Monday’s articles

I read several enjoyable articles today that put the market’s current situation in context.

The first is by John Hussman of Hussman funds. In it, he takes the Fed Model to task. The Fed Model says that the stock market’s earning yield can be compared to the yield on 10 year US Treasury bonds. As he clearly shows, this model looks great from 1980 to 1998, but would have given terrible investing advice from 1948 to 1980 and from 1998 until now. Does that sound like a good guide to investing–a method that worked during only 30.5% of post WWII stock market history?

He also takes to task the current practice of saying the stock market is reasonably priced by looking at forward price to earnings ratios and comparing that to historical trailing price to earnings ratios. Not only is this comparing apples and oranges by comparing projections and history, but it also ignores that profit margins are at all time highs and will almost certainly come down over time. As usual, his analysis brings a broader historical context to the situation.

The second is by Edward Chancellor (author of Devil Take the Hindmost: A History of Financial Speculation) and appeared in the Washington Post. His title is, “Look out. This crunch is serious.” In it, he argues that comparing current market problems to the short term problems of 1987 and 1998 may not be valid. His warning is that credit splurges have turned into major market problems in the past, and this one may look more like 1929 when everything is said and done.

The third article, in the Financial Times, is by Gillian Tett. In it, Tett argues that bond insurers, like MBIA and Ambac, may be in for serious trouble because they’ve insured so many structured financial products that contained bad credits. As he suggests, it’s very hard to know what these bond insurers have backed, so holding on to them as investments may prove foolhardy if it turns out they must actually support the insurance they’ve underwritten.

The last is by Bill Gross, of PIMCO, and appeared in Fortune. Gross compares current market turmoil to playing Where’s Waldo. Everyone seems to know a lot of bad credits are “out there,” but no one seems sure who is exposed to such fallout and by how much. Problems keep turning up in unexpected places, like German and French bank’s books. These problems were created by financial wizards on Wall Street who believed they could turn lead into gold, and, unbelievably, some people actually believed them!

In my opinion, it will take a long time to fully understand the severity of the current situation. This may turn out to look like 1987 or 1998, but it could also be much worse. For those who believe that credit excess always ends badly, it’s a great time to play defense and bet on those who can benefit from debt implosions.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Interest rates

For those of you not paying attention, the bond market has had an amazing month and a half!

If you are thinking to yourself, “What does the bond market have to do with anything, I buy stocks,” hold on to your hat.

Bonds are frequently used as the discount rate or the base rate from which discount rates on stocks are computed. This is most prevalently seen in the Fed Model, but is also the way almost every finance textbook used in business school starts.

If bonds drop in price, and their yields go up (as has happened lately), then stock prices should go down (all things being equal, and they never are). By how much? I’ll get to that below.

Back on May 2nd, the 10 year yield on US Treasury bonds was 4.64% and the 3 month yield on US Treasury bills was 4.87% (according to Value Line’s May 11 Selection and Opinion). Today, according to PIMCO’s website, the 10 year is yielding 5.30% and the 3 month is yielding 4.72%.

This is a massive change! The 10 year’s yield jumped 0.66% and the 3 month’s yield dove 0.15%. Because the bond market has such a huge impact on all discount rates in the market, this is a huge change!

For those of you thinking the stock market’s recent sell off has taken account of such a discount rate change, think again. The DJIA was at $13,211.88 on May 2nd and closed at $13,295.01 today, a 0.63% increase. All things being equal (assuming estimates on company earnings haven’t changed), the DJIA should be at $11,566.60–down 12.45%! Instead, it’s at $13,295.01, implying that earnings estimates for the DJIA have increased by 14.95% in the past month? I doubt that.

I’m NOT suggesting the Fed Model is correct or that stock prices should move precisely with bond yields, but I am suggesting that the stock market, and perhaps other markets, have not taken full account of recent bond price and yield movements.

Also, how do you think bond price moves will impact mortgage and housing markets? A 30 year mortgage on a $300,000 house should go up around 7% per month (or $130) based on this bond price change. Does it seem like that’s been figured into market prices for home builders and mortgage companies? It doesn’t seem like it to me.

As usual, I’m making no assumptions about what will happen in the market and when, but I do find recent bond market moves disturbing.

Perhaps bond prices and yields will go back to where they were, vindicating recent stock market moves. Perhaps fundamentals are improving just as quickly as bond prices are dropping and this justifies no move in prices.

I can’t predict what will happen much better than the next guy, but I am scratching my head and wondering what other people in the market are thinking.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.