Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

U.S. and German Bond Yields Plunge, Signal Deflation

The only bull market these days lies in the Treasury bond market. While virtually all other assets have plunged in value in a miserable 2008 for investors, T-bonds remain highly bid amid a rapidly contracting American economy.

The benchmark ten-year Treasury bond opens this morning yielding 2.97% -- the lowest yield since the late 1950s and breaking the previous post WW II low of 3.29% set in June 2003.

Over the last 12 months ten-year Treasury bonds have gained a cumulative 13.9% compared to a crushing loss of 40% for the S&P 500 Index and a chilling 29% decline for commodities as measured by the Reuters-CRB Index.

The entire spectrum of non-Treasury bonds has also declined, except fixed rate mortgage-backed securities, up 7.2% since November 2007. Junk bonds, emerging market bonds, municipal bonds and corporate bonds have all suffered big losses this year.

With stocks crossing 1997 levels following last week’s decline, investors continue to scramble to the short end of the U.S. yield curve or, mainly, short-term Treasury’s. Benchmark two-year T-bonds yield just 1%.

In Europe, government bonds are also attracting safe haven inflows, mainly German bonds, or bunds. This, despite a failed German government bond auction two weeks ago where even the almighty Germans couldn’t raise their targeted auction goals. Since September, several other weaker Euro-zone governments scrapped weekly auctions because of poor investor demand, including Belgium, Italy and Austria.
Germany, though probably in recession, is in far better economic shape than her neighbours with mortgage speculation far more muted compared to Ireland or Spain and consumers harbouring among the highest savings rates in Europe at 13% of GDP. Unlike Spain or the United Kingdom, the Germans didn’t leverage their economy to the same extent relying on mortgage financing.

Benchmark German government debt has soared since September at the expense of weaker credits like Italy, Spain, Greece and Belgium where comparable bond yields have ratcheted higher because of rising credit default risk. The market has started to gradually discount the possibility of European government funding shortfalls, namely in those markets where economic growth has fallen off a cliff and funding auctions has grown more expensive.

There’s no doubt that global government funding obligations are set to skyrocket over the next 12 months as the Treasury and the European Union raise record amounts of debt to finance global bank bailouts and other failed industries, including broad consumer fiscal measures to alleviate growing economic hardship. Bond yields will eventually rise once calmness is restored in world markets. But for now the best game in town – and certainly the safest strategy – remains buying intermediate-term government debt in the United States and Germany.

Deflation has arrived, and only government debt will appreciate in value in an environment otherwise hostage to plunging prices and declining global demand.

Have a good Thanksgiving Holiday weekend. See you on Monday.

U.S. Bailouts Now Total Almost 35% of GDP

First it was the banks. Then Fannie Mae and Freddie Mac followed by AIG, Citigroup and now possibly auto companies, the home builders and the legacy airlines.

Increasingly, the American government is becoming Corporate America’s largest investor. And with that big shareholder responsibility comes a new wave of government regulation in 2009 as Congress moves to unseat greedy banking executives and curtail salaries and bonuses. More government won’t be good for business.

The U.S. government now owns or operates approximately 35% of the entire economy’s production or gross domestic product (GDP).

The Feds now control banking, investment banking (what’s left of Wall Street), swaths of insurance, mortgage lending and will probably loan huge chunks of taxpayers’ funds to Detroit’s Big Three, the airlines and anyone else who qualifies as a systemic threat to the U.S. economy.

Now it’s time for consumers to get some relief.

On Monday, the Treasury announced plans to boost consumer loans by introducing another in a series of measures to unclog lending. The government will spend $800 billion dollars to finance mortgage debt purchases, effectively hoping to bring long-term mortgage rates down. That strategy worked wonders on Tuesday as fixed-rate mortgages tumbled after remaining elevated for more than 12 months despite aggressive Fed rate cuts. The 30-year fixed-rate mortgage fell to 5.81% this morning from 6.08% four weeks earlier.

Under TALF (Term Asset-Backed Securities Loan Facility), the government will lend up to $200 billion dollars of certain holders of high grade securities backed by assets tied to student loans, credit card loans, auto loans and small business loans. Some of these backstops or guarantees will be funded by TARP, or the Troubled Asset Relief Program.

If this whole exercise in bailouts and emergency funding has you confused, join the club. The U.S. Treasury under Hank Paulson has caused more confusion than clarity on vital market measures to boost a depressed consumer and a fractured banking sector. TARP and TALF don’t address the root of the problem – a bear market in real estate and an ongoing decline in housing values.

Until the bleeding stops in housing, it’s fair to assume that derivative based mortgage-backed securities will continue to remain under pressure and largely illiquid with few bids. Nobody wants to purchase a sliding asset.

Judging by Tuesday’s solid rally in mortgage-backed bonds and most other fixed income markets, the government’s relentless efforts to unclog credit markets is beginning to work. We still have a long way to go before this credit crisis is over; the good news is that it’s probably a good time to start accumulating some riskier forms of credit – battered since September and still trading at huge discounts compared to their long term price trends.

Fed Launches New Assault with $800 Billion to Unclog Credit

The Federal Reserve this morning announced new plans to unclog credit markets as the economic recession continues to deepen across the country, stifling bank lending and resulting in widespread hoarding of cash.

The Fed announced two new efforts to unfreeze credit for homebuyers, consumers and small businesses, committing up to $800 billion dollars. The move is timely as LIBOR rates ratchet higher again after a period of tightening since mid-October. Corporate bond spreads are also widening while mortgage rates remain elevated.

The Fed will purchase up to $600 billion dollars of debt issued or backed by government chartered housing finance companies. The central bank will also establish a $200 billion dollar program to support consumer and small business loans, the Fed said in a statement prior to the market’s opening.

Thus far, unprecedented efforts by the Fed and other central banks since August 2007 have failed to calm investors. Credit spreads remain historically high and three-month interbank lending rates as defined by LIBOR at 2.19% are well above the Federal Funds target rate of 1%. Though that’s much lower than 4.85% earlier in October at the height of the crash, it’s still high and testifies to a lack of counter-party confidence among lenders.

The Fed is clearly throwing everything it’s got at deflation. Bernanke is rapidly becoming “Helicopter Ben,” referring to his speech a few years ago where he warned that if deflation surfaced under his tenure as FOMC boss he would print money like crazy. That’s now happening.

The Fed’s balance sheet is expanding like a massive balloon since August with over $1 trillion dollars in assets swapped or arranged through all sorts of fancy bridge loans, collateralized loans, interbank SWAP facilities even to the emerging markets and goodness knows what else that isn’t reported in the financial press. In short, the Fed is out of control.

In Washington, the government is now guaranteeing about 30% of total U.S. GDP through backstops in financial services (Citigroup the latest bailout), insurance (AIG) and probably extending to the auto sector and, possibly, homebuilders. Pretty soon, half of GDP might be guaranteed by the U.S. government.

Throw in the cost of financing protracted conflicts in Iraq, Afghanistan and another huge stimulus package by President-elect Obama in January are we’re already in the hole for trillions of dollars.

Credit markets are still badly fractured, stocks have collapsed and housing remains in a freefall. The government’s backtrack on TARP is also confusing as investors debate whether a slush fund will be created to harbor toxic mortgage-backed securities. Or, as evidenced by Citigroup’s effective bailout on Monday, the government is sitting on residual TARP funds to attack the next disaster instead of throwing everything it’s got all at once at the crisis.

It’s no wonder gold is starting to look attractive again, even amid deflation. Investors forget their history when alluding to gold as only an inflation hedge; true, gold is primarily an inflation hedge as prices rise, but it is also emerging as a surrogate currency as the dollar, still the reserve currency of the world, heads into the abyss drowned by bailout after bailout and a seemingly never ending expansion of credit and money supply.

Gold was not freely traded post-1934 when FDR confiscated the metal. It’s therefore impossible to predict how gold will perform now in the first credit deflation since the 1930s. But I’ve got a feeling its moment has yet to arrive ahead of the next dollar sell off.

I’ll bet on gold.

Market now in No Man’s Land; Buyer Beware

Despite Friday’s big 500-point surge, the Dow and all other U.S. indices remains hostage to the consequences of major technical damage inflicted last week. U.S. stocks broke important support levels starting on Thursday with equities touching 5 ½ year lows.

Bonds, a safe haven since last year, saw benchmark Treasury yields crack new multi-year or multi-decade lows. Ninety day bills, for example, now trade at just 0.04% -- the lowest such level since the 1930s.

The odds are quite high that any follow through this morning won’t last and investors will once again step up to the plate and sell stocks – just as they’ve done in previous rallies or bursts of buying. After breaching technical support last week, all major indices will retest those levels.

The market has completely lost control as signs of economic recession intensify amid plunging employment, rising bankruptcies, a busted credit system and weak loan demand from businesses and individuals. Making matters much worse, Treasury Secretary Paulson’s recent about-face on TARP (Troubled Asset Relief Program) is adding even more uncertainty about the government’s resolve to finally solve the toxic asset problem.

Over the last ten days I’ve also made a point for the contrarians, or investors looking at deep values in stocks despite the ongoing carnage. Value investors believe that equities offer fair value at these levels accompanied by the highest dividend yields in years. This positioning is normal, considering the S&P 500 Index is down almost 50% in 2008. Still, bargain-hunting has resulted in more pain for value investors over the last 16 months; every time stocks decline the proceeding rallies have occurred with less conviction, ultimately breaking down again and hitting new lows.

The Dow Jones Industrials hit a bear market low of 7,286 in October 2002. At current levels, the Dow is barely 700 points above that pivotal level. If you believe, as I do, that this recession will be a long and painful multi-year event then you must also subscribe to the view that we will re-test those October 2002 lows. Therefore, buying stocks even at these levels is not a wise investment decision. Investor confidence has been shattered and there’s no way a new bull market is about to begin with the macroeconomic outlook so poor and rapidly deteriorating.

If you must buy stocks then consider covering your exposure with a reverse index fund so you can at least break-even in this volatile environment if stocks collapse again. I would also remain very liquid with high cash levels.

Value investors are right to an extent. If you’re a long-term investor then the broader market is a good purchase now. But I imagine it would be a better idea to spread that buying over the next 12-36 months because the economy is deteriorating, not improving and investor confidence has been totally shattered following massive losses.

This is still a secular bear market, hostage to a credit environment that is largely fractured and only grudgingly improving. Be careful.

Let Detroit Die and Revive TARP’s Original Mandate

Since September 1, the S&P 500 Index has now crashed a cumulative 39% -- the worst decline since 1931 for common stocks in the United States. The MSCI World Index over the same span has been pummeled more than 45% -- its worst year since 1974. The latter benchmark was created by Morgan Stanley back in 1969. There isn’t one index in the world that has posted a gain in a miserable 2008.

Declines of this magnitude in a short period of time have probably destroyed more wealth worldwide since the Great Depression.

Spectacular Loss of Wealth

This bear market is clearly in the record books with stocks defying the average 30% bear market decline at this point and combined with the ongoing breakdown of credit markets, is far worse than anything anyone alive has ever witnessed. In all likelihood, the current generation of investors will not return to the stock market for a long time, if ever.

Over $6 trillion dollars of stock and bond market wealth has literally evaporated globally this year. Combined with huge losses recorded in real estate, mortgage-backed derivatives, credit default swaps and leveraged loans, the figure is probably well north of $10 trillion dollars thus far.

Auto Industry, TARP Uncertainty

With the auto industry now the bailout “flavor of the month” in November, investors are fretting over the possible demise of one or, possibly, all three U.S. automobile manufacturers. The Big Three have seen their respective stock prices almost disintegrate this year with GM trading at the same nominal price it did during the Great Depression.

Conservatives in Washington are balking at an auto industry bailout and investors are worried that any delay in helping Detroit will result in the collapse of the industry, hundreds of thousands of jobs and the long chain of suppliers tied to the ailing auto sector.

Chrysler, General Motors (GM) and Ford don’t deserve a bailout; all three companies have bled billions of dollars in cumulative losses over the last 25 years and a rescue will only postpone the inevitable – bankruptcy.

Combined with Treasury Secretary Hank Paulson’s reversal on TARP (Troubled Asset Relief Program) last week, the stage for another market crash has arrived again this month as stocks threaten to violate the October 2002 lows. The Dow Jones Industrials Average bottomed in October 2002 at 7,286 or just 267 points below Thursday’s close.

Paulson doesn’t want to create a special SIV or Structured Investment Vehicle to pool toxic mortgage-backed securities after all. Now the Treasury wants to keep its powder dry with the remaining $400 billion dollars of the initial $700 billion in TARP funds to bailout any other systemic threats to the American economy.

Instead of dealing with the problem, which is largely a spectacular lack of counter-party confidence among banks, Paulson is extending the bear market.

Banks Need to Dispose Toxic Assets

Paulson, in my opinion, is making a big mistake. The government should create a special fund or company dedicated strictly to buying troubled or illiquid bank assets.

In the absence of such a plan – originally cheered by investors last month – the markets have no grasp as to which banks hold clogged assets, ultimately delaying the cleansing process for badly damaged bank balance sheets. Confidence won’t return to counter-parties until banks or lending parties fully understand what other institutions continue to hold on their balance sheets.

The Battle against Deflation

The only dose of positive economic news lately is that Hewlett-Packard reported solid third quarter earnings – largely the result of aggressive cost-cutting. Yet this news didn’t help the market, either. Unemployment claims hit 1982 levels for the latest period reported on November 20 and more companies are warning of weaker revenues in 2009.

Wholesale inflation and the consumer price index plunged in October as commodity prices tanked. Since peaking at $147 a barrel in July, crude oil prices have plunged 67%. Other commodities have also crashed, including the grains, base metals and the precious metals. Commodities have collapsed at exactly the same time demand for goods have fallen of a cliff.

Deflation, not inflation, is now a war the Federal Reserve and other central banks must win in order to safeguard the financial system from total collapse. At this point, investor capitulation seems to be near with massive selling engulfing the markets since November 5 and Treasury bond yields at multi-year or multi-decade lows.

One way to restore investor confidence is to finally let Detroit die a quick death. The industry is a lousy business model and propping-up bad companies with good taxpayer’s money is a total waste. The resultant demise of Detroit’s biggest industry would be painful but supporting these money-losing enterprises is the wrong policy. We all know more money will be required in six months, a year, whenever.

Let the Big Three crash and revive TARP’s original mandate by removing the uncertainty plaguing bank balance sheets.

Bears Gone Bulls Badly Hit since late October

The S&P 500 Index and other major U.S. indices violated important support levels on November 19 suggesting the market is now poised to break its October 2002 lows. The S&P 500 Index is now down 45% in 2008 – its worst year since 1931.

Several high profile hedge funds and traditional equity fund managers turned bullish on stocks following the crash in October. Through yesterday, these advisors are sitting on losses exceeding 15% as stocks continue to swoon.

A long time bear, John Hussman of the Hussman Funds in the United States, turned bullish on stocks in late October pointing to a laundry list of contrarian indicators suggesting a major rally was in the cards.

Though stocks did indeed rally 18% off their late October lows, they subsequently plunged again starting on November 5. In November, the S&P 500 Index is down 15.8% following a 17% drubbing in October. Since September 1, the broader market has collapsed a cumulative 36%.

Here’s some compelling contrarian data that compelled Hussman and others to turn bullish in late October:

• Investment Advisor sentiment is now approaching record levels of bearish sentiment. This has historically served as a contrarian indicator for stocks;

• Mutual fund investors have been big net sellers of equity funds since July, also a contrarian reading since individuals harbor the worst sense of market-timing;

• The VIX or CBOE Volatility Index sits at 74.26 – a record. A VIX Index above 30 is extreme and at 74 continues to point to an absurdly oversold market;

• The Japanese yen at 96 is also overbought and historically suggests that we might be at a major turning point for stocks since the yen has already surged over the last 12 months as the infamous carry-trade unwinds;

• U.S. Treasury bills and T-bonds now yield their lowest rates in years. Thirty-day bills trade at just 0.12 basis points and benchmark ten-year Treasury’s yield 3.33% -- the lowest yield since June 2003. Near-record low yields for government bills and bonds points to a very oversold market as investors lunge after safety;

• Hedge funds are now poised to suffer their worst string of redemptions in history as the important December 31 redemption window approaches. A tide of investor redemptions in hedge funds, like mutual funds, also suggests that too many investors are running for the exits at the same time;

• The U.S. dollar is now a “safe haven” amid global chaos. The dollar is not a “safe haven” and instead is the beneficiary of global de-leveraging as investors sell global securities and convert these proceeds into dollars to meet redemptions or liquidity targets. The whole notion of the dollar is “King” is false with the United States effectively bankrupt and now embarking on the greatest expansion of credit in modern history to finance industry bailouts.

Obviously, Hussman and others like him who became bullish in October were too early. The Hussman Strategic Growth Fund has plunged 11% in November.

The stock market is now primed to violate its October 2002 lows. Until we flush all the sellers out, the primary trend remains down. Value investors or contrarians might be right eventually, but timing is indeed everything in the markets. Too bad the contrarians were early.

More Countries to Impose FX Controls

Indonesia announced foreign exchange controls last week, triggering the first round of restrictions or limits on foreign currency trading. Other nations are sure to follow as economic growth falls off a cliff this quarter compounded by plunging exports.

As the global financial crisis deepens and spreads to the real economy, more countries will resort to protectionist policies in the emerging markets, eventually imposing semi or hard foreign exchange controls.

The G-20 Summit last weekend in Washington saw a pledge by all members to keep trade flows free of protectionist sentiment; one of the main drags on the 1930s Great Depression was the introduction of the Smoot-Hawley Tariff Act of 1930, which raised imports tariffs on foreign goods and, in some cases, shuttered access to U.S. markets. In retrospect, Smoot-Hawley was a disaster, prolonging the Depression in the United States and elsewhere until World War II commenced in September 1939.

With countries like Russia now drowning amid a market meltdown and draining its reserves, I would not be surprised if Russia is next imposing foreign currency controls.

Just a few months ago, Russia was boasting its vast oil and gas reserves, asserting an aggressive foreign policy in the region and demanding more political muscle in the G-7. With oil prices crashing more than 60% since July and Moscow’s stock market literally in a freefall, the Russians have moderated their opposition.

Russia continues to bleed foreign currency reserves since September following a $250 billion dollar stimulus package. The rouble, however, has remained relatively strong compared to the euro; in 2008 the rouble has declined 12% versus the dollar but has risen 4% against the euro. Still, some sort of quasi-foreign exchange control is likely in Russia.

Other prospective countries on the FX control block include Ecuador, Bolivia, Kazakhstan, Ukraine, Turkey, South Africa and, possibly, South Korea, where the won has collapsed 55% this year.

Venezuela, a major oil exporter, has already absorbed big losses financing Ecuador, which is contemplating a bond default this week. Venezuela’s hard Bolivar, or Bolivar fuerte, is fixed by the central bank and the currency has been non-convertible for more than 15 years.

Extreme economic conditions usually result in severe policy responses by government – including major economies.

Starting in 1997, several Asian countries imposed foreign exchange controls or restrictions following a regional economic collapse. Many countries restricted foreign currency trading, conversion and some imposed outright controls, including Malaysia.

In the early 1970s, the United Kingdom, mired in economic turmoil, imposed foreign exchange controls. And in 1934, FDR confiscated gold.

It’s not unlikely that some major industrialized countries might do the same or, at the very least, implement the first stages of foreign asset restrictions or foreign property ownership.

The United States, Europe and Japan are getting hit hard over the last few months as economic growth contracts and even deepens in Q4. Gold confiscation, foreign exchange restrictions and new reporting rules for personal assets lie ahead as Big Brother delves deeper into our daily economic lives in a time of rapidly declining prosperity.

Investment-Grade Corporate Bonds Deserve a Premium

Are investment grade corporate bonds the new “safe-haven” for investors?

You certainly wouldn’t think so following their worst monthly drubbing since 1980 in October. September and October sliced and diced investment grade debt to levels unseen in more than two decades with effective yields now at 8% compared to 3.7% for ten-year U.S. T-bonds.

Short-term Treasury bonds have been a magnet since the onset of the credit crisis drawing safe-haven flows from nervous investors worldwide ahead of redemptions, fund closures and panic selling since mid-September when Lehman Brothers failed. At the same time, investment grade debt has been smashed. The spread, or difference, between the Dow Jones Corporate Bond Index compared to ten-year Treasury bonds is 431 basis points; prior to the subprime blowup in August 2007 that spread was under 80 basis points.

But do corporate bonds really deserve this discount, even in the midst of asset deflation?

Judging by several poor auctions last week of government bonds, including a failure in Germany of a benchmark ten-year issue, investors might want to look at intermediate and short-term investment grade corporate bonds instead. Though companies can’t print money like governments, the majority of these AA and A credits harbor far superior balance sheets than global governments in late 2008.

Through September 30, U.S. companies held $675 billion in cash – the highest level in more than 15 years.
In many ways, U.S. companies are better credits than government agencies, states and municipalities. Large cap companies in the S&P 500 Index have already refinanced or financed new loans prior to August 2007 when rates were near record lows and, in most cases, don’t have high debt-to-equity ratios like financial companies and the Federal government.

Kraft Foods, for example, funds most of its ongoing debt commitments organically through revenues, unlike the government, states and municipalities. Personally, I’d much rather own credits issued by Kraft Foods, Nestle, General Mills, McDonald’s or YUM Brands.

Even financial company debt, like American Express and J.P. Morgan Chase remains highly attractive because of government backstops initiated in October to guarantee interest payments. If that’s the case, why would someone buy a U.S. T-bond paying 3.7% compared to 7% for an American Express bond when the latter’s promise to repay is now fully guaranteed by the U.S. government?

In Europe, a slew of governments will increasingly have trouble raising fresh capital as auctions saturate the market. It’s the same in the United States whereby weekly auctions will accelerate next year to fund the explosive cost of TARP and other bailouts as the economy continues to deteriorate. At some point, the world will tire of Treasury debt, especially long-term T-bonds, and, ultimately, the dollar. That’s when I expect Treasury yields to start climbing.

Meanwhile, deflation remains mired across the industrialized world this fall. Declining asset prices are causing all sorts of dislocations for governments, companies, individuals and especially those seeking to refinance debt. Credit is indeed hard to obtain.

Treasuries will remain well bid for now. But I suspect a big bear market to unfold for Treasury debt once this panic ends.

Credit Markets Unlock but Remain Vulnerable to LIBOR, TARP and Accelerated Deflation

LIBOR rates are well below their clogged levels four weeks ago and U.S. corporate bond issuance in October witnessed a strong rally following a drubbing in September. Credit markets are definitely regaining much needed traction and investors should be encouraged by narrowing credit spreads.

Is it now safe to buy non-Treasury debt after a collapse of investment-grade and junk bonds since September?

After rallying for more than twenty straight sessions off their all-time highs last month, three-month LIBOR, or the London Interbank Offered Rate, has plunged from 4.84% to 2.23%. But despite this narrowing in the all important overseas short-term dollar lending rate, LIBOR has started to ratchet higher again over the last few days. This suggests that although credit conditions have improved since the global stock market crash on October 8-9, lending rates remain vulnerable to another squeeze.

Will TARP Survive?

The principal concern now is that U.S. Treasury Secretary Hank Paulson has changed funding guidelines and conditions for TARP, or the Troubled Asset Relief Program.

That announcement on November 12 tipped stocks into another major plunge as investors ponder what Paulson will do with the next tranche of taxpayer funds released by Congress; it also ended LIBOR’s four week rally as three-month overseas dollar rates bottomed at 2.13% and have since risen to 2.23%.

Initially, TARP’s $700 billion dollar bailout plan was designed to buy toxic and mostly illiquid mortgage-backed securities from bank balance sheets and transfer those assets into a fund or something similar to the 1989-1990 Resolution Trust Corporation (RTC) model for distressed real estate. TARP has now morphed into a till for banks and, on Wednesday, a credit backstop for consumers and, possibly, even Detroit’s struggling auto industry. Just who will get new funding and on what terms is a new uncertainty for investors.

U.S. 30-Year Auction Goes Poorly

The risk of systemic banking failure has not been eliminated. It has simply been transferred from the global banking sector to national government balance sheets. The risk associated with this transfer of toxic debt has resulted in sharply higher credit default swap rates (CDS), or the cost to insure government bonds from default. The cost to insure weaker government credits, like Belgium, Italy, Spain and Greece, has risen markedly since September as investors scramble to German and U.S. short-term debt.

But even U.S. Treasury debt has become more expensive to insure since September. Although it’s highly unlikely the U.S. would default since it creates its own fiat currency, the market has started to fix a higher risk premium to seemingly super-safe T-bonds. That’s not a good sign.

On November 13, the U.S. government’s auction of 30-year Treasury bonds received a disappointing bid, with Treasury sharply increasing the auction yield from an expected 4.22% to 4.31%. This suggests that we may be at the “beginning of the end” for long-term Treasury bids as a wave of new supply comes to market over the next 12 months to fund the financial sector bailout and, now, consumers, autos and possibly other strained industries.

German, European Auctions Struggle

Last week marked the first time in the post-WW II period that Germany failed to raise sufficient investor capital to finance a 10-year bond issue. Since October, Germany, considered the most liquid of European government bond markets, has scrapped four bond auctions because of tepid investor interest. And, since early October, several European government bond markets have also failed to successfully auction, including Austria, Belgium and Italy. Though less than America’s massive fund-raising requirements, European governments will nevertheless issue more than $1 trillion dollars’ worth of debt over the next 12 months to plug gaping holes amid a credit crunch and mounting bank recapitalization costs.

Corporate Bonds a Safe-Haven?

Maybe AA and A investment grade corporate debt is safer than government debt…

Corporate investment grade debt might be the new safe haven as this crisis lingers. That’s because corporate credit default insurance is cheaper than sovereign credit insurance; maybe the odds of the Italian or Irish government defaulting are deservedly greater than McDonald’s, Kraft Foods or IBM.

In September and October, investment grade corporate bond prices literally collapsed to levels unseen since 1980. The spreads between Treasury debt and investment grade corporate bonds now sits at 4.27%, down from an all-time high of 6.18% just two weeks ago. Credit spreads continue to narrow into mid-November.

The average total return on investment grade corporate bonds was a hefty 7.4% loss in October – the worst monthly decline since February 1980, according to Merrill Lynch.

Earlier, in September, strong credits, like IBM and General Electric Capital, struggled to secure favourable financing terms as the credit crunch hit the entire spectrum of borrowers – even AA credits. The good news is that U.S. corporate debt issued in October are now in the midst of their biggest rally in years, as investors lunge after their A and AA yields. IBM, for example, sold $4 billion of five, ten and thirty-year debt on October 9, a record amount for the American multinational. The Dow Jones Corporate Bond Index yields 8.08%.

Focus on Strong Credits

The credit crisis is showing signs of easing since October 10. Credit spreads for the riskiest debt compared to Treasury bonds has narrowed, new corporate bond issuance has increased and the commercial paper market has started functioning again, courtesy of the Fed’s assistance. LIBOR has also collapsed from its historical highs just a few weeks ago – a plus for interbank lending.

Still, risks remain. The market is unsure about TARP or another version of the Treasury’s bailout plan, the spectrum of rising non-investment grade defaults into 2009 and the possibility of a sovereign bond default in the emerging markets. Also, LIBOR has started to rise again since November 12.

Value investors hungry for yield should focus on investment grade corporate bonds, TIPs or Treasury Inflation Protected Securities and, for aggressive investors, convertible bonds. These three segments of credit offer exceptional values now for long-term investors.

Avoid emerging market debt and high-yield, or junk bonds, as credit spreads widen into 2009 accompanied by rising defaults. Yields might be tempting but are not worth the risk at this stage of the economic cycle. Also, long-term Treasury bonds are overvalued ahead of a boom in new issuance to pay for the ongoing bailout and, ultimately, a short-term stock market rally, which will siphon funds away from Treasury bonds.

Volatility Levels off the Charts

Stock market volatility continues to shock most market participants this fall with enormous swings occurring almost daily. On Thursday, the Dow was down almost 300 points at its worst levels only to recover with a massive 552-point gain. That’s an incredible 850-point turnaround in the span of just four hours of trading.

The Dow, however, dipped under its October 27 low of 8,176 while the S&P 500 Index was far below its 848.92 low last month.

The CBOE Volatility Index, which measures options traders’ sentiment on the S&P 500 Index, plunged 10% to 59.83 (see above chart). That’s still a highly elevated level with the VIX in record territory since Lehman’s collapse in mid-September. In 2008, the VIX has surged 113% and has gained an average 73% annually since November 2005.

An extreme VIX reading continues to suggest stocks are seriously oversold. Other market sentiment indicators remain highly stressed, including investment advisor sentiment (highly bearish), high cash levels at mutual funds and hedge funds and record equity fund and hedge fund redemptions. With everyone heading out the door at the same time over the last 60 days contrarian investors believe stocks can post a major rally off the recent lows.

Since September 1, the Dow has crashed a cumulative 24% while the S&P 500 Index has plunged 29%. Worse, the MSCI Emerging Markets Index has collapsed, down a dizzy 39%. Over the same period gold prices have declined 12% while the euro has tanked 13%.

Just where the stock market is heading next is anyone’s guess. From one day to the next it’s like watching a wild rollercoaster; big price swings are indicative of a major transition ahead to either a bottoming process and then higher stock values, or worse, the next leg down for this bear market. It just seems that every time we have a big rally the sellers always tend to emerge.

I suggest investors remain highly defensive. It’s just not worth chasing this market. Remember, we are entering a “soft” economic depression as suggested by Swiss money-manager, Felix Zulauf. I embrace this view.

The economic news is still deteriorating and despite an oversold stock market, corporate earnings don’t look encouraging as global demand falls off the charts this fall. Any big rally should be viewed as an opportunity to sell unwanted stocks and raise shorts or reverse-indexing positions.

If you’re adamant about bottom fishing at these prices, consider going into the market carefully through income producing securities like bombed out convertible bonds, investment grade corporate bonds and TIPs. These are all highly attractive segments of credit right now and still miles below their highs following a major crash in September and October.

On Monday I’ll review credit markets, including LIBOR, commercial paper, credit default swaps (CDS) and other important measures of credit to decipher exactly where we stand at this point in the financial crisis.

Thank you for all your comments on this page. I receive a handful of commentaries each day and I’m delighted investors come for their daily fix. I enjoy your feedback.

See you on Monday. Have a good weekend.