Is the Correction Here?
(July 11, 2007)
Dear Subscribers and Readers,
In my last “full-blown” commentary on July 1st, I mentioned that there are now signs of stress creeping up in the CMBS sector, in addition to the troubles that we have been witnessing in both the CDO and the CLO market. Moreover, within the subprime mortgage market, we are also now witnessing significant losses in the 2005 vintage as well, as opposed to only the riskier 2006 vintage. Earlier on Tuesday morning, I managed to take some time out to get on a Goldman Sachs conference call discussing the latest developments in the subprime market. I have a posted a quick summary of that call on our discussion forum – I assure you, it is a must-read.
For those that don't have the time or patience to read that post in its entirety, I would sum it up in one sentence: The mess in the subprime space isn't over yet and there is at least one more year to go before the price of these securities (such as CDOs or housing prices) bottom out. For folks who have been looking for a quick decline and bottom in housing prices, I think you will be sorely disappointed – as the dynamics in the housing market aren't exactly the same as those in the stock or overall financial markets. For example, folks that have trouble meeting their mortgage payments don't usually like to sell out of their homes at a loss – even if they are going to inevitably default. That is, unlike the stock market (where brokers could sell your holdings without even informing you if you had an outstanding margin call), the distressed and subsequent foreclosure process is a much more emotional undertaking and could take over six months. Considering that the late 1990s technology bull market took over two years to unwind, it is reasonable to assume that the latest bull market in housing prices and/or the subprime market will at least take another year or so to unwind. This is especially evident when one takes a look at the delinquency rate of both the 2005 and 2006 “vintages” vs. both the 2003 and 2004 vintages (following chart is courtesy of Credit Suisse and Goldman Sachs):
Given historical trends – there is a very good chance that both the 2005 and 2006 delinquency rates will continue to rise, and given that the bulk of the subprime mortgages were originated during 2005 and 2006, the potential for a “liquidity event” will continue to rise at least for the foreseeable future.
And while Goldman doesn't believe there will be a significant spillover effect, there will no doubt be a general depressing effect in liquidity – at least in terms of U.S. assets anyway (the decline of the U.S. dollar index in response to the S&P downgrade of $12 billion worth of mortgage-backed bonds was a prime example). Moreover, even though many economists believe that U.S. GDP growth will be below potential during the 2nd half of this year, they are also forecasting for a substantial rebound during 2008. This consensus view on the U.S. economy may be a bit tad optimistic – given that the amount subprime ARM resets is still increasing and shouldn't peak until early 2008, as shown in the following chart courtesy of Lehman Brothers:
In other words, many of the mainstream economists may not have discounted the lingering concerns in either the housing or the subprime markets. Moreover, to my knowledge, neither the ECRI Weekly Leading Index nor the UCLA Anderson Forecast teams have taken the above upcoming resets or the credit concerns in both the 2005 and 2006 vintages into account, despite the fact that many of these factors can be easily predicted based on historical trends and factual data.
The liquidity picture continues to get bleaker as we shift our focus to the junk bond or high yield markets. As the following posts suggest – even though many corporations are still flushed with cash – the junk bond market is now having problems of its own as well, as earnings growth starts to decline and as approximately $87 billion in new supply of junk bonds are slated to hit the market sometime over the next six months. While many market pundits believe that corporate issues in general are very healthy because of the still-sizable cash hoard of the S&P 500 corporations, there are also those who think otherwise. One of those is Marty Fridson, known as the ultimately authority on high yields. In our June 7, 2007 commentary (“Mid-Week Liquidity Update: A Discussion of High Yields”), I stated at the time:
A couple of days, I had the privilege of attending a luncheon hosted by Marty Fridson, long considered as the authority on high yield bonds. After his discussion on high yield bonds, there was no doubt on what his current views are: That high yields are overvalued right now and that we be nearing the end of the benign cycle, although like everything else in the markets, timing is always uncertain. Moreover, the corporate bond market today – as broken down by rating classes – is very similar to the mix at the beginning of 2000. Based on this mix – if we are to have a “soft landing” scenario at some point over the next couple of years, then there is a good chance that we will experience similar default and default loss rates similar to the 2001 to 2002 period in the corporate bond market. Mr. Fridson emphasized, however, that the recession of six years ago was one of the mildest on record. Should we experience a “hard landing” similar to the 1990 to 1991 recession – then most likely, we will experience corporate default and default loss rates not seen since 1933.
In that commentary, we also showed you a couple of charts – one showing the historical monthly spread of the yield of the Lehman Baa Index vs. the Lehman Treasuries Index and the other showing the monthly spread of the yield of the Lehman CCC High Yield Index vs. the Lehman Treasuries Index. The purpose of that exercise was to show how overvalued corporate bonds (tight corporate spreads) were at the time. Now, for a recap on Baa bonds: While bonds that are categorized as “Baa” are still regarded as investment grade bonds, they are effectively at the lowest end of the totem poll when it comes seniority or claims on residual assets in the event of a corporate bankruptcy. As defined by Street Authority, Baa bonds are: “Bonds of medium grade quality. Security currently appears sufficient, but may be unreliable over the long term.”
Here is a definition on CCC bonds: Bonds of poor quality. Issuers may be in default or are at risk of being in default.”
Following is the chart showing the monthly spread of the yield of the Lehman Baa Index vs. the Lehman Treasuries Index – with data updated to the end of June:
Since the spread between the yield of the Lehman Baa and the Lehman Treasuries index hit a level of 1.17% at the end of May (which is close to the current cycle lows of 1.12% made on February 2006 and January 2007), it has spiked up to 1.28% at the end of June.
Now, following is the chart showing the monthly spread of the yield of the Lehman CCC Index vs. the Lehman Treasuries Index updated to June – which is much more instructive since this spread really captures how speculative the corporate bond markets are at any point in time:
At that time of our June 7th commentary, I stated: For comparison purposes, this spread of the most speculative class in the corporate bond market vs. U.S. Treasuries is now at its most speculative ever. While the spread has never gotten this low before, we did, however, witness similar lows in August 1987, February 1994, and March 1998. And – as the above chart shows – we all know what happened afterwards (do the 1987 crash, the 1994 rout of Wall Street traders and the Orange County Bankruptcy, 1998 Brazilian, Russian, and LTCM crises ring some bells?). For those saying that “we still have too many bears” for this to mark a significant top, I suggest you look again. While this author does not believe the cyclical bull market has ended yet, I do, however, believe that will have a very tough summer and Fall (no pun intended) over the next three to six months.
As of the end of June, this spread spiked up to 4.69% - and given the latest trend over the last ten days, along with the $87 billion flood of new junk bond issues over the next six months – it looks like this spread will continue to have an upward bias at least for the rest of this year. Given that high yields and U.S. equities have a 0.6 correlation over the last 16 years, my guess is that the stock market will continue to have a tough time this summer and possibly into the Fall as well.
Finally, while the amount of short interest still remains an “Achilles' Heel” for the bears and those that are holding cash, the latest breadth indicators continue to show a deteriorating stock market – as exemplified by the weakening NYSE A/D line and the number of new highs vs. new lows. This suggests to me that the probability of a further correction in the stock market is real and that the market should continue to exhibit weakness at least for the next few months. Following is a six-month chart showing the A/D line of the common stocks traded on the NYSE vs. the NYSE Composite, courtesy of Decisionpoint.com. Note that the A/D line topped out in early June and has been making lower tops since that time:
Now, following is the 10-day moving average of the NYSE 52-week High-Low Differential vs. the NYSE Composite, again, courtesy of Decisionpoint.com. Note that this indicator had actually topped out in early December 2006 and has been making a series of lower tops since that time. More importantly, the 10-day moving average of the NYSE 52-week High-Low Differential remained very weak even as the NYSE Composite made a new high in early June:
Henry To, CFA