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Capital Context Update: Market Observations offer a Bearish Bias
From Capital Context
Our ETF-based alternative HY-IG decompression trade is performing well but has more upside.
Credit markets are generating some worrisome signals. We are growing in conviction that investors are becoming more risk averse and have noted several significant factors in the last few weeks that make us increasingly nervous with regard holding risk assets.
In this chart-heavy post we lay out several of the reasons that we have been discussing recently, many unique to our cross-asset-class perspective, in an effort to provide some much needed context upon which to base this decision.
The suggested trades to profit from our view are HY-IG decompression (which can be positioned in ETF space as per our
May 5th entry in the weighted HYG-LQD trade
) or in CDS index space for our institutional clients, being tactically flat or underweight equities and/or overweight Treasuries or IG credit, positioning for a flattening of the front-end of the HY curve (particularly 3Y vs 5Y), or through an equity-to-debt position (short stocks vs long credit). For our long-only equity clients who are required to be at least minimally invested, we would suggest using the
A-List
to capture relative upside should we see further downside in equities as we suspect.
The Citigroup Economic Surprise Index rate of change is dramatically lower and has tended to signify turning points in the past.
With the macro background weakening and global growth seeming tipping towards a slowdown, the imminent end of QE2?s liquidity-fueled rotation into risk assets, and a series of systemic and idiosyncratic shifts in credit and equity relationships, we see equities as the most at risk asset class along with HY credit. Treasuries are more likely to outperform (as banks step back in post QE2 after being crowded out for carry curve flatteners) and IG credit perhaps the riskier of the safest bets (if we avoid financials in general) as fund flows and technicals (meaning supply-demand imbalances as opposed to technical analysis) will likely be sustained come rain or shine. Critically, we are more confident than ever that this is a market that will reward idiosyncratic risk more than systemic risk and suggest dusting off your fundamental analysis (or using our
factor model
to help with decision-making).
There are plenty of concerns
fundamentally
in both US and global economies, as we have noted before that EPS is a weak proxy for free-cash-flow (an actual real valuation-based metric as opposed to an accounting treatment) at cycle turns and periods of inflation of asset prices (where the cost of replacing assets is notably higher than the depreciating asset on the balance sheet - implying future hits to the balance sheet and perhaps one of the drivers of the large amounts of cash on corporate balance sheets).
For S&P 500 members as a whole, free-cash-flow per share has fallen for the last four quarters and while capex has indeed risen QoQ for the last four quarters, it appears to be stalling here notably below pre-peak levels. It seems, as ever, that the broad swathe of bullish investors rely on analyst EPS growth expectations (mother's milk analogies aside) and their projections judged against some inflation-induced multiple to get to ever-increasing S&P valuations.
EPS growth expectations for the S&P remain high but seem driven in large part by a dramatic rise in Energy sector earnings - which we see as reflexively bad for a global economy.
We decided to take a look at just what those expectations looked like in aggregate and saw some concerning expectations. The chart above shows the growth rate expectations for the S&P in aggregate and the Energy sector. With the Energy sector making up an increasing proportion of the S&P index itself, the seemingly high expectations for 40 to 55% growth in the next two quarters appear to make up a huge portion of what is driving expectations of a rising overall index.
Financials earnings, not shown in the chart, are also expected to grow significantly and we think this is even more egregious as the practice of borrowing from loan loss provisions to meet EPS will surely be heavily discounted by a market facing the housing double-dip and record deliquencies.
So to sum up
,
fundamentally - macro indicators are missing expectations to the downside
increasingly and future expectations for US equity growth seem hinged on
EPS growth
which is tied hugely to the
Energy sector's dramatic profit expectations
(something that
seems reflexively bad for global growth
). Corporate profit margins, a highly mean-reverting time series, are at peaks and look to get compressed as USD-numeraire price inflation eats away bottom-up and if you view profits as levered GDP as we do, then the recent bout of GDP growth downgrades should at least have you checking your stock enthusiasm at the door.
The rise in pairwise correlation in HY, divergent from stocks and IG for now, suggests early stages of derisking among professional investors.
Having got that vent on fundamentals out of the way, the
credit market is offering a number of interesting divergences
that we think warrant significant concern. The first is a little esoteric but worth the effort to understand. The
average pairwise correlations
of the components of the IG credit, HY credit, and S&P 100 equity indices are
diverging significantly
. Crucially, as seen in the chart, the correlation among the HY components is rising rapidly while IG components remain less systemically biased.
The simple interpretation of this rather unique insight is that HY credit, which is frequently a pre-sage of risk-appetite changes in general, is being more systemically sold (or rotated away from) while IG (and stocks) appear very much about idiosyncratic positioning for now.
HY credit spreads have been widening for three months and sit at their widest year-to-date while IG remains supported by fund flows and technicals.
The last time we saw this kind of divergence was in the run-up to the major growth scare and derisking of May 2010 and we suspect we are heading into a very similar environment - perhaps even needed by the Fed to justify its next round of easing efforts.
The point here is that HY spreads are widening and doing it in an increasingly correlated manner - this has tended to be a very negative signal for risk assets in general.
The decompression of HY while IG has held in relatively well reflects the heavy demand technicals that we have all seen from fund flows (and perhaps rotation from muni exposures also) aiding IG.
The technicals at play here are also interestingly virtuous as we
described recently
and reflect a self-fulfilling bias in corporate bond land that, like any self-organizing system, is prone to catastrophic failure thanks to only small changes in the drivers. We believe those drivers (laid out in the post linked here) are starting to adjust. Perhaps most evidently is the extreme steepness in HY credit spreads at the front-end of the term structure.
The term structure of credit spreads was forced extremely steep by QE2 and we believe will unwind notably as we exit Fed liquidity.
As is evident from the chart above, the onset of
QE2 pushed investors to extend durations
and take more risk. The blue line shows the relative size of 3Y credit risk to 5Y credit risk compressed dramatically as QE2 sped to our rescue from well over 80% to almost as low as 60% - levels we have not seen since the great moderation of the mid 2000s (not shown on the chart) and even then only fleetingly and created by CDO technical bid demand.
The red dotted lines show the average pre- and post-QE2 for the absolute spread differential rose from around 94bps to 135bps and we remain at the upper (lower on the chart) end of that range currently.
We are seeing the risk shifting back into the front-end of the curve
(the blue line is rising once again)
as HY investors and traders start to price in an end to QE2?s crowding out and return to more normalized risk differentials
.
The HY-to-IG spread differential is also following this path as both the absolute spread, seen in the chart above, and maybe more importantly the relative risk ratio, revert to more normalized levels.
It seems to us that the fixed income side of the market (both Treasury and corporate credit) has been starting to discount the end of QE2?s risk adjustment for a while now and stocks have only just begun to get the joke.
The S&P is currently significantly over-priced relative to its credit and volatility context - having surged during QE2 from around 12% rich to over 30% rich.
We have a thousand more charts to show but in an effort to keep it brief,
our tactical asset allocation (TAA) model (which we will unveil shortly) rotated away from stocks in late April
and on a considerably longer-term cycle basis, the chart above shows equities in the context of the HY and IG credit market as well as volatility and skews.
We do not use this for entry or exit signals, we prefer our more refined TAA model, but it is nevertheless useful for considering the credit cycle and how equities tend to overshoot and undershoot as credit contracts and expands.
The bottom-line is that both fundamentally and contextually, we are getting some very clear messages that things are not all well under the surface. As investors come to grips with what the end of QE2 will reveal about the true state of both our net worths and the real economy, we suggest (using the charts and logic above) that credit markets are providing a clear message that risk is not on.
The
shifts in secondary corporate bond markets
over the past few months also
support the thesis
above that we have seen a clear demand for new issues and duration extension as QE2?s risk-adjusting factor and our
virtuous cycle
sync up to build on each other. We believe we have seen the peak of that synchronization and that investors are already derisking slowly but surely behind the scenes (curves very steep, concessions dropping, basis compressed).
A clear preference for up-in-quality trades, up-in-capital structure trades, and idiosyncratic shifts (as opposed to systemic) suggest safety is winning over yield-grab for now and looks set to continue as markets revert back to pore QE2 risk relationships
. There are a lot of funds chasing very similar trades in the credit/CDS/corporate bond market (we mean the basis, flip-the-new-issue, or curve steepener) and as is always the case liquidity is there until you really need it. Our efforts tend to focus on finding low cost long vol style positions cross-asset to benefit from the high gamma potential of these moves and with spreads relatively tight and relationships relatively mis-aligned we think there are opportunities to do just that (drop us a line for details on these tail hedge ideas).
For a time, management can use low credit spreads (and low rates) to add value to their business - intentional relveraging for shareholder friendly dividends, buybacks or M&A - but unfortunately in the real world where WACC curves do not perfectly fit Modigliani and Miller's utopian economy, the cost of credit can eat back into future cashflows rapidly and reduce any positive initial impact. This is always seen in the credit-equity cycle as the period of equity outperformance and credit underperformance lasts 6-9months before the credit market begins to weigh on equity valuations once again.
Whether or not this 'soft patch' of economic data is transitory is unknown, but what we see from our contextual analysis of the credit, equity, and vol markets has us more nervous than we have been in a while
. Even if the softness is weak enough to warrant QE3, we believe its format will leave HY credit hurting still (remember stocks are USD-denominated but credit spreads are not and while there is a devaluation impact thanks to the linkage between debt and equity, HY will underperform stocks on that next surge should we see it - especially given how 'expensive' in general HY bond prices are).
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This weekly chart of the DOW has some bearish bias ...
http://stockmarket618.files.wordpress.com/2011/05/2011-05-10_dow-wk_xx.png
A+
Thank you CC for the conveyance. I guess the answer is painting the tape cannot be a long term mode but the latency of the lemmings is. Like the rest we are halfway. Meaning the answer is yes, and should be an interesting quarter as fact sorts out if Mr. Market ever had a true technical chart pulse.
i have a question
Is it really looking like 2008-2011 is looking very similar to 1929 - 1932?
And now we are in for 10 years of stagnation before a war sorts things out....
CC- by far, your posts have been extremely informative and helpful. thanks for taking the time to share.... priceless.
BLA BLA BLA. Central bank pozi scheme. They are doing whatever they want with the markets, hence whatever they want with the charts to fool you all. I controlled the game it would be simple to make the stock market do exactly as I wanted.
ya think?
Great post. In addition, a simple analysis of price action in the major markets indicates that momentum has been lost.
US - The broadest measure of US stocks (with the exception of one minor spike) has been flat for 4 months. And, the 200R and 50R is clearly negative. Also bullish percent indicators are clearly falling.
http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3225058&cmd=show[s234148398]&disp=P
http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3225058&cmd=show[s167561916]&disp=P
Latin America - long term sell signal + major trend line break
http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3225058&cmd=show[s218732904]&disp=P
without more stimulus or a large QE3,,, time to warm up the sell side bots.
Where's the daily ESBASKET risk trade analysis???
This was hinted at in your previous reports on credit dispersions and stock dispersions. Those are excellent sentiment indicators.
So when do we take a ride on the SDS? It's still a bleeding POS now....
Next week, when the Jobs Report misses by a mile.
The auto-manufacturer impact from Japan has been totally underestimated (see Durable Goods and any regional manufacturing release). Domestic suppliers have been smacked as the major auto companies have shifted down to half-time (see Honda, etc.).
Additionally, I'm sure we are finally needing some of those ditch-diggers down South as the oligarchy chooses whose private property gets wiped out ... but I suspect the rest of the work-force is in a bit of trouble.
Ponzi implodus ...