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Warning signs point to a slowdown
January 8, 2007 (Ambrose Evans-Pritchard - Telegraph UK)
The Goldman Sachs gauge of momentum in the global economy has turned negative for the first time in more than four years, raising concerns that America's slowdown is spreading to Europe and Asia.
The bank's closely watched index of Global Leading Indicators (GLI) has picked up a number of disturbing signs, subtle shifts that preceded past downturns in the business cycle.
The Belgian manufacturing survey fell in December; South Korean exports slid at the end of the year; and the inventory-to-sales ratio has risen in Japan and the US.
The momentum indicator fell from +0.14pc in November to -0.02pc in December. "As the first negative reading since 2003, this will need to be watched," said Dominic Wilson, the group's senior global economist.
Separately, the US Association Trucking Association (ATA) said its index of truck tonnage shipped across America was plummeting at the fastest rate since the dotcom bust.
The shipment index fell 3.6pc in November, following a 1.9pc fall in October. It is now down 8.8pc over the last year. "November 2006 marked the single worst month for truck tonnage since the last recession," said Bob Costello, the group's chief economist.
Road haulage accounts for 84.3pc of all goods shipment revenues in the US.
"The economic slowdown is in full gear. If we continue to see year-over-year reductions of similar magnitudes in the next couple of months, it could indicate a greater economic slowdown than economists are projecting at this point," Mr Costello said.
AntiSpin: I was starting to get nervous about my 2007 Recession prediction. (For newcomers you can read it here and listen to an interview about it here.) But reports like this one are starting to come in which may make this 2007 recession prediction look as optimstic as the iTulip prediction of the technology stock bust.
Back in 1999, iTulip predicted an average 87% decline in our basket of technology stocks. Last we checked in November 2000, it was down 85%. A portfolio of these stocks worth $100,000 in December 1999 declined to $15,000 by November 2000. Accounting for survivorship bias–the way indexes tend to discount stocks that go to zero because a company goes out of business but rather take stocks out of the index–the actual decline was more than 90%.
Let's face it. We're optimists.
It's also instructive to return to look back on the extremes of that time. In February 2000, the month before the bubble popped, the combined market cap of the companies listed as the bottom eight on the DOW were worth less than AOL. While many, including Greenspan, defended these ridiculous valuations, the market soon settled on a more reasonable level, after ripping a few million investors' lungs out.
Where do we see similar over-valuation? Unfortunately, in the corporate bond market. With spreads between junk and cash–BB and lower rated corporate bonds and US Treasuries–at all time lows, the market is over-pricing one and under-pricing the other. Or both. Also, as our John Serrapere recently pointed out, 70% of companies listed on the S&P today have junk rated debt, versus 30% in 1980.
This excellent and prescient piece by William J. Bernstein Credit Risk: How Much? When? written in 2000 for Efficient Frontier very cogently argued the right time to buy junk: when spreads are wide, such as after the dot com bust. Then, the Junk-Treasury spread looked like this:
He goes on to plot the Junk-Treasury spread versus the forward five-year difference in returns between junk and treasuries.
He explains why junk was a buy in 2000, and also the risks:
And market-time he did. Good call.
Using his same reasoning but in reverse, where are we now? Appears we're at the top of a junk bond bubble and headed for another period when "spread investors" get that "deer-in-the-headlights stare and the portfolios suffer from the bond equivalent of irresistible-force-meets-immovable-object."
Source: Prudential (PDF)
January 8, 2007 (Ambrose Evans-Pritchard - Telegraph UK)
The Goldman Sachs gauge of momentum in the global economy has turned negative for the first time in more than four years, raising concerns that America's slowdown is spreading to Europe and Asia.
The bank's closely watched index of Global Leading Indicators (GLI) has picked up a number of disturbing signs, subtle shifts that preceded past downturns in the business cycle.
The Belgian manufacturing survey fell in December; South Korean exports slid at the end of the year; and the inventory-to-sales ratio has risen in Japan and the US.
The momentum indicator fell from +0.14pc in November to -0.02pc in December. "As the first negative reading since 2003, this will need to be watched," said Dominic Wilson, the group's senior global economist.
Separately, the US Association Trucking Association (ATA) said its index of truck tonnage shipped across America was plummeting at the fastest rate since the dotcom bust.
The shipment index fell 3.6pc in November, following a 1.9pc fall in October. It is now down 8.8pc over the last year. "November 2006 marked the single worst month for truck tonnage since the last recession," said Bob Costello, the group's chief economist.
Road haulage accounts for 84.3pc of all goods shipment revenues in the US.
"The economic slowdown is in full gear. If we continue to see year-over-year reductions of similar magnitudes in the next couple of months, it could indicate a greater economic slowdown than economists are projecting at this point," Mr Costello said.
AntiSpin: I was starting to get nervous about my 2007 Recession prediction. (For newcomers you can read it here and listen to an interview about it here.) But reports like this one are starting to come in which may make this 2007 recession prediction look as optimstic as the iTulip prediction of the technology stock bust.
Back in 1999, iTulip predicted an average 87% decline in our basket of technology stocks. Last we checked in November 2000, it was down 85%. A portfolio of these stocks worth $100,000 in December 1999 declined to $15,000 by November 2000. Accounting for survivorship bias–the way indexes tend to discount stocks that go to zero because a company goes out of business but rather take stocks out of the index–the actual decline was more than 90%.
| Symbol | Name | Paid | Prev Cls | Gain | Earn/Shr | |||
|---|---|---|---|---|---|---|---|---|
| ABTL | AUTOBYTEL.COM | 58 | 3 13/32 | -$54.78 | -94.45% | -1.66 | ||
| AMZN | AMAZON COM | 110.63 | 28 15/16 | -$82.63 | -74.69% | -3.45 | ||
| AOL | AMERICA ONLINE | 87.75 | 42.9 | -$43.78 | -49.89% | 0.54 | ||
| ATHM | AT HOME CP A | 99 | 7 29/32 | -$91.69 | -92.61% | -4.80 | ||
| BAMM | BOOKS-A-MILLION | 47 | 3 | -$43.97 | -93.55% | 0.26 | ||
| BVSN | BROADVISION | 72.375 | 30 13/16 | -$42.06 | -58.12% | -0.35 | ||
| CMGI | CMGI INC | 165 | 12 13/16 | -$153.38 | -92.95% | -5.26 | ||
| CNET | CNET NETWORKS | 79.75 | 21 | -$57.88 | -72.57% | 3.19 | ||
| DCLK | DOUBLECLICK INC | 176 | 14 1/8 | -$161.19 | -91.58% | -0.81 | ||
| EBAY | EBAY INC | 234 | 36 15/16 | -$195.81 | -83.68% | 0.11 | ||
| ELNK | EARTHLINK INC | 99.375 | 7 21/32 | -$92.19 | -92.77% | -2.66 | ||
| ETYS | ETOYS INC | 85 | 1 13/16 | -$83.00 | -97.65% | -2.15 | ||
| EWBX | EARTHWEB INC | 89 | 15 3/4 | -$74.50 | -83.71% | -4.30 | ||
| GEEK | INTERNET AMER | 61 | 1 1/8 | -$60.00 | -98.36% | -1.75 | ||
| GNET | GO2NET INC | 199 | 31 7/8 | -$167.12 | -83.98% | -0.92 | ||
| IVIL | IVILLAGE INC | 130 | 1 11/16 | -$128.53 | -98.87% | -6.94 | ||
| LCOS | LYCOS INC | 145.375 | 40 11/16 | -$104.31 | -71.75% | 0.20 | ||
| LTWO | LEARN2.COM INC | 10 | 1 1/4 | -$8.88 | -88.75% | -0.32 | ||
| MKTW | MARKETWATCH.COM | 130 | 4 1/2 | -$125.25 | -96.35% | -5.80 | ||
| ONEM | ONEMAIN.COM INC | 46.75 | 10 1/8 | -$36.62 | -78.34% | -5.48 | ||
| PRGY | PRODIGY COMMS | 50.625 | 3 | -$47.69 | -94.20% | -2.51 | ||
| RNWK | REALNETWORKS | 131.875 | 16 | -$116.69 | -88.48% | -0.47 | ||
| TGLO | THEGLOBE.COM | 48.5 | 15/32 | -$48.06 | -99.10% | -2.85 | ||
| TSCN | TELESCAN INC | 26.375 | 1 1/2 | -$24.88 | -94.31% | 0.38 | ||
| YHOO | YAHOO INC | 244 | 40 7/8 | -$203.88 | -83.56% | 0.45 | ||
| ZDZ | ZIFF-DVS ZDNET | 55.5 | 11 3/4 | -$43.75 | -78.83% | -0.05 | ||
| -$2,292.50 | -85.48% | ||||||
Let's face it. We're optimists.
It's also instructive to return to look back on the extremes of that time. In February 2000, the month before the bubble popped, the combined market cap of the companies listed as the bottom eight on the DOW were worth less than AOL. While many, including Greenspan, defended these ridiculous valuations, the market soon settled on a more reasonable level, after ripping a few million investors' lungs out.
| - | GoodYear Tire | $3.732B |
| - | Union Carbide | $7.337B |
| - | Sears | $11.055B |
| - | Caterpillar | $14.183B |
| - | International Paper | $18.038B |
| - | Eastman Kodak | $18.246B |
| - | JP Morgan | $20.106B |
| - | Alcoa | $27.068B |
| AOL = $123.2B | Bottom DOW eight | $119.805 B |
Where do we see similar over-valuation? Unfortunately, in the corporate bond market. With spreads between junk and cash–BB and lower rated corporate bonds and US Treasuries–at all time lows, the market is over-pricing one and under-pricing the other. Or both. Also, as our John Serrapere recently pointed out, 70% of companies listed on the S&P today have junk rated debt, versus 30% in 1980.
This excellent and prescient piece by William J. Bernstein Credit Risk: How Much? When? written in 2000 for Efficient Frontier very cogently argued the right time to buy junk: when spreads are wide, such as after the dot com bust. Then, the Junk-Treasury spread looked like this:
He goes on to plot the Junk-Treasury spread versus the forward five-year difference in returns between junk and treasuries.
He explains why junk was a buy in 2000, and also the risks:
There's a pretty clear-cut relationship here: As expected, the higher the spread, the greater the advantage of bearing credit risk.
For a believer in efficient markets, these conclusions are profoundly disturbing, but not unprofitable. Although most of the time, it does not pay to take credit risk, there are periods when expected returns are too high to ignore. Yes, the devout efficient marketeer will point out that there's a reason why one does not often find $10 bills lying on the sidewalk, and that if this junk-bond opportunity were really a free lunch, it would have been arbitraged out long ago. However, there are limits to arbitrage. I ran smack into this limit at a conference of institutional fixed-income managers recently. It was easy to pick out the "spread investors" they were the ones with the deer-in-the-headlights stare and the portfolios suffering from the bond equivalent of irresistible-force-meets-immovable-object. I'm talking about huge mutual-fund-redemption demands running smack into illiquid, impossible-to-price securities. If you're a small investor with modest portfolio exposure to junk, say 1% to 2%, you can afford to wait a few years for prices to recover. These folks looked like they didn't even have a few weeks.
Belief in the efficient market theory does not relieve one of the duty to estimate asset-class returns. Because of the term structure of high-yield bonds, returns will tend to mean-revert more quickly, and more surely, than equity. Yes, there is risk. But when their long-term expected returns start approaching 5% over Treasuries (as they did not so long ago), it looks like a risk worth taking with a small corner of one�s portfolio. One caveat: Because most of the return, similar to REITs, accrues as ordinary income, junk bonds are appropriate only for tax-sheltered accounts.
Are we market timing? I suppose. It's the lesser of two evils; I'd rather violate the efficient market hypothesis than ignore appealing expected returns with a relatively short time horizon.
For a believer in efficient markets, these conclusions are profoundly disturbing, but not unprofitable. Although most of the time, it does not pay to take credit risk, there are periods when expected returns are too high to ignore. Yes, the devout efficient marketeer will point out that there's a reason why one does not often find $10 bills lying on the sidewalk, and that if this junk-bond opportunity were really a free lunch, it would have been arbitraged out long ago. However, there are limits to arbitrage. I ran smack into this limit at a conference of institutional fixed-income managers recently. It was easy to pick out the "spread investors" they were the ones with the deer-in-the-headlights stare and the portfolios suffering from the bond equivalent of irresistible-force-meets-immovable-object. I'm talking about huge mutual-fund-redemption demands running smack into illiquid, impossible-to-price securities. If you're a small investor with modest portfolio exposure to junk, say 1% to 2%, you can afford to wait a few years for prices to recover. These folks looked like they didn't even have a few weeks.
Belief in the efficient market theory does not relieve one of the duty to estimate asset-class returns. Because of the term structure of high-yield bonds, returns will tend to mean-revert more quickly, and more surely, than equity. Yes, there is risk. But when their long-term expected returns start approaching 5% over Treasuries (as they did not so long ago), it looks like a risk worth taking with a small corner of one�s portfolio. One caveat: Because most of the return, similar to REITs, accrues as ordinary income, junk bonds are appropriate only for tax-sheltered accounts.
Are we market timing? I suppose. It's the lesser of two evils; I'd rather violate the efficient market hypothesis than ignore appealing expected returns with a relatively short time horizon.
Using his same reasoning but in reverse, where are we now? Appears we're at the top of a junk bond bubble and headed for another period when "spread investors" get that "deer-in-the-headlights stare and the portfolios suffer from the bond equivalent of irresistible-force-meets-immovable-object."
Source: Prudential (PDF)
A top in junk bonds has been called several times in the past two years. We've resisted doing so because we have learned over the years that a bubble in motion tends to continue for years past all well reasoned warnings and until the market provides clear and present evidence of impending collapse. The evidence in this case will be defaults on the leading edge of the coming recession led by the housing bust. Junk bond holders will see these first defaults, then suddenly and all at once demand higher yields to compensate them for the "new and surprising" risk. And so the junk bond bubble pops.
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