There have recently been signs of a marked decoupling of equity and credit markets, says Ian Scott, global strategist at Lehman Brothers.
”Although credit has - understandably - been the latest obsession for equity investors, the links between the two asset classes have not been as close as some might think,” he says.
Mr Scott points out that, while over the past year or so, the equity of companies with lower credit ratings has underperformed that of companies with higher ratings, this has not been the case during the past month.
Have the credit and equity markets been responding to very different fundamentals in the past month, or are there lags at work? Is the equity market in denial about the acute problems in the credit market? And what does this mean for investment strategies? Mr Scott answers your questions below.
We all know now that the Libor/Fed Funds differentials were early warnings of trouble to come in equities. At this stage of the credit deleveraging, what is the sign one should look for that trouble in the credit markets will likely spill over to equity markets again?
Jim Pursley, Caldas Novas, Brazil
Ian Scott: I think equity markets have de-coupled from the developments in credit markets since mid-January. Stocks have traded above their January lows, while credit spreads have widened sharply. I think the recent widening in credit spreads has been the result of factors specific to the credit markets: forced selling by leveraged investors, and the unwinding of structured derivative positions rather than a major deterioration in credit fundamentals.
Rather than looking for the problems in credit to spill over into equities, I think we should be focused on the ability of equities to continue to rally in spite of credit. Developments in the past few trading days have rather seen credit spreads narrowing, reversing some of the huge expansion since mid January. This stabilisation should help stocks to continue their recent recovery.
Do you believe Benjamin Graham was correct in using trailing ten-year earnings to price as a proxy for valuation risk in equities? Moreover, there have been only a few times in equity market history that trailing ten-year earnings to price have been as high as they are today (1929, 1969, 1971, 1999, and 2000); does this situation concern you?
Ian Scott: Mike you ask an interesting question, I would answer it in three ways. Firstly, in using the 10-year trailing earnings as a basis for valuation, the proponents of this approach are effectively trying to define where ”trend” or ”normalised” earnings are. We would rather attempt to fit a trend directly to the earnings and then use that as the basis for an adjusted valuation. On this basis, when viewed globally, we do not agree that stocks are expensive.
Secondly, we have tended to look at equity valuation in the context of the level of (real) interest rates. When one considers the currently low level of real interest rates globally, we think stocks look cheap by comparison.
Finally, valuing equities can be seen as an art rather than a science. We have our approach which we think shows stocks to be underpriced currently. However, we are keen to supplement valuation with a more behavioural approach. Specifically, if we look at the behaviour of companies, they are not issuing very much equity (net of buybacks), indeed, net supply is at its lowest level in over twenty years. This suggests that executives view stocks as being underpriced - hence their desire to buy. History tells us to follow this behavioural signal and buy when companies are buying, at least on a 12 month view.
Is it not correct that the ratings are as often wrong as right? Was not this the genius of Michael Milken in demonstrating that high-yield, low-rated bonds historically performed better than low yielders?
Mike Brear, Canada
Ian Scott: I am not sure if we can say that credit ratings are wrong as often as they are right, but as an equity person, I would point to the fact that within the equity market, during 2007, poorly (credit) rated companies saw their share prices underperforming those companies with better credit ratings. However, since January 9 this year, the reverse has been true, poor credits have beaten good credits in the stock market. At the very least, equity people seem to be taking a different view (in recent weeks) than their colleagues in the credit market.
With the current markets in a liquidity crunch, there is a strong chance that both of them may move inversely. Though investing in debt looks attractive because of spreads, this will make debt cheaper soon. Can this spur a credit bubble in the corporate market?
Anshul Shah, Dubai
Ian Scott: I agree that there are forces working in the credit markets that might explain the recent inverse movement with respect to equities. It is unusual, but then so are current conditions. Secondly, I would agree too with your suggestion that investing in corporate debt may indeed be a good idea given the spread widening that we have seen recently.
Indeed for the first time in several years, the case for buying some distressed corporate credits looks as attractive as buying stocks. Where I would be more cautious is in discussing the creation credit ”bubble”. Arguably we have already had bubble-like conditions in credit markets in recent years, and the recent spread widening reflects the unwinding of those conditions, as opposed to a deterioration in credit quality. I think we are a long way from ”bubble” conditions in credit markets.
De-coupling has been a theory bandied about with regards to emerging markets and the US markets but increasingly dismissed as wishful thinking. Could the current state of decreased correlation between equity and credit markets go the same way? Could current optimism in the equity markets be a case of collective wishful thinking without which the illusions might collapse?
Judy JL Yeo, Singapore
Ian Scott: Of course there are no ”guarantees” but I think there are several reasons for thinking that stocks can do well despite wider credit spreads. Firstly, while spreads have expanded, interest rates have declined on government bonds and for good credits (most large cap equities) interest costs have not in fact risen very much.
Secondly, we think credit markets have been influenced recently by a number of ”technical” factors that have sent the market beyond levels justified by current credit conditions. Specifically, I am talking here about the lack of liquidity in credit markets, forced selling by leveraged and other investors required to reduce their risk profiles. In addition, if we look at developments within the equity market since 9th January, the share prices of companies with the lowest credit ratings have risen by an average 5 per cent, while the shares of companies with the best credit ratings have declined by an average 4 per cent.
So not only have equities and credit de-coupled at the aggregate market level, but they have also done so at the individual stock level too. As far as ”wishful thinking” in equity markets, global stocks are trading on their lowest multiple of forecast earnings since consensus data was first available in the 1980s. Of course analysts may need to cut numbers somewhat, but the 25 per cent reduction required to return the multiple back to average levels implies a hit to earnings estimates greater than those experienced during the two recessions since we have had consensus numbers available.
Along with other “emerging markets”, Indian equity benefited twice over from the liquidity boom of the early part of this decade - lower interest rates enabled investment, and global flows raised PEs. Will the on-going credit crunch have a symmetrical effect that drives emerging markets down further?
Mohit Satyanand, New Delhi, India
Ian Scott: Yes it is true that Emerging Equity Markets have benefited from both a re-rating and strong underlying earnings growth. We think the re-rating has now run its course and the future for Emerging Markets will depend upon their ability to deliver superior earnings growth. We think the Indian economy, and by extension earnings, will growth strongly over the medium term.
When we factor in these superior underlying growth rates, coupled with the high returns and strong re-investment rates of listed Indian companies we are optimistic about the prospects for the market. Indeed, one would have to say that the credit crunch has had a rather limited impact on Emerging Equity Markets so far, and we doubt that they are going to suddenly succumb to a further credit related decline.
I believe that the denial we see in the equity markets is a testament to our optimism as capitalists. Also the lion’s share of equity trading is executed by automated proprietary algorithms which could have few inputs from credit market metrics. Do you believe that this automated trading contributes to this de-coupling at all?
Adam Griser, Beverly Hills
Ian Scott: I don’t think the increase in the use of algorithmic trading is contributing to the de-coupling of equities and credit. Many of the equity trading algorithms used are rather short term in nature, while the de-coupling of the two markets has occurred over the past five or six weeks. Moreover, I think there are sound fundamental reasons for stocks to have de-coupled given the lack of liquidity and rather ”technical” factors that have been dominating credit markets recently.