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A Tale of Two Markets, Part 3


Credit market speaks and message isn't pretty.

This is the final installment of a 3-part series. Part 1 can be found here. Part 2 can be found here.

Option Adjusted Spreads (OAS) are defined by Bloomberg as "A methodology using option pricing techniques to value the embedded options risk component in a bond's total spread."

OAS (Option Adjusted Spread) of 30 year FNMA 6% Mortgage Pool

Click to enlarge

In plain English, it simply tells us how much an investor is being compensated to own a security (in this case a 30 year Fannie Mae 6% mortgage pool) and all of its embedded call options, or prepayment risk in mortgage backed securities.

So you might think that after all of the stimulus, bailouts, surprises, and rule changes that credit spreads would tighten. But no, OAS in most mortgage securities is at recent highs, which simply means that the stimulus isn't having the desired impact.

This is what I call "Zero Hour," a concept I have been featuring for years that was originally brought to us by Barry Bannister.

I wish that wide spreads were contained to FNMA, GNMA or FHLMC, but sadly they're not. In fact, spreads in the credit markets are at historically wide levels and show no signs of tightening. It is my belief that the credit market is a rational place where balance sheets, cash flow, and write-downs/write-offs are burying many companies into a hole that they will not be able to emerge from for quite some time.

Equity markets, on the other hand, are much more emotional and susceptible to trades like "Get Shorty." "Get Shorty" would be a very tough trade to pull off in the credit markets, so Fed, SEC and Treasury officials concentrate on equities, even though if credit spreads don't tighten and credit isn't made more available to individuals and institution, the system will continue starving for much needed stimulus.

For another example, consider the case of American International Group (AIG), the once great insurance behemoth. It's now, in my opinion, been reduced to a company that is spinning out of control, unable to determine how bad its credit portfolio is and how bad its investment portfolio is. Mind you, this is a company with $1 trillion in assets, but bonds that are going down in price quickly and probably not coming back anytime soon. I have been contemplating ever since Stage 2 of the Credit Crisis began what company would be first to not be able to finance themselves.

I thought it could be Lehman Brothers (LEH) (it still could), Merill Lynch (MER) (they sold their Bloomberg stake and other assets and diluted common shareholders at 10-year lows just to stay alive), but I hadn't considered AIG and the insurance companies. But I am now.

Take a look at how AIG bonds are trading after its disastrous announcement. It's absolutely un-economical, in my opinion, to raise more capital as it already buried equity and preferred buyers on its last asset-raising go-round, so I don't know how it stays alive.

Its comments in the press clearly demonstrate the lack of risk-controls. The problem here, of course, is that AIG isn't alone. It's just one of scores of companies that cannot finance themselves. The credit market is speaking, loud and clear.

AIG 5 Year Corporate Spreads versus 5 Year Treasuries

Click to enlarge

Note that prior to the credit crisis's beginnings, AIG paper traded at a mere 69 basis points above 5 year Treasuries and has ballooned all the way to 675 basis points above Treasuries.

I watch the debt trade all day as trades stream across my screens and it is the same here as it is for many regional banks and brokers. Some of the banks I expect to survive, like Bank of America (BAC), JP Morgan (JPM), UBS (UBS) and Wells Fargo (WFC), which trade pretty well.

Citigroup (C), with all of its troubles, and all of its lack of controls and general disdain for clients, will likely survive in one way or another. It's probably too big to fail but I imagine will likely be broken into many parts.

The overall credit market, though, is a mess, and unlikely to recover anytime soon, which leads me to my beliefs of the ultimate path of equity prices.

The Equity Market Speaks-In a Very Different Tone than the Credit Market

Stocks' prices seem to be random lately with 200-300 point swings in the Dow Jones Industrial Average on a daily basis. Many cite the move in commodities, the dollar index (DXY), short interest, and returns of many a hedge fund and mutual fund have become nearly as random on both a daily and monthly basis. While my prides itself on our Harbor Pilot Fund on low volatility of return, a focus on absolute returns and constant "defined risk," even we are experiencing higher than usual volatility on a daily basis, although well within our range of potential outcomes. Since we rarely, if ever are un-hedged and/or leveraged, we can control risk. I can't imagine running a long/short fund with 5x-10x leverage, I can't imagine the daily volatility. No thank you!

But while the credit markets seem rational and in tune with financial reports from many sources, stocks remain extremely emotional, and more importantly, as over-valued as I have seen in many years. I know that this may seem draconian, given the sell off that began last summer, but earnings are dropping faster than stock prices, credit costs are on the rise, and commodity prices, (while recently retreating) are still much higher year-over-year.

We are finally seeing analysts' estimates decline for the S&P 500 from nearly $95 per share at the beginning of the year to $85 now. Those pesky write-downs that I like to refer to are now approaching one-half trillion dollars and including Fannie Mae (FNM), Freddie Mac (FRE) and AIG, are greater than a half trillion dollars.

I continue to believe that earnings will continue to disappoint because so much of the stimulus that we have received over the last year will likely be removed as we roll into and past the 2008 presidential election.

In fact, if you include the pesky half-trillion dollars of write-downs, then the trailing 12 month S&P earnings is a measly $50, according to Bloomberg, bringing the current price/earnings ratio to a whopping 25. Considering that at best, financial companies will continue to, or in fact accelerate their common share issuance then the denominator of the calculation of earnings per share will do nothing but depress earnings for years. And before everyone gets excited about the fall of commodity prices, note that the only area of earnings power/acceleration was in the materials and commodities space.

All of this could drain earnings per share of the S&P 500 even further and makes me more confident in my long term goal of S&P 500 of 650-900. Even if the short-term emotional, short squeeze rally in the S&P 500 extends to 1300-1350 on a cash basis.

Writedowns, According to Bloomberg, Since Mid-2007

S&P 500 Earnings Data (Courtesy of Bloomberg)

Credit Market Remains Dysfunctional, Stocks Remain Emotional

In summary, unless the market is given oxygen (more available credit) and the patient is revived, the economy, at best, will sputter. Without precious oxygen, the higher cost of the credit market will smother the economy and equity investors. I remain defensive, perhaps the most defensive ever.
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