Why it pays to ignore the market

By Felix Salmon
February 24, 2011

At the end of 2008, the loan market was in stunningly bad shape. There was almost no bid for loans in general, and cov-lite leveraged loans in particular were treated like they were radioactive. If you looked at the prices they were trading at, the market was clearly expecting a huge wave of defaults in the very near future, along with very low recoveries.

Two years later, the picture could hardly be any different. High-yield bonds are being issued within 40bp of the state of Illinois. Cov-lite loans are being churned out at bubble-era pace: the $8.8 billion so far this year is 25% of all loans year-to-date, already tops the 2010 total, and works out to an annualized pace of something in the region of $65 billion. The defaults that everybody was expecting generally failed to occur, and the few defaults that did happen had surprisingly high recoveries.

The WSJ‘s Mike Spector is at pains to point out that “creditors aren’t guaranteed to lock in these better recoveries. Distressed-debt exchanges, while giving good recoveries in the short-term, could later prove a mirage should firms falter again.” This is true broadly, but false narrowly: if creditors want to lock in their recoveries they can do so very easily by selling their shiny new bonds and loans in this frothy market at very high prices.

When I started blogging full-time in 2006, I formulated a principle — that the market is the best pundit. Sometimes the market is wrong and some specific pundit is right, as I’m sure my boss at the time, Nouriel Roubini, would love to remind you. But the expectations priced in to the market are a more reliable base case than any other forecast you might use.

That principle didn’t work out well for me in the case of mortgage bonds. Or just about anything else: the market took it upon itself to go completely bonkers, with a level of volatility bespeaking zero reliability whatsoever when it came to priced-in expectations. Even so, in the midst of a massive recession it did seem reasonable that crazy cov-lite loans would start defaulting en masse — no matter what the Fed did in terms of monetary policy.

But something interesting happened: it turned out that these bonds and loans were big enough to concentrate the minds of the creditors. Banks and investors worked hard to avoid realizing losses, in a manner which has most emphatically never happened in the mortgage market or with small business loans. You can call it “extend and pretend” or “delay and pray” if you like, but it seems to have worked, with a lot of help from the Fed. That was unexpected, and because it was unexpected it had a huge effect on prices, which outperformed massively in 2009 and 2010.

So when the market seemed unreasonably sanguine, in early 2007, it was wrong. And when the market seemed reasonable in its pessimism, in late 2008, it was also wrong. Right now we’re back to unreasonably sanguine again — Bethany McLean says, sensibly enough, that the recent uptick in cov-lite issuance is “a sign that some kind of reckoning is in store.” But the one thing I’ve learned over the past three years is that the market just isn’t a sensible or rational place.

If you’re being logical about such things, stocks look incredibly frothy right now, just as bonds do, both in terms of valuation and in terms of psychology. But this market has a way of making everybody look foolish, no matter how logical they are. Which is ultimately just another reason to spend as little time as possible paying any attention at all to the market. It’ll just drive you mad.


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That’s funny… :) Mean reversion is essentially a fancy way of saying that the market is always WRONG. The exact opposite of your earlier principle.

I like your new principle better, “It’ll just drive you mad.”

Posted by TFF | Report as abusive

Debt and equity markets look frothy now because, after the dust from the 2008/9 wealth re-distribution plan settled, those who still had wealth wanted somewhere to put it, and 0.5% interest-paying bank accounts and mattresses just don’t cut it. The money has to be somewhere, so those two markets are a good place to park the cash. Just by the very nature of more money going into those markets, asset prices will rise. And then, at some point, some people will say “that’s as high as they will or should go”, and start selling. And when that happens, prices will drop, because there will be lots of people selling.

So if you don’t time it right, you will look foolish. But how else can you make money off your money, without working (or devising innovative financial products)?

Posted by KenG_CA | Report as abusive

“how else can you make money off your money, without working?”

Master Limite Partnerships still pay +5% and their distributions are still trending upwards which offers a bit of protection if rates rise. Spread your money around though because MLP’s are risker than most people realize.

You can make a pretty compelling case for private investment in real estate if you can stomach buying destressed properties.

I think the oil and coal sector is STILL undervalued by 20% if not more.

While equities in general are 100% higher than the March 09 lows I’ll also point out that interest rates at zero means this time actually IS DIFFERENT. Assume that the Fed will not move rates until US unemployment drops below 7% no matter what inflation does. If that happens than the dollar is going to get totally trashed and equities will very like hurt you less than cash or bonds.

Think about this… right now 5 year treasuries are paying ballpark 2.25. If you assume that in 5 years they will be paying 5% (which is about what they were paying about 5 years ago) than todays 10 year treasury at 3.50 is going to be a 5-year 150 basis points behind the new issues. Your “safe” T-Bonds are going to be trading at 90 cents on the dollar! If you think we’re going to face 5% inflation in the next 5 years (which I think is very likely) then the “safest” investments are totally shot.

I’d rather take a big risk in exchange for a small return than take small risk for no return.

Posted by y2kurtus | Report as abusive

Stocks are frothy? Depends where you look. The S&P level is a very poor way to assess the valuation of individual stocks, given that the S&P includes companies that still aren’t generating regular profits due to the financial crisis (BofA, AIG), young companies with questionable moats that are at 80x earnings on speculative momentum (Netflix), and megacaps that have seen no real earnings impairment from the financial crisis and are at 10-15x earnings (Microsoft, Walmart, Target, Abbott, J&J, etc.). I don’t think people who pick from the last list need to worry that much about how many covenant lite bonds idiots want to buy, when $8.8b is just not that significant compared to the size of equity and debt markets. I’m also pretty sure that quality equities are less risky than long Treasuries for the reasons mentioned above.

Posted by najdorf | Report as abusive

Felix, re your “extend and pretend” or “delay and pray” comment; I think this is where one has to acknowledge the feedback mechanisms between financial markets and the events they purport to estimate. “Reflexivity” is the term Soros coined for this phenomena.

For example, analysing the extent to which equities forecast recession is difficult given that broad-based declines in equities may in fact contribute to recession (e.g. by triggering minimum coverage clauses in loan agreements, etc). You might also ask whether the market was adroit in anticipating the collapse of Bear Sterns, or whether the market was the driving cause of the event it sought to predict.

Unlike betting on the outcome of a horse race, the bet and the outcome of the event are not independent. As a result we see the apparent “irrational” outcomes described in your post.

Posted by DanGroch | Report as abusive

Good insight, najdorf. One of the fictions promoted by index investing is that there are only two distinct securities in the world: “stocks” and “bonds”. People forget that different segments of the stock market have very different characteristics.

Note that this isn’t necessarily an attempt to “beat the market”. Some stocks are at risk of losing 90% of their value in a recession. Some are not. Pretty easy to tell the difference between the two classes. The riskier stocks will almost certainly produce better returns as long as things go well, but individual investors have to decide whether or not that additional return is worth the additional risk TO THEM.

Posted by TFF | Report as abusive