Friday, January 04, 2008

A disturbance in the Force

I don't comment about the stock market very often, but something isn't right. Take a look at the chart below. The S&P 500 is in red, charted on the left axis. Corporate bond spreads are blue and are inverted on the right hand axis. Thus when the blue line "falls" that should mean the economic picture is deteriorating.

From my seat, watching corporate bond spreads widen dramatically over the last 6 months, you'd certainly think recession is on the horizon. In fact, if you draw a horizontal line from where we are now in corporate spreads, you'd see that we've rarely been wider than current levels. We are wider than the worst points during the 1991 recession and 2001 recession, although we did touch a bit wider during 2002.

And yet the stock market is very near all-time highs. I did this graph up through 12/31, so the S&P would be a bit lower. But the basic story would be exactly the same: the stock and bond markets don't agree about where we're going next.

There are some logical reasons why stocks and bonds can diverge. One is that companies are increasing leverage. So equity returns might increase but bond risk rises. That's not happening right now. Financial companies have gone into capital preservation mode, and all companies are finding the bond market quite inhospitable.

I think the economy is going to be weak in 2008, and corporate defaults will surely rise from the ultra low levels of recent years. That being said, corporate bonds look pretty good right now, given that you are getting paid about as much as you ever have for taking credit risk. I don't know what the catalyst for pushing spreads tighter might be (remember the "proving a negative" discussion). It will probably take most of 2008 for spreads to get markedly tighter. And you can bet on spreads being very volatile.

But what's in store for stock holders? I have a hard time making a good argument for stocks to move a lot higher from here. That's not to say I'd advocate anyone selling all their stock portfolio: even if they manage to get out before a sell-off most people don't buy back in time. But looking at the graph above doesn't inspire a lot of confidence.

Anyone care to make a rational argument for why stocks are holding up?


Anonymous said...

I haven't been able to figure it out for over a year, and I am not going to start trying now LOL

I have been in the equity side for over 20 years, and I don't ever remember a time where you have catastrophe in so many big companies [Fnm, MER,fre,mbi,C, CFC etc.] at the same time you have meteoric rises in other big ones [amzn,goog, etc.]

Something has to give, and my guess is that QQQ will underperform the S&P by a lot this year

Anonymous said...

Since December 27th, the yen has been skyrocketing against the dollar. 108 yen fetches a dollar right now which is the lowest the dollar has been against the yen for a long, long while.

I believe that a lot of dollars have been bought with borrowed yen (carry trade) and pumped into stocks. For whatever reason that's unwinding.

The key question is whether it will wind back up.

The answer is no. December 27th is just before year end. Billions of dollars started being turned back into yen before the year ended. It's going to continue.

AI, you just didn't wait long enough.

Anonymous said...

Maybe the TED spread component is more technically driven than usual so the widening looks more dramatic than it really is.

cak said...

Perhaps there is no relation. Chart shows corp spreads topping in June 97 but the S+P didn't take the gas for another 2 1/2+ years. During that time, LTCM in '98 put the screws to the credit markets but was only a blemish on stocks.

Also, Greenspan was pushing up interest rates at that time. The discount rate jumped from 4.75 in June 1999 to 6.5 by May 2000. So credit was getting tight anyway. And with the Naz at 5000 sporting a 100 p/e, things were ripe for fall.

Right now, rates are low and going lower, perhaps a whole lot lower. (I'm thinking we'll see a 3.25 handle on the discount rate by the end the year). I'm not sure about current p/e on the S+P but I think it is in the neighborhood of 14-15?

We'll have to see how the profit picture stacks up the next couple quarters. If this morning's number is a sign that things are grinding down then profits could be severly impacted. We shall see.

mOOm said...

As your chart shows, the stockmarket held up into mid 2000 as spreads widened too.... the difference now is P/Es are lower than in 2000 so though we should expect downside in the stockmarket I don't think it will be as bad as 2001-2.

BackOfficeMonkey said...

Since the early 2000s we saw the emergence of the emerging markets economies... BRIC and others, with this came a excess liquidity from petrodollars and their high savings rates/trade surpluses looking for a new home to invest. Could it be that with these new players realized their optimal portfolio has to include US Equities? Thus propping up demand for US Equities. I.E. before their portfolio was not on the efficient frontier.

Deborah said...

I wonder if it is fool hardy governments that have decided to invest. I know the Canadian government has $121 billion invested and I've read the odd report about other governments coming up with this brilliant idea that they will invest tax payers' money. I am sure I have read about a few.

Anonymous said...

It seems to me that the majority of stocks are down quite a bit. The averages may be holding up but that really masked what is happening with stocks in general. This is a stealth bear market if you just look at the averages.

Anonymous said...

You've captured my dilemma precisely. I do feel like a bear market is coming and part of me wants to pull the trigger and move my assets somewhere "safer". But I don't know how I'd know when to move them back again. And then I worry about the tax consequences (for my taxable account). And so I sit, with my mutual funds and diversification and wait. For what I do not know.

Anonymous said...

Conjecture only, but I would think this is because the huge increase in bond spreads is not a result of realized defaults throughout corporate America but the repricing of risk/increased risk aversion due to acute problems in a - now - narrow part of the economy. As lenders' fears turn into reality and defaults appear in earnest on many of these crummy bonds/loans, the equities will follow.

Anonymous said...


I think you've got it exactly right. The spread between the number of new highs vs. new lows has been increasing dramatically, and steadily. The major indices are being propped up by a VERY small number of stocks..


Anonymous said...

"Anyone care to make a rational argument for why stocks are holding up?"
Perhaps there is a case of money illusion here is, stocks aren't "holding up, p/e ratio have compressed significantly over the past 7/8 years.Another point,you are comparing apples and oranges by taking s&p prices levels against yield bond spread.Try this: s&p earning yield less t-bills against the yield bond spread.

Anonymous said...

And please note where the S&P is headed...



ftn said...

You're graphing a mean-reverting process against a non mean-reverting process. OAS is a spread, and thus inherently mean-reverting. S&P 500 Price Levels are an asset price level, and thus are non mean-reverting.

Try graphing the first difference in log price changes: log(P(t)/P(t-1)) versus the Lehman OAS and I think you'll see a very different picture.

If you want to go into more depth, try looking up "covariance stationary prices." The reason economists always work with returns or log-returns is that price processes are not covariance stationary.

It's a somewhat technical point, but essentially you're trying to relate something that always (almost) goes up over time versus something that HAS to mean-revert. Equity returns versus spreads has economic meaning; S&P levels versus spreads does not.

cak said...

Looking at the new high/ new low list on the NYSE is a solid indication that we are in that "stealth" bear market - 4 highs vs 406! new lows. And that low list is a who's who of Americana :

Every airline just about
Macy's/JCP/Kohl's/Home Depot/Target
Fed Ex/UPS
Dominos/Mortons/Olive Gard/Wendys
Bear Stearns/Merrill
Speedway Motor Sports
Stanley Tools
Regal Movie Theatres
Time Warner/CBS
Sheraton/Comfort Inn/Holiday Inn
Sherwin Wms
Waster Mgmt
American Express
even Family Dollar

On and on. And there were 350 new lows on the Nasdaq vs 4 new highs.

So, it's pretty ugly out there.

Sivaram V said...

Although some posters are right in saying that something like earnings yield vs corporate bond spread is possibly a better comparison, I still think AccruedInterest is fine with plotting a price level. His view is that rising bond spreads imply economic weakness, and hence stock prices should see weakness as well. The fact something is or is not mean-reverting misses the point...

Anyway, my opinion on what is happening comes down to one word:


What has been keeping the S&P 500 going--not just recently but over the last few years--is commodity-related stocks. A huge chunk of the S&P 500 gain over the last few years are due to the energy and materials sectors. Others, in industrials, emerging market-oriented, etc, that rely on a commodity boom have also done well. I have to double-check but I believe energy is the largest sector in the S&P 500 right now.

When the commodity-related sectors turn down, especially energy, I think S&P 500 will finally see massive weakness.

Anonymous said...

AI - long term, stocks have demonstrated very little correlation with the economy overall, or with credit conditions. Sometimes stocks "look ahead" at anticipated better conditions, other times they reflect a tulip bulb mania, and other times they reflect lack of faith in accounting statements.

Please tell me how dot-coms, with no business plan and no earnings, sent stock indexes to all time highs? What does that have to do with credit spreads?

Your "analysis" chart looks at 1989 to present only -- so you are looking at a subset of the market history that was dominated by Easy Al Greenspan. Even Easy Al has commented that the current environment is very different from what he faced.

Even if we look at your very limited "data set" -- stocks rallied as spreads widened from 98 to 00, then stocks collapsed while credit spreads were largely unchanged (very volatile, but average level basically the same as in 00). There is no consistent correlation even within your limited data set.

You have made the assumption that the current "crisis" (problem, issue, whatever label you like) is predominantly a liquidity issue.

If you offer to lend some builder money at a lower rate, do you honestly believe he is going to go build another condo in Florida? Do you truly believe the halt in home building is predominantly because they can't get a loan? The massive inventory of houses that can't be sold isn't the problem? Have you noticed that mortgage brokers started making subprime loans because the credit worthy borrowers already had all the housing they needed for some time to come?

If you want to get a loan, and you put down 20% (80% LTV), and your monthly payment is around 30% of your income -- ie if you meet all the criteria that loan officers used up until 2001 -- you will find you have zero trouble getting a loan.

If you don't have the income and/or cannot make the down payment you would have been rejected in every time period except 2001-2006 -- and you will be rejected now. Reversion to the mean/norm is not a liquidity crisis.

Whomever is going to point out that many (most?) buyers cannot afford to put down 20% and/or the monthly payment on a McMansion. That's just a fancy way of saying most people cannot afford current home prices.

Either incomes have to go way up, or home prices have to go way down.

Fed Funds rates have absolutely nothing to do with it.

Once you accept that, I think the "discrepancy" between equities and bonds won't be an anomaly at all.

Anonymous said...

The chart clearly shows a lead/lag relationship between deteriorating TED spreads and the S&P 500. The S&P has started this month a decline that will likely continue for several months.

Anonymous said...

I agree with Gramps 100%. Well said.

Deborah, are you referring to the Canadian Pension Plan Investment Board? Of course that money is invested in securities - just like any corporate pension fund. The Canadian pension plan is fully funded - just like say, GE's (or maybe not if GE is underfunded). If the US had a fully funded retirement pension fund, it would be invested too.

Anonymous said...

newb question:

which fund(s) would you recommended for individual investor to get into corporate bonds?

Anonymous said...

@AI Good graph, but I like anon 3:42AM's "Try this: s&p earning yield less t-bills against the yield bond spread" idea very much.

Fully concur with cak@7:20PM. Multiples have been quite moderate since 2003. I can't find a single day where the S&P 500's next-twelve-month P/E (Operating Earnings) has touched 16, Ben Graham's 1970-ish minimum sell trigger. Worse yet, for the entire period bonds have consistently enjoyed a premium with respect to stocks, in sharp contrast to years like 1987 and 2000.

Yes, we all expect the S&P 500 to go lower. 1370? 1280? They're going to have to really fumble the ball before it falls all the way to 900.

Harleydog said...

bond market players are a lot smarter than the 'short bus' riding stock market participants. Ignore the credit markets at great risk.

Accrued Interest said...

Great discussion all.

JR (and others): We haven't seen much in the way of realized corporate defaults. And even if corporate defaults rise to 4-5%, as many are predicting, current bond spreads would still support investing. What we obviously have is very high risk aversion, but why hasn't that same risk aversion hit stocks?

Several people are making the comment that these two series haven't always correlated real well. Yes one is a time series and the other is "mean reverting" or at least shouldn't have a consistent direction. But my point in showing both together was to show that one was indicating economic weakness and the other was not.

Gramps: You and I seem to talk past each other sometimes. If you make the case that housing problems will cause the economy to be very weak in 2008, fine. But then why have stocks held up?

I've thought of some reasonable arguments for why stocks have held up which I'll post soon.

LQD is an exchange traded fund of corporate bonds which is reasonable.

Anonymous said...

Here is a clue: try thinking about whether or not the so-called benchmark treasury is fairly (or over-) valued. Distorts all types of spread-based analytical conclusions.

Eyal Bar said...
This comment has been removed by the author.
flow5 said...

Stocks rise when the rate-of-change in the money supply exceeds the rate-of-change in inflation. The other requirement is that money & credit growth are not so excessive that prices rise above the FOMC’s inflation target. The concept is dubbed “real-money” and it’s supposed to follow real-gdp.

Currently most private economists are forecasting slower economic growth. And under Bernanke’s leadership, the FOMC’s forecasts have been reasonably accurate. So the conclusion would be that any “easing” by the Fed (to counter recessionary tendencies)would translate into higher stock prices, ceteris paribus.

Anonymous said...

Weak knee'd shorts are creating a floor in the stock market. Once the covering starts, the momentum quickly changes direction and everyone piles on. Derivatives also tend to create ceilings and floors on volatility.

Anonymous said...

I think that much of the analysis is thinking way too hard and that the original blog post was closest to the truth. What kind of companies tend to issue lots of debt? Answer - stable, highly capital intensive companies that need leverage to produce high ROE's - financials, cable's, some older industrials. What kind of companies do not issue debt? Fast growing, or commodity based companies where revenue changes dramatically based on commodity prices or those companies that have expensive, risky and long lead times on new products (pharma). Now look at what has been keeping the S&P within about 10% of the october highs - fast growth companies. Take Apple for example up basically 100% in 2007 adding about 75bn in market cap. I would contend that the stock market not far from the highs because the terrible losses in credit sensitive sectors is by and large balanced by growth and commodity stocks that are small players in the credit markets.

Hottest Penny stocks said...

Funny to read this post now that we know what happened to the stock market.

James Morgan - Puritan Financial Advisor said...

Financial companies have gone into capital preservation mode, and all companies are finding the bond market quite inhospitable.