Credit Markets Lead Stock Markets
Financial stocks continue to dominate the headlines. The attention has now moved from banks and mortgage originators to the monoline insurers. They are called "monoline" insurers, because they only do one thing: they insure bonds against default, that's it. They originally insured municipal bonds against default, thus enabling the issuing municipalities to obtain AAA ratings and therefore lower their cost of funding, even after deducting the insurance premium. This was a nice business to be in (that's why Warren Buffett wants to get into it also) because municipalities usually don't default, so as an insurer you get to keep the premium. To make a long story short, the monolines eventually expanded into insuring not only municipalities but also structured securities like CDOs. That line of business is now coming back to haunt them. In 2007, amid a housing market decline, defaults soared to record levels on subprime mortgages and innovative adjustable rate mortgages, such as interest-only, option-ARM, stated-income, and NINA loans (No Income No Asset) which had been issued in anticipation of continued rises in house prices. Monoline insurers posted losses as insured structured products backed by residential mortgages appeared to be headed for default. On November 7, ACA, the only single-A rated insurer, reported a $1B loss, wiping out equity and resulting in negative net worth. On November 19, ACA noted in a 10-Q, that, if downgraded below A-, collateral would have to be posted to comply with standard insurance agreements, and that 'Based on current fair values, we would not have the ability to post such collateral.' On December 13, ACA's stock was delisted from the NYSE due to low market price and negative net worth, but ACA retained its A rating. Finally, on 12/19, it was downgraded to CCC by S&P.; The following month, on January 18, 2008, Ambac Financial Group Inc's rating was reduced from AAA to AA by Fitch Ratings. Due to the very nature of monoline insurance (their AAA rating holds as long as the insurer holds its AAA rating) the downgrade of a major monoline triggered a simultaneous downgrade of bonds from over 100,000 municipalities and institutions totaling more than $500 billion. The result this week was, that even municipalities with solid credit could not refinance. This Bloomberg article explains how it could come to this.
The first picture above shows the Loan Credit Default Swap Index, which represents a tradeable index with 100 equally-weighted underlying single-name loan-only credit default swaps. The blue line shows the index value, which recently fell to a new low, the red line shows the interest spread over LIBOR. The index trades like a bond, which means that when interest rates or spreads rise, the index falls and vice versa. The second picture above shows that same LCDX-Index in comparison to the S&P; 500. Now you see what I am getting at. It looks as though the stock market has reacted more to credit crunch concerns than to economic or profitability concerns in the past 9 months. The LCDX seems to act as a barometer of risk appetites in general. A falling LCDX index means that investors demand increased compensation for the risk they assume when they buy the index. This increase in compensation is expressed as a rise in the interest rate they expect to be paid. Last week these interest rates on Loan Credit Default Swaps threatened to surpass 8% (3.1% Libor plus almost 5%) for the first time. The rise in interest rates equates to a fall in the index. Over the past 9 months each fall in the LCDX has always led to a fall in the S&P; 500. The last four weeks, however, show a divergence. While the S&P; 500 stabilized after the two massive rate cuts last month, the LCDX continued to deteriorate. The question now arises, whether the LCDX indicates that the stock market will reach new lows or whether stocks can stabilize and pull the credit markets up. If only it was just this black and white. How about a complex solution? Stock markets usually discount economic developments 6 months in advance. I will present two working theses for your entertainment:
1. The fact that stocks are stabilizing could be a sign that the economy is stabilizing. Credit markets are having issues of confidence, trust and issues of impaired liquidity. Eventually, though, the second half of 2008 should bring stabilizing credit conditions and an improvement in the economic backdrop, which should stabilize credit markets. Stocks are anticipating this outcome already.
2. The LCDX continues to point down; therefore stock will continue to fall. Stocks are currently marking time. The oversold condition will be eliminated shortly by another bear market rally which will fail again and then initiate the next phase of this bear market.
You must admit, both alternatives are plausible. Which one strikes our fancy is probably dependent more on our internal disposition than on certain external facts. So what is a somewhat agnostic investor like me to do? We look for evidence in other areas, like everybody else. I have to tell you though; right now there is no uniform set of indicators that would give us a long term indication of where stocks are headed next. Credit markets are in turmoil but might get worse (or not), the economy is decelerating and might be in a recession (or not) and stocks must have discounted the worst (or not). Again, no easy solution. One set of data, however, gives me comfort at least for the short term. Institutional investors are more risk averse now than they have been in seven years, according to Merrill Lynch's Survey of Fund Managers for February. A total of 190 fund managers participated in the global survey from February 1 to February 7, managing a total of U.S. $587 billion. A total of 171 managers participated in the regional surveys, managing U.S. $393 billion. The headline reads:
30 PERCENT OF RESPONDENTS HEDGED AGAINST FURTHER EQUITY SELL-OFF
The two charts above illustrate this mindset also. Advisor sentiment polling is conducted by Investors Intelligence. Cutoff for the poll is Friday, and the results are released to the media the following Wednesday. Charts are aligned to reflect the effective date of the poll cutoff, not the release date. The daily as well as the weekly chart show that sentiment numbers are inching toward excessive bearishness. This gives me comfort in a complex solution, where short term sentiment in the stock market favors a rally. By the time that rally is exhausted, we will know what the LCDX and the economy have given us in terms of new information. Until then, I will (and you should) buy weakness.