Speculation Away From Subprime, Part 2

What a week, huh? Even with all of my cash on hand, I did a little worse than the S&P 500. One house keeping note before I get started, the file problem from my last insurance post is fixed. On to speculation:

  1. When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
  2. We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can’t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don’t), volatility is reduced, and panics are more slow to occur.
  3. Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
  4. The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here’s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
  5. Shhhhh. I’m not sure I should say this, but maybe the investment banks are cheap here. I’ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
  6. Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
  7. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
  8. Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
  9. Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
  10. Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.

We’re going to have to end it here. Part 3 will come Monday evening.

3 thoughts on “Speculation Away From Subprime, Part 2

  1. David,

    Do you subscribe at all to the theory that scrapping the “short only on an uptick” rule has contributed to the velocity of the decline? It seems an attractive theory to me, at least in part, as a contributing factor to the speed at which the repricing of higher overall corporate bond yields has occurred. As of yet, I haven’t heard a decent explanation for why they scrapped the rule.

    That said, if stocks were truly cheap, I don’t think that technical rules such as this would matter; it’s more of an issue for stocks at what I consider more of a general fair valuation, currently.

    In any case, bring on a bounce, I sure would applaud one!

  2. First I think the whole uptick rule is funny – as if momentum buyers haven’t rammed prices higher in the past? I guess panic blow off tops are ok but panic declines are inherently bad? So much for free markets…and basic logic.

    As for the 1987 analogy, it appears to me that this cycle is dominated by excesses in the credit markets – though there have certainly been some in the equity/PE markets as well. Using the relative valuations between stocks and bonds comparing the two eras misses this critical point in my opinion. Rationalizing stocks to be cheap by comparing them to a heavily inflated asset class seems wrong headed to me. Funny thing about over-leveraged markets is that once they begin to explode valuation metrics mean little. I doubt that the fact that investors looking to sell segments of the bond market who cannot get ANY bids is due to valuation metrics….

    If this thing does snowball, then it will likely have nothing to do with valuations – relative or otherwise. Just as the unprecendented leveraging up of the global financial system has lead to a global asset boom, the other side of the trade could be even more “impressive”.

  3. When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.

    Can you share the particulars on this oscillator? Is it a variation on some other standard TA oscillator?

    Shhhhh. I?m not sure I should say this, but maybe the investment banks are cheap here. I?ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.

    What are your favorite names in this space? GS would seem to fall into the “best of breed” category.

    Comparisons to October 1987?

    Interesting comparison. Absolute valuation levels are basically the same, although as you point out relative valuation levels are different. FWIW, the longer-term charts IMO are similar. You had a bull market that began in 1982 (2002) and ran approximately 5 years until 1987 (2007) and it really picked up steam in 1986 and early 2007 (2006 and early 2007). It is scary just how similar the charts look. Maybe that is just meaningless coincidence and my brain is searching for patterns that repeat. And maybe not.

    Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.

    This is a very interesting comment, partly because I hear it repeated so often. I’d be a very rich man if I had a dollar for everytime I heard a strategist or analyst make some variation of the remark, “Earnings are going to be up X% over the next 6-12 months, therefore stocks should be up Y%”. Is this true though?

    Obviously, over the long-term stock prices should track corporate earnings, but I have read some notes that state that there is a zero correlation between year-over-year changes in earnings and stock price changes. Obviously, this is something that isn’t an opinion. Either it’s true or it’s not true. I haven’t run the analysis myself, but I have no reason to doubt the veracity of the note. In fact, a note I recently read indicated that earnings grew 50% during the 73-74 bear market and that there was no decline in earnings during the 87 crash. Perhaps 2H07 earnings really won’t have any relevance to 2H07 stock performance?

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