What Corporate Yield Spreads Are Telling Us About Equities

Despite the government’s best and varied efforts to address the credit crunch, the average yield spread on medium-grade (“Baa” or “BBB”) debt obligations stands at a record high of 642 basis points against a comparable (1962-2008) average of 188 bps. Have corporate bond spreads peaked? And, must bond spreads peak, and trend decisively towards the 40-year average, before a bottom in equities can be called with a degree of conviction?

 

According to a brief analysis issued by the Bespoke Investment Group on Wednesday, there are at least three instances (in 1971, 1974 and 1982) when the S&P 500 bottomed well before bond spreads peaked. The Bespoke analysis cites one example (late 2002) when bond “spreads peaked at the same time as the S&P 500 made its low”.

 

But history provides no guidance in today’s unique and unprecedented financial and economic environment. There is every reason to believe that, this time around, corporate bond yield spreads will not approach anything close to the 188 bps average at all. In fact, this writer’s bearish call on equities (DIA, QQQQ and SPY) is, in good part, based on the assumption that the very sustainability of the historically high spreads is eroding the foundation of equity valuations.

 

For starters, the quality of the benchmarks themselves is now in question, as credit default swap spreads for 5-year and 10-year US treasuries settle above 60 bps, in preparation for a move into the 80s as the $8 trillion-plus bailout saga unfolds over the next two months. Secondly, it is obvious from the post-September behaviour of the CDX and iTraxx high-yield indexes that the average yield spreads on corporate bonds today would be closer to 850-900 bps if it were not for systemic-risk-offset actions taken by the Treasury and the Fed.

 

Thirdly, sophisticated lenders are now rationalizing yields after taking into consideration the cost of default insurance on institutional and corporate borrowers; in this regard, before on gets to the corporate spectrum, it should be noted that CDS spreads even for government bailout targets in the US and in Europe are at levels nobody could forecast a few short months ago. For better of for worse, CDS spreads for ex-blue-chip names like Goldman Sachs (340 bps), Morgan Stanley (440 bps), Citigroup (250 bps), UBS (205 bps), Credit Suisse (185 bps) and Deutsche Bank (140 bps) are having a direct impact on determining corporate bond spreads.

 

Finally, there is this rather complex issue of rating downgrades in a climate where it is evident that the leading rating agencies are overwhelmed by the task at hand. As was more than obvious in this week’s downgrades for Goldman Sachs and Morgan Stanley, and rating cuts for a number of sovereign issues, the best the rating agencies can do now is to follow the news. Since, early warnings, as opposed to after-the-fact announcements, are now well in the past, uncertainties surrounding the fate of certified credit quality are also playing a significant role in keeping bond yield averages at 40-year highs.

 

In summary, this writer’s stance is that the bond-yield-spread matrix has undergone an irreversible transformation; despite some excellent analysis on yield-to-equity correlations and breakouts being provided by Bespoke in recent weeks, history is certainly not repeating itself. On the contrary, what the matrix is telling us is that when fundamental cost-of-capital and debt-equity relationship considerations are applied to the corporate spectrum, a significant decline (20%) in equities is overdue.

 

Perhaps we may have to wait (a) for the market to acknowledge the limited effectiveness of the stimulus packages being proposed by the new administration before we see the S&P 500 at 700 and lower, and (b) for investors to realize that the finger-in-the-dyke Dutch legend, which Ben Bernanke and Hank Paulson are currently applying to systemic risks, was actually an all-American literary invention, not historical fact.

 

 

 

 

 

 

Why State Capitalism Creates Zero Value For Small Investors

Do Washington’s bailouts and rescues simply amount to an intervention in the American free market system on behalf of elite institutions and big capital, against the interests of the American consumer? And is there a fundamental disconnect between the principles guiding such intervention and the shape of the global economy?

 

If the answer to both questions is “yes”, retail investors are best advised to forego bullishness and to use all significant rallies in the S&P 500 to sell (QQQQ, SPY) aggressively, and to buy put options when such rallies are accompanied by record implied volatility. After the sharp fall in equity markets on Monday, a number of mutual fund managers continue to espouse the longer term view in one television appearance after another, despite the fact that economic data on the domestic and global front is clearly telling us that the deleveraging process is certain to have painful repercussions for asset valuations and for consumer loan delinquencies through 2009 and beyond.

 

In a classic free-market capitalist society, financial institutions and corporations are not protected from market forces. The $8 trillion government program involving both cash outlays and guarantees is not only destroying the dynamics of private capital; it is also creating new systemic risks, while claiming to remove underlying threats to the process of capital accumulation and to mainstream deposit and lending mechanisms. The biggest system risk being established today pertains to the qualitative deterioration in the “full faith and credit” of the US government.

 

Of more immediate concern to retail investors should be the alarming inability of rescue targets to bring any post-rescue credible business models into the public domain. American International Group (AIG), Goldman Sachs (GS) and Citigroup (C), for example, remain in semi-permanent restructuring mode. Others accessing government funds and guarantees are still refraining from identifying the full extent of asset depreciations; General Electric (GE), for example, needs to restate its emerging market assets (given the turmoil in India, Thailand, Turkey, Brazil and the Middle East) before anyone can figure out how its stock should be valued. This week the focus will be on Detroit, and there is every reason to believe that aid in the face of a failed business model will be termed a medium-term loan.

 

In the absence of any detailed business plans from the bailout targets, it is best not be misguided by the rather vague argument that, in time, the American tax-payer will actually benefit from concerted and widespread government intervention. On the contrary, the targets will simply drift along, in the hope that either the domestic stimulus packages will result in a sustainable improvement in household balance sheets and overall credit quality, or the stimulus packages in Europe, China, India, Brazil or Russia will lead the world out of this deep-rooted recession.

 

The Obama administration has been touting the recently-announced stimulus package (expected to reach $800 billion) as being friendly to the American worker. History does not support that proposition. The fact remains state capitalism has always been about the control of the means of production and the related financial superstructure by the state; the evidence shows that, even in instances where the state (e.g. Russia and China) claims to represent workers and peasants, it is the political elites who control the ebbs and flows of capital, and the fate of the population at large. So check who controls or directs Washington’s lawmakers before executing any long-term bullish trades.

 

This short call is premised on the ideological assumption that state capitalism, at its roots, is bad for the retail investor, near-term or long-term. For a profound analysis of the state capitalism phenomenon, study the post-WW II analysis of the Soviet Union by Tony Cliff and Raya Dunayevskaya at your leisure. Both writers were of the view that America’s Cold War enemy was not a communist state in the first place!

 

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