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Increasing Signs of Systemic Stress

May 21, 1999

While it was a difficult week to make money as a bear, it was one of the more encouraging weeks in some time as fundamental developments strongly shifted in our direction. For the week, the Dow lost 84 points, or less than 1%. The S&P500 declined about one-half percent, the Morgan Stanley Consumer index traded unchanged, the Utilities gained about 3%, and the small cap Russell 2000 rose 1%. The economically sensitive sectors came under some selling pressure, with the Transports declining 3% and the Morgan Stanley Cyclical index falling 2%. Technology stocks had a wild week, as a huge rally finally succumbed to selling towards the end of the week. For the week, the Morgan Stanley High Tech index rose 1 ½%, and the semiconductor stocks gained 3%. The NASDAQ 100 was about unchanged and The Internet index dropped about 1%. Toward the end of the week, the financial stocks were under selling pressure. For the week, the S&P Bank index declined 2%, and the Bloomberg Wall Street index lost about 1%. It was particularly interesting today that the financial stocks performed poorly despite a rally in the Treasury market.

As the week came to an end, there were increasing signs of financial stress both here and abroad. Actually, it looks like the recent strong rally in Latin American stocks and bonds has come to an end. Today, equity markets in Mexico and Brazil dropped 3%, while in Argentina stocks were hit for 4%. For the week, these markets declined more than 5%. Latin American bonds also came under significant pressure. For the week, the JP Morgan emerging market spread index widened from 933 basis points to 1107, in the worst week since the devaluation of the Brazilian real in January. During the past two weeks, emerging debt markets have declined 8%, the poorest performance since the emerging market crisis late last summer. Interestingly, it is not just the rallies in Latin America stocks and bonds that appear to be ending. Stocks in Asia and Europe were also unimpressive this week. Previously hot markets in Hong Kong, South Korea and the Philippines lost about 5% this week.

Today was quite interesting, as there was considerable speculation as to the reason for the dramatic change in the performance of the emerging markets, particularly in Latin America. Many pundits blamed the weakness on supposedly false rumors that the Argentina currency peg was to be broken. Others reasoned that market perceptions had quickly changed regarding the outlook for the region's economies, while others focused on the vulnerabilities of these weakened financial systems. Whatever the reason, however, the key was that there was talk of liquidity problems and considerable difficulty today completing some large sell orders. There is nothing like the recognition of faltering liquidity to instantly change perceptions. But wasn't it just a few weeks ago when there appeared an almost insatiable demand for Latin American stocks and bonds and a virtual buyer's stampede? What has changed?

Well, it is certainly our view that this week's tumult in the emerging markets goes much beyond regional concerns and difficulties. Actually, we think the heart of the problem is right here at home. And to the above question, "What has changed?" we respond that the answer lies specifically in the faltering liquidity conditions throughout our credit markets. With interest rates rising, our overleveraged financial system has come under increasing stress. Importantly, many leveraged players are being forced to dump securities. In addition, the crowd of derivative players, many that have written derivative insurance against higher interest rates, have been forced to sell government securities as well as Treasury futures contracts to hedge exposure. And when the leveraged community becomes a big seller, it is not so easy to find cash buyers. With many selling, the end result of this is sharply higher interest rates and increasing market dislocation for other credit market instruments.

Until recently, most did not consider higher interest rates as much of a problem, with the bulls focused mainly on various credit market spreads. Last year, remember, it was widening spreads that led to the collapse of Long Term Capital Management, as they, and many others, had basically shorted Treasuries to go long other higher yielding instruments. When the Russia crisis led to market dislocation and sharply widening spreads, huge losses were suffered that forced the unwinding of highly leveraged positions. Market liquidity quickly vanished and our highly leveraged system was near collapse. Now, with Treasury yields rising sharply over the past few weeks, the bulls have taken great comfort in the fact that spreads had not widened. Apparently, it has been their view that only wider spreads would pose a potential problem for the bull market.

Well, we think the bulls have been too complacent. The main reason spreads remained narrow was due to the significant selling pressure in the Treasury market, much likely emanating from derivative-related selling. But it is certainly our view that this has been but the first inning of the developing liquidity crisis. During this first inning, the leveraged speculators that were long Treasuries have been hit hard. Now, it looks as if increasingly impaired speculators are now beginning to liquidate other risky securities. Today, we suspect that the leveraged speculating community was trying to get out of emerging market debt instruments and this is behind the sharp price declines. And with unprecedented leverage and speculation permeating our entire financial system, we don't think it will be long until more aggressive selling is felt in junk bonds, mortgages, and other corporate debt securities.

Actually, it appears this selling began this week and only intensified as the week came to an end. Today, the spread between investment grade corporate securities and Treasuries widened 5 basis points. Over the past nine days, this spread has widened eight basis points. This is not a good development for those having shorted Treasuries to finance the purchase of corporate debt instruments. There is also increasing talk that Wall Street has accumulated too much inventory over the past few months and is now trying to unload some of this paper before the losses become too great. Interestingly, yesterday Fannie Mae sold $1.5 billion of 30-year bonds at a spread to Treasuries of 55 basis points. Yet, much to the consternation of the buyers, the spread at the close today rose to 61. This may not seem like a big loss, but it is for the highly leveraged buyers. We see this as a key development that is indicative of too much supply and not enough demand for credit market securities. With more than $200 billion of debt sales during the first three months of this year, it looks like supply has finally taken its toll.

This week also saw a sharp reduction of new debt sales. Through yesterday, there had been less than $5 billion of new corporate debt issuance, the slowest pace so far this year. Last week, for example, $18 billion of new debt had been sold. Demand certainly appears to have faded quickly in the junk bond market. Sales this week fell to $1.8 billion, this after $12 billion of issuance over the past two weeks. Importantly, this was also the second straight week that investors pulled money out of high-yield mutual funds. And with liquidity faltering, companies that did sell junk this week had to accept interest rates at the high-end of expectations. Several companies had to reduce the size of their deals or simply cancel them all together. And while there still appears to be demand for stronger issuers, the market for the more risky deals is all but disappearing.

And with growing tumult in emerging markets and corporate securities at the end of the week, Treasuries had a nice rally. We don't see this, however, as at all bullish. Sure, the yield on the 30-year bond dropped to 5.75%, or 17 basis points from last Friday. The yield on the 5-year, however, declined only 7 basis points, to yield 5.43%. This relatively poor performance for the 5-year is key, as the 5 and 10-year Treasuries are used extensively for hedging. The more corporates that need to be hedged, the more selling pressure and the higher interest rates will move. Going forward, the key to the markets will be all the hedging and derivative trading. We certainly saw sharply wider derivative spreads today, and we see this as much more significant than today's Treasury rally. In fact, it is likely that, going forward, the movement of various spreads will take on considerable importance. As was the case last year, many leveraged players short Treasuries to finance leveraged speculations on higher yielding securities. These players had been largely immune from losses, as rates have risen, at least until this week. If spreads continue to widen and these players are forced to dump holdings, things could get interesting in a hurry. In this regard, we often ponder who will buy all the securities if the leveraged players sell. Clearly, with credit excesses permeating our financial system, this is all one big accident waiting to happen.

As the week came to an end, signs of stress were becoming more visible throughout our financial system. Importantly, faltering liquidity in our credit markets is now beginning to impact other markets. If, as we suspect, the leveraged players continue to suffer losses, they will be forced to sell securities. And, importantly, once the crowd begins to sell, it can rapidly become a race to get out the door first. The stock market, of course, is trying to ignore these developing credit market problems. We believe, however, that it can do this for only so long. The bulls just fail to appreciate that all the leveraged speculation in the credit markets is the true source for the liquidity that has fueled this most historic stock market bubble. And it has also been this massive leverage and resulting stock market bubble that has powered our booming economy. So, with this in mind, we believe current developments are of the utmost importance and we are following the situation very closely. We certainly view these developments as encouraging for Prudent Bear Fund investors. It was another challenging week, but we are most happy to have option expiration week behind us and look forward to next week.

We will conclude with a quote made this week by legendary Federal Reserve Chairman Paul Volker. "The fate of the world economy is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings."

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