Thursday, August 27, 2009

Despite the huge rally, pricing is still very bearish

This chart shows the Option Adjusted Spread of the Merrill Lynch Corporate Master Index. That's an index that is currently comprised of some 3800 investment-grade issues with a market value of $2.8 trillion. We've seen a tremendous rally in corporate bonds, as spreads have narrowed from their unprecedented highs of late last year. Those highs occurred last November, when the market feared that the economy was headed for something worse than the Depression of the 1930s. We had never seen such depressed pricing, not by a long shot.

Now, with lots of indicators suggesting that the recession has already ended or is very close to ending, the fears of last November look outrageously wrong viewed from today's perspective. As a result, and not surprisingly, asset markets have repriced. Equities are up over 35% since mid-November, and IG corporate bond prices are up over 20%.

But as this chart shows, credit spreads are still wider today than they were at the peak of the corporate bond debacle in late 2002. That was when financial markets were experiencing unprecedented panic over the prospect of massive corporate defaults (e.g., Enron, WCOM), and accounting and management scandals. We see this same story with the Vix index, which at 25 is still far above levels (10-15) that prevail in "normal" times. Similarly, the implied volatility of bond options is still far above normal or average levels. And of course the spreads on junk bonds are still in the stratosphere.

So we've made a lot of progress to date, with the market's implied economic forecast improving from one of a double-deep depression to one of a nasty recession. Judging from the pricing of corporate bonds today, and judging from the levels of implied volatility, the market is still very fearful of of the future. It may seem difficult to buy stocks and corporate bonds today since they they have rallied so much from their lows, but if you believe the economy is on track for even just a modest recovery, then the market is attractively valued today.


Burt said...

Note the actual volatility of the S&P has been running about 17%. Dec futures vol is 29%.

Scott Grannis said...

The fact that implied vol is higher than actual vol underscores the fact that the market is still plagued by fear.

Burt said...

Same holds true for the put/call vol skew.

Veneratio said...

Even if we do see a pullback in the stock market, is it not still feasible that corporate debt could continue a bullish trend or do you see the spreads and the market moving together?

Scott Grannis said...

Credit spreads and the stock market don't always move together. Just consider the Feb-Mar collapse of stocks to new lows, while credit spreads continued to decline. But eventually I think the two must follow the same path (equity prices up and spreads down). Ultimately we're talking about one capital market; if default risk on corporate bonds is going down (falling spreads), then something good must be having to corporate profits, and that should show up in higher equity prices.

It is possible for corporate bonds to outperform equities, however, especially if we get a lukewarm recovery. Bonds would enjoy spread narrowing, as well as relatively high coupon yields, even though profit growth wasn't strong enough to drive signficiant equity price gains.

Arun said...


I enjoy reading your blog and find it insightful although contradictory to my medium to long-term view. I find it surprising to see how bullish you are with the spreads being too high despite lack of technical pressures in the fixed income markets. What are your thoughts on the impact in markets from next wave of home foreclosures, $1.4 T of commercial loans maturing in the next 3-4 years, another several hundreds of billions of HY bonds maturing, combined with the loose monetary policy of the Fed. I think we are heading into a period of stagflationary environment in the US and other developed countries. I just can't fathom the thought US consumers will continue to spend they way they did when they see their own and their parents' net worth receive such a shellacking. Let me know your thoughts.

Arun said...

In addition to my comments above, there are several other factors that bears some attention: high insider selling (30x insider buying), higher short interest ratio, more bank faliures, and lack of excitement in the markets despite better outlooks from Intel and Dell. What gives? I am flummoxed. Thanks, Scott.

Scott Grannis said...

Arun: sorry for the delay. As for spreads still being high, I see that as part of the natural adjustment process. Nothing gets fixed overnight, and it takes a lot of time for the market to get comfortable with a lower level of spreads. Didn't it take over a year for spreads to come back to normal after their 2002 highs? I've already commented on the commercial loan foreclosures in a post today, but the short answer is that I think the market has already absorbed the likely losses. Easy money from the Fed just lubricates the process. Meanwhile the economy is improving, so that is mitigating the problem as well.

Inflation may indeed become a problem, but that too takes time (long lags from monetary policy to the economy). I think it's too early to let inflation fears keep you out of the equity and credit markets.

As a supply-sider, I don't believe that consumer spending patterns dominate GDP. The most important things are work, production, and investment. If they turn up then the economy turns up and eventually consumer spending turns up.

Everyone is trying to deleverage, but that won't last forever. So far the deleveraging urge is just making it easier for Treasury to finance the deficit.

Insider selling? A lot of insiders have to sell periodically to exercise their options. Lots of people must be selling these days every time the market reaches a new high--as they breathe a sigh of relief at having recovered some of their losses and swear they will never let another market decline catch them by surprise.

Short interest? I see that as healthy. If short interest is rising while the market is rising and the fundamentals are all getting better, that just creates the potential for a monster bid as the market continues to move up. I'm a contrarian.

The recent selloff? We've had lots of selloffs on the way up.

Arun said...

Thanks, Scott.