Beware the maturing bull

“Hold the front page — investment bank issues pertinent research.”

We didn’t say that, we hasten to add. It was fund manager Tim Price, at the Price of Everything blog. In the strategy note in question, Robert Buckland and Orrin Sharp-Pierson from Citi offer hint at an explanation for declining cyclical fortunes for the credit cycle but continued positive returns from equities - the “Maturing Bull.”

The Citi diagram is largely self-explanatory. In phase one, corporate spreads tighten as balance sheets are repaired. In phase two, both bonds and stock thrive as corporate cash flow improves. In phase three, spreads start to rise, risk appetite wanes and leverage goes out of fashion.

Stand by then for phase four - associated “with falling profits and worsening balance sheets” - a time to get out of both asset classes.

Price quotes Tim Lee of pi Economics as noting that:

Subprime mortgages are simply a manifestation of the divergence between credit and associated asset price growth and true savings. The credit bubble had allowed asset values, particularly including housing, to move far out of line with incomes and accumulated savings and now that bubble is bursting.

The extraordinary resilience of equity markets must “either reflect mass insanity, or at best total ignorance”, he adds, or it “must discount the possibility of a highly inflationary outcome.”

For Price, the housing market and subprime was the problem part of a “monumental financial debacle involving a deficiency of savings and a secular credit pyramid, naive borrowers and unprincipled mortgage brokers, unprincipled mortgage lenders, unprincipled investment banks and naive investors.”

It would be nice to think that the equity bull run still has legs, as [Citi] suggest — but the gathering and deepening storm clouds (not least the ominous rises in the prices of oil and gold) suggest otherwise, at least as far as western markets are concerned. The credit/equity cycle may not, in other words, be at 6 o’clock, but approaching 9. Concentrated and more aggressive investors may wish to start “derisking” their portfolios, if they haven’t already started. Equity markets may not be about to experience a Crash, but the huge amount of complacency out there argues strongly that discretion is the better part of valour.