T'was The Night Before Another Derivatives Induced Blow-Up?
By Brady Willett

Corporations with a global reach have long implemented hedged derivative programs to cushion the blow of currency fluctuations. However, it is custom nowadays for companies to use derivatives not only as hedges against currency movements, but to add profits to their bottom line. Case in point, gold stocks: all you needed to know when looking at gold companies 15 years was how many shovels, and holes the company owned, while today you are lost without knowing how many swaps, put options, and forwards each company owns, or is speculated to own.

The acceptance of derivatives into most industries is problematic given that these specialized financial dealings do not necessarily mesh cohesively with the industry/companies traditional business practices.  More simply, while derivatives have become the hottest financial instrument over the last decade they have remained the least understood.  For example, the OCC tells us that there is roughly $51 trillion (notional amount) in derivatives held by commercial banks – a large double sided number that has been grown by nearly 20% annual over the last decade.  However, no matter how hard you look into this number you will not find out the specifics of each trade by which the number is based.  Rather, the OCC tracks derivatives by contract type, and investment instrument, not by branch, and trade. Furthermore, corporate America usually places derivatives under the 'investment' umbrella, and adds an intricate set of footnotes that leave much to be discovered. Point being, while we know banks like to use interest rate, and foreign exchange swaps, we don't have any information telling us when such contracts are teetering on the brink. 

That said, thanks to new SEC rules investors are notified of changes in the value of derivatives each quarter (gain/loss on balance sheet translated into financial gain/loss), but what good are even these numbers when the damage dealt to LTCM, and Enron developed within days, not quarters?

Greenspan has long been a proponent of the use of derivatives (both exchange and OTC). His basic argument has been that 'the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.'   However, even though Greenspan fully realizes that OTC derivatives are largely unregulated he does not think there is cause for concern:

"As we approach the twenty-first century, both banks and nonbanks will need to continually reassess whether their risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly. Should they succeed I am quite confident that market participants will continue to increase their reliance on derivatives to unbundled risks and thereby enhance the process of wealth creation."  
Greenspan on Financial derivatives ~ March 19, 1999

The words 'should they succeed', referring to those entities playing with derivatives, is not exactly the words you would expect from someone in Greenspan's position. This just in: 'they' are not succeeding – Enron just asked a judge if they could 'terminate derivatives contracts as soon as possible', the FERC is scrambling to get some new derivatives reporting rules into place this week, Moody's is hacking down anything related to Enron, and when investors hear the word 'derivatives', and 'energy' they run for cover.  In sum, while the creation of wealth from the unregulated derivatives market seemed like a good idea yesterday, it is the destruction of wealth that ensures it is a bad idea today.

The Ratings Master?
As for Moody's (MCO), the company took a moment after last weeks hackings (Kmart is junk now too), to upgrade its own estimates for 4Q01: now the company expects to earn 0.34 cents – 0.36 cents in 'pro forma' earnings.  Perhaps with continued profits Moody's can make its own balance sheet look like less of a train wreck?   With current assets beating current liabilities by less than $10 million, and shareholders equity sitting at negative $295 million, you would not be wrong to quickly use the word 'junk' to describe Moody's.  That said, a bet against Moody's is, in effect, a bet against Buffett: Brekshire owns roughly 15% of the outstanding shares.  Yes, apparently 'cash-flow', and the intangible powers that are 'Moody's' handily beat any ROE considerations.

Driving Away Investors
Ford, perhaps sensing that big bad Moody's will soon make life a little bit more difficult, announced last Friday that they intend to sell $6.5 billion in various debt instruments.  Immediately following the announcement Group Vice President Don Winkler (head of Ford Financial) called it quits.
As for GM, the company will idle 2000 jobs in Oshawa for the month of January, and once again be reducing its 401K matching program.  While 401K reductions are supposedly a 'rare step', it is worth remembering that most plans did not exist 10 years ago.  As such, one is completely sure what the state of 401K's, and corporate stock programs will look like when the market finally bottoms. That said, if share plunges did not 'upset' employees enough during 2001, the loss of matching power could cause further aches, and pains:

"Many companies are trying to wait out the economy and hoping a business turnaround will not cause them to not make any drastic changes that truly do upset employees."   CBSMarketWatch
Related: Limit company stock in 401(k) plans ~ CSMonitor

Recession Ruins? 
With investor speculation running amuck concerning a possible late 2002 economic turnaround many investors seem to have forgotten one thing: you don't need a turnaround to find thriving areas within the marketplace.  With this in mind, below are the top 3 industries in 2001 based on return-on-equity (ROE):

Rank

ROE (Last 12 Months)

Industry

1

47.478

Tobacco

2

35.718

Beverages (Alcoholic)

3

31.457

Casinos & Gaming

From a collection of 102 industries

 

Notice how the words 'tech', 'chip', and 'internet' are no place to be seen?  Yes, the current recession is like all others in that people will always smoke, drink, and gamble.  To tie this rant into tech, a nation of speculators looks set to lose money in 2001 because they believed one of two things, or perhaps of combination of both:

1) Tech is not cyclical
2) The economic rebound is imminent.

Tech Wreck 2001

  

Rank

ROE

Industry

10

23.3

                      Computer Hardware

59

10.7

                      Software & Programming

83

3.8

                      Computer Services

84

3.4

                      Electronic Instr. & Controls

85

2.8

                      Computer Peripherals

87

2.1

Semiconductors

97

-2.6

                      Computer Storage Devices

100

-3.7

                      Computer Networks

102

-14.6

                      Communications Equipment


While ROE does not directly parallel stock price movements, it is an excellent indictor on the health of an industry.  Suffice to say, Tobacco, alcohol, and casino stocks have been a the healthiest sectors to own in 2001, and will remain stable in 2002 regardless of whether or not an economic recovery comes to pass. Tech on the other may not.

To further show how irrational tech stocks have been, and perhaps still are, take a quick glance at this tidbit from Kiplingers:

"A few weeks ago, Merrill Lynch came up with what I consider one of the more amazing investing statistics in recent memory: Utility stocks, once the choice of widows because of their healthy dividends, have outperformed Nasdaq since 1991."

Utilities crushing tech?  The world is finally starting to make sense…

Year-End Mambo
Those stocks that have declined this year could encounter further hardships before 2001 ends thanks to a healthy barrage of tax-loss selling. I use the term 'healthy' because such drops may uncover further undervaluation in the marketplace. By contrast, those stocks that have performed well in 2001 could find themselves locked into portfolios as investors try and avoid the tax-man until 2002. 

These types year-end antics confirm but one thing: don't look to the markets to tell you much of anything before 2002.  That is, of course, unless selling becomes popular again as 4Q01 warnings roll in, and investors plan to beat the rush to the exit doors that is set to arrive come January.

Selling is the easiest thing in the world to do in a market where news is bad, and expectations are good. You didn't think Buffett wanted to hold Moody's forever did you?

Baring the stock market spectacular the word will be on hiatus until 2002 as I work to complete the 2002 Wish List.   Happy holidays.


BWillett@wallstreetwishlist.com

December 19, 2001



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