Buy When Credit Spreads Are High, Sell When Low

Credit spreads and implied volatility are cousins. When there is complacency, both are low. When there is panic, both are high. For those of us with strong balance sheets, when do we buy?  We buy during panic. when we can get quality assets at bargain prices. When things are euphoric, we sell, or at least reduce exposure, increase quality, etc.

That’s why I don’t have much sympathy for articles talking about Great Moderation 2.0.  Ask yourself, “How did the Great Moderation work out?  Was taking a lot of risk then a good idea?

There were many that chased past returns 2005-7 that got hosed 2008-9.  So when I see articles like Trends Point to Growth & Stability, I shake my head and say, “Driving by looking through the rear-view mirror.”

I feel the same about this article, Investors Rewarded for Trek Into Little Known Markets.  Anytime a lot of new money spills into any new asset class, returns are high and implied volatility falls.  That tells us little about the future.

When implied volatility and credit spreads are low, that tells us that people are very certain about the future, and they are relying on things remaining stable. It doesn’t tell us when the bear market will come, but it does tell us that gains are limited before the bear market.

I can’t tell you when things will break, or how badly they will break.  I can tell you that stocks are producing earnings gains by levering up more, and not through organic growth.  In the short run, it pays to issue debt to buy back stock, but the additional debt eventually exacts its price — when the cycle turns, and the price of liquidity rises, the debts will still be there, and interest costs to refinance them will be considerably higher.  Or, equity might have to be issued at an unfavorable moment.

One practical tip — the area with the greatest percentage amount of credit growth is usually the one that performs the worst when the cycle turns — candidates for that include E&P firms engaged in fracking, student loans, US Government debt, and more.  If anyone can think of additional areas, please mention them in the comments.

I’m not running away.  I’m just trimming here and there, and investing in safer companies that seem to have good accounting.  All for now.

By David Merkel, CFA of alephblog

 



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.