“Some very critical things are hidden.”
After the white-knuckle sell-off of global equities that was finally punctuated by a rally late last week, everyone wants to know: Was this the bottom for stocks? And now Moody’s weighs in with an unwelcome warning.
If you want to know where equities are going, look at junk bonds, it says. Specifically, look at the spread in yield between junk bonds and Treasuries. That spread has been widening sharply. And look at the Expected Default Frequency (EDF), a measure of the probability that a company will default over the next 12 months. It has been soaring.
They do that when big problems are festering: The Financial Crisis was already in full swing before the yield spread and the EDF reached today’s levels!
And so, John Lonski, chief economist at Moody’s Capital Markets Research, has a dose of reality for stock-market bottom fishers:
For now, it’s hard to imagine why the equity market will steady if the US high-yield bond spread remains wider than 800 basis points [8 percentage points]. Taken together, the highest average EDF metric of US/Canadian non-investment-grade companies of the current recovery and its steepest three-month upturn since March 2009 favor an onerous high-yield bond spread of roughly 850 basis points.
Moody’s EDF began spiking last summer and has nearly doubled since then to 8%, the highest since 2009.
The average spread between high-yield bonds and Treasuries has widened to 813 basis points (8.13 percentage points). But at the lower end of the junk-bond spectrum (rated CCC and below), the yield spread is a red-hot 18.4 percentage points.
This chart shows the average high-yield spread (blue line) and the CCC-and-below spread (black line). Note how far we were already into the Financial Crisis before both spreads reached the today’s levels: March 13, 2008, and September 30, 2008, respectively:
So how does the yield spread impact equities and the broader economy?
A wider-than 800 basis-point high-yield spread reflects elevated risk aversion that will reduce capital formation and spending by non-investment-grade businesses. In addition, ultra-wide bond yield spreads favor a continuation of equity market volatility that should sap the confidence of businesses and consumers.
Which has consequences for stock prices.
Yield Spreads and EDF sink M&A.
The premium over market price that acquiring companies pay has been rocket fuel for share price increases in entire sectors as analysts hype the potential for all these companies to receive buyout offers with huge premiums.
Last year, US M&A activity (involving at least one US company) soared to $3.34 trillion, a record 18.6% of US GDP. The prior record was 17.8% of GDP in Q1 2000, just before the dotcom bubble began to implode. The report:
A cresting by M&A may offer valuable insight regarding the state of the business cycle. The two previous yearlong peaks for US company M&A were set in Q3-2007 at $2.213 trillion and in Q1-2000 at $1.745 trillion. Recessions struck within one year of each of those peaks.
But the markets didn’t wait for those official recessions. Stocks began their multi-year crash at the end of those quarters!
The buyout frenzy is funded in part by large amounts of debt. As corporations lever up, risks rise and downgrades hail down on them. In 2015, M&A-related “net downgrades” (difference between M&A-related downgrades and upgrades) by Moody’s rose to 36. This year, Moody’s expects them to increase further.
The M&A activity last year was fueled by low borrowing costs, high stock market valuations, and “diminished prospects for organic revenue growth,” as Moody’s put it euphemistically: S&P 500 companies waded through four quarters in a row of revenue declines!
The importance of the latter helps to explain why record highs for M&A tend to occur close to the end of a business cycle upturn. The urge to merge will be greater the more convinced corporations are of the imperative to meet long-term earnings targets via mergers, acquisitions, or divestitures.
M&A is the easy way to growth. But it comes at a high price, increased financial instability, subsequent downsizing and cost-cutting, and slow-moving waves of layoffs that then sap consumer demand and the economy.
Yield spreads and EDF sink share buybacks.
“In order to supply a more immediate lift to shareholder returns,” Lonski writes, companies lower total shares outstanding by buying back their own shares. This lowers the dilution that occurs when they issue new shares for M&A and executive compensation. These financial engineering tactics have been another type of rocket fuel underneath the market.
“A more uncertain earnings outlook,” as the report euphemistically calls the ongoing three-quarter earnings recession for S&P 500 companies, “will increase the incentive” to engage in share buybacks “as opposed to investing such funds in a company’s production capabilities.”
This leads to even more problems:
Sometimes, efforts to enhance shareholder returns trigger credit rating downgrades. Typically, strategies which benefit shareholders at the expense of creditors employ cash- or debt-funded equity buybacks and dividends.
So Moody’s downgrades stemming from “shareholder compensation” rose to 48 in 2015 but were still shy of the record 78 in 2007, at the cusp of the Financial Crisis.
At some point, market volatility, which means downward volatility because no one lambastes upward volatility, will put a damper on M&A and share buybacks, thus knocking over two of the remaining props under the market.
And more ominous still:
The two latest recessions were partly the consequence of markets not knowing the full extent of deteriorations in household and business credit quality. Not everything can be quantified, if only because some very critical things are hidden.
Ah yes, we won’t even really know how bad it is with our over-leveraged corporate heroes until the house of cards comes down to reveal what’s left inside.
But nothing goes to heck in a straight line. Read… After $7.8 Trillion Got Wiped Out in three Weeks, “Global Stocks Surge Most since 2012”
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Wonder if Buffett their handler sanctioned Moody’s sour view or something.
Anyway “The M&A activity last year was fueled by low borrowing costs, high stock market valuations, and “diminished prospects for organic revenue growth,” as Moody’s put it euphemistically” Yep one would think the companies would buy more of it stock at cheaper price now that many goosed up the earnings via fewer shares via borrowing to hilt.
Re “deteriorating business credit quality. Not everything can be quantified.”
Isn’t that the purpose of a rating agency to quantify those pesky sorts of issues like “business credit quality”? Although I do recall that they try to take more of a historical than forecasted view of credit quality. In fairly stable times this works rather well. But when facing protracted or severe economic and credit erosion, they show up after the “battle”and “shoot the wounded” so to speak.
Actually, you chopped off the most important part of the quoted sentence:
“Not everything can be quantified, if only because some very critical things are hidden.”
The key is “hidden.” He is talking about fanciful accounting that hides the “critical things” – and ratings agencies are NOT auditors. Ratings agencies rely on the accounting numbers that auditors certify are accurate. And he warns, more of these “hidden” things will ooze to the surface – perhaps during the next crisis.
Hi, Wolf, not surprisingly you make an excellent point. But if things are “hidden”, and ratings are only based on audited financials — which may be proven inadequate only after all the “hidden” stuff is revealed — then does this beg the question, how useful are ratings to begin with?
Pardon my skepticism here but in the last financial crisis, wasn’t it in Moody’s ( and others) financial interest not to look too hard for any “hidden” stuff related to deteriorating credit trends in mortgage-backed securities?
Sorry, but color me “unimpressed” with what shall hereafter be known as the “Lonski Ratings Conumdrum”.
You write: “then does this beg the question, how useful are ratings to begin with?” We have seen the answer time after time, especially during the Financial Crisis, as your “skepticism” points out: they’re not very useful in telling you that the bonds you hold will not collapse some day.
They’re always late to the game, they’re paid by issuers, and there are a million other problems with these agencies.
But here it is: when these optimists do downgrade (belatedly) and when they start fretting about things, it’s high time to pay attention.
Ignore their warnings at your own risk!
It is funny how people are easily manipulated with one/two day stock rally.
Do we/they learn anything, I mean ANYTHING.
Really hasn’t been much of a rally as it hasn’t even hit the 38.2% fib line on the SPY yet.. Most retracement rallies go to the 50% and many the 61.8% fib lines.. So this is either a very weak rally or it has more to go..
If I’d been betting, I would have bet this wouldn’t have stopped yet.
Agree with your comment but after that huge sell off in previous weeks this was short term relief.
They call it dead cat bounce.
Reality will settle down very soon.
The equity/bond contest has already ended and the bond holders won. If the companies collapse, the equity holders will be wiped out, and bond holders will get what’s left. That was settled at the beginning of the financial crisis.
I frequently see remarks about how unreliable the accounting is overseas, especially in China. Really? Does anybody think that mark to model, in America, is a legitimate form of valuing a company’s assets? I know it is not because I can create a model to value a company at any valuation they want. Does anybody remember Lehman and how they moved special purpose entities on and off the books to fix their earnings and valuations. What about Enron doing the same thing years before Lehman collapsed.
Listed companies in America don’t reflect the actual value created by their lines of business. Their value is derived by accounting tricks and demand for the shares on the open market. We need to fix that first and it will be very painful because the managements of listed firms don’t want to know the truth. Buyer beware.
The priority/primacy order is derivatives first, then bonds, and then equity. And so bond holders have an extra risk to look out for. The hidden risks in the derivatives book. Derivatives that are in the shadow finance sector could be big problems.
Seems to me the error in the thinking here is that “virtual reality” equals “reality”. One sees this error across the board, not just the financial world. The whole global warming hoax is based on it, health “insurance”, education, even philosophy. The youngsters have built their whole world on it; it is the “bedrock” of their construct. One yahoo with an off switch can reduce it to rubble. To quote the oft-maligned Ayn Rand, “if you arrive at a contradiction check your premises. You will find that one of them is wrong.”
How often does one hide good news?
Good comment . . . It reminds me of the point made by someone who opposed the Iraq war — ‘arguments for good policies don’t require lies’.
question is, What is *good news*? and can any declaration of *good news* be trusted in this environment?
I am a skeptic.
relates to the above about accounting practices too. When the tsunami of defaults finally hits (due to very reduced revenues), I am expecting to see most of our existing corporations that have been swimming naked, left on the shore as the tide goes out. And the ensuing wave to change the world as we know it.
Could be they’re just very modest and don’t want to boast about how well they’re doing?
And today on the DJI newswire – RE: Bonds
DJ How Bad Is Retail? Look at the Bonds
01/25/16 15:07:00
By Matt Jarzemsky
Bonds of major retailers that went through leveraged buyouts have fallen to distressed levels, a signal that their private-equity owners are running out of options.
Investors have sent the price of bonds in J. Crew Group Inc. and Nine West Holdings Inc. down to 27 cents and 23 cents on the dollar as of Friday, respectively, around 70% below where they started 2015. Bonds issued by Claire’s Stores Inc. have lost nearly 39% to about 60 cents, Gymboree Corp. bonds have plunged by 32% to 26 cents. Some Toys “R” Us Inc. bonds fell to 69 cents in mid-December before rising again to about 82 cents.
The declines reflect growing nervousness among bondholders about the retailers’ prospects as their private-equity owners remain bogged down in the companies with little prospect of selling them off anytime soon.”
(He then glosses over default failure with the following – B.S.)
“The companies aren’t on the verge of default, as some of the bond prices would typically indicate. Instead, the retailers are caught between a long-running shift in favor of online competitors and troubled public markets that aren’t likely to welcome initial public offerings by retailers.
”
The commentary continues: “Market watchers expect tougher borrowing conditions to lead to more bankruptcies in the retail industry–which typically lead to steep losses for shareholders. For private-equity firms with heavy exposure to troubled retailers, bankruptcy filings could threaten the billions of dollars they have invested in the industry. ”
“Borrowing costs for deeply indebted companies rose last year after concerns about the beleaguered energy industry spilled over into other sectors. That’s a pattern that is likely to continue this year if the Federal Reserve further bumps up interest rates after raising them for the first time in nine years last month.”
Are analysts reading Wolfstreet now????
“So, Mom and Pop got into bonds thinking, “I don’t trust stocks after the last crash, so I’ll load up on bonds cuz they’re safer”, right? Only now they see they’ve been led into a minefield where they might not get out in one piece.”
http://www.counterpunch.org/2016/01/25/stock-buybacks-and-the-wall-street-sharktank-a-whole-lotta-stealin-goin-on/
moody’s on the spot. as usual.
tell me, what is oil and gas and mining equipment worth in liquidation when no one has any money to buy it, let alone mothball it?
uh oh, asset side of the balance sheet looked attractive, but…….
whatever, next.