Tuesday, April 21, 2009

Bonds beat stocks (4)

This chart revisits the subject of earlier posts. It compares the yield on junk bonds (inverted) to the S&P 500 Index. The two markets are highly correlated, as you see in the chart, and this is typical over longer periods as well. The interesting thing to note is that the market for high-yield (junk) bonds has improved significantly so far this year, while stocks have languished.

Newer readers probably missed seeing my post in mid-November titled "Is this the end of the world or the opportunity of a lifetime?" In it I described key features of the Great Depression (e.g., real GDP declined by 26.5% over four years, and the peak of rate of defaults on all corporate bonds reached 14% in 1936), and compared it to the assumptions implicit in the pricing of equities and corporate bonds at the time (e.g., 24% of all corporate bonds would default within 5 years, and GDP would decline by almost twice as much as it did in the 30s). In other posts I have commented on the strong deflation expectations that were built into TIPS, and how these were questionable given that monetary policy in this crisis has been massively stimulative, while monetary policy was massively contractionary in the 1930s.

In short, in November our markets were priced for a future that would be much worse than the Great Depression. If the market was to be believed, then we were about to witness the end of the world as we know it. I thought that was pretty unreasonable, and so I thought that stocks and bonds were so incredibly cheap that it was hard to believe.

Now, six months later, the corporate bond market has repriced itself sharply higher (as yields and spreads have fallen), which means that the market has dramatically reassessed the likelihood of corporate defaults. This improvement was foreshadowed by a significant narrowing of swap spreads last year, another subject I have commented on many times, and it is supported by all the "green shoots" that we have seen in recent months which suggest that the economy is stabilizing. TIPS have also improved, as deflation expectations have receded. Equities, however, haven't improved at all on balance. What does this tell us?

A: The equity market is simply slow to catch on to the improving fundamentals.

B: Since the economy no longer looks to be in freefall, default rates are likely to be much lower than the market earlier feared, but the outlook for profits remains dismal, due to fears of higher tax burdens, increased government regulation, cap and trade, nationalization, etc.

C: Deflation risk has dropped significantly; this makes bond defaults much less likely, but does little to improve the outlook for profits.

D: All of the above.

I would choose D, for want of a better explanation. Regardless, we are still left with a puzzle. With so many things having improved, including corporate bond prices and TIPS prices, why aren't equities doing much better? Even if equities rallied another 30%, they would still reflect an economic outlook that could be described as no better than grim.

Full disclosure: I am long IVV, TIP, WIW, EMD, PAI and HYG at the time of this writing.

7 comments:

Tom Burger said...

Scott,

How can we even talk about the "market" for bonds. The degree of government/Fed intervention is beyond any prior experience.

Contrary Investor quoted James Grant this week: "As Jim Grant recently opined, what is occurring now in terms of printing/borrowing and guaranteeing credit markets, financial markets broadly and the support for the US financial sector specifically isn’t unprecedented, it’s unimaginable."

Whatever happens in these markets has very little to do with the independent judgment of investors and capitalists. The price signals we are getting are more likely to be erroneous than they are likely to be valid.

JMHO.

Scott Grannis said...

I would call your attention to Michael Milken's op-ed in today's WSJ, "Why Capital Structure Matters." Among other things, he describes the improved climate and improving prospects for the corporate bond market, and he notes that "In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market."

We're so jaded by trillion dollar deficits that maybe 840 billion doesn't sound like much, but that is still real money we are talking about, and it's coming from real investors. I'm not aware of any government program that involves buying new corporate issues.

utahcribs said...

Well thought out.. So in a nut shell, or to dumb it down for everyone else. The economy is showing signs of stabilization? Perhaps? But with so many unknowns the markets a nervous to react accordingly. Maybe we will see a big rebound, or perhaps a gradual natural uptick?

Scott Grannis said...

I think there is now a decent variety of indicators that suggest that at the very least the economy is not in freefall, and that it is likely in the process of stabilizing. I still think we will see the economy bottom by mid-year.

Investors, however, are "twice burned, triply-shy" at this point, and very reluctant to take anything on faith.

I should have mentioned in the post that high-yield bonds have an almost irresistible lure, since they are paying double-digit yields and will continue to do so unless default rates go to multiples of their current levels. Staying out of the HY bond market is much more "expensive" (in terms of opportunity cost) than staying out of equities, where dividend yields are only about 3%.

I would also note that all the fears which investors legitimately worry are what make for those "walls of worry" that bull markets must repeatedly scale.

If this were easy, things wouldn't be so cheap.

Donny Baseball said...

While defaults won't be at Depression levels they will increase, so many companies are already the walking dead, in which case the debt is the equity, meaning the value of the company will accrue to debtholders. Only when defaults come down and stabilize and the dead wood cleared will equity catch up.

luminati said...

for an academic study consistent with (a) look at:
http://people.bu.edu/sgilchri/research/GYZ_30Mar2009.pdf

Scott Grannis said...

luminati: Thanks very much for the link. This strongly supports my long-held belief that swap spreads (curiously not mentioned in the study, but highly representative of the high-quality spreads with the most predictive power) are excellent leading indicators of economic and general financial conditions.

Fortunately, swap spreads continue to forecast improving conditions.