A large-ish number of people have asked me to write this piece. For those with access to RealMoney, I did an article called The Fundamentals of Market Tops. For those without access, Barry Ritholtz put a large portion of it at his blog. (I was honored 🙂 .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish. I don’t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion — yes, residential real estate was near its top. My friends, being bearish, and grizzly housing bears, heartily approved.
So, a number of people came to me and asked if I would write “The Fundamentals of Market Bottoms.” Believe me, I have wanted to do so, but some of my pieces at RealMoney were “labor of love” pieces. They took time to write, and my editor Gretchen would love them to death. By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures. They really made my writing sing. I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different. Tops and bottoms are different primarily because of debt and options investors. At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up. Option investors get greedy on calls near tops, and give up on or short puts. Implied volatility is low and stays low. There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms. They spike multiple times before the bottom arrives. Investors similarly grab for puts multiple times before the bottom arrives. Implied volatility is high and jumpy.
As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.” That is what differentiates tops from bottoms. At tops, no one cares about debt or balance sheets. The only insolvencies that happen then are due to fraud. But at bottoms, the only thing that investors care about is debt or balance sheets. In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders. In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times. I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Whew! For an introduction to an article, that’s a long introduction. Tomorrow, I will pick up on the topic and explain how one sees market bottoms from a fundamental perspective.