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Buy Stocks When Credit Spreads are High, Sell When They are Low

Credit spreads and implied volatility are cousins.  When there is complacency, both are low.  When there is panic, both are high.  For those of us with strong balance sheets, when do we buy?  We buy during panic. when we can get quality assets at bargain prices.  When things are euphoric, we sell, or at least reduce exposure, increase quality, etc.

That’s why I don’t have much sympathy for articles talking about Great Moderation 2.0.  Ask yourself, “How did the Great Moderation work out?  Was taking a lot of risk then a good idea?

There were many that chased past returns 2005-7 that got hosed 2008-9.  So when I see articles like Trends Point to Growth & Stability, I shake my head and say, “Driving by looking through the rear-view mirror.”

I feel the same about this article, Investors Rewarded for Trek Into Little Known Markets.  Anytime a lot of new money spills into any new asset class, returns are high and implied volatility falls.  That tells us little about the future.

When implied volatility and credit spreads are low, that tells us that people are very certain about the future, and they are relying on things remaining stable.  It doesn’t tell us when the bear market will come, but it does tell us that gains are limited before the bear market.

I can’t tell you when things will break, or how badly they will break.  I can tell you that stocks are producing earnings gains by levering up more, and not through organic growth.  In the short run, it pays to issue debt to buy back stock, but the additional debt eventually exacts its price — when the cycle turns, and the price of liquidity rises, the debts will still be there, and interest costs to refinance them will be considerably higher.  Or, equity might have to be issued at an unfavorable moment.

One practical tip — the area with the greatest percentage amount of credit growth is usually the one that performs the worst when the cycle turns — candidates for that include E&P firms engaged in fracking, student loans, US Government debt, and more.  If anyone can think of additional areas, please mention them in the comments.

I’m not running away.  I’m just trimming here and there, and investing in safer companies that seem to have good accounting.  All for now.

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4 Responses to Buy Stocks When Credit Spreads are High, Sell When They are Low

  1. JoeSpringer says:

    I don’t know about its industry peers but Philip Morris has issued a lot of debt for a lot of buybacks, CEO and chairman sold millions in last 2 months, if you are a bear on foreign currencies vs. the dollar lookout PM..

  2. gv says:

    The fracking industry looks like the most obvious short opportunity somewhere in the future. Another area I’m looking at right now is autodealerships. The combination debt and low margins deserves my attention.

  3. […] David Merkel, “Credit spreads and implied volatility are cousins.  When there is complacency, both are low.  When there is panic, both are high.”  (Aleph Blog) […]


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.

Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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