Re: [TNF] Corps take on more debt

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

When money buys more (prices falling), convention calls it deflation. When money

buys less (prices rising), convention calls it inflation.

In any transaction, it is the instinct and formal objective of the seller to
keep the price up and the buyer to keep the price down. Price is normally
influenced by supply and demand, the relation of which is
influenced by the viability of alternatives and a host of other factors,
including calculations of profit and loss. A buyer will buy high if there is
still profit in the tansaction.  A seller will sell low if the lost can be
reduced by the transaction.  Demand includes more than want.  It includes
ability to pay which in turn depends in large measure on liquidity. Prices are
also affected by anticipation, and the risk of false anticipation.

Confidence as a factor of economic behavior has been recognized to various
degrees by many economists.  Confidence in rising income tends to be
inflationary, because buyers find declining marginal utility in expanding time
and energy to shop for a lower price.  When one income is $1,000 per hour, and
is working 12-hour days, one is not likely to spend three hours to shop for a
price saving of a few hundred dollars.  On the other hand, he/she may spend
weeks to push down the price of a muti-million dollar deal.  He may not bargain
if he thinks the market is rising.  Thus in a rising market, assets are often
sold at asking price.  In real estate, a market most people have direct
experience, list duration (the time a property remains available) is a big
factor in its final transaction price. Stagflation occurs when listing time has
no effect on price reduction.

On Wall Street, liquidity refers to the ability to buy or sell an asset quickly
and in large volume without substantially affecting the asset's price. Shares in
large blue-chip stocks like GE or GM, used to be considered liquid, a
description long since rendered invalid because of routine market volatility.
Furthermore, new rules put in place since 9:11, 2001 allow corproate buybacks
that distort liquidity. Immediately after the 9:11 attacks, the Federal Reserve
saved the government-bond market from seizing up. The Fed pumped more than $45
billion into the banking system when it became clear that Bank of New York,
which had offices near the World Trade Center, had huge problems in processing
trades. And after Bank of New York, a middleman in many fund transfers, delayed
making up to $100 billion in payments to other banks, the Fed flooded the
financial system with more dollars. The Fed bought government securities to let
the investment banks selling them meet immediate funding needs after others
failed to pay them quickly for pending trades.  The banks were allowed great
leeway regarding Rule 23-A, a Depression-era law that prevents banks from using
customer deposits to fund their risky broker-dealer business.  The Fed was
willing to suspend time-honored regulations to make sure financial institutions
felt sufficiently protected. This was critically important: Big banks and
securities firms borrow heavily to fund day-to-day activities, so a funding
crisis could have been devastating. To ease cash concerns among primary dealers
in bonds -- which include investment banks that were not able to borrow directly
from the Fed -- the Fed snapped up all the government securities offered by
dealers, $70.2 billion worth in one day on 9:12. The next day it poured even
more into the system, buying a record $81.25 billion of government securities.

Of the several dimensions of market liquidity, two of the most important are
tightness and depth. Tightness is a market's ability to match supply and demand
at low cost (measured by bid-ask spreads), while market depth relates to the
ability of a market to absorb large trade flows without a significant impact on
prices (approximated by volumes, quote sizes, on-the-run/off-the-run spreads and
volatilities). When market participants raise concerns about the decline in
market liquidity, they typically refer to a reduced ability to deal without
having prices move against them, that is, about reduced market depth.

The usual indicators typically capture only a single dimension of market
liquidity and none of them is forward looking in nature, making it difficult to
draw any conclusions as to what liquidity conditions might be in times of future
stress.

While idiosyncratic factors might be cited as being responsible for the
perception of low liquidity in specific markets, reduced liquidity is unlikely
to be a purely conjunctural phenomenon.  Such structural developments may have
served to reinforce the links between liquidity and credit risks, but also the
distinction between normal times and times of stress. Some elements of recent
developments,  such as financial consolidation, the increasing use of
non-government securities as hedging and valuation benchmarks, might influence
the behavior of market participants in a way suggesting that market dynamics in
times of extreme stress may have changed significantly. This has heightened
concerns about credit risk, which can undermine market participants' willingness
to enter into transactions and thus weaken market liquidity in a more uncertain
environment. Other elements, such as
collateralisation practices and developments in risk management policies, which
should generally enhance market stability, could add pressure in times of
extreme stress.

Price is a function of liquidity which can be quite detached from normal value.
Liquidity offer a new paradigm as the key to understanding why and how the
markets move. Liquidity is consistently a reliable indicator on which to base
the timing of trading and investment decisions.

Liquidity is the key determinant of the direction of the stock market. The
aggregate capitalization of any market or market sector, whether stocks, real
estate, precious metals, etc., is a function primarily of
liquidity, with the economic value having only secondary impacts. The total
value of any market is impacted by the current liquidity trend.

Liquidity is the relationship between changes in the total trading float of
shares in the entire stock market and the change in cash available for
investment. Stock market liquidity has two components: the change in
the trading float and the change in the cash available to buy shares. Liquidity
analysis, in essence, is measuring change in the trading float of stock and
tracking the movement of cash.

Some analysts offer a daily liquidity number (Daily Liquidity Trim Tabs) that is
determined by adding US equity fund inflows, 2/3 of newly announced cash
takeovers, 1/3 of completed cash takeovers and
subtracting new offerings. Their longer term analysis of the underlying trends
in liquidity takes in account stock buybacks, insider selling and margin debt.
Mutual Fund Trim Tabs survey over eight hundred and fifty equity and bond funds
daily. US stock market liquidity looks at flows into equity mutual fund that are
not international specific. International equity and bond funds flow are
determined separately.
Trim Tabs Market Capitalization Index measures the market value for all NYSE,
NASDAQ and AMEX stocks. The AMEX is included but not listed. Trim Tabs Market
Cap Index does not include ADR?s.

Liquidity analysis starts with the overall economy's cash flow. The best way of
watching US cash flow is daily and month income tax collections. Higher income
tax collections means higher incomes.  Thus a tax cut leads to a temporary
distortion of liquidity perception.

The conventional "value" paradigm says that the overall market capitalization is
a function of the growth of aggregate cash flow of all stocks, basically, that
the stock market discounts future earnings. This
has never worked in reality. Market cap (price) is a always function of
liquidity.

The conventional value paradigm is unable to explain why the market
capitalization of all US stocks grew from $5.3 trillion at the end of 1994 to
$17.7 trillion at the end of 1999, generating a geometric increase in price
earnings ratios and the like. Liquidity analysis provides a simple answer.
Between the end of 1994 and the end of 1997 the trading float of shares shrank,
and from early 1998 through the end of 1999 the trading float was unchanged.
Over those same five years the amount of money looking to buy that shrinking or
stagnant pool of shares kept growing. The result was that market cap kept rising
regardless of
economic value. The end result was a stock market up over three times in five
years.  It is a clear evidence of the Quantity Theory of Money at work.

Money flows from buyers to sellers. If the buyers retired the shares purchased
(as in corporate buybacks) and the sellers - mostly portfolio managers - had to
replace their holdings in a smaller float, that adds liquidity. If the sellers
vend newly printed shares and used the cash for anything other than buying other
shares, that reduces liquidity.

Historically, float change (the number of shares outstanding) is the best
leading indicator of future market direction. The float shrinks via stock
buybacks and cash takeovers of public companies. The float grows
through new public offerings of stock (IPO) where the proceeds go to the company
- meaning the money is not reinvested in shares. The float also grows via
insider selling of previously unregistered shares, known as #144 sales, and when
stock options are exercised and sold. When insiders exercise and then sell an
option, the company takes back the exercised price and withholds estimated
capital gains taxes. Of the remaining maybe 50% of the sales price, no more than
half is reinvested in stocks, or at most 25% of the sales price.

While there is no cash in the stock market, there is cash sitting in the
checking accounts of stock market intermediaries. Daily mutual funds flow of
equity and bond funds are closely monitored by market
participants. Yet the best leading indicators of future stock market performance
are the actions of corporate investors. When corporate investors are net buyers
of their own and other public company shares, the overall market sooner or later
goes up. Similarly, when corporate investors are net sellers, stocks go down.
Mutual fund flows, while large in size, are of less value as a leading
indicator. Recent studies have shown that flow is a coincident indicator. That
means liquidity changes in the same direction as the market does. Knowing which
way the flow will be going is often the key to determining short term swings in
the direction of the market.

Therefore, if one knows where liquidity is headed, one knows where the market is
headed. With regard to this, liquidity analysis has consistently proven to be a
reliable indicator on which to base the timing of trading and investment
decisions; the key to understanding why and how the markets move.

Liquidity determines how strongly news will affect stock prices. Positive
liquidity can spur the market significantly higher when other indicators are
positive and cushion the fall when those indicators are
negative. Conversely, negative liquidity can dampen the effect of good news.
Liquidity almost always stays in step with the market and visa versa.

For the economy as a whole, the lower the present rate of interest, the larger,
ceteris paribus, would be a future rise, the larger the expected capital loss on
securities, and the higher, therefore, the preference
for liquid cash balances. As an extreme, though unlikely possibility, Keynes
envisaged the case in which even the smallest decline in interest rates would
produce a sizable switch into cash balances, which would
make the demand curve for cash balances virtually horizontal. This limiting case
became popular among Keynesians as the liquidity trap.  In his two-asset world
of cash and government bonds (the latter that proxy a typical government
security for which the central bank can influence the rate of interest), Keynes
argues that a liquidity trap would arise if market participants believed that
interest rates had bottomed out at a "critical" interest rate level, and that
rates should subsequently rise, leading to capital losses on bond holdings.  The
inelasticity of interest rate expectations at a critical rate would imply that
the demand for  money would become  highly or perfectly elastic at this point
(implying both a horizontal money-demand function and LM - liquidity
preference/money supply - curve).  The monetary authority, then, would not be
able to reduce interest rates below the critical rate, as any subsequent
monetary expansion would lead investors to increase their demand for liquidity
and become net sellers of government bonds. Money-demand  growth, then, should
accelerate when interest rates reach the critical level.

Keynes argued that there were three reasons why people hold money. They hold
cash for transactions purposes, which is what the quantity theory had always
said. They also hold money for precautionary reasons, so that in an emergency
they would have a ready source of funds. Finally, they hold money for
speculative purposes. The speculative motive arose from the effects of interest
rates on the price of bonds. When interest rates rise, the price of bonds falls.
Thus when people think interest rates are unusually low, they would prefer to
hold their assets in the form of money. If they invested in bonds and the
interest rate rose, they would suffer a loss. Hence the amount of money people
would want to hold should be inversely related to the rate of interest. People
will want to hold more money (liquidity) when interest rates are low than when
they are higher.

Keynes' introduction of the interest rate into the demand for money has survived
in modern finance, but not for the reasons he gave. Keynes was thinking in terms
of a two-asset world: money (which earned no interest but which was liquid and
had no danger of a capital loss), and bonds (which earned interest but which
were not as liquid and which could yield a capital loss). If one thinks not in
terms of a two-asset world, but in terms of the range of assets or intruments of
assets which actually exist in the current financial world, there is no reason
to hold cash balances for either precautionary or speculative purposes. There
are assets which are both very liquid and which earn interest, such as money
market accounts and Treasury bills, and these are a better form in which to hold
assets for these purposes, not to mention all manners of options in structure
finance.

Though Keynes' explanation of why interest rates influence the demand for money
is outdated, his other
explanations are sound. Money held for transactions purposes is much like
inventory which businesses
hold. Holding inventories either ties up funds on which a business could earn
interest, or uses borrowed
funds on which it must pay interest. Thus if a firm can sell $100,000 of its
inventory, it has $100,000 in
cash which it can either invest to earn interest or pay off debt on which it
must pay interest. The cost of
inventories increases as interest rates rise or as the size of inventories
increases.

However, there are also costs to holding inventories which are too low. If
inventories are too small, a
business may run out of items and lose sales. Further, if inventories are held
at low levels, the business
will need to reorder often, and there are usually costs to reordering.
Thus the business must balance these costs which rise as inventories increase
with the other costs
which fall as inventories increase. The problem can be solved elegantly using
calculus, but you should be able to see intuitively that a rise in interest
rates will decrease the optimal size of inventories, and a rise
in the cost of reordering will increase the optimal size.  Modern management has
introduced
just-in-time inventory which renders this argument mute.  Moreover, Detroit has
been ahead of the Fed on its zero interest car loans to stimulate car sale.

When people hold cash balances, they may no longer hold their assets in a form
that earns no interest, yet interest rates does generally tend to increase with
less liquidity. If interest rates rise on non-money assets
relative to money, the cost of holding money in terms of interest foregone
rises, and one would expect people to try to economize on cash.
A business, for example, could shift money from checking accounts into t-bills,
or resort to loans instead of selling assets with high future value. It would be
worthwhile to make more transactions into and out of
interest-bearing assets to take advantage of the higher interest rates. When
interest rates are very low, these transactions may not be worthwhile, and the
business may be willing to let money lie idle for
short periods in checking accounts.

In a nutshell, the argument boils down to the store-of-value function of money.
Money becomes a less
desirable way to hold wealth when interest rates on other assets rises, and as a
result people will hold
smaller cash balances. These considerations lead to a revised demand for money
function. The demand for money, or the average amount of money people want to
hold, depends positively on expected transactions and negatively on the interest
rate. The coefficient should be a negative number because with higher interest
rates people should want to hold smaller cash balances.

To complete this part of the model, a money-supply equation and an equilibrium
condition is needed. A
simple money-supply equation is that money stock is determined outside the
system by policy. The
logical equilibrium condition is that the market for money balances is in
equilibrium when money supply equals money demand. When interest rates are very
low, people have no special reason to avoid holding idle cash, and will hold
considerable amounts. If they hold lots of cash idle, the fixed amount of money
cannot support very much spending. Lots of idle cash means that the
representative dollar is not being spent very frequently - i.e. low velocity.

On the other hand, if interest rates are very high, holding idle cash is costly,
and people will try to keep
their cash holdings low. This means that they will spend money rapidly, or that
the velocity of money will be high. With higher interest rates the same fixed
quantity of money will support more spending than it did
when interest rates were low and people were holding idle cash balances.

The LM curve (Liquidity Preference/Money Supply) shows how much spending some
fixed amount of money will support. When interest rates are high, money is spent
rapidly and supports a lot of spending. When interest rates are low, the money
stock supports less spending.  A flattened LM curve is  a representation of
Liquidity Trap.

The addition of interest rates to the quantity theory allows fiscal policy to
have effects within the logic
of the quantity theory. If, for example, the government reduces taxes, thereby
raising its deficit, it must
borrow more. This added borrowing increases the demand for loanable funds and
the price of these
funds, which is the interest rate, should rise. The higher interest rate makes
holding idle funds more
expensive, and should result in an increased velocity of money.

Examining the way the ISLM (Investment/Saving - Liquidity Preference/Money
Supply Equilibrium)
model is constructed reveals that a change in fiscal policy alters only
equations that are used to build the IS curve, and changes in monetary policy
alters only equations used to build the LM curve. An expansionary fiscal policy
will shift the IS curve, increasing interest rates and income. An expansionary
monetary policy will shift the LM curve, increasing income but decreasing
interest rates. The way in which one shifts these curves is exactly the same as
how one shifts curves in the model of supply and demand.

To keep the demand for money constant (which means that the velocity of
circulation remains
constant), the nominal interest rate must remain constant.

Further, the rate of inflation independently affects the demand for money by
changing its desirability as
a store of wealth. In cases of very serious inflation, such as the German
hyperinflation of 1923, people try
to spend money as quickly as possible because it is losing its value. As a
result, the velocity of money
increases. To some extent, estimates of how sensitive money demand is to
interest rates may be catching
this sensitivity of money demand to inflation because rates of inflation and
interest rates move together.
A liquidity trap tend to develop in a price deflation environment.

IS curve is a function of the real interest rate; LM curve is a function of the
nominal interest rate;
IS-LM curve must be drawn with the real interest rate (nominal interest rate -
expected inflation rate)
and LM curve cannot go below the nominal interest rate = 0 (or the real interest
rate - expected
inflation rate).

On November 6, 2001, the United States Federal Reserve Board cut Fed Funds rate
by another half a percentage point. It was the 10th rate cut this year and
brought the total amount of monetary easing to 4.5 percentage points to the
current 2%.  Greenspan's decision to cut rates in half-point stages
every month in 2001, despite criticism that such actions were "too little, too
late," was constrained by concerns about inflation. With the CPI still rising at
0.4% in Sept, 2001 and whole sale prices rising at 3.7% annually, Greenspan is
facing zero or negative real interest rates.  Obviously, excess capacity in the
Old and New economies prevents an interet-rates induced capital spending. The
amount of nonperforming loans held by U.S. financial institutions is on the
sharp rise. There is also a huge telecom loan fiasco unraveling, not to mention
airlines and energy. This trend continues despite interest rate cuts.  A credit
crunch is developing in which lender are having difficulty finding qualified
borrowers at prime rate. Long-term interest rates, which are not easily affected
by Fed policies has been rising. The yield on 10-year Treasury bonds, which at
one time had fallen to levels around 4.5 percent, have recently risen to around
5.73 (June13) and 5.49 (Nov. 6). High quality corporate 10 year bonds yield
6.35% This reflects the limits of credit easing and the possibility of future
inflation. This rise in long-term interest rates, coupled with the macroeconomic
slowdown and the decline in corporate earnings, forms the backdrop against which
stock prices are falling. This could also lead to a vicious circle in which
lower stock prices affect consumer spending.

The U.S., just as Japan, appears to be falling into a liquidity trap. Today's
WSJ front page (11/7)  headlines: Is the US economy at risk of emulating Japan's
long swoon?

Henry C.K. Liu




Gary Funck wrote:

> (With the equity market tapped out, corporations are resorting to selling
> converts. Admittedly, rates are low, that is one favorable factor.  On the
> negative side, many of the companies selling bonds are generally already in
> debt; selling more debt just pushes their debt burden higher.  And, the
> basic nature of the convertible sets up future selling pressure on the
> stock, and dilution - should the stock move above the strike price.)
>
> http://www.trimtabs.com/news/liquidity/latest.htm
>
> CORPORATE LIQUIDITY BEARISH WHILE HEDGE FUNDS & INDIVIDUALS BULLISH. RECORD
> DEBT & CONVERTIBLE ISSUANCE. LEAST NEW CASH T/O'S IN OCT. SINCE PRE-1997.
>
> The good news: the stock market has not only regained all of its losses
> since September 11, but the TrimTabs Market Cap index of all non-ADR US
> traded stocks topped $14 trillion for the first time since early September.
> Also in the good news camp, Gallup reported that investor confidence last
> week soared to the highest level since early last March when the Market Cap
> was $16 trillion. Unfortunately for investors, the market has sold off
> steadily since then - other than for two one-month rallies in April and this
> past month.
>
> There is at least $300 and perhaps as much as $400 billion sloshing around
> in hedge funds these days. There is no doubt that hedge funds have been
> hefty buyers since the market started coming back the last week of
> September. After all it is now clear that the world is not yet coming to an
> end; there's a huge stimulus package in the works; we're bombing the Taliban
> daily and everybody knows that you have to be in the market before the
> economy bottoms or else you will have missed the big up move.
>
> CORPORATE LIQUIDITY STAYS BEARISH. GD-NEWPORT NEWS $2.1 BILLION CASH T/O
> BUSTS.
>
> When most stock market participants think about liquidity, what comes up is
> inflows into equity funds or the $3 trillion sitting in either money market
> accounts or bond funds. We still keep hearing about how a great deal of the
> money sitting in money markets and bonds just can't wait to find a reason to
> start buying equities. Sure. And Santa Claus is making a similar list of
> those naughty and nice.
>
> Unfortunately for the bulls, that type of liquidity has less to do with
> future market performance than whether corporate investors or either
> shrinking or growing the overall trading float of shares. Why we say
> unfortunate is that corporate investors are now incredible bearish, as
> bearish as we have seen since starting tracking liquidity.
>
> Not only have there been very few new cash takeovers - less than $2 billion
> over the past four weeks vs. an average of $4.5 billion per week during 1999
> and 2000 each - but the General Dynamics $2.1 billion cash takeover of
> Newport News was aborted on Friday. Unless there are some new cash takeovers
> announced early this week, that will make October the first month ever with
> a negative cash takeover total.
>
> What's more, new stock buybacks were just $2.3 billion last week. Last week
> was the height of earnings season and historically that is usually the
> biggest week of the quarter for new stock buyback announcements.
>
> $20 BILLION IN NEW OFFERINGS SO FAR IN OCTOBER MOSTLY CONVERTIBLES.
>
> And then there's the convertible bond nightmare. Yes, corporate America is
> quite fortunate that the "free-riding" game exists whereby companies that
> could not sell new shares at any price - such as Motorola - are able to
> peddle $1 billion worth of convertible bonds solely because hedge funds can
> short that many shares. While that is good for those companies short term,
> over the medium term that will drive down the overall market.
>
> One could say that $20 billion in new offerings is well below the $40
> billion all time record for the sale of newly printed shares set in May. The
> one difference between now and then - the US economy is much weaker today
> and likely to weaken further.
> [...]
>