Jamal Mecklai: Another exotic bet
We are beginning to see a range of views about the equity market, which confirms that we have passed the bottom of the crisis
A month ago in my column, I had recommended an exotic bet — “go long nickel volatility and short copper volatility — the long-term average of the spread is plus 13 per cent, whereas today’s value is minus 7 per cent.” The spread has moved in the right direction and on April 27, was at minus 2.25 per cent; the bet would have returned nearly 70 per cent in one month. Incidentally, it is still a good buy.
Another exotic bet that looks like a winner is to buy US investment grade corporate bond spreads, which are still huge at 500-plus basis points over Treasuries. Given that since October of last year, the spread between three-month LIBOR and three-month T-bills has come down nicely, and even junk bond spreads have fallen from nearly 20 per cent to below 15 per cent, this still elevated investment grade spread seems odd. Sure, spreads have come down a bit — from 597 bp on March 9 to 532 bp last week — but they still remain way, way above the long-term average of around 220 bp.
Clearly, investors are still not convinced that the knock-on effect of the recession on corporate results has played itself out. However, my sense is that investment-grade bond spreads have not moved to the same extent as other spreads because of the hangover from the trauma in the CDS market. If this is true, corporate bond spreads should come crashing down when investors finally come around to believing that the bear market is over.
There is already very strong activity in the primary market — around $70 bn of corporate bonds were issued in each of January, February and March of this year; that’s more than what was issued in the first quarter of 2008, before the crisis really gathered steam. Clearly, companies are borrowing, but it is hard to tell how much of it is to refinance existing debt and how much is for new investment.
Again, we are beginning to see a range of views about the equity market, which, to me, confirms that we have passed the bottom of the crisis, when (almost) everybody and his bhaijan were unabashedly bearish. There are many who see the current equity market move as a bear market rally, which means they believe we will see new lows on the Dow (below 6,500) in the near term. My belief — and it is comforting that I am no longer alone in this view — is that that the bear market is over and that we will not fall below the recent lows again, at least in this cycle.
Of course, this doesn’t mean we are going to drive straight into a bull market — to the contrary, I see an edgy trading range for a long time. As was explained in our January special report, “.., even though US output will start to improve, house prices will remain stagnant, as investors will need to slowly build up their savings. Hence, equities, too, while turning up, will not show any real strength.”
The movements in the VIX index, which reflects the volatility of US stocks, and is widely seen as the best measure of global risk aversion, seem to confirm this view. The good news is that the VIX is down to around 35, the level at which it traded immediately after the Lehman collapse. It has been falling steadily for the past couple of weeks, and appears ready to settle in the 30 to 40 range, a far cry from the 75 and 80 levels seen at the peak of the crisis. Of course, even a 30 to 40 range is a whole lot higher than the VIX’s long-term average (around 22). This indicates, unsurprisingly, that while investors are calmer, their risk aversion is still quite a bit higher than it has been over the past twenty years or more. (The three-month LIBOR over three-month T-bill spread, mentioned earlier, also seems to be settling at a slightly higher level than its long-term average.)
Higher risk aversion means that investors would demand a higher return for a given amount of risk — in equities, a higher VIX would mean a lower price to earnings ratio (P/E). The long-term average P/E for the S&P 500 is in the range of 16 to 20, corresponding to a VIX of 22. If the VIX settles, as seems likely, in the range of 30-40, the S&P500 P/E would need to move down — say, to a range of 14 to 16, or perhaps even lower. Given that when the S&P was at 870 (Dow 8,150), its P/E was around 17, a back-of-the-envelope calculation suggests a range of 6,800 to 8,200 on the Dow, till corporate results start to show some improvement, perhaps by Q409. As if confirming this, the Dow was already looking short of breath when it crossed 8,000 recently.
So, while equities bounce around in the current range and the crisis slowly but surely dissipates, where will the money go?
Into corporate bonds, of course. And while these spreads, like the others, will likely also not fall to their long-term average (about 220 basis points), there’s still a lot of room from the current 500-plus levels. Hurry, call your broker.