To Worry or Not to Worry: The Eternal Market Question

by: David Merkel, CFA

I always get a little amused when the permabears emerge from their dens and parade around for the media to observe. I myself am often bearish, but I have an investment policy that keeps me from expressing too much confidence in it. I have no doubt that the permabears will eventually be right on much of what they are claiming will happen… but permabears by their nature are too early, and miss more gains from the “boom” than they typically make in the “bust.”

In general, and over the long run, prudent risk taking is the best strategy. The only exceptions are when there is war on your home soil, and aggressive socialism. That said, in this post, I want to detail reasons to be concerned, and reasons to not be concerned. Here we go:


1. Earnings growth is slowing year-over-year to about a 4% rate, and actually fell from the third to fourth quarters of 2006.
2. Loan covenants for loans to private equity have almost disappeared. Bullish in the very short run, but what are the banks thinking?!
3. Anytime the bond market maxes out in a given sector, tht is usually a bad sign for that sector. 42% or so of the whole Investment Grade corporate bond market is financials. (Contrast that with its weight of 21% in the S&P 500.) I would be very careful with financial companies as a result. Were I running a corporate bond portfolio, I would deliberately tilt against financials, and give up income in the process.
4. Have you noticed the small stocks have begun to underperform? Not bullish.
5. The balance sheets of US consumers are in poor shape. The further down the income spectrum you go, the worse things are.
6. Abandoned housing is becoming a problem in many parts of the urban US. (Hey, I’m in the suburbs, and I have two abandoned homes on my block!)
7. According to ISI Group, corporate capital expenditures exceeds free cash flow by $70 billion. (That’s what’s driving corporate bonds!)
8. In 1998, one of the causes of the volatility was a rise in the Japanese yen, which blew out the “carry trade” at that time. That may be happening now.
9. Chinese and Indian inflation is accelerating.
10. In general, central banks of the world are tightening monetary policy. The US is an exception, which helps to explain the weak dollar. Even China is tightening monetary policy.
11. I don’t worry about the budget deficit; it is part of the overall current account deficit, which I do worry about – particularly the fact that investment income we receive from abroad is exceeded by that which we pay out. This shift occurred in 2006, and is unprecedented for at least 50 years.
12. Inflation is above the FOMC’s comfort zone, even with the bad way that the government measures it.
13. Private equity is overlevering otherwise stable assets. That is bullish for the public markets in the short run, but unsustainable in the intermediate term.
14. Merrill had to withdraw a CPDO in February; to me, this means that corporate default spreads had reached their absolute minimum.
15. According to Bloomberg, Moody’s says that $82 billion in corporate bonds will mature between now and 2009, and 61% is rated B1 or less.
16. Actual volatility of stock prices has risen relative to implied volatility. Further the average holding period of stocks has declined markedly over the last four years, to around seven months, according to the WSJ citing Bernstein.
17. Margin debt is at its highest level since the 1920s, though as a percentage of market capitalization, it is lower than it was in 2000.
18. Troubles in subprime and Alt-A lending are leading to declines in US residential real estate prices.
19. Mortgage equity withdrawal is declining significantly in 2007. The higher quality the loan, the lower the equity extraction generally. A reduction in subprime and Alt-A affects this considerably.

Not to Worry

1. In general, stocks are better buys than bonds at present. The earnings yield exceeds the 5-year Treasury yield by 120 basis points. Note though, if profit margins mean-revert, bonds will be the better asset class.
2. At present, there is no lack of financing for CDOs and private equity, and corporations are still buying stock back aggressively. Investment grade corporate bond issuance is robust, surpassing the amount issued in 2006 YTD. On the other hand, high yield has slowed down considerably. (CDO mezzanine and subordinated debt spreads have widened though, particularly for asset-backed deals. The arb spread has not been so wide in years.)
3. Many new BBB bonds are coming with change in control covenants.
4. The VIX hasn’t closed above 20 yet.
5. Investment grade corporate balance sheets are in relatively good shape.
6. The relationship of earnings yields to corporate bonds is a fuzzy one. From the seventies to the nineties, P/Es moved inversely to bond yields. Not so, so far, this decade, or in the 1960s. If bond yields rise due to growth expectations, P/Es may follow along.
7. Money supply growth is robust in the US and globally. In the short run it is difficult to have a bad market when money supply growth is strong, and measured inflation is low.
8. There is a still a desire to purchase US assets on the part of foreigners; the recent fall in the dollar has not affected that.
9. My view is that we won’t have a recession in 2007, and that we might have one in 2008.
10. ECRI forecasts inflation falling in the US, together with decent growth in 2007.
11. Proxies for systemic risk have been receding, though they are considerably higher than one month ago.
12. Export sectors are finally showing some decent growth, partly due to the weak dollar.
13. IPOs are outweighed by LBOs and buybacks. With a few exceptions, IPO quality doesn’t seem too bad.
14. Global demographics favor net saving because of the various baby booms after WWII. Excess money growth is going into the asset markets for now.
15. Most M&A deals are for cash, which is usually a bullish sign. M&A waves typically crest with a bevy of stock deals. Deal premiums are not out of hand at present.
16. According to the ISI Group survey state tax receipts are quite robust, indicating a strong economy.
17. Also according to ISI Group, China is now a net coal importer.
18. Commodity indexes, scrap steel pricing, and Baltic freight rates are still robust.
19. Foreigners are buying some of the excess US homes as second homes. Having a residence in the US offers flexibility.

I did not aim for nineteen of each, I just went through my research pile, and summarized everything that was there. To me, this is a fair rendering of the confusing situation that we are in today.