Cognitive Dissonance, Financial Markets Edition

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It’s quite remarkable how indifferent to bad economic data keeps coming in and the markets keep shrugging it off. And what is of particular concern, if you are the worrying sort, isn’t the peppy equity markets (that’s for the optimistic types anyhow), but the near-total indifference to risk in the credit markets. Aside from a new sobriety among residential mortgage lenders, conditions, are, if possible, becoming even more speculative, as we learn in a Bloomberg story, courtesy Michael Panzner:

Never have so many made so much money from junk bonds, and that worries Dan Fuss.

Fuss, whose $10.7 billion Loomis Sayles Bond Fund has been the best performer among its peers the last 10 years, says high- yield, high-risk securities are showing unmistakable signs of a bubble. Yields are near record lows relative to government securities even though sales of the riskiest bonds increased 39 percent from last year, debt has grown faster than earnings and the economy is expanding at the slowest pace in five years.

“I haven’t felt this nervous about a market ever,” said Fuss, vice chairman of Loomis Sayles & Co. in Boston, who’s been working in the banking and securities industries since he joined Wauwatosa State Bank in Wisconsin in 1958. His fund has returned an average 9.91 percent a year for the last decade, the best of 45 funds with similar investment rules, according to Lipper, the mutual fund research firm.

Martin Fridson, head of high-yield research firm FridsonVision LLC, and Mariarosa Verde, managing director of credit market research at Fitch Ratings, say sales of junk bonds and the record $366 billion of leveraged buyouts may lead to the worst bear market for bondholders.

The last time junk bonds tumbled was in 2002, when companies defaulted on $166 billion of their securities, according to Moody’s Investors Service. Merrill Lynch & Co.’s High Yield Master II Index fell about 2 percent that year as yields on the securities rose to a record 11.2 percentage points over Treasuries. Speculative grade, or junk, bonds are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

Severe Downside

“The downside is likely to be very severe,” Fridson, who led Merrill’s high-yield strategy group until he left in 2003 to start his own firm, said in an interview from his office in New York.

Fridson predicts that in the next few years the default rate may reach or surpass the 2002 level, when WorldCom Inc. in Jackson, Mississippi, and Adelphia Communications Corp., then based in Coudersport, Pennsylvania, filed for bankruptcy.

About 1.5 percent of junk-rated companies have defaulted on their debt this year, near the lowest in a decade, Moody’s says.

“Defaults are almost non-existent today and, well, we know that doesn’t hold forever,” said Thomas Lee, who stepped down last year from Thomas H. Lee Partners LP, the Boston-based takeover firm he founded 32 years ago.

“When the economy goes bad, defaults will spike up from 1 percent into the 9 percent level,” Lee said at the Milken Institute Global Conference in Los Angeles on April 25. “If that happens then the financing part grinds to a halt” for LBOs, he said.

About $366 billion of LBOs have been announced this year, a rate that may eclipse last year’s record of $701.5 billion, according to data compiled by Bloomberg.

‘Fantasy Land’

More than half of the junk bonds sold this year were used to pay for leveraged buyouts and mergers and acquisitions, according to Barclays Capital. Money is so easy to come by that for the first time some investors agreed to let borrowers choose to make interest payments in cash or in additional bonds.

“This is fantasy land for corporate treasurers,” said Edward Altman, a professor of finance at New York University’s Stern School of Business. Altman in 1968 created the Z-score, a mathematical formula that measures a company’s bankruptcy risk. They “are smiling like Cheshire cats” and borrowing conditions “entice them to increase their leverage.”

As an aside, the 2002 defaults really weren’t that terrible (unless you were a bondholder, of course). This period bears a much stronger resemblance to the late 1980s, and the hangover from the doggy LBOs then was much worse.

Let’s contrast the unbridled optimism implied in these junk bond spreads with more confirmation of ongoing financial news themes: consumers are overextended and the housing market is deteriorating. Michaal Shedlock provides updates on both fronts:

The BLS is reporting Real Earnings Drop .5 percent in April.

Real average weekly earnings fell by 0.5 percent from March to April after seasonal adjustment, according to preliminary data released today by the Bureau of Labor Statistics of the U.S. Department of Labor. A 0.3 percent decline in average weekly hours and a 0.5 percent increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers were partially offset by a 0.2 percent rise in average hourly earnings….

The BLS also reported the Consumer Price Index for April 2007 today.

On a seasonally adjusted basis, the CPI-U advanced 0.4 percent in April, following a 0.6 percent increase in March. The index for energy increased 2.4 percent after advancing 5.9 percent in March. In April, the index for petroleum-based energy rose 4.6 percent versus a 10.1 percent increase in March. The food index rose 0.4 percent in April, slightly more than in March. The index for all items less food and energy advanced 0.2 percent in April, following a 0.1 percent rise in March; the index for shelter rose 0.3 percent after advancing 0.1 percent in March, resulting from an upturn in the index for lodging away from home.

Wages are not keeping up with costs. There is no other way to look at it. Yes home prices are dropping but with fewer and fewer people buying homes, the drop in home prices is simply not helping many.

Bloomberg is reporting U.S. Median Home Price Tumbles to 2-Year Low in Slump.

U.S. home prices tumbled to a two-year low in the first quarter, with declines in almost half of U.S. cities, the National Association of Realtors said.

“The market is clearing itself as the lower prices lead to less supply,” said Michael Darda, chief economist at MKM Partners LP in Greenwich, Connecticut. “Over time that will help to bring supply and demand into equilibrium.”

Over Time. Yeah right. Like how much time? Three Years? Five years? The statement is absurd actually given that inventories are still rising. In the meantime the slump in housing prices continues to cut off the housing ATM, removing a key source of funds for cash strapped consumers.

As Lance Lewis pointed pointed out today on Minyanville, the numbers excluding food and energy (what the Fed likes to look at), are now magically below the 2 percent threshold. If the Fed wants an excuse to cut, the 3 month rate in CPI excluding food and energy paves the way.

Unless that rate cut translates into lower mortgage rates, however, it will not help one iota. For those in the group of 430,000 First Quarter Foreclosure Filings it is already too late. Coupled with the latest weak jobs report as noted in Birth Death Model Fatally Flawed and Nonfarm Payrolls Vs. Gov’t Payrolls a disaster is forming.

Real wages are declining and corporate profits are not shared with wage earners except at the very top end. That skew makes the decline in wages worse than it even appears (and it appears bad). The squeeze on consumers is accelerating.

Per Shedlock (and many others) it’s widely known that the last best hope for continued growth, namely, consumer spending, is on the downswing. Yet the markets keep barrelling along. We wonder how long this Tinkerbell market can persist.

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One comment

  1. Anonymous

    Starting with the Great Wall of China -oops, I mean Chinese reserves- markets know that the fix is in. The boom will be undone by political factors, just as it was constructed by asian mercantilism in cahoots with western MNCs.

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