This fascinating composite chart below is courtesy of the Strategy desk of Morgan Stanley Europe. It shows what the average of the past 19 major Bear markets globally have looked like:
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The Chart represents typical secular bear markets based on MS’s sample of 19 such bear markets as shown after the jump.
There are obvious differences and similarities — the SPX fell 43% over 18 months, and snapped back 50% in 6 months. Almost but not quite as deep, but much faster a fall. What that means for the snapback is anyone’s guess.
There is no guarantee that the current market will track that amalgam, knowing what a composite of past Bears looks like can be helpful to your understanding of what is typical.
This table shows Secular Bear Markets and Subsequent Rebound Rally:
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Source:
The Aftermath of Secular Bear Markets
Authors: Teun Draaisma, Ronan Carr, CFA & Graham Secker, Edmund Ng, CFA and Matthew Garman
Morgan Stanley European Strategy 10 August 2009
The S&P 500 is now up 51.68% in the 165 calendar days since its March 9th closing low. Below we highlight all "official" bull markets for the S&P 500 since 1927 (a rally of at least 20% that was preceded by a decline of at least 20% is considered a bull market).
Many bears believe the recent gains are just a rally within a longer-term downtrend. But the argument that we'll eventually head lower than the March lows is becoming a harder and harder sell. One argument the bears use is that we saw a number of similar bear market rallies that were this extreme during the overall 86% decline that the market saw from September 1929 to June 1932. However, as shown in the table below, the current rally is now bigger and longer than any of the rallies seen during the 1929 to 1932 crash. The biggest rally during the '29 to '32 period was 46.77% over 148 days. The current rally is up 51.68% over 165 calendar days.
For the fourth time in six days, China's Shanghai Composite finished down more than 2.5%. On an intraday basis, the index is down 20.6% from its high just over two weeks ago. On a closing basis, the Shanghai Composite is down 19.9%, which is dangerously close to the 20% threshold for a bear market.
Copper is no doubt one of the most economically sensitive commodities in the world. Many investors even say the metal has a PhD because of its predictive value. The current rally in copper has been incredibly strong. So strong, in fact, that it makes me question my secular bear market thesis. Of course, it’s important to note that the Chinese stimulus plan has had a huge impact on the price of copper and will likely continue to influence prices in the coming quarters. As for now, the price surge has to be taken as an enormous vote of confidence in economic activity going forward. In the near-term, however, copper is already 5% off its highs and continues to struggle in today’s market. The low volume rally in stocks is not being confirmed by copper which is currently trading flat on the session.
USA Today reports on the (lack of) returns in money market space:
Money isn't everything, at least to investors in money market funds. Yields are at all-time lows, and nearly a quarter of funds yield nothing at all.With that as a background, this won't surprise you. Over the past twelve months, the Lipper Money Market Index has returned 1.01% (higher than 0.08%, but minuscule none-the-less).
The average money fund yielded an annualized 0.08% the week ended Aug. 4, the latest data from iMoneyNet, which tracks funds, show. At that rate, a $10,000 investment would return 15 cents a week. But 275 taxable funds have no yield, 23% of the 1,180 funds iMoneyNet tracks.
A P/E ratio rising from 10 to 18.35 is what happens when the S&P 500 rallies 50% (the P) while earnings (E) continue to decline. Below we provide a chart of the S&P 500 price to earnings ratio since the start of the 2002 bull market using trailing 12-month diluted earnings per share from continuing operations.
The S&P's P/E ratio reached its highest level since the end of 2004 earlier this week. While P/E expansion is not unusual during bull markets, investors will remember that the S&P 500's P/E actually declined from the start to the finish of the '02-'07 bull. This is because earnings grew even faster than stock prices. When looking at the chart below, you can see that the P/E did expand in the early days of the '02-'07 bull before earnings finally started to grow again in late 2003 and early 2004. Obviously if the current bull is going to have any sustainability at all, earnings will have to start growing again. But for now, as evidenced by the skyrocketing P/E ratio, investors are paying up on the hopes of future earnings growth.
Insuring against such events has helped returns for PIMCO's target-date funds and now the company is looking to expand this approach to other strategies.
Vineer Bhansali, managing director and head of analytics for portfolio management at Pacific Investment Management Co. LLC, Newport Beach, Calif., was instrumental in developing the firm's original fat-tail strategy as part of what he calls “offensive risk management.”
“Typically you think of spending money for insurance as a cost, but if you think of the performance of an investment portfolio in three or five or 10 years, you should expect to have the portfolio impacted by a fat-tail event, and having that cheap tail hedge can make the difference between surviving and having to liquidate,” Mr. Bhansali said.
The emphasis for PIMCO is not so much on anticipating the probability of a catastrophic event, but preparing for the severity of it — what Mr. Bhansali calls “just-in-case” insurance.
“When everyone sees the hurricane, you can't sell the house because everyone is trying to do the same thing,” he explained
The key to tail-risk hedging is knowing where to look. Mr. Bhansali describes it this way: “One market gets dislocated and then you have a blowout and the solution to that problem creates opportunity for cheap hedges.”
Until recently, PIMCO had been hedging liquidity risk. Today, it is hedging against the possibility of inflation.
“Inflation insurance is very cheap right now,” Mr. Bhansali said.
So far, the company has applied tail-risk hedging to its Global Multi-Asset Fund, a nine-month-old fund that Mr. Bhansali manages with PIMCO co-CEO and co-Chief Investment Officer Mohamed El-Erian and Managing Director Curtis Mewbourne, as well as its RealRetirement target-date funds.
PIMCO officials also expect to implement the strategy in portfolios where the hedges might be appropriate. PIMCO's positions in tail-risk hedged portfolios are slightly less than $9 billion in total notional value. The company manages $840 billion in assets.
Tail-risk hedging focuses on the far left end — or tail — of the probability distribution curve of investment returns. The simplest way to hedge is to not buy risky securities to begin with, Mr. Bhansali said. Barring that, portfolio managers look to invest in negatively correlated or uncorrelated securities on the tail, like U.S. Treasuries. They also seek out the cheapest instruments to buy, which may not be available in the exact markets they want to hedge but in cross markets, including equity options, bond options, currency options, inflation options, credit default swap indexes and index tranches.
Investors who use PIMCO's fat-tail strategy can end up paying 50 to 100 basis points for the underlying hedges, a costly price tag but one that Mr. Bhansali argues is worthwhile. Mr. Bhansali acknowledged that institutional investors have shown some initial reluctance to the approach, some of them reasoning that if they don't like the risks, they won't invest in them, so why bother with insurance?
“We're making significant headway but it's an interesting battle in certain areas,” he said.
Cynthia F. Steer, chief research strategist and head of beta research group at consulting firm Rogerscasey Inc., Darien, Conn., said the staffs of pension funds, foundations and endowments are still studying tail-risk hedging before making recommendations to their respective boards.
“It's still early days,” she said.
Nonetheless, she sees the strategy as a realistic option for institutional investors.
“We're in an era when we have to put risk in the portfolios as well as know when to take risk out of the portfolios,” Ms. Steer said.
She added that the likely early implementers of tail-risk hedging will be corporate defined benefit plans, followed by endowments and foundations in the next 12 to 15 months.
Erik Knutzen, CIO of NEPC LLC, Boston, said plan sponsors who are at risk of experiencing a liquidity crunch, where they would be forced sellers of assets at distressed prices, would likely see the most benefit from tail-risk hedging.
But, he added, most institutional investors don't have such a high percentage of assets that would become illiquid in an extreme environment.
“If you have a significant percentage of assets that are liquid, then the cost of the insurance can be exorbitant,” Mr. Knutzen said.
Diversified Global Asset Management Corp., a Toronto-based institutional hedge fund and funds-of-funds manager, set up an account with PIMCO in April 2007 with the sole purpose of protecting the tail of its portfolio from capital market crises and other exogenous events, according to Warren Wright, managing director and CIO of alternative strategies. Mr. Wright declined to disclose the size of the portfolio.
“In late 2006, early 2007, we approached Vineer (Bhansali) and began discussions to build a portfolio which would explode into value in a capital market crisis or when correlations are rising across markets,” Mr. Wright said in a phone interview.
At the time, DGAM was shopping around for insurance and settled on PIMCO because “it was a very large global long-only asset manager who could operate in all crises,” allowing DGAM to tactically adjust its hedge ratios regardless of market volatility, Mr. Wright said.
Fortunately for DGAM, it opened its account with PIMCO just before the financial collapse.
“We didn't know the crisis was going to hit, but portfolio insurance was extremely cheap at that moment,” Mr. Wright said.
As far as deciding whether to invest in tail-risk hedging, Mr. Wright said a lot depends on the cost of the insurance, the payoff of insurance under different scenarios, and the basis risk between the portfolio insurance and the portfolio itself — in other words, should catastrophic market events transpire, how will the insurance perform and will it offset losses on the long side of a portfolio?
Mr. Wright noted that given the implied volatility across markets, portfolio insurance today is expensive.
This year, DGAM has as much money in tail-risk hedging with PIMCO as it started with in 2007, having seen that investment quadruple in size at the height of the financial crisis and pocketing the profit, Mr. Wright said.
“We haven't exited completely but we've lowered our hedge ratios, buying less now than before because the systematic risk of a tail event is less today than at the beginning of the crisis,” he said. Mr. Wright also noted that the costs of hedging have risen and the basis risk is less clear.
That's part of the catch with tail-risk hedging. When investors want it, it's usually because an economic disaster is still fresh in their minds. But it is also when the strategy is most expensive.
“It's human nature to want to hedge right after the event and not think about insurance when the event hasn't happened in a long time,” Mr. Wright said. ?
Below we highlight the change in credit default swap prices for the major US financial firms from the start of 2008 to their peaks, as well as the change from their peaks to now. As shown, Morgan Stanley CDS prices rose the most of firms that made it through, followed by Citigroup, Goldman, and Bank of America. Default risk rose the least for Wells Fargo and JP Morgan. Since the peak of the crisis, default risk has also fallen the most for Morgan Stanley at -90%. Goldman has seen its CDS prices fall 82% to under 100 bps, and JP Morgan ranks third in terms of default risk decline. JP Morgan currently has the lowest default risk of the firms highlighted.
Subscribe to Bespoke Premium to track default risk on a regular basis.
A few days ago, the New York Fed released its latest "Probability of U.S. Recession Predicted by Treasury Spread," with data through July 2009, and the Fed's recession probability forecast through July 2010 (see chart above, click to enlarge). The NY Fed's model uses the spread between 10-year and 3-month Treasury rates (3.38% spread in June, the second highest since May 2004) to calculate the probability of a recession in the United States twelve months ahead.
Aug. 5 (Bloomberg) -- The world’s biggest debt investors say the steepest rally in the riskiest corporate bonds may be poised to fall apart.
Bonds with CCC ratings and the greatest risk of failure to make payments have gained 80 percent since March 9. The high- yield market is trading as if 7.94 percent of all issues will default over the next year, about 1.44 percentage point less than the actual rate since July 2008, according to Fridson Investment Advisors and Standard & Poor’s.
With the U.S. in its longest recession in seven decades, the riskiest bonds are soaring more than the Nasdaq Composite Index did in the five months before the dot-com bubble burst in March 2000. Debt of Austin, Texas-based Freescale Semiconductor Inc., which posted a record $7.39 billion loss last year, has jumped more than 800 percent since Feb. 27. Notes issued by Rite Aid Corp., the drugstore chain that hasn’t had a profit in two years, rose fourfold since March 9.
“It’s very difficult for some of these companies to survive with that wide a gap between their profit rate and their financing costs,” Mark Kiesel, global head of corporate bond portfolios at Pacific Investment Management Co., said in an interview from Newport Beach, California.
S&P forecasts a 13.9 percent default rate a year from now, or as high as 18 percent if economic conditions worsen, while New York University professor Edward Altman, creator of the Z- score formula that calculates a company’s probability of bankruptcy, puts the figure at 12.8 percent.
Better Value
Investors should dispose of high-yield debt, rated below Baa3 by Moody’s Investors Service and BBB- by S&P, because defaults are climbing and investment-grade securities offer better value, said Kiesel, whose firm oversees the world’s largest bond fund.
The U.S. economic outlook also may not justify junk-bond prices, especially on the riskiest debt, said Elaine Stokes, who helps oversee $124 billion at Loomis Sayles & Co. in Boston.
Real gross domestic product will expand 2.1 percent next year after shrinking 2.5 percent in 2009, according to a Bloomberg survey of economists.
“A very rosy economic scenario is being priced in,” said Stokes, who co-manages the Loomis Sayles Bond Fund and has been cutting holdings of CCC rated securities.
“We definitely don’t feel now is the time to be chasing CCCs,” she said. Debt with that rating lost 38 percent last year, Merrill Lynch & Co. index data show.
While many high-yield debt issuers have reduced costs to survive the recession, the junk-bond rally is reminiscent of the run-up in technology stocks during the late 1990s, said Martin Fridson, chief executive officer of the New York-based credit investment firm that bears his name.
Satellite Bonds
The Nasdaq rose 75 percent from Oct. 8, 1999, to March 10, 2000, reaching a peak of 5,049. Within five weeks, the index lost about 34 percent of its value.
As high-yield debt prices increased, issuers rated CCC by S&P or Moody’s, such as Ford Motor Credit Co. and XM Satellite Radio Inc., have sold $5.55 billion of bonds since April 24, compared with $650 million in the previous six months, according to data compiled by Bloomberg.
The average price of CCC bonds climbed to a one-year high of 73.1 cents on the dollar Aug. 4 from a record-low 31.6 cents on Dec. 12, according to Merrill Lynch data.
That’s the fastest and sharpest recovery during a credit cycle on record, with prices 10 cents higher than at similar points during the last two recessions, Bank of America Corp. strategists Oleg Melentyev and Mike Cho in New York wrote in a July 23 report.
‘Very Optimistic’
Debt rated CCC will return an average of 1 percent during the coming five years, they wrote. That’s even under “very optimistic” assumptions of 22 percent of those issuers defaulting and a 20 percent to 30 percent recovery rate -- or amount of face value an investor can expect to receive after payment cessation.
The 1 percent gain would be “paltry compensation” for the securities’ risk and assumes an economic recovery as “optimistic as any V-shaped scenario could be,” Melentyev and Cho wrote.
Bonds rated CCC are “currently vulnerable to nonpayment” and “dependent upon favorable business, financial and economic conditions,” according to S&P.
‘Instant Shock’
Average yields on high-yield bonds fell to 8.88 percentage points over U.S. Treasuries as of Aug. 4 from a peak of 21.82 percentage points in December, according to Merrill Lynch data.
Spreads may widen by about 2 percentage points after August if there’s an “instant shock” or investors sell to “take profits,” John Fenn, a high-yield strategist at Citigroup Inc. in New York, said in an e-mail message. The securities would then likely rally again because “there’s plenty of money willing to chase the market,” he said.
In Europe, the yield premium investors demand to hold high- yield notes rather than similar-maturity government debt has about halved to 11.42 percentage points, from 22.63 on March 9, according to Merrill Lynch’s EMU Corporate Index. The securities have handed investors a record 53 percent return this year, assuming reinvested interest, Merrill data show.
CCC rated securities averaged a 40 percent annual default rate from 1999 to 2003, according to the Bank of America report. The U.S. went through the first recession in a decade from March to November 2001, according to the National Bureau of Economic Research in Cambridge, Massachusetts.
Freescale Semiconductor
Freescale Semiconductor, a supplier to automakers General Motors Corp. and Ford Motor Co., posted a fourth-straight quarterly sales decline and a loss of $481 million on July 23. Yet the company’s 9.125 percent notes due in 2014 rose 815 percent to 59.5 cents on the dollar from 6.5 cents on Feb. 27, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
As of July 3, Freescale’s liabilities exceeded assets by $3.36 billion, according to the company. Blackstone Group LP and Carlyle Group led the acquisition of the company in a $17.6 billion private-equity transaction in 2006.
Freescale spokesman Andy North declined to comment.
Harrah’s Entertainment Inc.’s 6.5 percent notes due in 2016 have risen 690 percent to 41.5 cents on the dollar from 5.25 cents on Feb. 27, Trace data show. Excluding about $4.3 billion in gains from distressed debt exchanges and buybacks this year, the world’s biggest casino company hasn’t reported a profit in seven quarters.
Gambling Declines
Las Vegas-based Harrah’s was taken private by Leon Black’s Apollo Management LP and TPG Inc. for $30.7 billion in January 2008. Record gambling declines in Las Vegas and Atlantic City, New Jersey, the two biggest U.S. casino centers, led the company to report on July 24 that second-quarter revenue fell 13 percent.
Even after cutting debt, interest on Harrah’s more than $20 billion of long-term bonds and loans ate up 20 percent of revenue, according to the company.
Jacqueline Peterson, a Harrah’s spokeswoman, declined to comment in an e-mail message.
The rally in the lowest-rated bonds may be merited for companies such as Camp Hill, Pennsylvania-based Rite Aid that have trimmed staff, costs and inventories, said Robert Veno, an analyst at KDP Investment Advisors Inc., a high-yield research firm in Montpelier, Vermont.
‘Too Extreme’
“The original selloff going into March was too extreme,” Veno said in an interview. Now “people are giving them a lot of credit” for reducing costs.
Rite Aid’s 9.5 percent securities due in 2017 more than quadrupled to a 14-month high of 76.5 cents on the dollar from 18.9 cents on March 9, according to Trace. The third-largest U.S. drugstore chain has reported $4.12 billion of cumulative losses over the past eight quarters.
Karen Rugen, a Rite Aid spokeswoman, declined to comment.
Plunging high-yield bond prices earlier this year allowed companies including Freescale and Harrah’s to swap and buy back securities and loans at distressed prices, lowering debt and staving off default by pushing maturities into the future.
With signs of a thaw in credit markets, investors added $20.6 billion to speculative-grade bond funds through July 29, which exceeds any full-year total in at least eight years, according to Cambridge-based EPFR Global, which tracks $10 trillion in assets.
Economic Fundamentals
Some fund managers “are concerned that valuations may be running ahead of economic fundamentals,” Fridson wrote in a July 29 note. “But none of this appears to concern individual investors, who are pouring money into high-yield mutual funds at a prodigious rate.”
Fridson’s projection that the U.S. junk bond market priced in a 7.94 percent default rate as of July 31 was derived from the amount of bonds quoted at so-called distressed levels, which is when yields are 10 percentage points or more over benchmarks.
The 12-month trailing speculative-grade default rate is currently 9.38 percent, S&P said today. Moody’s forecasts the figure to peak at 12.9 percent in the fourth quarter before declining to 5 percent by July 2010.
The extra interest investors demand to own bonds with CCC ratings rather than Treasuries fell to 13.76 percentage points on Aug. 4, the lowest since Sept. 1, two weeks before Lehman Brothers Holdings Inc. collapsed. The record high was 44.29 percentage points on Dec. 15, according to Merrill Lynch data.
Recoveries on defaulted high-yield bonds averaged 21.8 percent in the first half of 2009, the lowest in at least a decade, according to Fitch Ratings in New York.
The flood of cash entering the speculative-grade market and looking for yield has made some investors “afraid to get out” in case prices keep going up, Stokes said.
“You go through periods like this where you’re much better off being a momentum guy, just jumping on the bandwagon and saying who cares whether they’re good value or not, they’re going higher,” said Fridson. “The fundamental people label that the bigger fool theory, and they tend to eventually get vindicated.”
While movements in gold over recent weeks have been overshadowed by the spike in equities, the commodity has quietly rallied to levels it hasn't seen in nearly two months. As shown in the chart below, the price of gold is currently at its highest level since June 5th. Just as the S&P 500 has little in the way of resistance between 1,005 and 1,100, from the looks of the gold chart, there aren't any roadblocks between its current price and $1,000.
Mark Hulbert [1] looks at the question of whether this is a once-in-a-generation stock market low (secular bull market) or a mere “cyclical” low.
To figure out which, he looks to Ned Davis of Ned Davis Research. NDR identified seven factors to determine if any given market low is a secular low, setting up the next lasting Bull Market.
The Seven Factors: There should be:
1. Money, cheap and amply available;
2. Debt structure that’s been deflated;
3. Large pent-up demand for goods and services;
4. Stocks that are clearly cheap;
5. Investors who are deeply pessimistic;
6. Major investor groups with below-average stock holdings;
7. Fully oversold, longer-term market conditions.
Looking at these elements, how does this cycle measure ?
1. Cheap Money? Neutral. You might think that this factor should be rated as “bullish,” given how accommodative the Federal Reserve is currently. But Davis notes that banks are also significantly tightening their lending standards. Given the heavy load of debt under which both consumers as well as corporations suffer (see next criterion), banks are finding it “increasingly hard to find ‘credit-worthy’ borrowers.”
2. Debt structure deflated? Bearish. This is the most negative of any of Davis’ seven dimensions, since by no means is the debt structure deflated. On the contrary, Davis calculates that the total credit-market debt load right now is nearly four times the size of gross domestic product, and that it takes more than $6 of new debt for our country to produce just $1 of GDP growth. That’s almost double the amount of debt required in the 1990s.
3. Pent-up demand? Bearish. Davis acknowledges that there has been improvement along this dimension from where things stood at the beginning of the bear market. But he is particularly worried by the ratio of total Personal Consumption Expenditures to Non-Residential Fixed Investment, which currently stands at a record high. At the secular bear market low in 1982, in contrast, this ratio was at a record low.
4. Cheap Stocks? Neutral. Though the stock market “got undervalued at the March lows,” it never became “dirt cheap.”
5. Sentiment? Bullish. Davis says that past secular market lows were accompanied by an extreme amount of pessimism, and his indicators show a similar extreme existed earlier this year.
6. Stock vs cash reserves? Neutral. While foreign investors have record-low stock holdings, according to Davis, household holdings — while low — are not nearly as low as they were at prior secular bear market lows. And institutional investors’ stock holdings “are only down to an average weighting historically.”
7. Oversold longer-term market condition? Neutral. Davis believes that, though many of the excesses of the real-estate bubble have been worked off, some still exist. That’s particularly a problem, he says, given that the stock market bubble of the late 1990s never completely deflated either. “As we saw in Japan after 1990, a double-bubble in stocks and real estate leaves it difficult to put ‘humpty dumpty’ together again.”
According to Davis, there is but one of the seven foundations of a major secular bull market in place. Three are neutral, three are bearish.
Conclusion: This is a Cyclical Bull market . . .
