Bob’s Journal for 9/27
We Mark the 25th Anniversary of When an Investment Fund’s Failure Shook the Markets and Changed Federal Reserve Policy
We recently marked the 25th anniversary of the failure of the hedge fund Long-Term Capital Management (LTCM).
The failure of what was a little-known investment fund shook the world’s capital markets and initiated important policy changes.
LTCM boasted of a staff of at least 25 Ph.D. holders, including two winners of the Nobel Memorial Prize in Economic Science. The fund’s founder and leader was something of a bond market legend, John Meriwether, formerly of Salomon Brothers.
The insight propelling its investment strategy was that markets were efficient. Prices always would gravitate toward rational levels. The firm’s leaders viewed historic relationships between the prices of different assets as the norm and deviations from the long-term averages were temporary and would be eliminated by price changes.
The fund used data and computers to scour the world’s markets for apparent pricing anomalies. Then, the fund would take investment positions that would be profitable when markets returned to rational or normal levels, ending the pricing anomalies.
The money to be made on each trade was very small. But LTCM made the effort worthwhile by borrowing money and using leveraged investments such as futures and options to amplify the profits.
Because of its big names and appealing investment theory, LTCM attracted a number of significant investors. It also obtained financing that eventually enabled it to use a leverage ratio of 50 to 1.
LTCM’s founders and employees were so confident of their strategy that they put a lot of their own money, including their children’s college money, into the fund.
In its marketing pitches, LTCM told potential investors its strategy would work except during a time when investors flocked to safety and wanted to own only conservative investments such as Treasury bills.
Initially, LTCM was very successful. Returns exceeded 40% in both 1995 and 1996.
But its success caused other investors to mimic the strategy, and market anomalies became harder to find.
LTCM began purchasing a lot of hard-to-trade securities and expanded the assets it invested in and types of trades it made.
In June 1998, the fund lost more than 10%, its biggest monthly loss since inception.
In August 1998, Russia defaulted on some debt and let the ruble decline. That triggered a flight to safety around the globe that eventually led to big losses at LTCM. In addition, LTCM was unable to sell many of its investments to meet margin calls, pay debts and reposition the portfolio.
Eventually, the Fed arranged a takeover of the fund by other Wall Street firms. You can read details in the book by Roger Lowenstein, “When Genius Failed.”
The Fed entered the picture because it was concerned about the effect on the banking system if LTCM defaulted on its loans. The Fed also worried that LTCM’s failure would lead to a sharp decline in the stock markets that would help cause a recession or worse.
In addition to arranging the takeover of LTCM, the Fed reduced interest rates and pumped liquidity into the economy. The Fed also waited a long time before raising rates to pre-existing levels and withdrawing liquidity from the economy.
The series of actions became known as “the Fed put.” In effect, the Fed established a floor on stock prices. For decades after, the Fed would rescue the stock market from steep declines and sometimes operated to prevent bear markets, such as in 2018.
Once investors caught on to the Fed put, they began to take more risk. That pushed stock prices higher and increased wealth for many. But it also raised stocks to the recent very high valuations and increased risk in the markets.
I’ve been warning that the Fed probably is changing its playbook, leaving behind the policies developed because of LTCM and returning to traditional policies.
The Fed is less likely to keep a floor on stock prices, which it showed in 2022. It is more concerned with containing inflation and returning interest rates closer to historic averages. Investors who assume the Fed is following the old playbook were hurt in 2022 and likely will be hurt again.
ESG Funds Are in Decline
The boom in sustainable, or ESG funds, appears to be over.
ESG stands for environment, social and governance. The acronym refers to investments that place at least as much emphasis on those factors as on generating profits. Or stated another way, the investments try to be profitable while doing good for the environment and society.
Not long ago, ESG funds couldn’t keep up with demand. Investment firms created new ESG funds at a rapid clip, and investors directed money into them. But the boom years appear to be over.
In September 2021, Morningstar reported that assets in sustainable funds hit a record high and were “on a steady growth trajectory.” A record number of new sustainable funds were launched in the third quarter of 2021.
But in July 2022 Morningstar.com had a post with the headline, “U.S. Sustainable Funds See Outflows for the First Time in Five Years.”
Now, financial firms are liquidating or merging ESG funds.
More than two dozen ESG funds have been closed this year, according to Morningstar. More ESG funds were closed so far in 2023 than in the three prior years combined.
In addition, investors now are withdrawing more money from these types of funds than they are putting in.
There are several reasons for the turn of events for ESG funds.
ESG funds tend to emphasize technology and other growth companies, and those types of stocks underperformed for much of 2022 and 2023.
Investors also have peered into the indexes and other criteria the funds use to choose their investments. The investors spotted a lot of inconsistencies and investments that don’t meet their personal definitions of ESG or sustainable investing.
I’ve discussed in the past some of the contradictions between lofty ESG goals, fund marketing and investments held by the funds. See, for example, Bob’s Journal of June 22, 2023 and July 14, 2022, and January 27, 2022.
There also has been a political backlash against ESG investing, which influences some investors.
Of course, fund companies often roll out a bunch of different funds when an investment theme becomes popular. After a while, there are too many funds with similar themes. The fund companies close the funds that didn’t catch on and focus on the others.
ESG seems to have hit its peak. Perhaps soon, investors who are interested in combining personal and political philosophy with their investing will have better options.
Expect Medicare Advantage Ads to be Different in 2023
The annual open enrollment for Medicare will start on Oct. 15. That means we’ll see a lot of marketing designed to influence beneficiaries’ choices of Medicare coverage.
Aggressive advertising for different Medicare plans, especially Medicare Advantage plans, drew a lot of criticism the last few years.
Celebrity endorsements, misleading or incomplete statements and implied government approval are among the criticisms. A Senate Finance Committee report issued in the fall of 2022 stated that complaints about Medicare advertising doubled from 2020 to 2021.
The Kaiser Family Foundation issued an interesting report with a lot of interesting details about last year’s Medicare Advantage advertising. For example, Joe Namath appeared in 10% of all Medicare Advantage plan ads.
In response, the Centers for Medicare and Medicaid issued new rules on Medicare Advantage advertising that take effect this year.
The advertisements can’t use the Medicare name, logo, card or certain language in ways that might mislead beneficiaries. The advertisements also have to be clearer and more transparent about the availability of any plan benefits and features mentioned in the ads.
Many advertisements, for example, mentioned extra benefits the plans offered without including important limits, such as that a beneficiary might be able to select only one of the listed benefits or the amount of each benefit is limited.
The advertisements also can’t list a benefit when that benefit isn’t available in the geographic area where the advertisement appears.
The biggest offenders in the past have been certain brokers, also known as third-party marketing organizations, that don’t have their own plans but try to sell plans offered by one or more insurers. These organizations now have to make audio recordings of marketing and enrollment calls to beneficiaries and have new restrictions on contacts they can make to Medicare beneficiaries.
There are a number of other features in the new regulations. The Medicare ads might be less entertaining this year, but could be more helpful to beneficiaries.
The Data
Existing home sales declined 0.7% in August after falling 2.2% in July. August marked the third consecutive month sales declined. The number of existing homes sold in August was the lowest since January.
The median price for all existing homes sold was $407,100, which was 3.9% higher than 12 months earlier.
New home sales fell 8.7% in August, the biggest monthly decline since September 2022, after increasing 8.0% in July.
The median price of new homes sold in August was $430,300, a decline from the $440,300 level reached 12 months earlier.
The average sale price of a new home in August was $514,000, down from $530,800 12 months earlier.
Home prices increased 0.6% in July, according to the S&P Corelogic Case-Shiller Home Price Index (HPI). The index had increased 0.9% in June.
Over 12 months through July, the index is up 0.1% after being down 1.2% through June. July marks the first time in five months the index is higher than 12 months earlier.
The House Price Index from FHFA increased 0.8% in July after increasing 0.4% in June. Over 12 months, the HPI is up 4.6% through July, compared to 3.2% through June. The HPI covers only single-family homes with mortgages insured by one of the federal agencies.
Durable goods orders rose 0.2% in August after falling 5.6% in July.
After excluding defense and transportation orders, which is considered a good measure of business investment, orders increased 0.9% in August, which followed a 0.4% decline in July.
The Dallas Fed Manufacturing Survey resulted in the General Activity Index declining to negative 18.1 in September from negative 17.2 in August.
But the Production Index, which is a measure of manufacturing conditions, bounced to its highest level of 2023 in September to 7.9, from negative 11.2 in August.
The Philadelphia Fed Manufacturing Index plummeted to negative 13.5 in September from positive 12 in August. Despite the decline in the index and most of its components, expectations for growth over the next six months improved.
The Richmond Fed Manufacturing Index improved to 5 in September, following a negative 7 reading in August. September is the first time since the spring of 2022 that this index has been positive.
The Consumer Confidence Index from The Conference Board fell to 103.0 in September from 108.7 in August. The index has declined for two consecutive months.
Confidence declined in all age groups and income levels but fell the most in households with incomes above $50,000.
Consumers said they were concerned about higher prices and interest rates, as well as the political situation.
New unemployment claims declined by 20,000 to 201,000 in the latest week. That’s the lowest level since late January.
Continuing claims, which lag a week behind new claims, decreased to 1.662 million from 1.683 million. The new number is just above the eight-month low.
The Markets
The S&P 500 lost 3.80% for the week ended with Tuesday’s close. The Dow Jones Industrial Average fell 2.62%. The Russell 2000 declined 3.57%. The All-Country World Index (excluding U.S. stocks) retreated 3.38%. Emerging market equities decreased 2.81%.
Long-term treasuries fell 4.23% for the week. Investment-grade bonds declined 1.61%. Treasury Inflation-Protected Securities (TIPS) lost 1.39%. High-yield bonds decreased 1.18%.
In the currency arena, the U.S. dollar gained 1.16%.
Energy-based commodities fell 1.36%. Broader-based commodities lost 2.30%. Gold declined 1.64%.
Bob’s News & Updates
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