The market's game of musical chairs

By Bill Fleckenstein

Those of you confused by various market levels and gyrations are not alone. That confusion is shared by none other than the chief steward of Harvard University's endowment, Mohamed El-Erian.

I found his recent comments in one of Kate Welling's weekly interviews for Weeden & Co. Research to be so fascinating and insightful that I read them many times -- to the point where all of my underlining and notes made it hard to see the type on the page. I cannot provide a link to the whole interview, as Kate's market commentary service is by subscription only. (In a few weeks, the interview should be available on the site's free section.) But I would like to share some thoughtful excerpts.

"There are conflicting signals emanating from the most liquid of all global markets," El-Erian says, citing "simultaneous inconsistencies (whereby) you get a cocktail full of all of these aberrations, these conundrums, these puzzles, all these conflicting market signals that people can't explain."

He attributes this to a combination of worldwide productivity, the major wealth transfer of poor nations lending to rich nations -- think China lending us money to buy stuff from them -- and derivatives.

The canary in the Kohl mine

Under the heading of derivatives, El-Erian also talks about the leveraged-buyout lunacy, which he says "is going to end in tears." Obviously, I agree. He thinks that the craze may have a fair bit of time left to run, but I believe it's possible that we could already have passed the point of no return. There are indications: the deterioration in the bond market, as well as a development at LBO firm Kohlberg Kravis Roberts, which, according to Tuesday's Wall Street Journal, has depleted its war chest and is seeking out investors to fund its $26 billion purchase of First Data (FDC, news, msgs).

Obviously, given the belief in the "LBO put" and the behavior it has inspired, that development is not something many people, including me, expected to see. Even I assumed that before the LBO operators ran out of capital, problems would first turn up in credit spreads and in junk debt that failed to be placed. Maybe this is just a one-off story, but I think it's definitely worth paying attention to.

But the subject I most want to focus on is the confusion surrounding liquidity vs. leverage. I laid out the difference in my daily Market Rap last November: "What we may have is the illusion of a liquidity fest. The stock market is acting as though there's an enormous fire hose of liquidity gushing forth -- when, what might actually be the case, is that a wanton derivatives/credit/lending mania is in full force."

Transmutation in LBO nation

El-Erian describes the illusion thusly: "What you have to envision is liquidity factories on Wall Street. So, I'm a pension fund. I have a dollar invested in U.S. equities. I take it out because I'm looking for private-equity exposure. I give it to a private-equity manager. The private-equity manager, through the alchemy of debt financing and structuring, turns that one dollar into six dollars. ... Nothing has really changed in the world, but both assets and liabilities have gone up."

Of course, there is a consequence to this alchemy, as he points out: "When the music stops, the question is going to be, who owns the debt?"

• Video: Harvard Management CEO talks about the economy, inflation

He cites the hubris on display today, whereby everyone thinks they'll be able to get out before something happens. I would just note an important corollary, which is that when folks no longer want to acquire LBO debt, the music will stop.

Reflection before action

Next, Welling asks: "Given all the derivatives and layers of complexity, does anyone have a prayer of figuring that out today?" El-Erian's response: "Not initially, but when a shock happens, you end up by getting quite a bit of high-frequency data on that."

Meaning that sometimes you have to wait, using the time to formulate some ideas of what you think may happen. "You just have to be able to observe, and have a risk-mitigating mindset," El-Erian says.

Then, when the billiard balls begin to move around the table in a way that starts to make sense, you can take action. And, if you don't have mountains of money to move, it's pretty easy to react to events, assuming that you're somewhat set up beforehand. Having said that, I must add that, this is the most extreme example of mispricing and leverage I have seen in my entire career, which severely complicates the process of trying to plan ahead.