The Debt-Equity Clock Is Ticking - Morgan Stanley

Interesting data out of Morgan Stanley (MS) recently. According to their “debt-equity” clock they say it’s time to prefer stocks over bonds. According to MS we are entering the recovery phase after having been in the repair phase of the cycle. During the repair phase balance sheets are tirelessly repaired by corporations, debt is paid down, costs are cut, cash is boosted and ultimately credit expands. MS believes the repair phase is just ending and we are moving into the recovery phase.

Although credit should continue to perform well in this operating environment they are moving to an overweight equities position for the following reasons:

1) Fundamentals - Earnings should rebound more sharply than expected. The steep yield curve should help drive bank earnings.

2) Valuations - Equities are cheap compared to high quality credit.

3) The Quality Disconnect - MS believes there is a quality disconnect. While debt markets have been led by the rally in high quality debt the equity markets have rallied on lower quality names. This has created a value gap which makes high quality equity more attractive to high quality debt.

4) Lower risk in high quality equities – MS believes low quality firms are likely to issue debt and take advantage of their strengthened position to issue debt and equity. This adds another layer of risk to owning lower quality names whose debt has rallied substantially.

Source: MS

Comments

[dw57:]

i wonder what they sell? it couldn't be they are brokers could it?

Oct 16 04:17 PM

[Johny Lee:]

As the Bureau of Labor revises upwards their estimates of job losses. But only by about 135,000 per month for the last six months! "A minor flesh wound" as lovers of Monty Python would say. Yipee yipee yipee, the good times are here to stay. Isn't life just grand.

Oct 16 04:30 PM

[Johny Lee:]

And the Bureau of Labor is adjusting job loss stats for the last six months. But it's only an estimated additional loss of 135,000 per month for the six month period - 810,000 in total. "Just a minor flesh wound" as lovers of Monty Python would say. Yipee, yipee, yipee the good time roll. Isn't life grand! Almost the best of all possible worlds.

Oct 16 04:34 PM

[Moon Kil Woong:]

Despite MS's nice normal cycle garbage chart, I have to agree that equity is better than fixed income simply because rates are artificially low compared to the risk of, say the US dropping 10% a year (poops it already has). Or that the Fed can't sell US Treasuries without raising interest rates even if they buy it up themselves (oops it already rose).

Equities are good for the same reason commodities are good right now, merely because no one can depend on the Federal Reserve to protect the value of the dollar, fight inflation, or even complete US Treasury bond sales at reasonable rates considering the risk. This is not an equities rally based on strength, it's a rally based on everyone trying to exit low yielding government bonds and hedging dollar depreciation and inflationary fears.

Does that sound like a typical business cycle?

Oct 16 04:37 PM

[Alan Young:]

I've seen this "high quality equity" line before. Does anyone know just what that is? If it's the same as "blue chip", well, AIG, BAC, C, F, GE were all blue chip stocks 2 years ago, and no one is calling them "high quality" now, are they?

Oct 16 04:38 PM

[Old Rick:]

I agree with the equity argument, but believe that most of the equity allocation should be 1) foreign or international (<20% US exposure) 2) be high quality with transparent balance sheets (rules out financials) and 3) pay dividends at around the same rate as long-term treasuries. I would also (and do) hold U.S. equities that are energy/commodity related. In regard to the foreign exposure, note the Niall Ferguson article in Bloomberg (quoted on Market Currents) predicting another 20% downside for the sawbuck.

Oct 16 05:30 PM

[Andrew Butter:]

Mmm....fascinating, MS think that now is a good time to prefer equities over fixed income. WOW!

Actually the "good time" to do that was 6th March 2009.

But it's nice to see that they got the picture at last, although if the long term interest rates go up (the alternative is the dollar goes down), then what happens?

Oct 16 06:45 PM

[Gary A:]

I would just stay out of both. Perhaps people should just take their money home. This is not an ordinary recession. Did Bank of America look repaired to any of you? A billion dollar loss is repair?

Oct 16 08:26 PM

[richjoy403:]

If I reacted to every SA article suggesting this is a good time to buy stocks, and to every article (and the super-bears commenting here) suggesting the stock market is going back to 666 and below...I'd be buying and selling my entire portfolio every day!

Instead, I know the economy (and thus the stock and bond markets) are cyclical, with peaks and valleys about every 4-5 years) it has been so in all my 35 years of investing. The preponderance of evidence says we have seen the low for the cycle and the economy is expanding again. I don't know how long it will last (but I do know it won't go straight up without correction); but unlike the bears, I have known for most of the 50%+ upward trend in the stock market that this is the time to be invested in stocks to the extent of my normal 60% stock allocation. I trust a diversified portfolio, but I especially like commodity stocks and emerging markets for a little extra return.

Thank God we have the bears. When the bears finally become convinced the positives outweigh the negatives and they buy stocks, the economic cycle will have approached its peak (think 2007) and the stock market will surely fall (probably next time for the usual reasons, like an overheated economy).

p.s Yes, MS does make a profit from stock and bond sales (and from arbitrage and IPOs, etc.), but their 'clock' is nonetheless appropriate and useful. Yes, housing and employment still suck...but do you really expect they can recover before sustainable profits are made, and employers are convinced to start re-hiring?

Oct 17 10:23 AM

[Dmarque:]

OK, "stocks".....IF you believe the dollar will regain it's credibility.
Commodities.....might be even a better alternative though since Washington is printing dollars into oblivion and only saying they want to strengthen the dollar BUT DO NOTHING to show that they want to strengthen our currency or our economic climate. Soviet Georgia is a friendlier economic environment than the U.S. under this administration.

Dmarque

Oct 17 06:31 PM

[Dmarque:]

Actually, being in Fixed Income vehicles over the last 7 months was just as lucrative with significantly less risk. In fact Preferreds (considered fixed income) in March were paying 14% yields PLUS the appreciation on the underlying vehjcle. e.g. the average $25 par vehicle was trading at roughly $8/ sh. Today those same issues are trading at $20. At the time it wasn't clear that we'd see the market do anything. These preferred allowed investors to collect a big dividend while they waited for the smoke to clear with the understanding that the government was going to back these issues and be senior to the TARP paper. There was a good reason to be in some issues when they had the ability to offer safety, income and very likely appreciation. I don't see much reason for sellling these issues either. The income is high and the accretion has provided much protection if things get dicey again. We aren't out the woods yet but high quality equities with decent dividends and the potential to raise those dividends might be a decent choice hto add. I just prefer industrial commodities with the way the dollar is currently being treated.


On Oct 16 05:30 PM Old Rick wrote:

> I agree with the equity argument, but believe that most of the equity
> allocation should be 1) foreign or international (<20% US exposure)
> 2) be high quality with transparent balance sheets (rules out financials)
> and 3) pay dividends at around the same rate as long-term treasuries.
> I would also (and do) hold U.S. equities that are energy/commodity
> related. In regard to the foreign exposure, note the Niall Ferguson
> article in Bloomberg (quoted on Market Currents) predicting another
> 20% downside for the sawbuck.

Oct 17 09:40 PM

[marketman54:]

OK, equities may still be a good value but this is my take on all of the wall street snake oil salesmen!!

They got TARP money and pumped billions upon billions into the market and inflated it to the 10,000 mark. Now the little guy on the street, ME AND YOU, think we missed something!

Main street gets sucked in and in two more months when wall street can't push the market against the real numbers that are coming out with unemployment, earnings, foreclosures, falling dollar.......BOOM - 2,000 points in the toilet and everyone is scared again.

There is no way we can have 4% to 7% growth with 26 million out of work and everyone else with jobs has cut back their spending!!!

Oct 18 09:46 AM

[pockyclips ...:]

I read somewhere that the P/E for the S & P 500 was 30% above
where the typical "bottom" of a recession is. So is recovery already "baked" in, or are in the first half of the "w" recovery?

Oct 18 10:00 AM

[Fibonacci:]

Points 3 & 4 in their argument seem to contradict one another. 3 says "debt markets have been led by the rally in high quality debt the equity markets have rallied on lower quality names". actually it's the other way around, the HY index is up just over 50% YTD. point 4 says "MS believes low quality firms are likely to issue debt and take advantage of their strengthened position to issue debt and equity. This adds another layer of risk to owning lower quality names whose debt has rallied substantially". well that last sentence proves my point but more broadly speaking issuing equity is a positive for low quality debt. Finally HY issuers have been tapping the market aggressively over the past several weeks, but for the most part it has been to push out debt maturities - which again is a positive for those issuers. I have, unfortunately also seen debt issuance to pay a dividend but so far that is the exception.

Oct 18 04:20 PM

[User 487586:]

Gary:

Can't do that ....Your "dollars" buy less every day. You have to convert your dollars into something that will grow or at least retain purchasing power. Right now that looks like commodities and Non-dollar denominated assets. Oil and Gas MLPs like PWE and LGCY and KMP are a decent start and DBB, GLD XOP and similar ETFs might be good stable mates.


On Oct 16 08:26 PM Gary A wrote:

> I would just stay out of both. Perhaps people should just take their
> money home. This is not an ordinary recession. Did Bank of America
> look repaired to any of you? A billion dollar loss is repair?

Oct 18 09:46 PM

[Charlie J:]

I used to be a Morgan Stanley high net worth client.

Past tense.

Oct 18 10:15 PM