My post yesterday on corporate bond spreads was received well. I want to amplify one point that I did not make strongly enough. During market crises, asset values cheapen not only in response to likely losses over the long run, but the possibility that there might be forced sellers due to:
- Reduction of leverage because of asset values declining
- Reduction of leverage because of brokers lending money get skittish
- Reduction of leverage because of rating agency downgrades
- Reduction of leverage because of client withdrawals
- Reduction of leverage because of an increased need for capital from the regulators
- Arbitrage from falling prices in related markets
This can temporarily self-reinforce falling asset prices, until unlevered (or lightly levered) buyers find the returns from the assets to be compelling. Though my piece yesterday was more fun to write, this makes the argument plain. Can you carry the asset through hard times? What about the rest of the asset holders?
The concept of weak hands versus strong hands is a very real issue, and for those with a subscription to RealMoney, I recommend these four classic (Labor of love) articles of mine:
These articles are core to my thinking, and I spent a lot of time on them.