Credit and Equity Markets: Analyzing the Divergence

There is a Street perception, which we generally share, that fixed income markets are "smarter" than equity markets.  At the moment, the fixed income signals are all very negative.  Many on the Street interpret this to mean bad news for equities.  The complete explanation for the discrepancy, now at record levels, between projected stock earnings and fixed income yields, is that stock analysts are completely wrong.  From this viewpoint, the economy and earnings are at serious risk.

What Happened Today

All sorts of credit spreads, indicators rarely followed by equity traders and investors, moved to very wide levels.  This stimulated yet another round of selling in any company in a financial sector.

Regular readers of "A Dash" have all of the pieces to figure this out, but it is time for a summary.  The key point is that credit markets are illiquid.  No serious economist or market analyst believes that an illiquid market generates valid prices.  Illiquidity forces the pressured fund or institution to sell  — and to do so at any price.  It also forces the sale of assets where there is liquidity.

At any given time, some hedge funds or financial institutions will be in this position.  In most circumstances there would be investors who would step up to buy assets that were undervalued, at least on a theoretical or "performing" basis.

When a market is in free fall, all bets are off.  There are now three distinct problems:

  1. Potential buyers are waiting to see "blood in the streets."
  2. FAS 157 rules generate a ripple effect.  With each distress sale, assets held by other institutions must be market to this new market price.  This means that a forced sale can generate a spiral of other forced selling.
  3. All of this is happening at a point where equity markets are trading near January lows, a level where many are looking carefully to see if this "support" holds, or if there will be another leg down.

David Malpass has a nice summary of the situation (you need a Bear Stearns account to get his complete analysis):

…(A) circular mark-to-market process is a key factor driving the credit market
deterioration
.  As we understand one example, a
major bank sold a small group of bonds at a low price late in February.  This
caused a mark-to-market decline in similar bonds elsewhere.  A margin lender
raised its margin requirement, creating a margin call for a hedge fund owning
similar bonds.  Unable to meet the margin call, the hedge fund sold bonds
quickly, adding to the volatility in that segment of the bond market.  This
began to impact the volatility in agency bonds, causing increased margin
requirements on them.  As volatility on agency bonds increased, margin calls
went out, forcing sales, driving prices down and forcing lower marks, a process
still underway after today’s market close.

A Multi-Faceted Problem.

In prior articles we pointed out that there are distinct issues — the housing market, the old mortgage market, and the "new" mortgage market.  As long as credit is artificially restricted for potential new buyers, the demand curve for housing is distorted.  This reduces prices, increases foreclosures, and generally makes everything worse.

The economic effects — whether there will be a recession, the level of corporate earnings, and the appropriate valuation for stocks — is not directly affected by these issues.  Mostly this is because the use of home equity has mainly been for home improvements, auto loans, and an offset to other investment.  This is another topic that Malpass has covered carefully, and nearly everyone has ignored.

Few are making the careful distinction between write-downs in financials and ongoing earnings in other sectors. Future financial earnings depend upon the ongoing businesses, not the level of past write-downs.

What Will Happen?

At some point we expect direct government intervention in the two key markets:  Existing and distressed mortgage CDO’s and further assistance to new buyers.  There will also be action to help those threatened with foreclosure.

Please note that this prediction is analytical, based upon our experience of what stimulates various  government institutions to action.  It is not a normative viewpoint.  Right or wrong, these steps will eventually occur.  When they do, markets will react sharply.  This might happen in anticipation, but as we have suggested in the past, there could be another Fed surprise like the TAF facility.

Wall Street analysts do not understand how government works.  Because the pace of action is slower than trading they infer stupidity and ignorance.  This is not true.  Solutions develop, but not always at the pace we hope for.

Trading Implications

We wish this had more immediate and direct trading implications, but it really does not.  As we noted yesterday, we fear the reaction to the highly-variable employment report.  We also note the "technical damage" seen by many analysts.

Current market levels are attractive by our methods — fundamental and technical — but all forecasts come with a time frame.

ETF Update

Given the factors we describe, it has not been a great time to be fully invested.  The TCA-ETF model has kept losses to a minimum, down less than 2% for this cycle.  This is in line with the S&P 500 and below the NASDAQ.

The model still sees plenty of sector opportunities, as the chart below indicates.  We provide this information each Thursday for the benefit of other ETF investors.  Those who are interested in the specifics of Vince Castelli’s approach (and you should be) can get a complete report upon request.

Etf_sector_report_030508

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8 comments

  • Mike C March 7, 2008  

    Interesting that you mention/cite Malpass, as I came across this blurb on Malpass from one of the other blogs on my regular reading list:
    “I really don’t like to single out any one firm or strategist for excessive criticism — hey, we’re all wrong on quite a regular basis. But, goddamn, if Bear Stearn’s David Malpass hasn’t been on the wrong side of more than a few major issues facing the economy over the past few years.”
    Now, to be clear, I don’t endorse or reject this view of Malpass as I have NOT personally vetted his track record.
    One of the recurring themes on this blog IMO is searching for content and recognizing expertise. Is Malpass an expert or is he someone who gets it wrong most of the time. I do not know. Maybe one day I’ll take the time to check it out thoroughly.
    I would just again point out vehemently that the individual investor should NOT be making investment buy/sell decisions based on David Malpass, Barry Ritholtz, Jeff Miller, or whoever else (myself included).
    The individual investor should study the classics of investing, develop and implement a coherent philosophy and strategy, and measure the results versus a passive buy and hold of the index. Otherwise, hire a professional with a coherent philosophy and strategy with a proven real money track record.

  • Jeff March 7, 2008  

    Mike –
    You will never take the time to review the complete record of Malpass or any other economist. Even if you did, what criteria would you use to determine if he is an expert? What skill do you believe is needed to review and critique the work of professional economists?
    That is why it is valuable to read people who are qualified to find the best experts and exercise care in their analysis.
    If you cannot see what is wrong with the quotation you cite, you are not as smart as I thought you were.
    Did you find the quotation from Malpass helpful? That is the point.
    And by the way, I am not giving investment advice online nor do I endorse investment advice from Malpass.
    Thanks for commenting. I really hope that you will tell us how you would determine whether Malpass is an expert. I am very interested in your answer.
    Jeff

  • Mike C March 7, 2008  

    Jeff-
    I shouldn’t have posted the previous comment, and should have kept my thought to myself. I just happened to read the other blog post soon after reading your blog post, and the first thing that popped in my mind, is should I be skeptical of David Malpass, and to point out a question anyone who is reading both blogs might have. As I noted in my previous comment though, I did not make a judgement one way or another. Perhaps that makes me not so smart.
    “I really hope that you will tell us how you would determine whether Malpass is an expert. I am very interested in your answer.”
    On an investment message board (Motley Fool) that I participate in, a professional money manager made an interesting comment recently that stuck in my head. He paraphrased Bill Parcells, and the quote was “You are what your record says you are”.
    Just as no good football team wins every single game, no expert gets every single forecast or analysis of every single issue correct. Losses and mistakes happen. But overall, an expert should have a good track record, and should get the really big picture stuff mostly right just as the good football team should beat the Dolphins.
    There is a fine line between the “gotcha” mentality you cite, and an evaluation of somebody’s past track record, forecasts, analysis, etc. Whether someone is an “expert” or not according to some technical definition of the term, I’m going to be somewhat skeptical of analysis that deals with the present and future, if their track record indicates major mistakes in the past, and that goes for both sides of any issue.
    I did not mean to imply that you were giving investment advice. I’ll be perfectly honest, and I hope you don’t take this the wrong way. My point is that the average individual investor trying to manage their portfolio is probably going down the wrong path considering any of this discussion.
    You’ve got an excellent blog but the overall tone is more academic in nature and your content is generally more relevant/applicable to the sophisticated investor/professional money manager looking to get additional color/perspective on stuff like how government policy intersects with markets. Are you writing for that audience? Or the novice individual investor trying to manage their portfolio without blowing up?
    One final thought on “experts”, and I know this won’t meet any kind of rigorous standard, but for me the the Supreme Court justice quote about pornography is somewhat applicable. Tough to define exactly, but I know it when I see it. For example, I regularly read David Merkel at Aleph Blog, and to me it is obvious he is an expert when it comes to the fixed income markets and issues surrounding bonds and interest rates.
    In any case, I would find a post on what exactly distinguishes an expert from a non-expert for you interesting? Does the totality of one’s entire track record matter at all?

  • Jeff March 9, 2008  

    Mike –
    Thanks once again for your helpful and honest comments. My own approach would combine the totality of the track record in economic forecasting along with explanations and methods.
    Malpass has been excellent on both counts, which is why I often feature his work.
    I am disappointed but not surprised that readers seem to enjoy attacks like that in the article you cite.
    Anyone doing a little research, even a cursory reading of the source material, would see that all three claims are incorrect. Information about two of them is already on my blog. The second was a topic on Kudlow, with objections from everyone that it was unfair. (The video has now been pulled down). I am surprised and disappointed that he would bring it up again.
    Anyway, your comment was an honest reaction, shared by many, who now believe that Malpass has been wrong on a bunch of key calls. It is their loss.
    If you wanted to do the world a service, you would click through on the links and report what you find.
    The last claim, on the dollar, is particularly offensive, since the self-proclaimed gonzo economist who needs no formal training gets to lecture the real economist, who has written extensively on the need for a strong dollar, and who understands all of the variables. I doubt that anyone bothered to click through and read Malpass’s original article.
    Jeff

  • Chris March 10, 2008  

    I wish I could read Malpass more often. Does he have any blog that is available to non-clients?

  • sharestar March 17, 2008  

    Bear Stearns gone under and with him gone Malpass. Hehe Mike u win.

  • Jeff March 17, 2008  

    Chris and Sharestar (and Mike) –
    Let’s be clear about something here. There are a lot of people doing very poor economic analysis and market commentary. I do not wish for any of them to lose jobs, stock options or otherwise be harmed. My view of the real weak links on the economy may be different from the viewpoint of some readers.
    I do not see why anyone would celebrate the problems of any honest employee of Bear Stearns. Also, we should all be open minded about hearing information from a wide variety of sources. Malpass’s voice is clearly in the minority right now. If you disagree with Malpass, all the more reason to read and carefully evaluate his viewpoints.
    Having said all of this, my hope is that JP Morgan will keep him and feature his work. If not, he will have no trouble finding a new home.
    I have never met Malpass, and I do not share many of his “political views.” I just look for good analysis to help my clients.
    I am curious about what other readers think, and as always, I appreciate any comments.
    Jeff

  • Chris March 17, 2008  

    I suppose the silver lining in all this is that I may end up getting my wish for more Malpass if JP Morgan or some other new employer makes his writings more freely available.