Despite short-term interest rates being only a whisper above zero, we increasingly hear assertions that “financial conditions have tightened.”
Now, understand that the reason they’ve “tightened” is that low-grade borrowers were able to issue a mountain of sketchy debt to yield-seeking speculators in recent years, encouraged by the Federal Reserve’s deranged program of quantitative easing, and that debt is beginning to be recognized as such. As default risk emerges and investors become more risk-averse, low-grade credit has weakened markedly. The correct conclusion to draw is that the consequences of misguided policies are predictably coming home to roost. But in the labyrinth of theoretically appealing but factually baseless notions that fill the minds of contemporary central bankers, the immediate temptation is to consider a return to the same misguided policies that got us here in the first place, just more aggressively.
Credit default swaps continued to soar last week, particularly among European banks. Given that risks surrounding China and the energy sector are widely discussed, European banks continue to have my vote for “most likely crisis from left field.”
With regard to the stock market, I suspect that the first event in the completion of the current market cycle may be a vertical loss that would put the Standard & Poor's 500 in the mid-1500s in short order. That area is a widely recognized “role reversal” support level matching the 2000 and 2007 market peaks and would at least bring our estimates of prospective 10-year S&P 500 nominal total returns to about 5%, which seems a reasonable place for value-conscious investors to halt the initial leg down. I’ve often noted the historical signature of market crashes: a sustained period of overvalued, overbought, overbullish conditions that is then coupled with a clear deterioration in market internals and hostile yield trends, particularly in the form of widening credit spreads. See my comments from the 2000 and 2007 market peaks about the identical syndrome at those points. Historically, what we know as “crashes” have followed only after a compressed, initial market loss on the order of about 14%, a recovery that retraces one-third to two-thirds of the initial decline; and finally a break below that initial low. That threshold is currently best delineated by the 1800-1820 level on the S&P 500.
Emphatically, I would reel back the urgency of all of these concerns if market internals were to improve materially. When investors are risk seeking, they tend to be indiscriminate about it. So favorable market internals, as discussed below, are indicative of risk-seeking preferences among investors. Understand now that given any set of conditions (e.g. valuations, leading economic data, Fed action), the markets and the economy respond differently to those conditions depending on whether people are inclined toward risk seeking or instead risk aversion. In a risk-seeking environment, investors incorrectly “learn” that historically reliable valuation measures are worthless, that every dip is a buying opportunity, that economic deterioration can be ignored and that Fed easing always makes stocks go up. In an environment of risk aversion, all of that incorrect “learning” is punished with a vengeance.
In the fixed income market, we wouldn’t touch low-grade credit at present. Once credit spreads widen sharply, the default cycle tends to kick in several quarters later. The present situation is much like what we observed in early 2008, when we argued that it was impossible for financial companies to simply “come clean” about bad debts, because then as now, the bulk of the defaults were still to come (see How Canst Thou Know Thy Counterparty When Thou Knowest Not Thine Self?).
