Good Evening: What started as trouble with subprime mortgage loans almost two years ago has now spread out and infected credits of all sorts, save the U.S. government. Perceptions about the credit-worthiness of Uncle Sam will take time to change, but the equity market is starting to realize that common shares represent the least senior claims to corporate cash flows. As such, equities are now playing catch up with the ever worsening credit markets. Whether this adjustment in the relative prices of credit and equity take place all at once or over time is the question investors large and small now have to grapple with.
The economic statistics out today lent currency to the view that the U.S. economy continues to shrink. Mortgage applications fell during the latest reporting week, CPI (both headline and core) was negative, and both housing starts and permits plunged to the lowest levels on record (see Merrill’s take on the latter two stats below). These reports did nothing to dispel the notion that our economy has hit more than just a temporary air pocket. The resulting concerns were easy to spot in the fixed income markets. Senior bank loans saw a fresh round of liquidation, and high yield bonds lived up to their name as yields in junk land are now pushing 20%. Shares of Citigroup plunged 20%, and even Warren Buffett’s Berkshire Hathaway came under assault (see stories below). When junior and senior bonds proffer equity-like returns, it becomes a lot harder for common equity to compete for the marginal investment dollar (except, of course, on the short side as a hedge). These latest convulsions in the credit world finally started to attract Mr. Market’s attention as today progressed.
Opening close to the unchanged mark, stocks tried to rally right out of the gate. They soon lost their footing, however, as the implications of the goings on in credit started to sink in. The major averages continued to slip until they were down some 3% or so at mid day. A period of nervous, sideways trading developed as those looking for last week’s lows to hold did battle with those who either wanted to or had to sell. The bottom pickers lost, and the indexes dropped another 3% during the final hour of trading. Last Thursday’s lows in the S&P couldn’t hold, and now the Dow 30 is the only index which has yet to break its old lows. The major averages finished with losses ranging from 5% in the Dow to 8% in the Dow Transports. Treasurys rallied once again, this time far enough to give the 30 year bond yield a “3 handle”. Currencies, for once, were not much of a story. The dollar index finished with little change, as did commodity prices. Crude oil set another new low, but it’s been getting harder of late to push many commodities lower. The CRB index was off 0.7% at the bell.
Having earned my trading stripes long ago in the rough and tumble commodity pits at the Chicago Board of Trade, I will always remember the wise words a veteran trader once shared with me. “In the long run, value (or a lack thereof) does win out”, he said, “but in the short run, it’s how people are positioned that matters most”. The latest evidence this now old gentleman is right can be seen in the prices of everything from senior bank loans to dry bulk shipping rates. Bank loans, for example, were cheap at 80 cents on the dollar, and were priced on top of “can’t lose” recovery rates when many reached 70 cents. Market participants took note and duly loaded the boat. Today I’m told some traded in the 60’s or lower as leveraged players continue to be shaken out of that market. Dry bulk shipping rates are down a dot.com-like 90% this year. The common theme afflicting credit prices is too many longs using leverage, while simply too many longs caught believing the BRIC miracle would continue are keeping commodity prices on a southerly course.
Could bone-jarring losses of a similar nature soon visit equity market longs, many of whom think “the bottom” is in? Given today’s action, it is most certainly possible. We could be in for a downside dislocation at any moment. If Berkshire Hathaway can get tattooed, then what stock can be considered “safe”? Then again, every time I’ve had this feeling since August of 2007, the stock market has managed to find a reason to scamper back to the upside. And, given all the bearishness around, a large rally is not out of the question. To register just one man’s opinion, though, I have to say I have a bad feeling as we head into Friday’s option expiration.
–Jack McHugh
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Sources:
U.S. Stocks Slide to Five-Year Lows as Banks, Carmakers Tumble
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=agudZCuyk73g
Fed Officials Saw Economy Shrinking Through Mid-2009 Last Month
http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=avbjEl4H4TMg
U.S. Economy: Consumer Prices Fall, Raising Deflation Danger
http://www.bloomberg.com/apps/news?pid=20601087&sid=a9qvRz4kZN18&
Loan Prices Fall as Funds Forced to Sell, Default Risk Rises
http://www.bloomberg.com/apps/news?pid=20601087&sid=a9zUAmGJyxsg&
Junk Bond Yields Reach Record 20 Percent as Economy Declines
http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a3XCBff054J0
Buffett’s Berkshire Falls Most in at Least 23 Years
http://www.bloomberg.com/apps/news?pid=20601087&sid=ayIRzsMlT.6k&
Download Your Report: Starts are finished.pdf
Download Your Report: CPI gets a big fat D .pdf
