Exactly When Will This Credit Crisis End?
Here's Your 5-Step Checklist to Know
It's Over Before Even CNBC Does
Today's comment is by Eric Roseman, our long-time Investment Director and editor of Commodity Trend Alert.
Dear A-Letter Reader,
I've already called this credit crunch, "the worst financial crisis since the Great Depression." And unfortunately, we're not through it yet.
It's true the worst of this credit storm has probably passed. But banks, companies and individual investors are still facing funding pressures. That tells me the absolute bottom of this crisis has yet to arrive.
The highest estimates I've heard say it will take US$1.7 trillion to clean-up this credit crisis. The more conservative projections allude to a US$500 billion cleaning bill (remember when half a trillion dollars seemed like a lot of money?).
Either way, it's not time to buy aggressively into stocks.
But investment-grade bonds are starting to look increasingly attractive - particularly as credit spreads start to stabilize among highly-rated corporate debt instruments and Treasury bonds. But it's still too early for bargain-hunting in equities and riskier debt markets.
The Smart Money Isn't Following the
Sucker Stock Rallies
This morning's edition of the Wall Street Journal points to lingering concerns in debt markets. According to the Journal, credit spreads for higher risk bonds, short-term inter-bank lending rates and investment-grade corporate financing remain under severe pressure.
Stocks might have mustered a big rally yesterday, but the smart money in credit markets is showing a very different picture on the state of the American economy.
How will investors know it's time to load-up on distressed common stocks again? Is there a set of indicators that allow you to measure credit stress?
As the bottom of this bear market eventually arrives, look to credit markets for signals that it's time to resume your buying. Bonds and credit spreads will provide a far more accurate gauge to global investors than stocks, which tend to harbor false recoveries or "sucker" rallies.
Yield-Curve Inversion Warning in 2006-2007
Back in 2006, the Treasury yield curve turned negative, and accurately forecast an economic recession. Back then, I was writing about it - warning about this dangerous anomaly.
Today, it's still my opinion that bonds represent the "smart money" in the financial markets. Historically, bonds have accurately predicted economic recessions more often than not.
An inverted or negative yield-curve occurs when short-term interest rates yield more than long-term rates. That's an anomaly in fixed-income markets that has historically preceded a slowdown or an economic recession about 12 months later.
At the time, most analysts refuted this price action, but it still proved incredibly accurate. By July 2007, the credit markets had begun to unwind and stocks tanked, finally hitting bear market territory for the first time since 2002.
While Treasury bond inversion accurately forecasted trouble ahead, that wasn't the case for the Dow or the S&P 500 Index.
In stark contrast, the S&P 500 Index in mid-2006 was still in bull market mode, defying the repeated warnings from the Treasury market as yield inversion grew louder. And most high-risk credit markets, namely high-yield or junk bonds, also continued to race higher even as the Treasury market began predicting trouble.
The Credit Crisis Check-List
I thought I'd give you a little insight to how I gauge the markets. These are the indicators I've been watching like a hawk for years. And today, I'm using this checklist to predict when the current credit crisis will bottom. More importantly, I've got my eye on these indicators so I know exactly when I can re-enter the stock market. You can do the same.
I'll elaborate on each of these indicators so you can better identify what to follow and eventually, call your broker and start loading-up on equities again!
- LIBOR and SWAP rates
- Credit spreads
- Mortgage-backed securities
- Junk bond defaults
- Credit hedge fund failures
LIBOR and EURO LIBOR are important short-term overnight lending rates. LIBOR or the London Interbank Offered Rate has historically traded slightly above the official Federal Funds rate. Euro LIBOR has also historically traded just above the European Central Bank's official base rate since the currency was introduced in 1999.
The SWAP Rate -
A Sign That Banks Aren't Confident to Lend
The difference between LIBOR and overnight interest rates set by central banks is called the SWAP rate. This spread number must relax or narrow before credit markets get a "green" light to unclog and start lending as usual again.
But since last summer when sub-prime began to boil, overnight lending rates have skyrocketed. Despite the Federal Reserve's best efforts to lubricate the wheels of the funding markets since last summer, inter-bank lending rates remain high. And institutions are reluctant to commit overnight funds to one another.
This lack of confidence among banks in the United States, Canada and Europe, is spreading to Asia. As banks grow wary of lending to one another and question inter-bank collateral, the cost of funds increases exponentially. And that slows economic growth.
LIBOR Rates Say Banks Are Holding onto Their Cash -
A Sign the Credit Crisis Is Still With Us
From its high last fall, U.S. dollar LIBOR SWAP rates managed to decline before Christmas. That was after the Fed and other central banks injected gobs of credit to stabilize the financial system.
But since March, LIBOR SWAPS and its European counterpart, Euro LIBOR SWAPS, have jumped. This is an important signal that the credit crisis is not over. Until LIBOR SWAP rates decline and return to normal spreads above central bank monetary targets, the crisis continues.
CREDIT SPREADS are another indicator worth watching. The spread between risk-free Treasury debt and other bonds like corporate debt and junk bonds is called a "credit spread."
When the economy is strong and deal-flow is rampant, credit spreads will narrow. That happened as we headed into 2007 last year. Junk bonds, which are below investment-grade credits, saw their yields hit historic lows versus Treasury bonds last spring. That was just ahead of the July sub-prime blow-up. At the time, high-yield bonds paid under two hundred basis points (2%) above T-bonds - unbelievably low.
Today, that spread is just below 10%. And it's likely it will rise further as default rates climb in a recessionary economy. Until credit spreads for riskier bonds begin to tighten or narrow significantly, the economy remains on the rocks.
Those Mortgage-Backed Securities
We're All So Fond Of
MORTGAGE-BACKED SECURITIES encompass a wide spectrum of instruments ranging from synthetic illiquid CDOs or collateralized debt obligations to bonds issued by government agencies like Fannie Mae (FNMA) and Freddie Mac (FHLMC).
You'll be able to tell when stability returns to the mortgage-backed area by watching the mortgage-backed derivatives and the more conservative mortgage bonds guaranteed by FNMA. When both of these numbers bottom, that's a sign this credit crunch is easing.
The good news is that PIMCO's Bill Gross, the world's savviest bond investor, has loaded-up on 30-year mortgage bonds guaranteed by Fannie Mae. These bonds yield almost 2% more than Treasury bonds. That's a bullish sign that investors are returning to the safest segment of the tattered mortgage market.
However, the mortgage-backed market still has a long way to recover. In all likelihood, the CDO market and other synthetics tied to mortgages will probably never trade at par-value again. But at some point, deep value investors will start buying some of the more liquid CDOs, and that will point to a bottom in this market.
Sometimes It Pays to Watch the Junk
JUNK BOND DEFAULTS typically hit a high in excess of 5% of outstanding instruments during a recession.
At the moment, the junk bond default rate is under 2%. That suggests many more financially leveraged and indebted companies will head into bankruptcy or credit default. I would have to see a much higher default rate among American high-yield or junk bond companies before turning bullish on the stock market.
CREDIT HEDGE FUNDS represent the largest segment of total hedge fund assets, now an estimated US$2 trillion. Combined with leverage, credit hedge funds are the dangerous pariahs of the investment world in 2008 as more of their investors scramble to redeem assets.
Many credit hedge funds have already collapsed or have been liquidated since 2007. As assets are liquidated to meet growing redemptions, hedge funds must unwind leverage and ultimately, abandon many positions in the credit markets that are illiquid. This will snowball into a major disaster for leveraged hedge funds in asset-backed, distressed and event-driven hedge fund strategies.
The end of the credit crisis will likely coincide with a major blow-up at one of the largest credit hedge funds in the world. To date, the failures have mostly represented second-tier or smaller industry players.
Hang In There, This Will Pass
The above credit market check list is by no means absolute. But if you're looking for a bottom in stocks, these numbers can help you gauge when it's time to buy again. And of course, I'll continue to watch all these indicators for signs of a bottom. And I'll let you know the moment I see it coming here in the A-Letter.
This credit crisis will eventually pass. The worst is probably behind us for most segments of the debt markets but danger still lurks for equity investors. Tread carefully and heed the signs of credit, not stocks, for a true bear market bottom.
ERIC ROSEMAN, Investment Director
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