The apparent fizzling out of the late-October surge in world equities carries two lessons. First, history does not repeat itself.
Investors have had it drummed into them that the biggest one-day percentage rises in the history of the Dow were sucker’s rallies in the great crash of 1929-33. The message: this is no time to trust rallies.
The second lesson is less obvious but equally important. Equity investors should pay more attention to the credit markets.
While world equities were surging more than 20 per cent recently, credit strategists were incredulous. What was there to be cheerful about?
It was all too reminiscent of last summer, when the broad equity indices in the US and UK hit all-time highs just as the credit crisis was beginning to blossom. Credit specialists thought that was crazy and they were dead right.
Equity bulls argue the market is a discounting mechanism, which looks across the valley to the sunny uplands. But the credit markets are discounting mechanisms too. And, as Suki Mann of Société Générale puts it, the question is when to start discounting.
Granted, some signs from the credit world have been ostensibly encouraging. Libor rates have dropped to levels that, though still abnormal, are lower than before the Lehman Brothers collapse. And in the US – though not in Europe – the commercial paper market is starting to function again.
But these are both the result of direct government intervention. When it comes to new issues in the bond market, there are far fewer signs of life.
This is crucial. There have not been many equity rights issues either. But equity is permanent capital that, unlike bonds and bank debt, does not have to be constantly replaced. And while it is helpful that US companies can now roll over their short-term commercial paper, refinancing longer-term debt is still cripplingly expensive.
Last week, Altria, the US tobacco company, issued bonds at 600 basis points over Treasuries, for a yield of almost 10 per cent. Yet this is a company with no net debt and the abnormally stable cash flow that comes from having addicted customers.
Granted, the spread on credit derivatives has narrowed. But cash bonds have not followed suit. The so-called basis – the difference between cash and derivatives spreads – has widened enormously. Unlike derivatives, cash bonds these days are illiquid. So a liquidity spread must be added to the default premium.
If the bond market is not working, neither is the banking system. Three weeks ago, for instance, I wrote about how the plunge in dry bulk shipping rates – the Baltic Dry Index – resulted partly from banks refusing to issue letters of credit.
The International Group of Treasury Associations – representing corporate treasurers – has since gone public on the issue. World trade, it says, is “freezing up”. And the problem, yet again, is that the banks do not trust each other.
This is because, when a company in one country is shipping goods to a customer in another, the buyer’s bank is supposed to supply a letter of credit to the seller’s bank so the shipper can get paid promptly. These days, it seems, no deal.
But to revert to the main topic. Why are credit analysts – in Europe especially – still pessimistic?
Partly because they are still waiting for the storm to break. Equity investors are now seeing the reality of corporate earnings falling, even if they seem curiously surprised by it. Credit markets, by contrast, are braced for defaults to start soaring, but the default rate is still very low.
It is, in other words, a trailing indicator. Mr Mann reckons it might not peak until 2010 – and that spreads ought not to peak until shortly before that.
This illustrates a basic problem. Some two-and-a-half years ago, I wrote about how equity and credit analysis seemed to be coming together. Analysts in those two very different disciplines were swapping ideas and information to reach a more sophisticated view of a company’s prospects.
However true that was then, it is certainly not now. One reason is that the pioneers of this approach were the hedge funds, in search of profitable anomalies.
These days the hedge funds have more brutal priorities, such as raising cash to meet redemptions. And the fundamentals are now so disregarded, in equities especially, that there is no guarantee that anomalies will not simply get worse.
Last week in this paper, the global head of institutional investment at Fidelity International urged equity analysts to drop their fixation with earnings and spend more time on cash flow and capital structures. As things stand, he is unlikely to get his way soon.
But in the meantime, remember the lesson. This is still first and foremost a credit crisis. If the equity and credit markets disagree, go with credit.
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