Do credit issues proceed equity issues?

Discussion in 'Economics' started by Trendytrader, Mar 15, 2008.

  1. This is an intresting article that the credit markets are pricing in armaggedon will the equity markets are pricing in a little slow down.

    I'd been wondering about that also as the market seems to be holding well considering all the bad news.

    When credit and stock markets are at odds, look out

    March 15, 2008

    Wile E. Coyote's futile attempts to catch his nemesis, the Road Runner, would often lead him over the edge of a cliff, where the cartoon carnivore would hang suspended in mid-air. Only when he looked down would he crash to earth.

    To many in the credit markets, the stock market looks a lot like Wile E. Coyote. It's already way past the edge of the cliff. Equity investors just haven't realized it. After all, even in a week that ended with the shocking near-collapse of a financial icon like Bear Stearns Cos. Inc., North American equities held up reasonably well.

    The Dow Jones industrial average actually rose 0.4 per cent, while the Standard & Poor's 500 slid just 0.6 per cent and the S&P/TSX composite slipped 0.4 per cent.

    Of course, stocks have fallen a long way since peaking in October - 18 per cent for the S&P 500. But that's not nearly as dramatic as the move by the CDR Credit Index, which shows that terrified investors have sent the cost of buying insurance against credit defaults by investment-grade companies almost six times higher in the same time.

    In other words, stock investors are pricing in a bit of worry that profits may suffer, while credit investors are fearful of a wave of defaults and insolvencies.

    "The equity market has sold off quite a bit since October but it's nowhere near the sweeping, Great Depression-esque, world-is-ending kind of selloff in the credit markets," said Dave Klein, a senior research analyst at Credit Derivatives Research, a California firm that tracks credit markets.

    According to CDR, more than 95 per cent of the roughly 250 big-name U.S. public companies the firm watches boast shares that are still overvalued relative to credit markets.

    In fact, given past precedent, the S&P 500 would have to fall to about 1,000 to create an equilibrium with current levels in the credit markets, according to Mr. Klein. That's 22 per cent below the index's closing level Friday of 1,285.48.

    The firm has a model that compares the values of credit default swaps, which are derivatives that measure the market's assessment of the risk of a company defaulting on debt against the value and volatility of stock prices.

    At the moment, the model shows the stock market is overwhelmingly more optimistic than the credit market about companies ranging from Alcoa to 3M to Macy's to Merrill Lynch, and it has been since October.

    "Over the past three years we've been looking at it, we haven't seen it stay disconnected for that long, and we haven't seen it as disconnected as it has been over the past few weeks," Mr. Klein said.

    The news gets worse - credit markets still haven't fallen to where they were before the prebubble days.

    "Is credit overdone these days? We're not sure about that," Mr. Klein said. "There's still quite a ways to go to get back to 2002 levels."

    Some argue that the equity market's fall shouldn't be as precipitous as the plunge in the credit market. After all, that line of reasoning goes, the equity market never had a bubble like the credit market did in the past few years. But that glosses over the fact that the cost and availability of credit is a prime factor in too many things that affect the value of stocks, from private equity takeovers to expansion projects to setting the discount rate that analysts use when valuing future cash flows.

    Whether the disconnect between equities and the credit market eventually disappears because stocks fall or because the credit market recovers may depend on whether or not the U.S. is truly in a recession.

    "A fairly common theme is that credit anticipates recessions, equity confirms them," Mr. Klein said. "If you believe there's going to be a recession, you'd expect equity to sell off and they'll come back together in terms of the stock market dropping. If you believe there's not going to be a recession, then maybe credit is overdone."

    Given what we know about the U.S. economy, stock investors better not look down