Wednesday, April 9, 2008

o liquidity where art thou...

one of the key lessons I have learned from years of covering stocks and companies is that they tend to be "cheap" or "expensive" for really good reasons. assets aren't valuable just because they're intrinstically good. at any given moment, they derive most of their economic value from investors' ability to pay for them. if investors are taking hits in other areas, they are less willing and able to pay X multiple for earnings. if they fear inflation, recession and home declines, they're also less likely to feel optimistic about the future.. and, now that many americans have enjoyed little income growth for the last 7-8 years, they're also less willing to buy stocks.

the key factor determining values is liquidity -- how much money can the market puke up at any minute to snatch up an asset. I remember the strange days of the bubble, when many companies could term out floating-rate short-term debt to 10 year periods and actually reduce their interest rates. it was a time when investors watched as the hedge funds, flush with billions of borrowed yen, drove in the spreads on countness debt offerings. the hedge funds were big clients of the big banks, and thus recieved major allocations for almost anything with decent yield. there was also strong demand from overseas investors recycling their trade surpluses.

that surge of liquidity has been draining out of the US economy at various points over the last few years -- depending on how you look at it. the dollar has been falling since 2002. but the yen was stable for much of that period and foreign purchases of US securities surged.

let's view some charts. I know they are crude, but my graphical capacity now is limited... the top one shows foreign purchases of US "corporate bonds" -- which by the Treasury's method includes asset-backed securities and non-agency mortgage bonds. the line is smoothed with a 5-month moving average.

next is the monthly change in the sp-500, smoothed with a 3 month moving average. this basically holds above or below zero depending on the market's overall mood. below are an approximation of corporate-bond yields -- which tend to reflect risk appetite.
the top and bottom charts show large liquidity reductions. spreads tend to move in sympthany with stocks. the one clear exeption on these charts was the early 1980s, when a violent rally in treasuries caused their yields to plunge. (it took corporates a few months to catch up.)
if you don't know, spread is the difference between treasury yields (say 4%) and the yield on corporate bonds (say 6.5%). for safe companies like GE, the difference is very small... obviously, the riskier the borrower, the wider the spread.
we enjoyed an ever-expanding bubble of credit starting with paul volcker's defeat of inflation in the late 1970s. now, I feel the danger of inflation is not being fully priced into stock stocks.
here's a fact: if you take a company's earnings and divide it by the share price, you get "earnings yield" -- essentially how much earnings you get for your money. in the 1970s, S&P 500 companies routinely had earnings yields of 10-13%.
as the post-inflationary confidence returned to financial assets, investors grew willing to accept less and less... by 1990, the earnings yield stood at 6.6%. at the height of the stock market bubble in 1999, it had declined to a mere 3.1%. now it's close to 6%. it will clearly go higher -- especially because much of the market's earnings now come from banks.. or, to be more accurate used to come from banks... lower earnings, less liquidity, but inflation for key things like energy and commodities.
now, we might see some more improvement in spreads for a little while.. I am not making any kind of near-term call here.. but it remains a bad picture for valuations on anything with risk attached. no liquidity, no fun.

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