Submitted by Jeffrey Snider – Alhambra Investment Partners
The risk budget this month is unchanged. For the moderate risk investor, the allocation between risk assets and bonds remains at 40/60 versus the benchmark of 60/40. The BofA ML US High Yield Master II OAS did widen on the month but still remains below the 7.5% level I identified last month as a trigger point for a further reduction in risk assets. The sell-off in stocks at the beginning of the year, interestingly, has not been accompanied by a significant change in credit spreads. It appears that stocks are merely playing catch up to spreads that started moving wider months ago. Despite the sell-off, it is noteworthy that stocks are still above their August lows. They are approaching those levels rapidly though and even if they bounce there, I believe we will eventually breach those lows.
- HY credit spreads are currently at 7.24% versus 7.1% at the last GAA update. There has been further degradation in lower rated credits; CCC bonds have moved another 81 basis points wider but with those spreads already over 16%, further widening probably has little significance.
- Valuations are still excessive and earnings estimates are still falling although analysts still seem convinced that earnings will surge in the back half of the year. I don’t think there is a lot of conviction about that, probably more a matter of inertia. Trailing P/Es have actually been increasing lately as earnings have fallen and stock prices have not. That is obviously changing even as I write this but trailing numbers really don’t provide much in the way of useful information anyway.
- Long term momentum has continued to weaken with short and intermediate momentum also now fully negative. Daily momentum readings are getting oversold but are not even yet at the August levels so this correction could carry a bit further before a decent bounce. With long term momentum fully negative and nowhere near oversold, rallies should probably be used to reduce or eliminate any questionable positions.
- The yield curve continued to flatten although the movement wasn’t significant. The 10/2 spread is now at 1.2% versus 1.26% at the last update. TIPS yields and inflation expectations were essentially unchanged over the last month which is quite interesting considering the action in the stock market since the beginning of the year. It seems the stock market sell-off is not being driven by a change in growth expectations, real or nominal.
While spreads did continue to widen over the last month, we have not seen a blowout as one might expect given the recent stock market turmoil. The junk bond market is obviously still stressed and with oil and other commodity prices continuing to fall, I see no reason to believe that we have seen the worst yet. Most of the stress – but not all as I’ve pointed out repeatedly – has been in energy and materials related names and there is no end in sight with oil now under $32. Arch Coal, a large coal producer, filed bankruptcy today seeking to reduce its $4.5 billion debt load. Somebody is going to take a haircut. The default rate is rising and if we get a more general recession it will accelerate. As to the odds of that happening I’d say they are somewhat higher now than they were a month ago if for no other reason than the recent drop in auto sales. If manufacturing was in recession with auto sales over 18 million that surely didn’t improve with them dropping to the low 17s. Continue reading