In November 2011, the New York Times published a story about a hedge fund manager from New York named Boaz Weinstein. It tells how he found an obscure corner of the financial markets where the prices were out of whack.
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A notoriously aggressive trader, the story says, he attacked. Although Weinstein didn’t know it at first, his target was the investment bank J.P. Morgan Chase. One of the bank's traders, Bruno Iksil, was about to bust a multi-billion-dollar hole in the bank's proprietary trading accounts.
What Weinstein has discovered was that a particular index for credit default swaps, intended to rise in value in the event that certain corporate bonds became riskier, was totally unconnected to the market it was supposed to represent. Weinstein and his team delved into the figures to try to understand what was going on.
Meanwhile, Iksil, known by many traders as the "London Whale," continued to short sell the index. Using Morgan Stanley’s deep pockets and the long leash the bank gave him, Iksil pushed the index’s value down. Every time Weinstein bought more of the credit default swaps, their value decreased and he lost money. But if Iksil expected Weinstein to blink, he was to be disappointed.
In February 2012, Weinstein appeared at an investors' conference and recommended that others begin buying the index. The audience of 300 or more professional investors began to buzz, and soon many other hedge fund managers were piling on board.
Yet the London Whale was formidable. He continued to drive down the price for months, punishing the hedge funds that were betting against him. One of Weinstein's investment funds lost 20 percent between January and the beginning of May. But then came the turnaround.
News reports about Iksil, based on sources at the hedge funds buying the derivatives from him, began popping up on both sides of the Atlantic. Suddenly, everyone was looking at the obscure index. Over the course of May, when the fears of a debt crisis in Europe reawakened, the index switched directions and the whale began to register losses. Weinstein covered his previous losses and within a few weeks began to turn a profit on his investment. J.P. Morgan's loss from the failed gambit would eventually reach a total of approximately $5 billion. The whale was forced to leave the bank.
It's not just on obscure indexes that prices lose all connection to reality. It can also happen on leading indexes, as appears to be the case unfolding now. Since the start of 2012 the local TA-25 stock index has risen 9.5 percent, the TA-100 index has risen 7.5 percent and the Dow Jones Industrial Average has risen 4.6 percent in value (in shekel terms). While the stock exchanges have returned to their pre-2008 financial crisis level, the global economic situation hasn't improved. In fact, it has worsened.
Europe is in a recession. Unemployment is soaring and it appears Greece won't be the last country to go bust. Spain, with 25 percent unemployment, is close to asking for financial aid and Italy isn't far behind. Portugal has been hit. The economies of Eastern European countries, like the Czech Republic and Hungary, are shrinking, and even strong economies like those of Germany and France find themselves weakening.
In the United States, the Federal Reserve has injected more than $1 trillion into the American markets. All the while, the U.S. government budget deficit has surpassed 100 percent of GNP. Elsewhere, the growth engines of China and India are showing signs of putting on the brakes.
If that weren't enough, an absurd situation has been created where companies are rich but countries are poor. Now the leaders have come to deal with the issue in the one way that they can – raising taxes.
The capital markets, though, have had a good year.
"In contrast to Europe, in the U.S. not everything is bad," says Gil Bufman, chief economist at Bank Leumi." The U.S. is growing at a stable pace, the high-tech market is showing encouraging signs, and the [Bank of Israel's] State-of-the-Economy Index is growing fairly nicely."
The housing sector is another area that has recovered, and seems to be generally headed away from its recent low.
"I'm not saying the housing market's in a good state," says Bufman. "The market still suffers from a hangover of home foreclosures, but there has been an increase in building starts, the building contractors' confidence index is rising and prices aren't falling." He adds, "The big problem for Americans is the labor market."
The Fed isn't blind to problems in the labor market. Its third quantitative easing program is supposed to get underway soon, and its target is the labor market, not the stability of the banks, from which it already bought toxic assets worth trillions of dollars.
"This printing of money with low interest rates creates fear of inflation," says Bufman. "But this [inflation] has yet to happen," he says as he points at a graph that shows how the price of commodities and shares increased following one of the previous quantitative easing programs.
"As long as money is being injected, the bubble expands and this is nice," Bufman continues. "Quantitative easing isn't Prozac, but rather a steroid," he says. "It’s a step that pushes the markets instead of calming them."
One of the risks is that the moment that the quantitative easing is stopped, the bubble will burst. Another risk is inflation.
"We haven't seen inflation break out and the reason is a monetary blockage," says Bufman. "Credit given by the central bank to the banks is stuck in the banks and doesn't reach the end-consumers. Consequently, it doesn't create inflation. The banks use this [credit] for their own needs, like proprietary trading investments." He continues, "In the U.S. now, the monetary system has begun releasing credit to the business sector, but not to households. Consequently, we’ve seen a rise in inflationary expectations."
Should you take the plunge?
Fears of inflation increase demand for inflation-adjusted bonds. As a result of the greater demand, bond prices have also increased, meaning their yields have declined. Absurdly, they are now being traded with negative yields in real terms. In other words, someone who places their money in bonds will discover at their redemption date that the sum he receives is worth less than what he deposited.
"In Israel there is an ongoing process of declining yields for government bonds. Thus, for example, fixed-rate, non-indexed ("Shahar") government bonds which traded with a yield of 10 percent in 2000, now trade around 4 percent."Safe money" sitting in bonds has lost its attractiveness," says Gilad Altshuler, owner and co-CEO of Altshuler-Shaham Group.
Altshuler is betting on Israeli stocks. "Excluding two stocks – Mellanox and Perrigo, that aren't really Israeli stocks- the market isn't rising," says Altshuler. "What we have seen in recent months is just a market correction. Because of the absences of players, it doesn't take a large sum of money to push the market upwards."
Itai Ben-Zeev, the deputy head of the capital markets department at Bank Leumi begs to differ.
"This is an on ongoing crisis that has proven false many economic paradigms," says Ben-Zeev. "For example, the view that in every decade investment in stock indexes provided the best return. We are in a crisis with new rules of the game and it hasn't finished."
Ben-Zeev adds that the financial situation of companies shows that they took advantage of the crisis to become more efficient. "The result is that the situation of companies is good, while the macroeconomic situation is bad," says Ben-Zeev.
Investors' fears led them to flee into American bonds. Despite their negligible yields, the Americans are successfully financing their deficit by issuing bonds to the entire world," says Bufman. "The world believes that American bonds are a safe place and is willing to pay."
The situation in the markets presents a dilemma to pension savers. On the one hand, the safe investment channels aren't providing returns. On the other hand, investing in the stock indexes is full of risks and the recent rise in stock prices only increases these risks. Ben-Zeev suggests that pension investors decide on the speculative component of their pension portfolios without reference to whether the stock markets are undervalued right now.
"The amount invested in shares must fit the maximum degree of losses that an investor is prepared to suffer. An investor who isn't prepared to suffer losses to the value of his portfolio at any time shouldn't be invested in stocks."