Category: Nugget of the Day

Many pundits often say something along the lines that the bond market is 6 months ahead of the equity market. I would like to examine why this can be the case and examine some current events that are occurring that may be signaling such a concept.

I would like to try to break this down in simple terms. Bond yields are the compensation an investor receives for lending money. There are a variety of risks that push up interest rates such as inflation risk, exchange rate risk, and liquidity risk, but for the purposes of this post we will focus on default risk. Other listed risks equal, bond yields are primarily based on default risk. One thing many people get confused with is the relationship between price and yield (interest rate). They move in opposite direction because when a bond is less intrinsically valued (demanded), then the yield must adjust higher in order to compensate the investor for the lower perceived intrinsic value. The idea here is if all risks among bonds are equal except for default risk, then bonds of entities with higher default risk will need to offer higher yields in order to attract buyers.

With some basics now out of the way, let us attempt to perform some application to today’s markets. Below you will find a chart showing corporate debt to GDP over time. Knowing that GDP is constantly growing in the long term, and seeing that corporate debt as a percentage of GDP is at all time highs, we can conclude that corporate debt is at all time highs.

Below you will find a chart showing that nearly half of investment-grade bonds are rated BBB. Bonds are either investment-grade or junk in the most general of ratings. So what does that mean? BBB signifies lower medium grade within the investment grade market. This is the lowest grade within the investment grade section. Many funds buy these bonds simply because their mandate forces them to buy any investment grade bonds. The issue is that if these bonds were to downgrade, then those particular funds would be forced to sell to comply with their investment policy. If those funds were to cease buying these bonds due to a downgrade, then yields would surely rise due to less demand for those bonds and the admittance of the rating agencies that these bonds are at more default risk than their prior BBB rating would have portrayed. Holders of BBB bonds would lose due to having to take any price in order to get out of the downgraded position, investors in company stock of those downgraded BBB bonds would lose due to increased borrowing costs eating in to future earnings, and the junk bond market would get hit with over supply.

So one question to ask is how accurate are the ratings? Jeffrey Gundlach is known as the “Bond King” on Wall Street. He spoke last night and said that “By historic standards 62% of BBB rated bonds should be considered junk status right now but are not.”

So what? There will come a time when the rating agencies have no other choice, but to downgrade some of these “BBB” bonds. This could simply be due to the fact that over the past few years interest rates have been steadily climbing, but more importantly than the climb is the percent change in the climb. Companies will eventually have debt coming due, which was previously locked in at much lower rates, and when that occurs companies that over-binged on cheap credit for the past decade will be in for a rude awakening when they have to refinance at higher rates. Below you will find that this time called “eventually” is now. Through 2022, the amount of debt coming due to many S&P 500 companies will be rising year over year. In a rising interest rate environment, this is a no bueno situation keeping the above logic in mind. One last note is to consider all the companies that are likely on the brink of downgrade based on Gundlach’s comment…do you really think that they will remain investment grade if an inevitable recession were to occur?

The below situation of PG&E being downgraded due to liability from the California fires is entertaining to mull over. My takeaway is that rating agencies will not issue downgrades until it would become obscene if they did not. The point is that when recession eventually hits profitability of debt-riddled companies, then ratings will finally come down.

Let’s imagine that a glut of BBB bonds hit the junk bond market via downgrade. Since, there is only so much demand for junk bonds, then all things equal junk bond yields will have to rise in order to absorb the larger supply. Below you will see that junk bond yields began a significant rise back in September. One way to read that is to presume that such a glut of future junk bonds hitting the market is beginning to be priced into the junk bond market. Therefore, junk bond investors are preparing themselves for such an event. Also, Lisa Abramowicz is on the mark here as she speaks to the volatility growing within the junk bond space, which means a diminishing amount of liquidity due to junk bond investors being more apt to stay on the sideline during this uncertainty.

In conclusion, I think it is possible that the junk bond market is pricing in recession based on the over 50% rise in junk bond yields since September. I will continue to watch how things develop and keep you updated as best I can.

Today was a relatively quiet day in terms of daily news in the market. With that in mind, I would like to revisit an analog that Ray Dalio has been vocal about. Below, you will find an image I screenshotted some time ago that shows history rhyming within the markets in tandem with an excerpt from Dalio’s Principles for Navigating Big Debt Crises. I am not going to get into the spark notes, but once you familiarize yourself with the analog, the piece that is missing is war…

I am often skeptical of mainstream news. An understanding that I am beginning to reach is that it is of the utmost importance to be aware of news before it reaches the mainstream outlets. This is one of the reasons I love twitter. Anyways, geopolitical tensions in the South China Sea are getting mainstream attention now, which leads me to a crossroads of how to read into it. One possibility is that the conflict has reached a point of inability to ignore, and the other is that it is in the best interest for markets to create fake fears and then reverse them in order to give markets artificial good news. Time will tell which is the case of course.

The second thing I noticed today that was a bit comical was that it only took 4 days to reverse the rhetoric that the IRS would not issue refunds during a government shutdown to refunds will be paid. My 2 cents is that with the bulls and bears battling that the government realized the importance of this money in the hands of consumers both literally and mentally (kind of like a mini wealth effect or at least the avoidance of a reverse wealth effect) for future earnings.

Why does the government care so much about the stock market? Thanks for asking. The first answer is most obvious and that Trump has taken credit for rising equities, which makes it politically necessary for the stock market to keep rising for this administration. The sometimes missed answer is that when equity markets are at extremes relative to GDP, then tax receipts are heavily dependent on capital gains. This correlation is quite visible from the image of the Wilshire 5000 overlaid on federal government tax receipts.

Hopefully tomorrow we will have more pressing news.

Markets have a funny way of hurting as many people as possible. I will get a page up shortly on why recession is imminent and why this bear market is short in the tooth, but assuming that recession is upon us, the jobs “blowout” is exactly the type of data that will ignite some short term market strength. If past is prologue, then today’s job report may be the perfect catalyst for a sucker’s rally.

Total non-farm payroll employment increased by 312,000 in December. Consensus expectation was for a rise of about 176,000 jobs.

https://www.bls.gov/news.release/empsit.nr0.htm

Largest month over month winner in job growth goes to the below average wage paying jobs within “Leisure and Hospitality.”

More citizens needing multiple jobs is not a sign of economic strength. It is a potential sign that the consumer is so strapped with rising costs of living, rising costs of debt, and the reverse wealth effect of falling stocks causing citizens to desperately seek more income.

As one can see from studying the above chart, monthly changes in non-farm payroll jobs are quite volatile. Simplistically, the thing that is standing out to me is that the last time we had a spike above this December one was right after the February crash. As we all know, we also just had a December crash. Again, if past is prologue, then a rally may be upon us.

To further support current market sentiment and this sucker’s rally, Kudlow said today that there is “No recession in sight,” so obviously we’re safe, but more importantly we had some dovish speech from Powell.

Time will tell what the market deciphers of this news. Resistance levels to watch on the S&P 500 include: 2550 (whole number), 2588 (3/19/18 bottom), 2600 (whole number), 2619 (2/5/18 bottom, 11/19 bottom, and 61.8% Fibonacci retracement of the current move since 12/3/18).

The ISM Manufacturing PMI in the US fell to 54.1 in December, the weakest since November 2016, from 59.3 in November and missing market expectations of 57.9. It was the largest monthly drop since October 2008 as growth in new orders, production and employment slowed sharply. Business Confidence in the United States is reported by Institute for Supply Management.

https://tradingeconomics.com/united-states/business-confidence

Regional Fed Surveys were already beginning to show collapse.

Also, please see great point from Julian Brigden below.