Credit Crisis Most Likely Over. Now What?
(September 18, 2007)
Dear Subscribers and Readers,
Note: The author is publishing an ad hoc commentary as a response to the events (and incredible market reaction) of yesterday. Our regular midweek commentary will be published as plan on Thursday morning and will be written by one of our regular guest commentators, Rick Konrad.
In cutting both the Fed Funds and the discount rate by 50 basis points yesterday, the Federal Reserve has acted both preemptively and decisively in order to end the current credit crisis that is not only plaguing Wall Street, but across Europe as well. While the Bank of England and the Financial Services Authority's move to guarantee all Northern Rock's depositors (beyond the usual guarantee of 100% of deposits up to £2,000, and 90% up to £32,000) could be viewed as an implicit guarantee to all depositors in the UK and thus a guarantee on the entire UK banking system, what sealed the end of the current credit crisis was undoubtedly the 50 basis point rate cuts by the Federal Reserve. That is, the Bank of England and the UK's Financial Services Authority were only able to contain the fire, but it required the Federal Reserve to douse it out not with a fire hose, but with a decisive tankful of water and retardant from an Erickson S-64 Helitanker.
The easing in the credit markets were not only reflected in the general rally of broker/dealer shares and the U.S. stock market. As can be seen in the following two charts (courtesy of Markit.com), both high yield spreads and leveraged loan spreads also narrowed significantly yesterday:
In fact, credit swap spreads for U.S. high yield issuers are now at their lowest levels since mid-July, just a few days before the Dow Industrials and the S&P 500 made all-time highs.
Leveraged loan spreads are now also at their narrowest levels since mid July.
However, readers should continue to keep in mind that while the current credit crisis should be over that everything is far from being perfect. For example, while junk bond and leveraged loan spreads may have narrowed, they are still much wider than they were as recently as June (the former is about 50% wider while the latter is 100% wider). Moreover, instead of focusing on financial systematic risk, subscribers should now focus on third quarter earnings reports starting with Morgan Stanley (September 19th), Goldman Sachs (September 20th), and Bear Stearns (September 20th).
Going forward, the life of this bull market will increasingly depend on whether earnings per share can continue to grow. While investors will most likely tolerate a mere slowdown in earnings growth (in fact, studies have shown that the stock market has historically done very well when earnings growth was slowing down, as opposed to dramatically rising or declining), the rules will quickly change if there is a reasonable chance that earnings over the next several quarters may actually decline on a year-over-year basis. For now, we are still not there yet, but at this point it is difficult to see, at least, how the 2008 earnings of the S&P 500 financial sector can best its 2007 highs, judging by the freezing up of the CDO market, the mortgage market, and the leveraged buyout market, as well as the sub-par performance of hedge funds over the last couple of months. At this point, however, most analysts are still looking for earnings of the financial sector to grow next year, as can be witnessed in the following chart showing both historical and forward earnings estimates from Reuters (up to 4Q 2008):
Interestingly, aside from the energy sector, all sectors of the S&P 500 are expected to earn more in 2008 than they did in 2007. For now, this is the consensus view, but as more light is shed on consumer spending and employment growth over the next few weeks, the above consensus can quickly change. We will continue to tread carefully until we get clearer signs that the earnings power of the S&P 500 is here to stay.