The Rules, Part XVII

In a panic, only two attributes of a financial instrument get priced — liquidity and quality/survivability.

In a panic, all risky assets become highly positively correlated with each other.

Given that correlations tend to rise in a panic, a reasonable measure of sentiment is to measure the average absolute value of 10-day correlations.

Markets cannot survive for long periods of time at high levels of actual or implied volatility.  They eventually revert to normal.

Panics and booms are different — they may be opposites, but they behave differently.  Panics are events, often multiple events, and booms are processes.  The nature of this is best explained through the credit cycle.  The boom phase of the credit cycle involves rising profits of corporations.  Stocks and bonds behave differently here.

Say the expectation of income moves from negative to a low positive figure.  Stocks will rally; bond may rally more, because the threat of bankruptcy is lifted.

Now suppose that the expectation of income moves from a low positive to a normal positive figure.  Stocks will rally a lot, but bonds will rally a little.  The odds of the bonds being paid rise a minuscule amount.  The stocks estimate of future distributable profits rise a great deal.

Now suppose that the expectation of income moves from a normal positive to a high positive figure.  Stocks will rally some, but bonds will not rally much.  The odds of the bonds being paid don’t change.  The stocks estimate of future distributable profits rise, but with a sense of possible mean reversion.

So in a boom, credit spreads [the difference between the yields of corporate bonds and Treasury bonds] tighten quickly, tighten slowly, and then stop tightening, even though things seem to be going great.  The end of the boom, as far as the credit market is concerned, can last a long time.

The end of the boom comes when a significant amount of companies the overextended their balance sheets during the boom find themselves in a compromised condition, and have a hard time gaining financing.  The suspicion of credit troubles travels fast, and all of the companies where investors waved their hands at problems now get a fresh look with a different set of eyes.

The moment incremental financing seems less likely or more expensive, companies that will need financing get re-evaluated by the market — stock prices move down, bond yields go up.  This is when analysis of the balance sheet and the cash flow statement are worth the most, and the income statement is worth the least.  The bull phase of the cycle is all about income statements, and estimating what future income will be.  The bear phase of the cycle is about estimating  cash flows, and the strength of balance sheets, to identify who might not survive the bear phase well.

During the boom phase of the cycle, the degree of correlation of asset returns is low.  There is noise, and not everything does equally well.  There are multiple risk factors and strategies that are working.  But in the bust phase, the acid test of survival dominates.  One factor gets priced, whether an asset is money good or not. [For bonds, “money good” means the par value of the bond will be repaid at maturity.]

But panics don’t last long — usually two years or so.  As the panic drags on three processes take place:

  • Companies in horrible shape default.
  • Investors examine companies in okay shape, and find weaknesses.  Some will default, and some will clean their acts up.
  • Companies clean up their acts, and it becomes obvious that they will survive.

Toward the end of the bust phase, like a fire running out of fuel, there is a moment of clarity where some realize that things aren’t getting worse.  Most companies have cleaned up, and there will be fewer future defaults.  That sets the scene for the next rally.

Through the bust, equity volatility and credit spreads remain high; they are correlated phenomena, but there is a point of exhaustion.  High yields attract needed financing to companies that are mis-financed, rather than insolvent.  Credit spreads can only get so high before money comes in willing to buy no matter what the future may hold.  Equity volatility can only get so high before players begin writing short straddles, knowing that the odds of winning are tipped in their favor.

It pays to watch both the equities and bonds, and other related securities — it gives a richer picture of what is going on.  In particular, when the bull phase has gone on for two full years, watch for equity volatility and credit spreads to stop falling.  That is a sign that the bull market is getting close to the end, and most of the easy gains have been made.  Watch for telltale signs of cashflow shortfalls where banks are less than willing to plug the gap at a price.

Learn this well, and your ability to play the market will improve considerably.