Widening Rich/Poor Gap Spreads Contradict Global Recovery

As debt securities in the “AAA” categories began trading at yields spreads of 1000-plus basis points over comparative treasury maturities this week, bond market veterans were reminded of a popular slogan Senator John McCain used on the stump: if you live long enough, you will see everything. Across the Atlantic, debt pricing specialists watched in horror as default probabilities within the commercial mortgage-backed securities market soared to what were junk thresholds just a few short weeks ago.

Within days, the pricing reality of the CMBS matrix must start exerting a significantly adverse influence over the debt universe, both in the industrialized nations and in the emerging markets. More importantly for retail investors, this radically changed world of Libor+1200 yield spreads for investment grade issuers, 550-600 basis-point CDS spreads for supposedly superior names like Berkshire Hathaway and highly suspect credit ratings should force the application of substantively revised methodologies to equity valuations.

Specifically, are the post-CMBS-meltdown yields-spreads telling us that the major equity indices are due for a sizable downward adjustment, even after the Dow closed below 8000 on Wednesday and after Asian markets recorded new lows on Thursday morning? In other words, is it too early to be talking about market bottoms, despite the fact that trillions of dollars have been spent by G20 governments on bailouts, rescues, stimulus packages, interest-rate fixings, subsidies and currency interventions? In brief, how low can we now go?

Thus far, equity, bond and emerging market analysts have been avoiding the fundamental ideological issues involved. This writer is of the view that the post-Cold War enhancement of shareholder valuations was predicated on (a) overstated assets, (b) easy credit, (c) flawed solvency ratios, (d) misleading balance sheets and (e) the widespread, popular belief that the emerging markets would continue to create sustainable pockets of consumer demand, year in, year out.

This global recession is finally exposing the weaknesses in an overwhelming majority of corporate balance sheets. Though the process of bringing a semblance of reality to shareholder valuations has begun, and current share prices do indeed capture part of that process, S&P levels in the 1990-1995 period are a more accurate reflection of where we were certainly headed in early September, prior to the extensive support mechanisms created by governments across the world.

These support mechanisms are gradually destroying the principles upon which the notion of private capital was founded. So any 2009 forecasts of the Dow or the S&P 500 must, to a large extent, be conditioned by evolving political agendas. The considered view, however, is that state capitalism is failing in Russia and China, and there are no grounds to believe that state capitalism will be a success in the Western world. Sell aggressively on rallies; look for the S&P 500 to go well below 700 within the first half of next year.

The contrarian opinion is that the global recession is, for investment purposes, a cyclical phenomenon, that equities have already absorbed a significant amount of negativity, that the trend in declining earnings will reverse itself by 2010, that the degradation of assets has been largely recognized and that the longer-term approach justifies buying on any sharp declines from this juncture.

This writer’s aggressive short call is cemented by the proposition that the failure of third-world governments (almost without exception) to make profound structural changes within their economies is finally bringing into sharp and robust focus the tensions between growth and poverty, between optimism (GDP numbers) and despair, and between town and country. And, as a consequence, the shaky (even dangerous) political landscape overrides the merits of a classic cyclical interpretation. One needs to look beyond Wall Street and Washington, and beyond the spin which is being delivered 24/7 by lawmakers and regulators everywhere, before advocating 5- and 10-year investment horizons.

Disclosure: Author holds a short position in SPY

Comments

[Jimmy Lathrop:]

Great article, crummy headline. That is not the fault of the author. That is the fault of the SA editorial board. The headline is a small part of the overall thesis which is much more illuminating than the tag leading into it.

2008 Nov 20 07:27 AM

[Shira Jacobson:]

Hi Jimmy,

The title of the article is actually the author's own. What do you recommend for a better title?

Thanks,

Shira Jacobson
Seeking Alpha Editorial Team

2008 Nov 20 07:33 AM

[bosun.j:]

The author wrote:

This global recession is finally exposing the weaknesses in an overwhelming majority of corporate balance sheets.

AND

The considered view, however, is that state capitalism is failing in Russia and China, and there are no grounds to believe that state capitalism will be a success in the western world.

Those weaknesses being utter lies?

As for capitalism, it is glaringly apparent that Extremist-Capitalist western capitalism is unsuccessful too.

2008 Nov 20 07:46 AM

[Jimmy Lathrop:]

I would base the headline on the thesis of the last paragraph, something along the lines of, Widening Rich/Poor Gap Spreads Contradict Global Recovery. Especially since most people reading this site understand that triple AAA, as defined by GE, does not exist.

But what do I know, I'm just some dumb dirt lawyer from Brooklyn. Me talk pretty someday.

2008 Nov 20 07:59 AM

[investor88:]

Support Rakesh short position in SPY and agree with his logic that sp500 will hit 700 maybe sooner than he thinks. No time to be fooling around, shorting may be worthwhile.

2008 Nov 20 08:09 AM

[bosun.j:]

Jimmy:

The editor's response above brought to mind the line from Cheech and Chong: Bailiff! Whack his pee pee!

2008 Nov 20 08:20 AM

[Shira Jacobson:]

Jimmy: We used your headline. Thanks for your insight.
Regards,
Shira Jacobson
Seeking Alpha Editorial Team

2008 Nov 20 08:28 AM

[bosun.j:]

Ouch! Is there a Urologist in the house?

2008 Nov 20 08:41 AM

[Rong:]

Dirt lawyer/Jimmy L., enjoyed your comments. Who did you bill, how much for the time you spent on this?

2008 Nov 20 10:42 AM

[rsinvestor:]

Actually, the contrarian view would be: the more articles like this that come out and spell doomsday, the closer we are to a bottom. I am not agreeing or disagreeing with your thesis (you make some good points), but a true contrarian sees all these "Headlines of Disaster", and starts buying.

And by the way, Capitalism is most assuredly not dead. The hiccups we go through every so often are a natural stepping stone to a more efficient form of capitalism. What doesn't kill it makes it stronger.

2008 Nov 20 11:30 AM

[Jimmy Lathrop:]

I work from 9 to 5 and wrote it on my own time. I see you posted at 10:42 which is the Rong thing to do on company time.


On Nov 20 10:42 AM Rong wrote:

> Dirt lawyer/Jimmy L., enjoyed your comments. Who did you bill, how
> much for the time you spent on this?

2008 Nov 20 01:17 PM

[Tony Petroski:]

I read the article (based on the title) expecting a nostrom on the gap between the rich and the poor. I was planning to point out that at the start of today I was in the top U.S. quintile and now at the end of the day I'm in the bottom quintile. I now really hate those rich people.

2008 Nov 20 05:41 PM