1) Credit cycles tend to persist for more than just one year.? That is one reason why I am skeptical of the run in the high yield corporate bond market at present.? Sharp short moves are very unusual.? To use 2001-2003 as an example, we got faked out twice before the final rally commenced.? So, as I look at record high defaults after a significant rally, I am left uneasy.? Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion.? S&P is still bearish on default rates.? I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.
2) Of course, there are bank loans in the same predicament.? Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs.? Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.
3) Where should your asset allocation be?? Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000.? Good timing, that.
David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields.? For that bet to work out, deflation must persist.
One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks.? Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.
4) Maybe demographics are another way to consider the market.? When there are more savers/investors vs. spenders, equity markets do better.? I’ve seen this analysis done in other forms.? So we buy Japan?? I’m not ready for that yet.
5) Illiquid assets require a premium return.? After the infallibility of the Harvard/Yale model, that rule is on display.? As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets.? Harvard and Yale may indeed have gotten a premium return versus equities.? It’s hard to say, the track record is so short.? One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need.? As such, investors in alternative investments are looking for more liquidity and transparency.
6)? There are limits to arbitrage.? As an example, consider long swap rates.? 30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.
7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks.? When managements are confident, we see that; managements are not yet confident.
8 ) I would be wary of buying into a distressed debt fund.? Yields have come down considerable on distressed debt, and I think there will bew better opportunities later.
9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies.? I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.
10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.
great points but number 10 sounds too glib to me. Investors in new projects/investments (VC, entrepreneurs, project lenders, etc) reallocate money from low risk to higher risk uses.
For people who only play in existing traded products, your observation sounds right
Dear David- I very much appreciate your diverse and well grounded perspective. So what will be the end result looking out 3-5 years? If we assume mortgage equity withdrawals and new fangled securitization products drove an extra 2-3% GDP for at least most of the 2000s, does the govt hope to somehow replace such malinvestment with a new drive to artificially enhanced single digit GDP growth? Too many institutions continue to reject allowing assets to find their proper level (lower) while numerous problems remain nearly insurmountable. Low discount rates alone is a poor panacea for what ails us. Global competition continues to intensify, the populace at large is in a weakened state of eroding incomes (potentially permanent), employment conditions and employer/employee negotiating power has dramatically worsened, higher taxes are expected at all levels, and the education system is well established but perplexingly little promise of providing a proper return for one’s time put in and exorbitant debt incurred. I won’t lengthen this by adding my thoughts about the financial system restructuring which is critical to our survival. As a nation we are simply not investing in an efficient and focused manner to drive sustainable wealth generation for all. The republic is rotting from the inside out.
David,
On your point #6, John Jansen referenced on his Across the Curve blog this week that a recently issued Colgate-Palmolive bond traded through the relevant Treasury issue (I think it was minus 14 bps). It’s not particularly arbitrageable, just like the swaps, but wow…trade about a relative value trade!
Steve
“gamblers” as you call them bring also liquidity, which in a sense reduce the risk for the investors.
Gamblers don’t always bring liquidity — they often take it. Do short term speculators tend to use limit orders to enter positions, which offer liquidity? They more often use market orders, which consumes liquidity. In exiting positions, do they use limit orders or market orders? There, more often limit orders — though not always — if a stop is triggered, more often, a market order is generated, taking liquidity.
My experience is that long term investors tend to use limit orders more, which offer liquidity. Speculators/gamblers tend to use market orders, which consume liquidity.
As an aside, with bid/ask spreads so small, it is one reason why market makers are a smaller part of the market. When margins are so narrow, no MM will put up significant size.
hi david – great blog. i’d add to your nice list the massive amount of insider stock sales. what do you make of them?
I would re-characterize #10 into three categories:
1) Investors (Same definition as you)
2) Speculators – People who attempt to make money by betting on asset prices.
3) Gamblers – People who, on the surface, “act” like investors or speculators, but who participate purely for emotional fulfillment. (A gambler who speculates is pretty easy to imagine. A gambler who invests could be someone who invests in long-shot IPOs for the status, etc.
Investors and speculators want to make money. Gamblers also want to make money, but not at the expense of getting “action.”
When 1, 2, and 3 all line up on the same side of the trade, then you have a problem.