This bear market is primarily a credit concern, not an equity “bubble.”
Historically, most bear markets concentrate on common stocks as earnings compression results in sharply lower values ahead of an economic recession. And ahead of declining equity values, central banks typically tighten credit conditions – better defined as a classic liquidity squeeze.
But that’s not the case today, nor was it the case back in 2001 when the Federal Reserve began aggressively cutting interest rates. It’s rare in financial history that a prolonged bear market can occur amid easing liquidity conditions, but that’s exactly what happened seven years ago, and it appears to be repeating once again in 2008.
This bear market is predicated mainly on credit, and it’s still spreading. From sub-prime to leveraged loans, auction securities and bond insurers, this entire credit bubble has started the painful unwinding process.
From 2003 until July 2007, bond yields across the yield spectrum were incredibly low and financing deals, including leveraged loans, was a cinch as cheap money prevailed. The Greenspan Fed had no business cutting rates to 1%; that fueled an incredible rush to credit that spread to real estate, emerging markets, commodities, and of course, spawned the Japanese yen carry-trade.
As a result, corporate credit spreads touched all-time lows heading into last summer’s sub-prime fiasco, including high-yield securities, commercial paper and mortgage-backed securities. Then the party ended.
As for common stocks, they continue to look quite attractive compared to government bond yields at this point. Yes, earnings will compress and analysts’ expectations are too bright for the first half of 2008; but as the year progresses I think markets will find a bottom. I’m sticking to my original forecast that stocks will finish the year in positive territory. Government bonds are overbought, stocks are oversold.
For the last two years, I’ve been warning against ultra-low credit spreads and how interest rates on the riskiest paper or debt had to rise. I’ve adamantly warned against buying emerging market debt, junk bonds and most other fixed-income securities since 2005 because rates were simply too low or spreads barely above the risk-free yield available on T-bonds. I still feel that way, with the exception of high quality investment-grade corporate debt.
For the first time in years, I’m looking to buy corporate bonds this spring as spreads look quite attractive compared to T-bonds in a low interest rate environment. My upcoming recommendations in the March issue of The Sovereign Individual focus on two long-dated corporate issuers, both rated A or better that have big capital gains potential as the Fed and eventually, the ECB, unleash another era of cheap money.
Comments