General Market Comment: September 28, 2009
Life goes on . . . we are now a year after the collapse of Lehman and this week we will anniversary the near death experience of Sept. 29, 2008 when the Dow dropped over 700 points. Back then Congress was dithering over the TARP, banks were failing/being shotgun married off, money market funds were “breaking the buck” . . . It was all together as unpleasant a time as I have ever experienced or ever to care experience again.
So – where do we stand today?
The broad equity indexes are approaching or matching levels from just prior to that time. Multiple indicators are signaling economic recovery is taking root. While many of the indicators we read about everyday, such as the labor statistics we will see this week, are lagging data I was curious what some of the forward looking indicators are telling us.
One forward looking indicator I like is the price action of high yield bonds. This is a market that is played overwhelmingly by pros – no retail money should tread there. The market is a proxy for the health of the companies that have issued high yield bonds, a signal for the outlook for interest rates and importantly the risk appetite of institutional investors. The market for high yield bonds has fully recovered and is above last September’s level.
This is a remarkable turn around. Logically one should consider if this action is sustainable. One tool that helps us with this task is the trend in credit default swaps and the spread in those swaps between investment grade corporate debt and high yield debt. Have a look at the following chart from Scott Grannis’s blog “Calafia Beach Pundit”. (the indexes measure the spread between the relevant corporate rate and the 5 year Treasury note).
This forward look into default risk has improved dramatically in absolute and relative terms. So far it suggests at least two outlooks. Firstly, it suggests there is more upside to bonds as the price as expressed by the spreads remains high relative to pre-Lehman crash levels. Secondly, it suggests the outlook for the economy is improving. The implication for the equity market is that it too should continue to improve. Bespoke Investment Group generated a compelling chart contrasting the change in the CDS index and the S&P 500 since the scary days of last September.
The CDS index in the chart expresses the default risk of 125 North American investment grade entities. As it went up, stocks went down and vice versa. An important point highlighted by Bespoke is that the S&P 500 would have to rise approximately 20% to return to the level of June 2008 when the CDS index was last at its current value. The very sharp drop in the CDS index in recent weeks may be signaling a material return to the markets by institutional investors as they transition out of money market investments and into higher return asset categories. We have in fact seen approximately $60 billion leave institutional money market funds in the last 30 days.
As I have said over the last several weeks . . . “The here and now data supports the case for rising tech stock prices and low and behold they continue to rise. I continue to believe we will NOT see any material correction (i.e. down 10% or so) as we move toward Q4. Q4 continues to shape up to be very strong. Money managers that have missed out on this year’s great rally will likely be forced into the market in the October / November time frame as the Q3 earnings season unfolds.”