Analyzing the Divergence in Credit and Equity Markets

by: Jeff Miller

There is a Street perception, which we generally share, that fixed income markets are "smarter" than equity markets. At the moment, the fixed income signals are all very negative. Many on the Street interpret this to mean bad news for equities. The complete explanation for the discrepancy, now at record levels, between projected stock earnings and fixed income yields, is that stock analysts are completely wrong. From this viewpoint, the economy and earnings are at serious risk.

What Happened Thursday

All sorts of credit spreads, indicators rarely followed by equity traders and investors, moved to very wide levels. This stimulated yet another round of selling in any company in a financial sector.

Regular readers have all of the pieces to figure this out, but it is time for a summary. The key point is that credit markets are illiquid. No serious economist or market analyst believes that an illiquid market generates valid prices. Illiquidity forces the pressured fund or institution to sell -- and to do so at any price. It also forces the sale of assets where there is liquidity.

At any given time, some hedge funds or financial institutions will be in this position. In most circumstances there would be investors who would step up to buy assets that were undervalued, at least on a theoretical or "performing" basis.

When a market is in free fall, all bets are off. There are now three distinct problems:

  1. Potential buyers are waiting to see "blood in the streets."
  2. FAS 157 rules generate a ripple effect. With each distress sale, assets held by other institutions must be market to this new market price. This means that a forced sale can generate a spiral of other forced selling.
  3. All of this is happening at a point where equity markets are trading near January lows, a level where many are looking carefully to see if this "support" holds, or if there will be another leg down.

David Malpass has a nice summary of the situation (you need a Bear Stearns account to get his complete analysis):

...(NYSE:A) circular mark-to-market process is a key factor driving the credit market deterioration. As we understand one example, a major bank sold a small group of bonds at a low price late in February. This caused a mark-to-market decline in similar bonds elsewhere. A margin lender raised its margin requirement, creating a margin call for a hedge fund owning similar bonds. Unable to meet the margin call, the hedge fund sold bonds quickly, adding to the volatility in that segment of the bond market. This began to impact the volatility in agency bonds, causing increased margin requirements on them. As volatility on agency bonds increased, margin calls went out, forcing sales, driving prices down and forcing lower marks, a process still underway after today's market close.

A Multi-Faceted Problem.

In prior articles we pointed out that there are distinct issues -- the housing market, the old mortgage market, and the "new" mortgage market. As long as credit is artificially restricted for potential new buyers, the demand curve for housing is distorted. This reduces prices, increases foreclosures, and generally makes everything worse.

The economic effects -- whether there will be a recession, the level of corporate earnings, and the appropriate valuation for stocks -- is not directly affected by these issues. Mostly this is because the use of home equity has mainly been for home improvements, auto loans, and an offset to other investment. This is another topic that Malpass has covered carefully, and nearly everyone has ignored.

Few are making the careful distinction between write-downs in financials and ongoing earnings in other sectors. Future financial earnings depend upon the ongoing businesses, not the level of past write-downs.

What Will Happen?

At some point we expect direct government intervention in the two key markets: Existing and distressed mortgage CDO's and further assistance to new buyers. There will also be action to help those threatened with foreclosure.

Please note that this prediction is analytical, based upon our experience of what stimulates various government institutions to action. It is not a normative viewpoint. Right or wrong, these steps will eventually occur. When they do, markets will react sharply. This might happen in anticipation, but as we have suggested in the past, there could be another Fed surprise like the TAF facility.

Wall Street analysts do not understand how government works. Because the pace of action is slower than trading they infer stupidity and ignorance. This is not true. Solutions develop, but not always at the pace we hope for.

Trading Implications

We wish this had more immediate and direct trading implications, but it really does not. As we noted Wednesday, we fear the reaction to the highly-variable employment report. We also note the "technical damage" seen by many analysts.

Current market levels are attractive by our methods -- fundamental and technical -- but all forecasts come with a time frame.