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