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Guest Post: Thoughts On The Long-Term Equity Cycle

Tyler Durden's picture




 

Submitted by CreditTrader

My thoughts on the long-term debt cycle (trying to ignore the impact of
the credit crisis specifically). The idea is that if you follow the
cycle of the relationship of debt to equity, a better understanding of
how debt and equity lead and lag one another through the cycle.
Furthermore, I think it can highlight how risk aversion at the tails
may put a floor on spreads in the short-term and implicitly a cap on
equity valuations. This chart can be done in P/E ratio-land (but given
the current silliness in valuations provides little insight), though we
suggest trying to build the same chart with the Shiller longer-term
P/Es (hint hint).

1) After 3-4 years of The Great Moderation and
an impressively easy credit cycle helped by securitization-demand,
credit spreads started to crack before equity did as over-zealous PE
firms started to ravage corporates (driving leverage up)...

2)
This (as it usually does in the credit cycle) leads from equity
outperforming credit to both credit and equity deteriorating as that
termed out debt (not delevered) comes back to roost and drives WACC up,
forcing equity valuations down (think structural models and the
implicit rise in business risk / asset vol)...

3) As the credit
cycle turned down we see credit leading equities down as the forces in
(2) take hold and a vicious circle of deleveraging 'expectations' takes
hold (whether by bankruptcy or actual debt paydown). These expectations
may or may not come to fruition during this period (they did not) as we
saw...

4) The spike to cycle wides in IG credit spreads remained
somewhat linear with S&P 500 levels from the past ten years but the
onslaught, breaking far beyond the dot-com/Enron cycle wides/low
valuations. However, the credit market remained highly levered and
defaults mounted but did not explode as we saw a virtuous cycle of
government-provided liquidity allow distressed firms to either a)
refinance/term out debt, b)receive explicit govt support, and/or c)
receive implicit govt support. This led to...

5) Spread
compression in IG credits as their term structures shifted from
inverted to upward-sloping once more as rather than deleverage,
corporates were able to term out debt, renegotiate secured lines down
to unsecureds, or see that debt guaranteed for a short-term. This
provided an optical improvement in risk over a medium-term horizon
(think 3-5Y perhaps) and so we see the credit term structures now very
steep in 3s5s and 5Y (the most liquid maturity) having tightened
notably.

However, the point of all this is that the light red
oval/cycle is what we expect as the new normal as we enter the next
downturn. Credit curves are pricing in a significant double-dip
recession via their steepness and it would appear that the debt-equity
markets are reverting to a 2001 risk-aversion perspective from the
chart.

The shift (3) in the chart is the key, as is the second chart comparing VIX to spreads where we see the clear regime change between a VIX<~20 and >~20 and its lack of correlation and clear dependence respectively. While VIX remains at the higher end of the old regime (and the bulls implicitly call for more compression and further rallies to normalcy), we suspect that credit and equity vol will re-emerge as strongly linked in the next credit cycle and that it will occur sooner than many believe.

The cognitive bias we have been provided by the extreme
drops in asset valuations has set a more 'careful' or risk-averse
mindset into investor's framing and while we can point to how far VIX
has come from its highs, spreads from their wides, equity from its
lows, TED spreads from their wides, it is worth remembering that before
the 1987 crash there was NO smile in option vols (tail risk aversion)
and while it would appear that this liquidity-driven rally for the ages
can continue forever on the back of the Fed/TSY's printing press, we
suspect that risk premia are in a new 'riskier' regime and we are at
the low of that new regime, rather than at the higher end of the old
normal regime.

 

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Thu, 12/17/2009 - 15:59 | 167861 AnonymousMonetarist
AnonymousMonetarist's picture

It is the flight of an arrow not the flip of a coin.

Unfortunately we do not know the Assumed Exponent of the HAND.

Thu, 12/17/2009 - 16:04 | 167871 crzyhun
crzyhun's picture

Phew, excellent- will read again and ponder. Good analysis. How to protect and lower risk in this env. proposed is  the question. Short etfs on equities and buy the vix. Anyother ideas? Nix on gold as we see it is nada at this moment with Greece on the precipice.

Thu, 12/17/2009 - 17:47 | 167917 Assetman
Assetman's picture

Not necessarily... but it appears you aren't getting paid much in risk premia for making new bets on the money printing trade.

What it likely means is that if your're in the money printing camp, you might want to hedge to cover yourself for an unexpected, nasty spike in volatility. Becuase if you're wrong, you'll be pureed Alpo.

If you're in the deflation camp, you've lost your shirt over the past 9 months, anyway. You're still sitting in cash wondering "what happened"?

This is an outstanding original post.

Thu, 12/17/2009 - 19:50 | 168188 mannfm11
mannfm11's picture

The door to get out of the inflation trade is about the width of an elephants asshole and there are 50 herds of them that are going to try to get out.  Needless to say, there are going to be a lot of heads up the ass. 

Thu, 12/17/2009 - 16:31 | 167907 I need more asshats
I need more asshats's picture

Credit where credit is due. Finally a good Guest post.

No forced religious or morality views. No guessing or misguided interpretations of facts and figures.

A knowledgeable professional sharing insight in a condensed well thought out manner. Good visuals that are easy to read.

Put him on the short list to step up to the big league.

Thanks CreditTrader.

Thu, 12/17/2009 - 16:33 | 167912 Anonymous
Anonymous's picture

This is outstanding, with enough explicit/implicit material to support many PhD theses in finance. I'd be interested in any comments or insight vis-as-vis second to last paragraph and what the expectations hypothesis might suggest about current curve steepness...

Thu, 12/17/2009 - 16:54 | 167950 Anonymous
Anonymous's picture

great stuff.

Thu, 12/17/2009 - 17:40 | 168032 pivot
pivot's picture

is this the same person as this: http://www.acredittrader.com/  ?

the credit trader blog was great, though there were only a few posts before they stopped blogging.  but each post was very detailed and went to a deeper level than i have seen practically anywhere else.

Thu, 12/17/2009 - 18:17 | 168076 Anonymous
Anonymous's picture

VIX Index, SPX Index, and ...? which index is the Investment Grade Spread?

Thu, 12/17/2009 - 18:38 | 168104 Anonymous
Anonymous's picture

So we are at the beginning of the end rather than the end of the beginning.

Thu, 12/17/2009 - 18:39 | 168105 Anonymous
Anonymous's picture

I like this type of analysis. To bad I'm color blind. :(

Thu, 12/17/2009 - 20:13 | 168216 Anonymous
Anonymous's picture

If this graph was animated it would have been awesome.

Thu, 12/17/2009 - 20:17 | 168222 Squid-puppets a...
Squid-puppets a-go-go's picture

those graphs make awesome abstract art.

 

Thu, 12/17/2009 - 21:01 | 168261 Anonymous
Anonymous's picture

Thanks Credit for the piece, interesting noting the decision I'm facing being a long-time XTO shareholder (i.e. sell now or take XOM stock). Perhaps THE central theme of Z.H. pertains to the relative risk of different assets as compared to the dollar. About one-third of my net-worth is in dollars, however the notion of owning XOM in the future after my recent D.D. is becoming quite viable.

Thu, 12/17/2009 - 22:15 | 168321 Anonymous
Anonymous's picture

Could some one simplify the presentation. I'd like to benefit from it but it's beyond my knowledge. Thanks.

Fri, 12/18/2009 - 08:13 | 168579 theprofromdover
theprofromdover's picture

Why on earth should anyone expect it to be cyclical?

Maybe people think in 2D.

If you look at it in 3D, you will see we are in a corkscrew pattern (downward spiral). On the Z-axis are all the financial gerry-mandering activites that pumped up the money.

Fri, 12/18/2009 - 10:35 | 168648 Fruffing
Fruffing's picture

Credit curves are pricing in a significant double-dip recession via their steepness

 

Thoughtful post.   Please explain how above statement conforms with conv. wisdom of negative sloped yield curves signalling pending recession vs. today's epic positive steepness.   

I'm not sniping.    Squaring this circle would be very helpful.

 

Thanks CreditTrader!

 

 

Fri, 12/18/2009 - 17:24 | 169227 ZeroPower
ZeroPower's picture

+1. Yield curve is no longer inverted?

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