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The Financial Times – John Authers: So is there anything out of the question?
Why has the S&P 500 fallen only 13 per cent from its all-time high, when other markets are behaving as though the world were in a deep crisis?
Stocks’ resilience is often cited by bulls. There was a (questionable) perception as the crisis started that stocks were cheap. If brokers’ estimates for this year’s earnings are accurate, then they are much cheaper now, as earnings are supposed to grow at double digits starting in the next quarter. Then there is a widespread belief that the firesale of Bear Stearns last month was a moment of “catharsis”. Folk wisdom is that such moments are the ideal moment to buy. But this argument is self-contradictory: so many people believe this that it is obvious that the market has not reached catharsis. Further, international indices tend to be quoted in dollars, and are inflated by the dollar’s weakness. In local currency terms, world industrial stocks are down 17 per cent from their top, and consumer discretionary stocks are down 26 per cent, according to MSCI.
Comment The question posed above is the most vexing question of this credit crisis. Understanding it goes to the heart of understanding the role the shrinking financial system plays. We addressed it in a Commentary on Friday:
This has, in turn, led to unusual activity wherein the highest credit quality instruments are doing far worse than lesser quality. Phrases like “worst day ever” and “widest spreads in decades” are often said in conjunction with instruments with credit quality near U.S government securities such as federal agencies, mortgage-backed securities and municipal bonds.
Investment-grade bonds, one notch down on the credit spectrum, are more stressed than their worst levels in 2002. However, high-yield bonds are not as stressed as comparable levels in 2002.
Finally, at the bottom of the credit spectrum, equities have yet to meet the commonly accepted bear market definition of a 20% decline.
Why The Best Credits Do Worse
Many have mistaken this unusual action of the best credit quality doing relatively worse as a sign credit ratings themselves are mistaken. In response, they proposed the federal government either guarantee the payment of municipal bonds or require government sponsored entities to guarantee so-called jumbo mortgages. These solutions are misguided. The problem never has been the credit quality of the securities. The problem is on the liability side.
High-quality credit instruments have a very small chance of defaulting. Therefore, they are favorites of hedge funds and other leveraged investors to buy with lots of borrowed money. A recent example of this was Carlyle Capital’s 32:1 leverage in owning federal agency and mortgage-backed securities; specifically, $800 million of equity supported $30 billion of securities. The shrinking financial system has made such leverage unavailable at present. More importantly, highly leveraged investors are being forced to reduce leverage by adding additional equity, selling securities or both.