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.