Interesting Reply
Drizzt’s Take:
I saw this post in SGFunds here where durio asked about Why equities fund go down, bond funds go up? The discussion wasn’t very eye catching, but Wilfred’s reply below was:
Wilfred:
“This has been a historical observation that bond and equity have a lower correlation.
But is this now still valid? There is so much liquidity in the market that both bonds and equiteis have one thing in common, in times of panic, investor just pull out from ALL assets back to the source. Sometime this “source” is actually just nothingness. Nothingness? I like to illustrate what this means:
I spoke to someone who taught me how many private bankers do business with their client. A typical scenario is this: The private bank sees that the client owns a fully-paid landed property. The private banker will proposed to the client that using the landed property as a colleterial, the bank is willing to lend him 70% of the property value. The loan is in YEN (because it has low interest). In order to protect the client from currency risk, he also sells him a hedging strategy to hedge against the appreciation of the YEN. Say the property is worth $1m, the client now got $700,000 in cash as a loan. This $700,000 is then invested into various instrument products like hedge funds. Hedge funds itself is often leveraged by x2. The hedge fund gives regular dividends. Therefore:
$700,000 becomes $1,400,000 through hedge fund levearging.
Say the underlying instrument of the hedge fund gives 5% dividend yield, it becomes 10% dividend yield after x2 leverage.
The client will receive a yearly income of $700,000 * 0.10 = $70,000.
But what was the capital in the first place? Nothing. There was no capital because the “capital” was merely a loan using the property as colleterial.
I think it sounds great in commission for the private banker.
(1) He earns a commission for selling the loan
(2) He earns a commission for selling the currency hedging product
(3) He earns a commission for selling the hedge fundCool! But then when the party ends, what will happen? All money will go back to the source which is nothingness. What can happen? The weakest link in the above example is that if the value of the property goes too low, a margin call will be issued. Then the entire food chain starts unwinging. Another week point is the hedge fund. Since it is x2 leverage, it can go down to zero easily. This means that the client will lost the entire $700,000. Since this is merely a loan which has to be repaid, he has to sell his entire property and be left with $300,000 to buy a HDB flat!
Conclusion:
It is because of this that the market is being filled with liquidity created out of nothing. That’s why we cannot safely say that if we buy bonds and equity, we are “safe”.”
Thought that was ingenious. Too bad my stupid brain didn’t thought of this.
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There is a fundamental wrong in “nothingness” by using this example. Actually using property, cash or anything cannot be say as “nothingness” assuming that I get the meaning of “nothingness” correct which is it is not there in the 1st place.
Using property as am example, there is something there, the property at certain valuation. It is just a conversion of hard asset to liquid asset which use to invest in capital market whether thru selling the property or using it as a collateral make no diff here. Relate to a company wanting to invest in new plant and equipments by taking secured loan(collateral loan) from bank. It can also be unsecured loan from bank as long as the bank are sure of the ability of future payment from the company either thru the cash in hand or future cashflow. For individual person, unsecured loan is difficult to get(a huge amount) unless that person is wealthy and good future cashflow. Eg Bill Gate can easily get huge unsecured loan if he want.
Looking back to the property example, should these 700k are not suppose to invest in capital market? It is not for me to say but just like any company capital expenditure, the reason for it is to get return, higher return in most case. It is the wiliness and the availability to convert hard to liquid assets which created that “huge” liquidity around.
The rest is like Wilfred written, all the leverage, hedge funds, etc. But it is happening all the time just that the availability increases.
I think the correlation thing between equity and bond is driving many people crazy. 1st of all, from those studies of historical data, there is lower correlation. But it never says correlation is NEGATIVE. Then period must take into consideration as well, 1 mth or 3 mths or 1 yrs or 3 yrs or more. So beside it is not negative, the period must be taken into consideration.
Lastly, the landscape must be taken into consideration as well. Liquidity can cause short term changes to the landscape but if the factors in that landscape change, the future will not be like the past. It is known that earth climate keep changing, from cold(last one is ICE AGE) to hot(currently) and will back to cold in the future. Most of what we see right now would not be the same when the next ICE AGE comes. Lower correlation is the result of what happened in history but all factors must stay the same for lower correlation to be true going forward. I am talking about long term factors and the problem with liquidity started long long time ago(I don’t know when but it is already there in 1800s). It just keeps growing bigger.