers to issue sooner rather than later. Summer is fast approaching in what has been a tiring start to the year for most asset managers and the debt ceiling (among other things) creates some uncertainty.

And while both the problems facing the banking system and the risk of recession have been “solved” this week, we’re not living in a video game or a boo.k. So I have no change in my risk perspective. This weekend, I might guide the Bills to a Super Bowl in Madden or enjoy the nice weather and play golf (which chatbots can’t do by the way).

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