Bob’s Journal for 4/1/21

Margin Calls Roil Markets Again

The best investment plans can be upended by the actions of an aggressive hedge fund or other leveraged investors you hadn’t heard of previously.

We learned that lesson again in the last week. Archegos Capital Management is a family office of a former hedge fund manager.

Archegos had large stock positions that were leveraged using total return swaps. These are investment contracts in which the dealer (usually a bank or brokerage firm) agrees to pay the investor the total return of an investment position after a stated period of time.

An appeal of a swap to the investor is that it doesn’t require much cash down, enabling the investor to take a far bigger position than could be obtained by buying the stock outright or even by using options or futures.

The dealer usually protects itself by hedging the underlying stock or by engaging in matching swaps with other dealers (who then would hedge the stock).

Unfortunately for Archegos, the prices of the stocks in which it had these large, leveraged positions moved in the wrong direction.

When a leveraged position moves against an investor, the dealer issues a margin call asking for additional cash or collateral. If the investor doesn’t post it, the dealer sells the stock. Often, the dealer doesn’t make strategic trades. It sells the stock for whatever price is available, basically dumping the shares on the market.

That’s what happened in the last week.

Archegos had significant total return swap contracts with several dealers. Once Archegos didn’t meet its margin calls, dealers dumped the shares. Prices for the stocks slumped.

Of course, the price declines affect other investors. Some also had leveraged positions. Their shares were sold after they didn’t meet margin calls. Other investors have “sell” programs in place under which a stock is sold automatically after declining below a certain price.

The stock price continues to decline until all the forced and automatic sales end or big buyers decide the price is too low and start buying.

That’s what happened in the last week, with some of the stocks in Archegos’ portfolio declining by more than 50% in less than a week. Chinese stocks and media stocks are believed to be Archegos’ major positions.

Events like this happen regularly. The price action in GameStop (GME) stock received a lot of attention earlier this year as leveraged investors moved the price.

The good news is that the effects of these events are likely to be contained and short term. The stock prices are likely to recover much of the decline, and the dealers will be able to handle the losses.

Similar events brought down major investment banks and helped bring on the financial crisis just over 10 years ago.

Now, the dealers, especially major banks and prime brokers, have much stronger capital positions, manage risk better and are more closely regulated. Some of the dealers will be hurt, but an event such as this is unlikely to bring down even one major financial institution and very unlikely to trigger a wave of failures at financial institutions as happened during the financial crisis.

When building a portfolio and considering investment moves, remember that outside forces such as these are a good reason to always have balance in your portfolio and to avoid placing big bets on one market or economic outcome. The markets are subject to many influences we can’t anticipate.

Look for a Surge in Economic Growth

The markets appear to be underestimating the bump in economic growth that is coming.

Recent market actions indicate that investors in general expect the economy will continue to grow and perhaps a little bit faster than at the end of 2020.

But there are a number of factors coming together that are likely to push growth higher than the markets expect.

The stimulus program enacted in March is extremely large. Many households already were in good financial shape because of the rising stock market and rising home prices. Plus, they fared reasonably well financially during the pandemic.

The stimulus gives those households even more money and puts a floor under those still struggling during the pandemic.

The economy is beginning to open rapidly as vaccines are administered. The vaccine manufacturers are ramping up supply. Indications are that there will be enough supply in the next few months to vaccinate most Americans who want to be vaccinated.

These actions join with the Fed’s continued very easy monetary policy, more spending coming from Congress and the return of warmer weather. Even without widespread vaccines, warmer weather would increase economic activity as it did in 2020.

When I review tracktherecovery.org and the New York Fed’s Weekly Economic Index, I see early signs of a very strong consumer spending surge. Other signs are the increases in airline ticket sales and hotel occupancy.

Consumer spending is likely to be higher than anticipated in the next couple of months. We’re already seeing a lot of supply problems as businesses cope to meet consumer demand in a wide range of sectors. Simply hiring enough people to meet demand, especially in the service sector, could become a big problem.

The result is likely to be shortages and higher prices. Some of the increased demand will be short term and fade as the stimulus spending winds down.

But as in 2020, demand will stabilize at a higher level than before the surge. Businesses will scramble to meet demand. We’ve already seen higher prices in a lot of sectors, and I think price increases will continue through the summer.

Where Were the Bankruptcies?

I’m always wary of forecasts and predictions. The pandemic provided another good example of why I’m skeptical.

Early in the pandemic, a common prediction was that individual and business bankruptcy filings would surge. It seemed obvious. With the economy closing, many people and businesses wouldn’t be able to pay their bills and debts.

But individual Chapter 7 bankruptcy filings in 2020 were 22% lower than in 2019, according to The Wall Street Journal. Chapter 13 bankruptcy reorganizations were down 46%.

Commercial bankruptcy filings did increase by 29%. But those were focused in a few sectors and we didn’t see the anticipated widespread liquidations of major companies. One widely anticipated trend that didn’t occur was a mass default on corporate bonds, especially high-yield bonds. Instead, the Vanguard High-Yield Bond fund (VWEHX) had a total return of 5.28% in 2020.

A number of factors intervened to mitigate the situation.

There were moratoriums on foreclosures, evictions and debt collections. The federal government’s unprecedented stimulus programs helped many households and businesses.

Also, the pandemic didn’t hurt all businesses. Many increased revenue in 2020. Some individuals and businesses were able to adapt by joining the sectors that were doing well.

It could be that the government actions during the pandemic merely delayed the inevitable. But the bankruptcies and defaults that didn’t happen show how difficult it is to invest based on predictions.

The Data

New unemployment claims increased by 61,000 to 719,000 in the latest week. But last week’s reported new claims number was revised lower from 684,000 to 658,000.

Continuing claims decreased by 46,000 to 3.8 million.

The total number of people receiving some kind of unemployment compensation declined by 1.5 million to 18.2 million.

About 517,000 new private sector jobs were created in March, according to the ADP Employment Report. In addition, the number of jobs created in February was revised higher to 176,000 from the 117,000 initially reported.

The March number is the highest in this report since September. The largest gains were in the leisure and hospitality sector. Service sector jobs increased 437,000.

Home prices climbed at their fastest rate in 15 years in January, according to the S&P CoreLogic Case-Shiller Home Price Index.

The index increased 1.2% in January and 11.1% over 12 months. It is the 12-month rate that is the highest since February 2006.

The FHFA House Price Index found that prices increased 1.0% in January from December’s levels and prices increased 12.0% over 12 months.

Demand from home buyers was strong because of very low mortgage rates. But the supply of homes available for sale is at or near record lows in most areas, forcing buyers to compete for homes.

Pending home sales decreased 10.6% in February compared to January’s total, according to the National Association of Realtors (NAR). That’s the second consecutive monthly decline.

Pending home sales are down 0.5% over 12 months. That’s the first 12-month decline after eight months of increases.

NAR said the decline is due to inadequate inventory of homes for sale. There is an adequate supply for higher-priced homes. But sales are lagging for homes valued below $250,000 because of the lack of supply.

The ISM Manufacturing Index shot higher to 64.7 in March from 60.8 in February. This is the highest level since 1983. New orders increased substantially, and manufacturers reported paying higher prices for supplies.

The Kansas City Fed Manufacturing Index increased to 26 in March. It was 24 in February and 17 in January.

The growth rate increased for shipments, new orders and order backlogs. Business conditions in the region now are comparable to their pre-pandemic levels.

The Dallas Fed Manufacturing Survey also reported higher growth in the sector. The Production Index derived from the survey was 48.0 in March, compared to 19.9 in February.

The General Activity Index from the survey increased to 28.9 in March from 17.2 in February.

The final PMI Manufacturing Index for March increased to 59.1 from 58.6 in February.

The Midwest economy surged in March, according to the Chicago Purchasing Managers Index. The PMI was 66.3 in March, compared to 59.5 in February. The measure has been near or above 60 for seven consecutive months.

Consumer Sentiment in March, as measured by the University of Michigan, increased to its highest level in a year. The Consumer Sentiment Index for March was 84.9, an increase from 83.0 recorded in mid-March and 76.8 at the end of February.

Sentiment regarding both current conditions and expectations increased. But the index still has recovered only 45% of its decline from the pre-pandemic highs to its low point.

Consumer Confidence, as measured by The Conference Board, increased to 109.7 in March, compared to 90.4 in February. That’s the highest level in a year.

Both the Present Situation and Expectations components of the index increased sharply.

Personal Income decreased by 7.1% in February from January’s level. The decrease was due to a decline in government benefits, because the bulk of the previous round of stimulus payments was distributed in January.

Personal consumption expenditures decreased only 1.0% in February. Households spent less on goods but increased spending on services. The spending increase was concentrated in housing, utilities and health care.

The Personal Consumption Expenditure (PCE) Index (the Fed’s preferred measure of inflation) increased 0.2% in February compared to 0.3% in January. The index increased 1.6% over 12 months.

Excluding food and energy, the PCE Index increased 0.1% in February and 1.4% over 12 months.

The Markets

The S&P 500 rose 2.27% for the week ended with Wednesday’s close. The Dow Jones Industrial Average gained 1.88%. The Russell 2000 increased 4.39%. The All-Country World Index (excluding U.S. stocks) added 1.55%. Emerging market equities rose 3.21%.

Long-term treasuries lost 5.24% for the week. Investment-grade bonds increased 0.15%. Treasury Inflation-Protected Securities (TIPS) lost 0.47%. High-yield bonds gained 0.77%.

In the currency arena, the U.S. dollar increased 0.72%.

Energy-based commodities declined 0.64%. Broader-based commodities lost 0.55% and gold fell 1.45%.

Bob’s News & Updates

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