Can Corporate Bonds Predict Equity Declines?
Brian Reynolds
We've written extensively how we feel that, as long as the corporate bond market remains in good shape, then equities will eventually advance.
Over the years, we've also pointed out how a worsening corporate bond market can be a negative for stocks. After the run that equities have had over the last 10 months, and with stocks in a technically short-term overbought situation, it becomes more and more important to look for signs of trouble.
So, we decided to look at every drop in the S&P of 10% or more (on the thought that a lesser drop is merely a correction) over the last 20 years to see if the corporate market had sounded any alarms in advance. It stands to reason that if investors high up in the capital structure (bond investors) are concerned about their investment, then investors at the bottom of the capital structure (equity holders) should be as well.
We counted 14 uninterrupted closing peak-to-trough declines in the S&P of 10% or more over that time. All but three of those declines were preceded by a worsening corporate bond market. We'll look at those that were, then those that weren't, and then try to draw some conclusions from this analysis.
Declines preceded by a worsening in corporates:
1/6/84-7/23/84: Down 13%
The S&P was coming off of a near 70% advance over the previous year and a half. Economic growth had hit super strong levels, making bond investors fearful of a return to high inflation, so the yield on 10-year Treasuries went from 11.5% to 14%, and corporate spreads, which had tightened significantly as the economic recovery began, started to widen on top of the rise in Treasuries. Growth eventually moderated, and yields and spreads returned to prior levels.
10/2/87-10/16/87: Down 32%
The crash of October 1987 was preceded by a strong economy which prompted a Fed tightening that began in April of that year and went from approximately 6% to 7.25% (keep in mind that the Fed did not announce policy decisions in those days). During that spring and summer, most every sector of the fixed income universe suffered significant deterioration: the 10-year Treasury went from a little more than 7% to a little more than 10%, and corporate spreads widened another 50-150 basis points on top of that.
There was one sector of the fixed income universe that didn't worsen during the Fed tightening that led up to the crash: very short-term Treasury Bills. The Tax Reform Act of 1986 led to a flood of capital gains payments into the U.S. Treasury in April of 1987. So, that spring and summer, the Treasury paid off many off it short-term notes, which resulted in T-Bill rates being artificially low. That spring and summer, T-Bill rates stayed at 6%, sometimes trading down to 5.5%, while the yield on bonds and other short-term instruments surged. This lack of movement had a big impact on the investment fad of the day, portfolio insurance.
Portfolio insurance had become the rage during that time. It basically involved selling stocks when they dropped through certain levels, and buying them when they broke up through other levels. That's accepted practice for nimble, speedboat-like traders, but it makes no sense for battleship-like pension funds that are supposed to be focused on long-term investing. Yet, pension fund after pension fund adopted this strategy. They hoped to beat the "risk-free" return of Treasury Bills but, since this rate had come to bear no relation to what was happening in the fixed income universe, they were shooting to beat a target that was set too low. When the Treasury finished paying down short-term notes in late summer of that year, T-bill rates surged 170 basis points in less than three months, racing to catch up with the rest of the fixed income world. That radically changed the calculus of anyone shooting to beat the risk-free rate, as that hurdle had turned into a pole vault crossbar. This made stocks suddenly "seem" a lot more risky to anyone using a methodology that incorporated Treasury Bills as the risk-free rate. If those investors had been using commercial paper or Treasury bonds as a bogey, the perception of increased risk would have started to grow much earlier, and much more gradually. In addition, the dollar, which had been falling for three years, became unstable due to some ill-timed political comments, and stocks quickly fell through newly-raised stop levels. All the adherents of portfolio insurance rushed for the exits, and the market crashed.
7/17/98-8/31/98: Down 19%
This downdraft was a result of the Russian/Asian crisis that brought down the Long-Term Capital Management fund. It happened in two stages: half the decline happened in the second half of July to the first part of August. The market flatlined for a few weeks, then plunged in late August.
If an investor had solely looked at a chart of corporate spreads, they might have avoided the second half of the plunge in stocks. Junk spreads had been about 250 basis points in the months leading up to the panic, indicating that bond investors had priced in a scenario that indicated all was well. From May to mid-July, those spreads widened to a little more than 300 basis points, not enough to indicate a panic. By mid-August, though, they were nearing 400 basis points. So even though stocks had flatlined since their initial break, that gap up in spreads should have been an indication to anyone looking at them that the financial system was in trouble.
If an investor had been more in touch with the workings of the fixed income market, and not just looking at a chart of spreads, the whole equity drop might have been avoided. There were a number of extraordinary indications that the risk level of the financial system was escalating rapidly.
First, trading activity in the corporate bond market had ground to a virtual halt over the summer. Dealers were "passing" on the most routine bids from customers. In hindsight, it turned out that the dealers' books were already filled with exposure to fixed income hedge funds like LTCM and their own proprietary trading; the brokers were unwilling to take on any more market risk by bidding for securities. A reluctance of dealers to bid, other than on normal seasonal occasions, is always a red flag, even though few people at the time realized how exposed the dealers were to their customers. Unlike the NYSE, there is no obligation for dealers to bid on anything in the bond market. As the summer wore on, that reluctance to bid turned into outright refusals. The joke amongst buysiders back then was "if you bought 'em, you own 'em" for even the most liquid corporate bonds. This realization that an investor shouldn't buy what they didn't plan to hold for a while was a reason why spreads initially didn't move very much: the lack of demand from the dealer community was almost offset by a buyer's strike, and issuance volume thus declined, making for less upward pressure on spreads.
Even trading in the money markets, the most liquid arena, was impacted throughout the summer before the equity plunge. Dealers were reluctant to bid for even short-term commercial paper. Trading in this instrument is often accomplished in seconds, but it often took hours to execute even modest customer sales in this arena. In addition, a number of dealers cut back or eliminated their repurchase agreement activity with clients (private sector repo dwarfs the amount that the Fed engages in for open market operations), even if the counterparties were AAA-rated money market funds.
The Post-Bubble Environment:
The next group of declines all occurred were all part of the bear market. We have written extensively how junk bond spreads never recovered after the Asian crisis. They hovered north of 400 basis points for a few months, then began a climb to a record 1100 basis points and a near meltdown in October of 2002. While the junk market was deteriorating, though, stocks ramped until early 2000, creating a very unstable environment for equities.
So, all of the next group of declines should be viewed in the context of a bad multi-year corporate bond market. If bond investors are pricing things as if they are unsure that they will be repaid on time and in full, then there is little justification for surging equity prices given that stockholders stand at the bottom of the capital structure. We will thus avoid repetition and make comments on only selected declines.
3/23/00-4/14/00: Down 11%
This is where the stock market finally failed to make new highs after nearly two years of a worsening corporate market.
9/1/00-10/12/00: Down 13%
11/7/00-12/20/00: Down 12%
2/1/01-4/3/03: Down 20%
This is when the initial stock market bounce and euphoria from the beginning of the Fed's easing wore off, as it became clear that bond investors, especially in corporates, were not going to bring long-term rates down along with the Fed.
8/2/01-9/10/01: Down 11%
3/19/02-5/7/02: Down 10%
Junk had staged a mini-rally in March, but it turned out to be false because the buying was for structured products (collateralized debt obligations) that there turned out to be little customer demand for.
5/17/02-7/22/02: Down 28%
This was precipitated by the Worldcom downgrade to below investment-grade, which decimated the junk market.
8/22/02-10/9/02: Down 19%
Stocks had staged a powerful rally from the July lows, but junk spreads remained near an all-time high. Midway through the drop, the action in corporates worsened, prompting a further drop in stocks.
Declines not preceded by a worsening in corporates:
8/1/90-10/10/90: Down 17%
Invasion of Kuwait
9/10/01-9/21/01: Down 12%
Terrorist attacks.
1/14/03-3/11/03: Down 14%
The months leading up to the Iraqi war saw the only time when the junk market advanced while the equity market sunk. Such a situation provided an opportunity to shift exposure from junk to equities.
Conclusion:
Of the three drops that were not preceded by a worsening corporate bond market, two of them were sudden, unexpected events that significantly altered the prospects for world peace. That illustrates the need for investors to continually re-evaluate their risk profiles, especially when markets are acting favorably. When such an event happens, only the nimble get out with minor damage. Interestingly though, these events produced such climatic selling that a defined trading bottom was put in shortly afterward.
The third instance shows that profitable opportunities can arise when individual markets point to opposite conclusions.
In all the other instances, the corporate markets worsened in advance of a significant drop in equities. That is why we are currently looking so hard for signals that the health of the corporate is deteriorating. We currently don't see any of those signs, but we will get a test of that as this month progresses and corporate issuance picks up. |
