Anatomy of a Melt Up

Most of us are quite aware of what a market meltdown is. What is rarely talked about and is equally if not more fascinating is when a market has a melt up.

Case in point, Thursday Oct 27th , news comes from Europe that a deal has been outlined with creditors of Greece. In a nutshell the deal is for Greece’s creditors to take a “voluntary” hair cut on moneys owed to them. Markets had been eagerly anticipating the outcome of the 13th emergency meeting in 22 months European leaders have had to discuss their worsening condition.

The result of the news is a spring board leap higher for equities with the S&P 500 rising approximately 4% (according to Bloomberg) in one trading day. Since that Thursday the equity markets have decided to give back all those gains and then some within 72 hours.

This quick rise and fall has many people asking “what the heck is going on”.

For those pondering such thoughts we will attempt to give you a basic level of understanding behind these moves without revealing too much of our ignorance.

Big institutions like Goldman Sachs, JP Morgan and Citi to name a few, make money in a lot of ways. One of which is in the world of derivatives.

An example of a derivative is a Credit Default Swap or “CDS”. CDS’s are essentially an insurance contract that an investor can buy that will pay if the respective company or government happens to default.

The buyers of these contracts are usually institutions that may have invested large sums into a company or government that is now showing signs of weakness. The hope is, if the company defaults, the winnings of the CDS will offset the losses on the bonds or stocks the investor may have owned.

Stay buckled in your seat because this is where things get twisted.

Let’s pretend Bank A has a large amount of Greek bonds in their portfolio. Fearing these bonds may default Bank A goes to Bank B and buys a CDS to cover their risk. Now Bank B has a risk. If Greek defaults Bank B will now have to pony up money to Bank A for the amount of the CDS.

In an effort to hedge their risk Bank B will use some kind of short position to hedge their risk. For simplicity let’s say Bank B shorts the S&P 500 with the thesis that if Greek defaults they lose on the CDS they sold to Bank A, but they win on their short position if the S&P500 declines in reaction to the default.

You still with me?? One more step to close the loop.

Thursday morning we wake up and the language of the agreement states that parties holding Greek debt will “voluntarily” accept a hair cut of 50%.

The word voluntarily is what triggered the market melt up. One simple powerful word. “Voluntary” was key as this would prevent the credit agencies from terming the deal a “default” therefore no CDS’s would be triggered.

With this news Bank B who shorted the market to hedge their default risk scrambles to cover their shorts which means they have to buy into the market.

A bunch of big Gorillas’ covering their shorts sparks a firestorm of buying and “Wah-Lah!” we have a melt up.

The problem with melt ups is that by their structural nature they can’t help but be temporary unless there is another piece of new stimulus to quickly follow.

The end result is amateur investors chasing the market on the way up to only be feeling remorse a few days later.

In addition to teaching novice investors a valuable lesson, it raises a very important question for investors that desire less volatility and uncertainty in their portfolios- especially those that are close to, or, are already in their retirement years.

Volatility is here to stay. One of the biggest reasons being the huge number of derivatives that exist in financial markets.

With all these unseen machinations behind the scenes it is more difficult than ever for individual investors to plan for their retirement income.

Which should raise the question for prudent investors …”Do you want your financial livelihood affected by unseen factors you have little to no control over?”

Luckily for those that are reaching the retirement phase of life and may be pondering this very question, you’re not alone.

With the incredible number of people reaching the age of 65 over the next 10 years financial services firms have worked hard to address this question and have created ways of managing risk.

Any company that is interested in handling retirement funds knows they need to give investors tools that will help them invest for the long term while providing some type of potential safety net if they expect to compete in this environment. The result is the creation and improvement of products like ETF’s, Annuities, GIC accts and structured notes to name just a few.

With the right knowledge and tools it is possible for individual investors to engage in financial markets with an understanding of what their risks are as well as what the potential returns may be.

With all the dynamics that are taking place in economies and markets it is imperative that investors do a serious risk analysis and focus on reducing risk as well as ways to hedge their risk.

For those that are interested in such ideas join us for lunch on November 15th where we will have an open discussion about today’s volatility and how individual investors may be able to provide some safe harbors for their retirement funds.

Warm Regards

Colby McFadden
Quiver Financial
Newport Coast Asset Management

Sources for article: John Mauldin. The opinions expressed are those of Colby Mcfadden and Quiver Financial as of November 2nd, 2011 and are subject to change due to market or other conditions. This is not a solicitation or recommendation of any investment; always consult a Financial Advisor before investing into any investment. Securities offered through Newport Coast Securities member FINRA/SIPC. Advisory services offered through Newport Coast Securities a SEC registered investment advisory.