Saturday, August 25, 2012

Bubble? What Bubble?

Jeff Cox of CNBC reports, What Bubble? Why Bond Pros Are Still Betting on Junk:
Plunging yields and surging supply has triggered a scare in high-yield bonds, but bubble hunters may be looking in the wrong place.

Average yields in the junk market recently slipped below the pivotal 7 percent mark, while global issuance hit its highest July ever last month. With economic growth slowing, some pros are speculating that the aggressive run in high yield is about to end.

But those fears come as cash remains around record levels on corporate balance sheets, defaults remain low, and the stock market continues to rally.

Still, the fears persist that the flock to junk, spurred by extremely low yields in government debt, is creating a bubble ready to pop.

"People wanted more yield than the United States Treasury was willing to give. So they went to other places to get it, and that's a risky situation," says Kevin Ferry, president of Cronus Futures Management in Chicago.

"My definition of a bubble is, when did you get out? If you sold at the high, then it was a bull market. If you're holding now and watching this stuff trade behind you..."

Indeed, Ferry and others suspect some of the froth could come off the junk market in the coming days. But that does not mean now is the time to start dumping high-yield. (Read More: Here's the Secret to Making Money in Stocks This Year )

Bespoke Investment Group examined the bubble fears — espoused in Barron's this week and elsewhere — and found that, historically speaking, high-yield is trading within a normal spread from comparable Treasury yields (explain this). A blowout in the spread would indicate a bubble, but that's not happening, with the gap about 5.89 percentage points, the market research firm said.

"When the spread is wide, as it was in 2009, investors are avoiding risk, while low spreads imply that investors are more tolerant of risk," Bespoke said in a note to clients. "The question investors have to ask themselves is that with high yield bonds essentially trading at their average spread (price) going back to 1997, does that constitute a bubble?

In fact, government debt, with its surging yields, might be closer to bubble territory than junk bonds.

"Treasurys are stupid. Who would do that?" says Brian Tinnerino, senior trader for retail high-yield trading at Stifel Nicolaus in Baltimore. "More money has been lost in the Treasury market in the last six weeks than has been lost in the high-yield market."

Exchange-traded funds tracking junk bonds, however, have underperformed this year. The SPDR Barclays Capital High Yield is up 3.7 percent year-to-date, while the iShares iBoxx $ High Yield Corporate Bond Fund has returned 2.7 percent.

Tinnerino thinks now is the time for investors to find well-priced high-yielding corporates, particularly in the mining and metals, retail and some fuel sectors. It's a viewpoint shared by other fixed income experts.

"The key for us in being successful in the high-yield market isn't in buying the market as a whole but rather looking at situations that are out of favor," he says. "There are well-run companies in these spaces that are trading cheap to their peers, they are cheap to the market. This isn't a case of hitting them where they ain't, it's just taking the other side of the market."

Strategists at Bank of America Merrill Lynch recently put out recommendations similar to Tinnerino's, advocating cyclical sectors including coal miners, steel producers and machinery and staying away from defensive sectors such as consumer staples, food retail, health care and electric utilities.

Moreover, the firm noted that the rise in Treasury yields is pointing toward stronger appetite for risk, meaning that high-rated corporate bonds, which offer protection against default but are vulnerable to rate increases, might not be as safe as they appear. Rising interest rates, as harbingers of inflation, eat into fixed income investments, particularly in higher quality instruments.

"The highest rated 'flight-to-quality' corporate bonds are not so safe after all, as they have the most interest rate risk and the least amount of credit risk," BofA credit strategist Hans Mikkelsen said in a note to clients. "Thus when interest rates rise further, which they will eventually, we think that these bonds stand to produce the worst returns as the reduction in credit risk provides relatively little offset."

Cronus's Ferry adds that the investors who are betting on a junk bubble must reason that "then the stock market is a bubble."

Even banking analyst Dick Bove at Rochdale Securities echoed the theme, saying the drop in junk yields shows that "investors feel a need to get a higher return on their cash hoards. Simply seeking safety in Treasury securities is not meeting the need of investors."

Global issuance for high-yield bonds hit $24.6 billion in July 2012, a staggering rise of 88 percent over June and the biggest July on record, according to Dealogic. Yet issuance for the year, at $210.5 billion, is 19 percent below the same period in 2011, suggesting that the risky rally in fixed income could continue, and spread elsewhere.

"It is a short step from there into common stocks," Bove said. "In the case of banks, if investors choose to look, profits are very high and valuations are very low."

I agree with Bove, US banks are cheap and a screaming buy at these levels, but if you talk to traders and investment bankers, they're all complaining about their shitty bonuses (boo hoo!) because volumes are down and IPOs are taking a summer snooze.

Moreover, strategists at Bank of America Merrill Lynch are bang on recommending cyclical sectors including coal miners, steel producers and machinery and staying away from defensive sectors such as consumer staples, food retail, health care and electric utilities.

I've already covered whether pensions are fueling the corporate bond bubble. Spoke to a senior fixed income portfolio manager at a large Canadian pension fund late yesterday and he told me he wasn't concerned.

What about the bubble in government bonds? This too is much exaggerated. A friend of mine sent me this video clip where an economist talks about the next American aftershock, promoting the second edition of his book, warning investors to prepare for inflation, higher interest rates, lower real estate prices and a run on the greenback (the guy claims he's not a gold bug but touts gold as a way to protect yourself from the coming crisis).

I'm tired of all these doomsayers spreading misinformation. The problem with quantitative easing is that most people do not understand it. Talk to any serious economist -- admittedly, there are fewer and fewer left -- and they will tell you that the Fed and other central banks are doing the right thing with their asset purchasing programs, directly intervening in markets.

And yet so many people get riled up about the Fed and central banks' actions. For me, it's simple, when politicians are all on austerity mode, monetary policy has to provide a cushion to the economy or else we'd be in a deep global depression.

Is quantitative easing perfect? Absolutely not. It exacerbates economic inequality, making the wealthy wealthier and destroys savers and pensioners.

But central banks are still fighting powerful structural deflationary forces that risk throwing the global economy into a protracted slump. In light of this, the policy remains to keep interest rates low, bolster corporate and bank balance sheets, reflate risk assets, improve confidence, spur job growth and introduce modest inflation back into the system.

And so far, it seems to be working, which is why I'm far from convinced that we need a third round of quantitative easing (QE3) in the United States. In fact, it's still far from a foregone conclusion, with traders and investors divided as to its likelihood and the effect it might have, if enacted.

Right now, I'm not worried about any bubble. I see huge opportunities in the stock market and agree with Michael Gayed, the rise in commodities favors equities over bonds:

As followers of my writings are aware, I proactively made the case starting June 4 that another melt-up was likely . I began arguing late June that the "Summer Surprise" would be an end to the end-of-the-world trade as reflation expectations strengthened, sending risk assets higher. With the media now specifically calling the market move a "melt-up," it is worth asking if the Summer Surprise is over, and if an end to the trend is in sight.

I have long argued that in order to make successful predictions when it comes to markets, one has to understand the conditions being operated in. The conditions that matter most for risk assets based on academic research and my own analysis is the direction of inflation expectations.

The key word being expectations, since actual inflation is only known with hindsight. Last year was entirely about a rise in deflation expectations due to Europe. By contrast, the most recent powerful move in stocks has coincided with a "Summer Crash" in bonds as yields rise.

There are many ways of getting a sense of crowd expectations, one of which relates to the behavior of commodities. When raw material costs rise, the market may soon begin to anticipate "cost-push inflation" which is what happens when companies try to pass down higher commodity costs used in the production of final goods to the end user. This contrasts with "demand-pull inflation" which is more buyer driven. Given globalization, primary inflationary pressures have come from the cost-push side.

Having said that, take a look below at the price ratio of the DB Commodities Tracking Index Fund ETF DBC -0.45% relative to the S&P 500 IVV +0.64% . As a reminder, a rising price ratio means the numerator/DBC is outperforming (up more/down less) the denominator/IVV. For a larger chart, visit https://twitter.com/pensionpartners/status/238106616652783616/photo/1 .









Admittedly, this is an imperfect way of tracking commodities given the roll cost of maintaining continuous futures exposure, but that aside, I think identifying out/underperformance relative to stocks can be quite telling.

First, note how poorly commodities did as the ratio peaked in the middle of August 2011 as the Summer Crash was taking place. A bottom appears to have formed mid June of this year, with oil prices themselves surging since then. Note that a potential new “breakout” in ratio strength may be underway, and just getting started.

A continuation of strength in commodities would further increase cost-push inflation expectations, and favor equities over bonds. This, in turn, means that the trend higher for risk assets may not be over just yet. Intermarket analysis in other areas of the investable landscape are also confirming this, meaning that the next rotation into materials may be at hand.

Again, I agree, the strength in commodities suggests that the global economy is nowhere near the precipice that doomsayers claim we're at. Ignore the endless talk of Grexit, US fiscal cliff, and the Chinese collapse. This is all rubbish!

I see the rally in risk assets continuing and think many investors who are sitting on the sidelines will feel the heat and start dipping their toes into stocks. What will it take? More quantitative easing in the form of QE3? Maybe but doubt we need it, especially if the next US jobs report in early September shows employment growth picking up steam. Stay tuned.

Below, Paul Hickey, co-founder of Bespoke Investment Group says the fund flows into junk bonds may be huge but debt pricing isn't historically unusual. "What you have to measure in fixed income products is their spread versus the risk free asset, which is Treasuries," notes Hickey in the clip below. "We're at a little under 600 basis points right now; the average going back to 1998 is 600. So we're about 10 basis points below the average."

And Jim Bianco, president of Bianco Research LLC, and James Paulsen, chief investment strategist at Wells Capital Management, talk about the outlook for U.S. markets and strategy. They speak with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance."


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