Reading the Tea Leaves (Financial Markets Edition)

At junctures like this, when markets have come a bit unglued and may be undergoing a sea change, making forecasts is as scientific a process as reading tea leaves. And since I am (literally) at sea with pricey satellite access, I’m limiting myself to checking the usual suspect media sources rather than being as comprehensive in surveying the landscape as I’d like to be.

Nevertheless, at this greater-than-usual remove, we’ll hazard a few observations:

1. It is striking how much the press (which presumable reflects their sources) is trying to sound a reassuring tone. For example, the Wall Street Journal, in “Investors Surf Choppier Markets,” asserted that things aren’t as bad as they seem:

Rising volatility, along with heavy trading volume, isn’t necessarily troubling. There have been similar recent periods when volatility, or sharp moves in the prices of securities, soared to these levels, and each time markets rebounded sharply. And a surge in volume doesn’t indicate which way stocks are headed next.

It feels worse this time around to some, though, because it has been so long since they had to deal with these kinds of jumpy markets.

Even the usually cold-blooded Financial Times offered some solace in its Lex column, “The end of LBOs.” It argued that, despite the seeming unending stream of ever bigger transactions, private equity was not playing a large role in equity price formation, hence its exit would not be a death knell for the stock market:

Private Equity Intelligence provides an estimate for “dry powder” – committed equity as yet unspent – for buy-out funds. To this can be added the likely capital raised by private equity outfits on the road now to produce a total of $548bn. It is reasonable to assume that this money is spent on takeovers that are three-quarters debt-financed and occur at a one-third premium to the stock market price.

On this basis the total LBO takeover premium due to be paid to stock market investors is $506bn. This is only 2 per cent of North American and European market capitalisation. Of course, this might be concentrated in specific areas – smaller capitalisation stocks for example – and in certain countries such as the UK. But if investors are accurately discounting the immediate pipeline of activity, anticipated LBO takeover premiums are not heavily distorting equity prices in aggregate.

Might stock markets instead be discounting a much longer golden era of near indiscriminate buy-outs? This is what fans of private equity predict: the underwriters’ research on Fortress Group, for example, is comically bullish, in one case forecasting assets under management of $23bn top $260bn by 2016.

Yet it is doubtful that public equity investors accept this kind of “new paradigm” argument. If they believed the conditions were ripe for a sustained, massive rise in leverage, big quoted companies would not have prudent balance sheets and be valued on earnings multiples that imply profits may be near a cyclical peak. Public equities most likely reflect the view that the LBO boom is a cyclical phenomenon of finite duration and questionable wisdom.

Michael Panzner characterized this sort of commentary as a sign of complacency; it reads to me instead as participants trying to talk down collective, and perhaps their own, fear.

Bloomberg is calling a rally in “Cheapest Stocks in 16 Years Draw Investors Amid Rout,” pointing to demand for health care, tech, and telco stocks.

2. The market’s slide continued despite the release of a strong GDP data. Not only did GDP rise at an annualized rate of 3.4%, but the GDP deflator, the Fed’s preferred measure of inflation, rose at an annualized rate of only 1.4%, versus 2.4% last quarter. This is just about as good as it gets once you are past the initial phase of a business cycle, yet the markets shrugged it off. A decline in the face of good data indicates entrenched bearish sentiment. However, it’s possible that investors will take this information to heart by Monday.

3. The underlying cause of this mini-panic, the suddenness and severity of this credit contraction, does not yet appear to be relenting and credit market participants are worried it could extend its reach. As the Financial Times, in “‘Wake-up call’ for investors,” tells us:

A flight to safety saw US government bonds rally, the yen strengthen and emerging market debt and equities stumble. An index of the main indicators of risk across asset classes compiled by UBS showed that risk-aversion had hit its highest level since the terrorist attacks in September 2001.

From Bloomberg’s “Treasuries Rise Most Since September Amid Credit Market Rout”:

“If we get a couple days without any big blowups, a good amount of the risk that’s been priced in will start to reverse,” said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., one of 21 primary dealers required to bid on Treasury auctions. “The market will focus more on fundamentals, which will bring a rise in yields.”…..

Credit-default swaps based on $10 million of debt in the CDX North America Investment Grade Index soared as much as $13,500 yesterday to $81,000, according to Deutsche Bank prices, the highest since the CDX indexes were created in 2004. The iTraxx Europe Series 7 Index of 125 companies with investment- grade credit ratings jumped 16,000 euros ($21,800) to as much as 60,000 euros, the biggest increase since the index was created three years ago….

The difference in yields between two- and 10-year notes rose to 25 basis points from 19 points a week ago, the highest since September 2005, suggesting investors are seeking the safety of shorter maturities.

The much anticipated and dreaded unwinding of the carry trade is playing into the credit contraction. If it reverts to its old pattern, the debt markets would benefit from the increased liquidity, but if the yen continues to rally, a rocky situation could worsen. From the Financial Times:

The strengthening of the Japanese currency indicates an unwinding of the carry trade, in which investors borrow in cheaper currencies to buy higher-yielding assets elsewhere, which has been a significant source of liquidity in global markets.

Bottom line: equity markets are being driven by bonds. If conditions in credit markets remain uncertain, expect more volatility and erosion in stock prices. If the credit markets regain their footing, and risky borrowers can again obtain funding (presumably at richer prices), the stock markets will shrug off this week as it did the traumatic two weeks that started February 27.