Leverage, Liquidity and Volatility – the three pale riders of value destruction

Blain’s Morning Porridge Oct 18^th 2022 – Leverage, Liquidity and Volatility – the three pale riders of value destruction

“A drop of Nelson’s blood wouldn’t do us any harm!”

This Morning:. “Leverage, Liquidity and Volatility upturn markets, triggered by policy mistakes, ignorance, hubris or plain getting it wrong. These are dangerous times as multiple issues threaten confusion – so some simple market mantras might help!”

Interesting markets…. I can’t help but feel the perilous forces of Leverage, Liquidity and Volatility are conspiring against us. Bring it on….

I am not going to write about politics!

I am not going to write about politics!

I am not going to write about politics!

But of course I will probably will.

Why do I insist on boring readers of the Morning Porridge with politics?  What you are looking for is great insights into market value and opportunity…

Ok – here is a market insight:

TESLA – FANTASTIC CAR MAKER: ENTRY POINT COMING UP!

I admit I have been utterly wrong about Tesla for many years. It has become a highly profitable and successful company, making decent profits from successfully innovating Electric Vehicles while overcoming multiple  production and funding issues. It may not produce as many cars, or have the same margins, as other auto companies, but its order books show just how successful it is, and how its model is being copied.

 Tesla is down around 50% since its high on Nov 5 at $414.50. Against the expectations of sceptics like myself, it has become a great automaker, and is set to become a future market leader – although there are risks around lithium batteries and competition.

I therefore confidently expect its stock price to fall a further 80% to about $80 reflecting the reality it is a fantastic, profitable, mature EV maker commanding a substantial premium relative to other auto manufacturers.   

I ascribe zero real value to its “battery business” because that is highly competitive and free of entry barriers, and autonomous driving is not a thing, and is unlikely to become so for many years by which point Tesla’s imagined IP in the “not-a-thing” area will also be zero.

But Tesla will remain a fantastic car company. At $80 I will be a buyer! I might even buy the car.

There you go. Later this week I will explain why I am also looking at the metaverse and for an entry point into Facebook META.

Meanwhile, back in politics, you might not want to read my opinions of why one political party’s policy is crazy while the other’s is simply stupid. But, Politics, alongside a host of other “bads”, is what makes markets.

Market sentiment boils down to a function of stability and uncertainty, (St = f{Sb+Uc}), while stability itself is a function of how many Adults are in the play-room. Not so many I fear when it comes to politics. The ongoing kindergarten politics of the West leaves open the gates to yet more shocks to come….. I could list them… but risk flashpoints like US gridlock after the mid-terms, or European tensions as energy shocks and recession deepen, will only bore you… Yet they are important.

But I suspect the next shock are already hiding in plain sight. Let me tell you a story….

I met an old markets chum for a quick drink yesterday. What he doesn’t know about trade structuring, derivatives and investment strategies isn’t worth knowing – but he admitted to being absolutely shocked by the scale of the Liquidity Driven Investment (LDI) strategies UK pension funds have been playing.

He knows UK pension managers are frankly duller than ditchwater, need multiple sign-offs to buy a new BIC biro, and have every single investment thesis tested, tested again, and retested by “advisors” and “consultants”. How had the investment banks got the trades past them? He understood exactly why the real money funds took on board leverage driven strategies – to raise returns to meet future liabilities in the QE era of distortedly low interest rates.

What surprised him was that nobody had addressed the risks the use of leverage raises in times market volatility. If funds were 4 or 5 times levered, then a single large move in the underlying gilts would drive a massive swing in the derivatives driving the returns. That’s what triggered the market-to-market margin calls that threatened to overwhelm the gilts market 2 weeks ago.

His question was simple: why had no one foreseen or asked about it before? Actually… the issue of LDI leverage was raised many times within the ECB and the BOE… but apparently whoever in the quant department understood the margin and counterparty risks from volatility, must have assumed someone in risk or prudent market regulation would then run with the question. Apparently not.

It looks like the consequences of LDI trades were missed. Its another example of how leverage can trigger crisis in volatile markets almost tripping liquidity in Gilts. Was it just another policy failure the financial authorities hadn’t addressed or that investors didn’t understand?

As LDI came close to spiralling the UK’s government bond market into chaos – and was quite avoidable – you have to wonder what other dangers lurk below the surface…

(Queue the theme-tune from Jaws playing in the background….)

What is going to shock us next?

• Policy mistakes – can cover about anything under the sun – are the great triggers of market instability and price volatility. Politics and Central Banks make the big ones, but lets not draw any distinctions between them. The policy mistake risks have never been higher in the nearly 40 years I’ve been messing around in markets..
• Ignorance is another – not realising what you know is what you know. It’s what you don’t know that’s the problem. There is an awful lot more data swamping market common sense that ever before. I suspect the sheer volume of information available today actually hides the underlying trends and obscures the facts. We tend to see what we want to see in the morass of market inputs.
• Exuberance, or the issue of who is swimming naked when the market tide goes out is another. Everyone wants to call the rally. Everyone is greedy. Everyone wants the easy money. Assessing the risks is more difficult when everyone is wedded to thematic investments.
• And of course, there is simply being wrong… Like thinking banks can’t go bust, houses will never lose their value, cryptocurrencies are real, or markets have reached their bottom because the Fed might be about to pivot and rate rises are limited.

Collectively we are not as clever as we think, and we don’t fully understand the mechanics of the financial environment we swim in. Back in the 1980s I marvelled at the East End “Barrow Boys” who dominated market trading in the early Eurobond markets. None of them had degrees, but they were smart, clever and absolutely sensed the market. They did so intuitively – they didn’t overthink it. The Force was with them. Today any trader is a function of whatever straight-jacket thinking the risk managers impose on them.

Today we probably do overthink it. Trying to really understand money and the real issues around bank monetary creation absolutely does my head in! Time wasted when I really should be calling clients and getting them to deal!

There are broadly three financial forces that underlie the way risk becomes pain: Liquidity, Leverage and Volatility = LLV.

Its how they interact that turns great market decisions into career ending market risks. Highly Levered trades in Volatile markets prove impossible to exit from because of Liquidity constraints.

These are dangerous times… So this morning let me share some of the key Blain’s Market Mantras with which to address them:

• The Market has but one objective: To inflict the maximum amount of pain on the maximum number of participants.
• The Market has no memory – and neither do buyers…
• The moment to buy/sell an asset is some point before you first think about it.
• Walking out first is better than crawling out last – The first cut is the cheapest!
• In an illiquid market a bid is a bid is a bid! And you should hit it harder and faster than the proverbial red-headed step-child.
• Facts change. Don’t stand still.
• Ratings are someone else’s expensive opinion.
• Opinions are like bottoms. Everyone has one.
• The worst time to raise new capital is when you need it

Good luck out there..

Bill Blain

Strategist Shard Capital