When the Music Stops…


When the Music Stops…

By Alton Cogert

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” – Charles Prince, CEO, Citicorp, July 9, 2007

You will undoubtedly remember that quote, as it was a harbinger of the sub-prime crisis, one of the fire-starters of the Great Recession.

But, what few people remember is what else Mr. Prince had to say:

“The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be,” he said.

“At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don’t think we’re at that point.”

So, you see, he really did get it right…just the wrong timing for dear old Citicorp and its bankster buddies.

Why do I bring up this quote now?

Because the Fed will soon end the greatest injection of liquidity into the US economy in history. 

The Fed’s balance sheet now stands at over $4 trillion.  And, although it has reduced its Treasury and Agency MBS purchases slowly over the last year, we must remember it still was buying.  And that buying meant more money created for the economy.

Come October, assuming the Fed stops buying Treasuries (but still buys Agency MBS to offset the natural payments and prepayments on those bonds), no new money will be created.

That means no new money (other than temporary ‘open market operations’) for risky assets, no new money to offset what may be a continuing decrease in the velocity of money (basically, how often a dollar changes hands in the economy), and no new money to help cover the US governments consistently accumulating (though slowing) fiscal deficit.

This certainly does suggest certain changes to financial markets.

However, it is incredibly difficult to guess what the ‘disruptive event’ noted by the estimable Mr. Prince might be…and when it might occur.

Does this mean you should reposition your portfolio in light of the Fed’s announced changes in October?

Considering such a change means you believe you can successfully time the market through tactical moves that add value.  Alas, for many asset classes, that has proven to be a mug’s game.

Instead, it certainly does make sense to continue reassessing your company’s strategic asset allocation on a periodic (usually annual) basis.  Such an analysis should consider long term risk, reward, and correlation, at a minimum, of various asset classes, as well as your company’s lines of business, capitalization, etc.

We’ve also noted that your focus should be on the overall investment process, not just on results.  A good process can produce solid results, while a bad process that produces solid results at a given point in time is called luck.

Eventually, the music will stop. 

Equities do not increase in value 30% (like last year) every year. 

Corporate bond yields in excess of US Treasuries (spreads) can only get so tight – it is doubtful any corporate bond should consistently trade below US Treasury yields, since no corporation in the US can print its own money or levy taxes. 

Below investment grade bonds and leveraged (bank) loans will not stay the darlings of yield hungry investors forever.  And, oh yes, there will be a return to more normalized rates of defaulted bonds.

Risk will return to the markets when the music stops.  It is just a matter of how and when. 

Just ask Charles Prince.

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