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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“Recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested element of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead.”
Joseph Schumpeter1
Equity markets are exhibiting a remarkable degree of complacency. The VIX has rarely traded below 15 since the financial crisis, although it traded at an average of 13.6 during the 2004-early 2007 period. What that tells us is that the VIX is currently at extremely low levels and that it can maintain those levels for a long period of time. The recent rally is a great example of the Wall Street adage that markets climb a wall of worry. In fact, the worse things get in terms of the economic data, the higher the market goes on hopes of central bank stimulus. At this rate, the Dow will peak just as the world is coming to an end! The level of the VIX may not worry the markets but it worries me. It tells me that markets are counting on a degree of central bank support that may not be forthcoming.2
The other data point that could throw a wrench into the works is higher Treasury rates. Treasuries have sold off meaningfully over the past couple of weeks, and this morning the 10-year is back up to 1.76% and the 30-year up to 2.86% as this is being written. That is a significant move off recent lows. There are many cross-currents involved in parsing this data. Ordinarily, one would think that higher rates speak to an improving economy and/or inflation. In this case, however, rising rates are inconsistent with generally deflationary economic data (at least the “official” inflation data).
Surprisingly strong July retail sales (+0.8% versus -0.7% in June) have caught the eye of the media (and perhaps the bond market), but one month of data does not constitute a trend. The entire retail industry is experiencing an unusually competitive and paradigm-shifting phase that renders monthly data problematic as an economic barometer. In the current environment, higher rates are unlikely to impress the equity markets as a sign of economic strength or impending inflation. They might, however, cap the rally if they persist because that is what rising interest rates tend to do. But the world is still caught in a deflationary dynamic, and we do not view higher Treasury rates as the beginning of the long-expected sell-off in these certificates of confiscation.
Europe
Markets seem to be trading as though ECB purchases of Spanish and Italian debt are a done deal. Whether or not such purchases come to pass, they are merely another stopgap measure that would accomplish little. In the near term, it may lure markets into further denial, but in the long-run other such action will only further corrupt the ECB’s balance sheet. ECB President Mario Draghi has conditioned such repurchases on substantive reforms by Spain and Italy, and those countries have adopted serious fiscal and labor reforms. The problem, however – particularly in the case of Spain, which is in the midst of a true economic depression – is that the damage being incurred today is rendering the country worse off in terms of its future ability to repay its debt. Only a restructuring of Spanish debt in which creditors take haircuts will afford the country a genuine opportunity to revive and restructure its economy. Right now European authorities are merely engaging in triage when they need to undertake reconstructive surgery.
Talk of another LTRO is even more delusional since that program merely strengthened the link between sovereigns and their banks and added more debt to mountains of debt that can never be repaid. One rumor that has been circulating, and is likely to come to pass, is that the ECB will extend the maturity on existing LTRO loans from three to five years. Whether a term extension is done now or later, it is inevitable since few if any of the Spanish and Italian banks who borrowed from the LTRO will be in a position to repay these 1% loans after three years of recession/depression.
Some observers have written in the Financial Times and elsewhere that Mario Draghi’s huffing and puffing has laid the groundwork for Europe’s troubled countries to regain credibility.3 We have heard such promises too many times before to believe them. It is entirely possible that short-term events may shape up in a manner that will provide traders with an opportunity to profit, but the current policy path (even were Mr. Draghi to accomplish all of his goals, which is highly unlikely) will never fix what ails Europe. There is too much debt and too much intellectual and ideological detritus to overcome. Hedge funds abandoning their short euro trades are succumbing to the structural realities of their business (month-to-month performance reporting, potential investor withdrawals) at the cost of the high probability if not certainty of substantial long-term gains. Those who stay the course will be happy that they did. It took not only the 13 years since the European Union came into existence but the decades of intellectual debate and political maneuvering that preceded it to create the economic monstrosity that is inflicting untold damage on Europe today. It is unduly optimistic to believe that the Band-Aids being applied to this gaping wound will stanch the bleeding.
Technology stocks
Equity valuation is another form of money of the mind. While Wall Street invests an enormous amount of intellectual and marketing energy trying to justifying valuations, in the end the value of a stock is nothing more or less than what the market believes it to be. The market is as much a psychological as a computational mechanism, and therefore shares a strong element of the irrational, as all psychological (i.e. human) systems do. Nowhere is this better illustrated by comparing today’s valuations of large technology stock with their valuations at the height of the Internet Bubble. Buyers of Treasury bonds should take special note of this discussion.
Fred Hickey, editor of
The High Tech Strategist, called attention to this phenomenon in the most recent issue of his invaluable newsletter. Mr. Hickey points out that while Apple Inc. (AAPL) has gained more than $500 billion of value over the last decade, Cisco Systems Inc. (CSCO) has lost $490 billion over the same period and is currently trading slightly above its 2002 low. Hewlett-Packard Co. (HPQ) stock is 86% lower today than its 2000 high; Dell Inc. (DELL) is 34% lower than its high, and its current market cap of $20 billion is 87% lower than its 2000 peak of $154 billion. Nokia (NOK) has lost 97% of its 2000 peak value of $289 billion; Alcatel-Lucent (ALU) has shed 99.3% of the combined $358 billion valuation of Alcatel and Lucent in 2000; Ericsson’s (ERIC) $30 billion valuation is 85% below its 2000 high; and JDS Uniphase’s $2.2 billion valuation is 98% lower than its 2000 valuation of $115 billion. Looking at a stock much in the news today, Yahoo! Inc. has lost 85% of its 2000 value, when it was a $100 billion stock (which we called ridiculous at the time). Finally, at their 2000 highs, the combined value of Intel Corp. (INTC) and Microsoft Corp. (MSFT) stocks was $1.1 trillion; today it is $375 billion and Microsoft is considered a value stock by many investors. These comparisons not only illustrate the extent of overvaluation that occurred during the Internet Bubble and the magnitude of investor losses, but the fact that it can take years for valuations to recover. In many cases, they will never come close to retracing their highs.
1. Douglas V. Brown, The Economics of the Recovery Program (New York: McGraw-Hill, 1934), reprinted in Joseph Schumpeter, Essays: On Entrepreneurs, Innovations, Business Cycles, and the Evolution of Capitalism (New York: Transaction Publishers, 1989).
2. Surprisingly strong retail sales in July further – although only marginally since it is only one month of data – reduce the odds of QE3 in the United States. As we have written before, QE3 would be a mistake. We do not expect Chairman Bernanke and his colleagues to act prior to the election in any event.
3. See, for example, Jerome Booth, “Europe must seize the day now that Draghi has acted,” Financial Times, August 8, 2012, p. 18.
In contrast, Google Inc. (GOOG) and AAPL trade at multiples in the low-to-mid teens today. Many argue that these valuations are “cheap” based on these companies’ high growth rates and comparisons to earlier tech stock valuations. These are arguably two of the most transformational companies that have ever been created, yet the market is “only” valuing them at a market multiple. In contrast, Facebook Inc. (FB), which admittedly is much younger and new to the stock market, is being valued at a much higher valuation that is more consistent with Internet Bubble metrics (which we know now – and some of us knew then – were fanciful). FB certainly can claim to be transformative in its own way, but only time will tell if its impact will endure or end up being a stage on the way to something else. It would be unfair to consider FB a fad because it appears to have permanently changed many aspects of communication, particularly among young people but also among businesses. But it has yet to prove, however, that it can monetize its massive membership into a large and sustainable enough revenue stream to justify its current $50 billion valuation. If FB were valued by the market in the same way that GOOG and AAPL are being valued, it would be trading in the single digits. FB will need to drop much lower before it would make sense to even consider buying it. GOOG and AAPL, on the other hand, are far more attractive from a business and stock standpoint.
It seems that investors have not forgotten all of the lessons of the Internet Bubble, however, despite the FB IPO. Since the Groupon Inc. (GRPN) IPO on November 3, 2011, investors in GRPN, Zynga Inc. (ZNGA) and FB have lost a collective $58 billion in market value. GRPN and ZNGA are both down 70% from their IPO prices and FB is down 44% and likely to lose as much value as the other two before long (I don’t know why I keep using $15/share as a target price on the stock – maybe I just feel sorry for Sheryl Sandberg – when I know the stock will see single digits before year end). Of the high profile social media stocks that have come public over the past 12-18 months, only LinkedIn Corp is partying like it is 1999 again.
The Apple retail fallacy
J.C. Penney Co. (JCP) just announced its second consecutive quarter of awful operating results as former Apple retail guru Ron Johnson struggles to implement a new retailing strategy based on the Apple retail model. Since his hiring in 2011, Mr. Johnson has started to transform JCP’s stores with mobile check out, iPad access, simple pricing, chill-out zones and mini-boutiques. There is only one thing missing – iPads, iPods, MacBooks and other incredibly cool Apple products. There is a good reason why Apple’s stores are so successful – and it isn’t the layout of the stores (some might argue that they are overcrowded and somewhat chaotic in their layout). The stores haven’t been successful because they are a museum that people want to visit to check out the latest Apple invention – they are successful because they move a lot of product. If JCP were selling iPhones, iPads, MacBooks and the rest of Apple’s line-up of products, the internal layout of its stores or its pricing strategy would not matter. For that reason, the belief that Mr. Johnson can duplicate the retailing success he enjoyed at Apple is a fallacy. Investor Bill Ackman may wax poetically about the retailing strategy at JCP, but he is an extremely savvy investor and a master marketer of his investment ideas. Unless we are very much mistaken, Mr. Ackman he is looking to the real estate and not the clothes and other shmatas that J.C. Penney sells for his future profits (much like Eddie Lampert is doing at Sears Holding).4
High-yield bonds
It is easy for lay people to confuse the concepts of spread and yield in evaluating bond investments. Spread represents the risk premium that the market places on a debt security and is expressed in the number of basis points (1/100 of 1%) above whatever is considered the “riskless” rate of interest. Government bonds have traditionally been used to measure the “riskless” rate although some would take issue with that concept today. Yield is the total amount of interest (or, looked at another way, the total number of basis points) that a bond pays; it is the sum of the spread plus the riskless rate. These may seem like elementary concepts, but they paint a complex picture in today’s zero interest rate world.
High Yield Now and Then
Figure 1 above shows a comparison between today’s spreads and yields those in May 2007 for each ratings category. While spreads are much wider today, yields are much stingier. In other words, investors are receiving significantly lower compensation for owning high yield bonds today than they did on the cusp of the financial crisis in May 2007 (with the exception of CCC-rated bonds). Last week, the spread on the Barclays High Yield Bond Index tightened to +577 bp over 5-year Treasuries. That brought the yield down to 6.81%, which is a record low. To place this in context, when spreads reached their historical low on May 31, 2007, they were at +238 bp but the yield was a much higher 7.48% because 5-year Treasuries were at 4.85% instead of today’s 0.70%.
4. Mr. Ackman has enjoyed success in previous investments in companies that held real estate such as General Growth Properties. His losses on Target Corp. (TGT) were in part the result of his failure to convince the company to monetize its real estate, a plan that I wrote at the time would have burdened the company with too much debt the way Mr. Ackman was proposing it. The real estate is the reason JCP’s bonds make an interesting investment.
The biggest difference between now and then is that credit quality is far superior today to what it was in May 2007. Corporate balance sheets and debt amortization schedules are far healthier than they were in 2007, which significantly lowers the chances of rising defaults. In 2007, it was obvious that credit quality was deteriorating and that defaults would soon spike. The market did not disappoint, and defaults reached a record high of 13% in 2009 (the previous high had been 10% in 2001). Today, the corporate default rate is under 3%, far below the modern high yield market’s historical average of 4.6% (a number, by the way, that is swelled by the double digit defaults of 2001 and 2009). For this reason, investors can still earn a respectable yield and a significant spread over Treasuries without fearing that they will lose all of their earnings or principal due to subsequent defaults.
This is not to say that 6.35% is a reasonable return or that +577 bp is a reasonable risk premium for owning high yield bonds. Absolute yields are clearly too low for bonds rated below investment grade, although the risk premium is reasonable. There is a meaningful chance, however, that both yields and spreads could go lower if the financial markets remain stable for the foreseeable future. Fixed income investors, particularly those in the high yield space, have incredibly short memories and use the wrong tools to manage risk. Spread is a fixed income tool that is being employed to manage a security that is a hybrid of debt and equity. Particularly in the case of B and CCC-rated bonds, the equity component is more significant than the fixed income component in terms of measuring repayment probabilities and risk of loss. For that reason, investors should be focusing more on yield and less on spread in evaluating the risk/reward associated with lower rated bonds. For the most part, BB-rated bonds are of significantly higher credit quality than even B-rated bonds and are more appropriately evaluated in terms of spread.
Unfortunately, traditional high yield investors continue to cling to spread as their indicia of value. This is evident if one reads as much high yield research as I do, where Wall Street analysts dwell on spread and recommend trades (there are only trades, not investments, today) based on concepts such as “spread tightening” and opportunities to arbitrage bonds and credit default swap spreads. In part, the explosion of the credit default swap market has perpetuated the reliance on spreads, which not only leaves that market terminally mispriced but solidified investors’ use of a flawed analytical tool. And that brings up another point, which is that spreads are by definition a measure of relative rather than absolute value. When the entire world is distorted by zero interest rate policy, relying on relative rather than absolute values is very dangerous. Investors learned that lesson during the Internet Bubble with regard to the valuations of Internet stocks, which were priced in relation to each other rather than to non-Internet stocks. This created a self-referential universe of overvaluation that collapsed in tatters. The same sad phenomenon hits the high yield credit markets every few years in part because high yield bonds are valued in terms of each other rather than in terms of the absolute returns they generate.
There is one final flaw in the high yield analytical apparatus. In a zero interest rate world where one needs a magnifying glass to identify Treasury yields, it is fallacious to view Treasuries as a riskless rate against which to measure the risk premium. If anything, Treasury rates illustrate just how risk-filled the economy is. Using Treasuries as the benchmark leads to an understatement or undervaluation of risk, a trap into which herd-following portfolio managers too often fall.
If one puts all of these pieces together, most investors in the high yield market utilize the wrong risk measurement tool and a highly distorted riskless interest rate to value bonds. In view of that combination, it is little wonder that this market breaks down every four years or so. It collapses under the weight of its own analytical confusion. Thankfully, understanding these flaws is precisely what creates the opportunity to earn attractive risk-adjusted profits.
In order to earn appropriate risk-adjusted returns in high yield bonds, an investor must seek out bonds that are trading at appropriate absolute valuations. This requires a greater focus on yield than spread. Such bonds exist, although there are fewer today than there were two months ago when the spread on the Barclays High Yield Index was over 700 bp. Ironically, some of the best opportunities today exist among the lowest rated bonds in the B-/CCC+ category. Many of these opportunities involve some of the large leveraged buyouts that were done in the mid-2000s in which private equity firms overpaid for companies (which I have criticized in other contexts as extremely ill-advised transactions). Today, some (not all) of these large buyouts have stabilized their balance sheets and are fully capable of servicing their debts (even though it may take years or decades to pay them all back, which is a problem for their limited partners and shareholders). Their low ratings overstate their default risk while appropriately pointing to their continued high leverage.
Figure 1 showed that the only ratings category where the spread and yield are higher today than they were in 2007 is CCC-rated bonds. The near 10% yield on these bonds compares favorably with many equity investments in today’s world. In a normalized interest rate environment, the yield on these bonds would be in the mid-to-high teens, which would be considered an appropriate equity-like return for a high yield bond in a highly leveraged company. But where equity returns are compressed like they are today, the yield on CCC-rated bonds stacks up reasonably well with equity investments that rank lower in repayment priority than bonds.
Sears
I am no longer of the view that the common stock of Sears Holding Corp. is a short. This is not based on the Barron’s article of last weekend, although that article did point to the considerable value in Sears’ holding company bonds that I have written about before. While the stock has dropped significantly from its highs for the year, it is still trading sharply higher than its January 1, 2012 price. Sears stock is too treacherous to fool with in view of Eddie Lampert’s control of the float. Any value placed on the stock at this point in time would be purely theoretical since it would be based on the liquidation value of the assets; the retailing business appears to be in terminal decline. For that reason, investors should avoid the stock on either the long or short side.
Michael E. Lewitt
Disclaimer
All opinions and investment recommendations expressed by Michael E. Lewitt in The Credit Strategist as well as on Twitter under the Twitter name @credstrategist are solely the opinions of Mr. Lewitt and do not reflect the opinions of Cumberland Advisors or its affiliates or employees, managing directors, owners or principals.
Disclosure Appendix
This publication does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. This report contains general information only, does not take account of the specific circumstances of any recipient, and should not be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient. Each recipient should consider the appropriateness of any investment decision having regard to his or her own circumstances, the full range of information available and appropriate professional advice. The editor recommends that recipients independently evaluate particular investments and strategies, and encourages them to seek a financial adviser’s advice. Under no circumstances should this publication be construed as a solicitation to buy or sell any security or to participate in any trading or investment strategy, nor should this publication or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. The information and opinions in this report constitute judgment as of the date of this report, have been compiled and arrived at from sources believed to be reliable and in good faith (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness) and are subject to change without notice. The editor may have an interest in the companies or securities mentioned herein. The editor does not accept any liability whatsoever for any loss or damage arising from any use of this report or its contents. All data and information and opinions expressed herein are subject to change without notice.
The Credit Strategist
Michael E. Lewitt, Editor
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