MacroProfit: This Time It’s Different

Irving FisherSome call Irving Fisher “the greatest economist the United States has ever produced”. His work has brought forth such mindboggling theories as: the Fisher equation, the Fisher hypothesis, the international Fisher effect and the Fisher separation theorem. He developed theories on capital and interest. His most important work, however, dealt with debt deflation. Unfortunately for all his groundbreaking work he is only remembered, popularly, for his prediction, three days before the crash of October 29th high plateau”.

“Once the Great Depression was in full force, he did warn that the ongoing drastic deflation was the cause of the disastrous cascading insolvencies thus plaguing the American economy because deflation increased the real value of debt fixed in dollar terms. Fisher was so discredited by his 1929 pronouncements, and by a failure of a firm he started, that few people took notice of his ‘debt deflation’ analysis of the depression. People instead eagerly turned toward the idea of Keynes”.

Seventy-five years later the pronouncements are once again bold. They can all be summarized in one term – TINA (There Is No Alternative) and it’s inflation, it is thought, not deflation, that we have to be concerned about because this time it is different. The number of bears is at record lows. The leverage, through margin, though off slightly recently, continues to be at record levels. The relationship between ETFs and equity mutual funds relative to money market is at a record level of 4.29 to 1. All in all it would seem that the overriding attitude is risk-off.

However, at MacroProfit, we peel back the onion skins and look beneath the covers. The old adage is watch what they do not what they say. For the past several years, in search of yield, many advisers have been recommending high yield bonds, in exchange traded funds or mutual funds, which became a staple of most people’s portfolios. Simply put, yield was the driver. This time would be different, of course, since the recovering economy would support lower rated companies in their quest to go mainstream.

Prices rose and yields plummeted. The spread between junk and treasury bonds became narrower and narrower.

Herein lies either a coincidence factor or a trend worth following. The junk-treasury spread usually trends with the DOW and is a key component in reflecting investor’s preference in the risk factor. The narrower the spread, the belief is lower risk in a rising DOW. The wider the spread, the belief is a greater risk in a falling DOW. The difficulty is in understanding the reverse position, the danger increases as the spread narrows.

In May 2007, the spread shrunk to a record low of 2.33%. Just as the DOW was reaching its all-time high, the spread reversed as junk was being sold thus widening the differential. Risk in the junk bond arena was being recognized and holders were fleeing for the exits. This was a precursor to what was to come as the DOW proceeded to drop over 60%. It was definitely risk-off.

As we examine the data the exact same scenario is occurring today. The spread between junk and treasuries reached a low in June of this year at 3.23%. Since then it has widened persistently as the DOW was making historic advances.

We can disregard this warning if, in fact, we believe it is different this time, or we can be alert that it is just another bear signal that is warning danger directly ahead.

Should we continue to buy high yield? The answer is obviously no. In fact, for the more adventuresome, Rydex offers a fund that will take advantage of rising high yield interest rates and falling prices. Entry levels are always important but it would seem that junk’s best days are behind it and there is a long way to go before junk truly becomes junk again.

What will help precipitate this decline is the highly leveraged small shale oil companies who have forayed into the high yield market in order to expand their drilling. Unfortunately for these companies falling oil prices is not a welcome sight. Shrinking revenues and rising costs make these companies lower ratings justified. Since the energy field makes up a disproportionate amount of the S&P 500’s earnings the impact on the index could be significant as many close their doors.

We have already seen ConocoPhillips and BP announce cap-ex reductions and layoffs. The junk companies don’t have the capital base like the big brothers and will scramble just to make bond interest payments.

Sherlock Holmes used to say “Come Watson, the game’s afoot” and so it is the junk bond arena becomes a tumultuous pit of fright and danger not for the faint of heart.

Till next time,

bill_sig

Written by
With his passion for economics, Bill Tatro has been entertaining audiences on the radio and in seminars for over 30 years. Bill’s dynamic and no nonsense style has made him one of his stations’ most popular show hosts.