Relative Leverage's  Instablog

Don't be fooled...


Disclosure:  No Positions

"Hope Is a Good Thing, Maybe the Best of Things, and No Good Thing Ever Dies." - From the Shawshank Redemption

If I could sum up the past 4-5 months of market activity into one word, that word would undoubtedly be...HOPE.

There are only a few emotions that are powerful enough to blind someone from reality.  Hope is one of the most powerful.

Don't get me wrong, hope is a good thing, but hope is not a strategy...especially not an investment strategy... 

Rally of Hope

Even though the macro fundamental data has shown little improvement, the hope of an economic recovery has been strong enough to propel markets higher across the board.

Hopeful of a credit market recovery, yield-hungry investors have now driven corporate bond prices up over 50% from the recent lows. 



The S&P 500 is also up about the same amount since hitting a low of 666.79 on March 6, 2009.  However, the rally may be running into resistance. 

 
 
Risk and Reward 

The rally in corporate bonds has cut yields in half (see graph below from Altman's recent High Yield Bond Report).



The willingness to accept "junk" bond risk for half the return is somewhat surprising given that default rates are still rising significantly [July 30: High Yield ETFs: Keep this "Junk" Out of Your Portfolio].

In addition, the weighted average recovery rate on defaulting issues so far in 2009 is very low by historical standards. The recovery rate was 22.7% for the first half of 2009.  Note that the mean recovery rate from 1978-2008 was 45.07%.

According to Altman's estimates, the U.S. and Canadian dollar-denominated default rate for the last 12 months ended June 2009 rose to 11.08% from 8.01% at the end of the first quarter (see graph below).



As you can see from the graph above, the current default rate (~11.0%) is still below the peaks of the past two recessions (13-15%). And taking into account the reckless lending standards of 2006 and 2007, I think default rates could peak out around 20% this time around...which means we are still only in the 4th or 5th inning of this game...

Default Rates and Equity Prices

Since debt is above the equity in the capital structure, rising default rates tend to put downward pressure on equity prices.  If bonds prices are falling, the value of the equity should also fall (and vice versa).  This is why equity prices usually bottom out right around the same time that corporate default rates peak.

Let's look at the past two recessions:

• Early 1990's - Default rates peaked in Q4 1990 / S&P bottomed in Oct. 1990.
• Early 2000's - Default rates peaked in Q3 2002 / S&P bottomed in Oct. 2002.

If corporate default rates really do peak around 20% this time around, it probably won't happen until Q1 or Q2 of 2010...and there's a good chance the S&P may be making new lows around that same time...

I hope that I am wrong...


Full Disclosure:  No Positions  
 

The media can spin anything in a positive light.  The market was up big yesterday on the news that jobless claims were "slowing".  However, if you dig a little deeper into the unemployment situation, you might discover that the glass is actually half-empty...

From Bloomberg:

The number of Americans filing claims for jobless benefits last week held below levels seen in late June, before auto-related distortions set in, indicating firings are slowing as the economy stabilizes.

Applications rose by 25,000 to 584,000 in the week ended July 25, higher than forecast, figures from the Labor Department showed today in Washington. More than 600,000 claims were filed every week last month. The number of people collecting unemployment insurance decreased for a third week.

 An analyst at Labor said distortions from the timing of auto-plant shutdowns “worked themselves out” of the data last week, returning claims to “trend.” While a resumption in hiring will be slow to materialize, payroll reductions are likely to slow as housing and manufacturing, the areas that led the economy into the worst recession in five decades, steady.

Who cares that the rate of claims is slowing? The magnitude of claims is still significant...more than 600,000 claims were filed every week last month. In addition, the unemployment rate is still increasing and will likely be in the double digits in the near future.



This glass still looks half-empty to me...and this isn't even the real picture.  It's been estimated that the real unemployment rate in the U.S. is closer to 20%.  These estimates include “underutilized” workers in the U.S. (i.e., those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking). Prior to the early 1990's, this was the method of calculation.  Now the government manipulates the number in order to suit its political aims...

Regardless of which unemployment number you believe to be correct, the scary truth is that the U.S. is likely entering a "new normal"...and we may never see 5%-6% unemployment again.

Bill Gross discussed the his "new normal" thesis in Pimco's July Investment Outlook:

PIMCO’s driving thesis however, if not a juxtaposition, is succinctly described as a “new normal” where growth is slower, profit margins are narrower, and asset returns are smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the “gorging” of goods and services that we grew used to in decades past.

Forecasts based on econometric models inevitably miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior, and long-term trends involving risk-taking and in turn derisking are decidedly human in their origin. Bell-shaped curves with Gaussian/random distributions fail to anticipate that human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another. Humanity’s personal and social computers appear to be programmed that way. And so, instead of “normal” distributions, economists and investors must learn to be on the lookout for “black swans,” and if not, then certainly “fat tails,” which differ from the measurement of natural phenomena accepted in science. “New normals,” flatter-shaped bell curves, and structural shifts in previously accepted standards become not only possible, but probable as human nature reacts to itself and its prior behavior. The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking.

The question we should all be asking ourselves is: How will a "new normal" affect the returns of various asset classes over the next 5-10 years?  I'm guessing that the answer probably won't be as rosy as the media is leading you to believe...
 

Full Disclosure:  Long SDS