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Part IV: The Compression Continues

I have been a student of the fixed income markets for some time. I am entering my 27th year in the industry (that was hard to type!). I don’t know if this qualifies me as an expert, but the markets have a way of making experts feel rather silly on occasion.

To wit, the very first trade ticket I ever wrote was in 1981 for $25,000 of a Sayreville New Jersey School District municipal bond that carried a 13.5% coupon at 100 and was rated AAA (it’s easy to remember your first ticket). Back in those days, folks had been through the inflation rate explosion in the late 70’s and early 80’s. Let me tell you—I had to beg this woman to buy the bonds that had a taxable-equivalent yield north of 20%.

I have lived through the stock market crash of 1987, the demise of Drexel Burnham Lambert (I was a bond salesman there), the credit crisis of 1990-1991 (the RTC was my client!), the financial crisis of 1997, the Long Term Capital management fiasco in 1998, a broken bubble in Internet stocks in 2000, the unfortunate day of September 11, a housing bubble and subsequent burst, and now, the slow unwinding of a credit bubble.

What has all of this experience done for me and my clients? For the most part, we have managed to avoid losses and silly mistakes, but to be frank, we have sacrificed some upside as a result of being prudent. After all of these events and dislocations, one would think that investors would begin to demand compensation for assuming credit risk. Given what I have observed, one might think BBB rated industrial bonds would yield more (a bunch more) than Ginnie Mae’s, which have the explicit backing of Uncle Sam. I recently had a buy program to purchase short-term Fannie, Freddie and Ginnie paper in the two to three year part of the yield curve. Due to all of the credit market dislocations that exist today, I was able to buy bonds in large quantities at yields that approached 5.12%, or 120 basis points above Treasuries. And these were the most stable mortgage backed securities in terms of prepayment risk. You would think that the yield of BBB rated industrial corporate bonds would fetch a much higher yield, would you not? Plotted on the screen below, courtesy of Bloomberg, are the yields of BBB Industrials as of 9/28/07. If you average the two-year yield and three-year yield you get…..yep, 5.12%. The exact yield I received for taking no credit risk. Seriously, you have got to be kidding me!

BBB Industrial Bond Yields

Click here to enlarge.

Part V: Technology is a "Safe Haven" Again

After the 85% beating tech stocks took from 2000 to 2003, I thought it would be quite a while before I would hear the phrase "tech stocks are rallying as they are a safe haven". Foiled again-I hear it daily now as the NASDAQ rolls higher each day. Forget that companies like Google (GOOG) and Apple (AAPL) sport market caps north of $135 bln, each. These are good companies for sure and I use their products daily, which are of the highest quality. But safe havens? I beg to differ. Readers of my newsletters know that I like to compare today’s activity to that of previous periods that are similar in terms of magnitude, duration and investor sentiment.

I was fortunate to miss the tech debacle by seeing the comparison of the Nikkei’s rise and fall and the similar parabolic rise of the NASDAQ. Further, I was fortunate to miss the next bubble breaking, namely homebuilders and the problems that come with the bubble unwind. The newest bubble? China. I keep hearing that "it is different this time" and that "Chinese stocks are impervious," etc. I have updated my bubble comparison chart to include the Nikkei, NASDAQ, Homebuilders and now, China. I am not short China as I respect what Keynes said: “Markets can remain irrational longer than you can remain solvent.” But I openly wonder what would cause their market to fall.

There are many similarities to the 1920’s in the U.S., the NASDAQ in 2000, and China. In each instance, novice investors were dragged into the fray to take expensive stocks off the hands of savvy sellers. What many people forget is that what is driving China’s economic growth and markets are the fact that they sell so many goods to Japan and the U.S. As Japan again flirts with recession and the U.S. is on track for one as well, what would happen to the Chinese economy and its market if they were to both go into recession? China's economy would certainly slow and its market would come back to Earth. In fact, this seems a likely scenario to me, and one that troubles me. If China's savings glut retracts, who will be left to buy all of the U.S.' Treasuries at 4.3%? Yep. You and me. And I won’t buy them at 4.3% with an inflation rate that I calculate to be closer to 7% rather than the reported rate of 2% per annum.

Bubble Comparison Chart

Click here to enlarge.

Given all of these bubbles brewing and bubbles bursting the past 20 years, one would think that risk-taking appetites would certainly contract. Indeed, the speculation in China is spilling over into Hong Kong, Vietnam, Mexico, Russia, Brazil and others. This borders on insanity to me (I understand the developing market theory but question the prices people are paying to participate). But the speculators continue to speculate no matter how high the risks. Seriously, you have got to be kidding me!

Conclusion: A Correction Cometh?

At a recent dinner with perhaps the most knowledgeable person I know in the fixed income space, we were talking about the economy and credit market dislocations, that as everyday market participants we see up close. My friend was a trader at a couple of large dealers and really knows his stuff. He is also one of the most "bullish on America" folks I know. The conversation turned to the stock market after we all agreed (my partner Rob was there as well) that the only question to be answered about the credit market is not if, but when will it correct to more sane, or cheap levels. Keep in mind this was before the Fed eased, and before stocks took flight and credit spreads contracted.

We started talking about all of the "crash comparison charts" that were making their way around Wall Street. Many of these charts were coming from bond traders! I commented that no matter how fouled up the economy and credit markets look to me, when bond traders start e-mailing me stock market crash comparison charts, the market most certainly won’t crash. Mr. Market will likely rally as he has a habit of frustrating the crowd, particularly at extremes. This is known as the "pain trade"-the trade that hurts the most people at the same time.

Now that those charts have been erased and the pattern has changed, people that shorted stocks and bought puts in hope of profiting from a crash have now likely covered their positions. Or they saw their puts expire worthless, otherwise known as "going to option Heaven." So when would the most pain be inflicted on people? Now, when many have been run out of their positions and are now obliged to be long the market because "it just refuses to go down."

Bears are being dragged, kicking and screaming, into the market. There is a chart Ned Davis Research provides to me on a daily basis, comparing the period 1929-1941 in the Dow Jones Industrial Average to the bubble and bursting of the NASDAQ from 1998-present and is then extrapolated to 2011 which is shown below. I humbly say that I do not know if this will occur, but I sometimes feel I am the only person looking at this comparison. Since people tend to make the same mistakes over and over and over again, a serious correction makes sense to me, led by the "safe haven" tech stocks.

Comparison of DJIA 1929-1941 to NASDAQ 1988-present

Click here to enlarge.

Considering all of the economic news and dislocations, it will be difficult to predict the economic picture. Perhaps stocks will double from here, the dollar will get carved in half again, homebuilders will all go bankrupt, corporate spreads will trade below Treasury yields. If the unthinkable has already occurred, more unthinkable things can occur, in spite of what we think they should be doing. There is a phrase on Wall Street—"it is not about being right, it is about making money." Prudence has not always paid the highest dividends, but in the longer-term, it usually does.

I will continue to make portfolio decisions that focus on a sensible evaluation of macroeconomic and market conditions. In every case I will make selections based on quality, relative value, and prudent thought. I work hard to avoid your incoming phone call which opens with “You have got to be kidding me!”