11/16

JUNKYARD DOGS

Bow Wow Wow, Yippee Yo Yippee Yaa...Once again, we invoke the words and thoughts of Ray DeVoe when we tell you that "liquidity is a coward".  It vanishes at the first sign of trouble.  Given the action in the credit and equity markets these days, we're just guessing that you already know the truth of this statement.  If not, well it appears as though the education has just begun.

We've been harping for some time now on the fact that credit excesses developed in the economy and the financial system during the Greenspan reign would at some point have to be reconciled.  Both consumer credit and corporate debt.  Whether a major global economic power or a tiny developing third world nation, it seems that the pattern of credit expansion, excess and eventual bust is endemic to the human "economic condition".  The cycle has been repeated so many times throughout history that the characteristic traits of each phase of the cycle are virtually unmistakable.  The continual unknown is the timing and severity of each phase of unique credit cycles.

"Take A Vacation Or Invest In A Hot Stock"...Despite a roaring economy and stock market, the experience of the American consumer in terms of personal leverage has been anything but pleasant over the last 10-15 years:

Particularly striking about the above chart is that although personal debt payments as a percentage of personal income are currently near the highs of the last twenty years, the level of personal bankruptcies is over three times the level seen when the ratio was previously at this height.  Moreover, at the last peak in debt relative to personal income, nominal interest rates were much higher than they are today.  Possibly the single biggest wildcard in terms of how the current credit cycle unfolds is the US consumer.  We have the strong feeling that as the economy turns down and enters its next recessionary period (whenever that may be), the consumer may retrench much more than the current consensus may believe.  Leverage, exposure to financial assets and highly valued real estate, etc. will be the ingredients for significant perceptual change as the macro economy slows.  Just look at the implied appetite for consumer debt in the early 1990's in the chart above.  The consumer slowed debt expansion as the economy slowed (albeit interest rates were also coming down allowing refinancing of existing debt).

Having said this, we thought it was high time we discuss the current state of the junk bond market in the US.  Shifting from the consumer to the corporate side of the unfolding credit cycle if you will.  The reason we preface the corporate view of the world with the consumer is that the consumer ultimately effects the corporate credit outlook.

Junkyard Dogs...As we describe on our managed account activity page, we have stayed away from junk debt investing now for two to three years.  Conceptually, we want to play in the garbage dump at or near the bottom of an economic cycle, but avoid toxic junk debt near a top.  Cash flow is king in junk land.  We want to know just how bad cash flow can become before we commit capital in this area.  Given the excesses in credit creation over the past decade or so, there are sure to be plenty of DOA candidates in junk land over the next few years, but invariably there will be opportunities.  Is it time to commit capital right now?  We're not committing a penny quite yet.  What we do suggest is that investors begin to do their homework here.  The junkyard is beginning to attract our academic interest.  Not only do we smell blood, but it's actually beginning to run in the Streets.  We've turned the green lamp shade on, but have not broken open the piggy bank yet.  This cycle may turn out to be a bit "special" on the way down.  But that's what future opportunities are made of, now aren't they?

Current trouble in high yield land is nothing new.  For anyone who has been monitoring the marketplace, trouble has been brewing for a few years now.  We hear the Street speak of the spread between Treasury and high yield debt as significant, but we believe this analysis is missing the boat this time around.  The Treasury Dept. buybacks of government debt in the open market are clearly skewing Treasury yields lower than may be seen in the absence of these activities.  We suggest the correct method of monitoring pain in the junk market is to look at the spread between high yield debt and high quality corporate debt.  The following, if you will:

As you can see, this spread has currently surpassed the LTCM crisis period experience of late 1998 and is approaching the worst of the junk bond blow up days of the early 1990's.  Pain in junk debt land has not just begun, it's more than well underway.

Welcome To The Jungle, It Gets Worse Here Everyday...What we are clearly monitoring and suggest will be different this time is that excess liquidity of the last five years will ultimately be met with a significant lack of liquidity as the cycle unravels.  The reciprocal of excess.  The proverbial pendulum swing.  At the moment, despite reported GDP growth that is still acceptably positive, high yield bond default experience resembles that of periods marked by recession.  See what we mean?

Moody's recently projected high yield debt defaults to approach 8% in 2001.  As you can clearly see, we are approaching record levels last seen in the recession of late 1990.  How bad will defaults become we if now enter a recession?  Who knows.  The simple answer is worse than we possibly expect.  

What we sincerely believe is "different this time" is the new era.  The perceptual effect of the new era in credit issuance in the last half decade or so, that is.  As you know, the lending to telecom, speculative tech and 'Net companies over the last few years has been quite significant.  Not only debt issuance in the open bond markets, but also the explosion in syndicated bank lending under the conceptual tranquilizer of "sharing the risk".  The following chart gives you a little feel for the explosion in high yield issuance during the hardcore new era mania period of 1999.  What is also striking in the chart is that new high yield issuance this year appears to parallel the rise and fall in the stock market like clockwork:

Although we fully expect the downside of the credit cycle to be severe, blood is now flowing in the Streets and on corporate P&L's and balance sheets.  First it was quality conscious Wachovia a few months back followed by Union Bank Cal.  Now it's BofA, First Union, Sun Trust, and the brokerage community.  Bridge loans by Merrill to telecom companies in 3Q more than doubled over what they extended in 2Q.  Looking like a future problem.  The telecom debt question/problem at MSDW.  ICG telecom filed a few days back and left junk debt holders wondering just what to do with their $2 billion in par value paper.  This is blood.  It's scary, it hurts and it is flowing.   

The data we have shown you indicates that the high yield market today is in much worse shape than during comparable "phases" of prior credit cycles.  It's a testimony to the profligacy of the credit expansion this go around.  Yield levels generically in the junk area are well into double digits:

(When looking at the above chart, remember that yield levels in aggregate were higher in the early 1990's than we now experience.)  Nonetheless, we are starting to do our homework on selected areas of the high yield market.  Shaky telecom operations are off limits.  Emerging market debt (especially foreign) is not even a consideration.  Although we do not believe now is the time to start investing, it is the time start examining cash flow.  The worst case is that one never does anything and the study of cash flow makes one a better stock investor.  We expect corporate earnings and cash flow to deteriorate in the quarters ahead.  We likewise expect liquidity conditions in the high yield market to suffer.  Possibly opportunity lies two to three quarters out.

You Want A Taste Of Bright Lights, But You Won't Get There For Free...High yield investing is hard work when looking at and investing in singular issues.  A real possibility is to go with a fund approach for pure diversification purposes.  As you know, part of the dismal performance of high yield debt in general has not only been because of beginning to live through the "other side of the credit cycle", but also because investors have shunned/sold bond funds in general in favor of stocks.  (Open end funds have an additional element of risk due to individual redemption possibilities.  Closed ends do not suffer redemptions but do experience price volatility based on both bond prices and general liquidity.)  The high yield market is estimated to be about $700 billion in total size.  As you know, roughly equivalent to the combined market caps of GE and Microsoft.  Liquidity is not significant.  Moreover, scared liquidity is nowhere to be found in an environment like the present:

High yield funds or investments should never be a large portion of anyone's portfolio.  Risk is high, plain and simple.  As contrarians, our sworn solemn duty is to examine the factual information surrounding any investment opportunity, regardless of how either distasteful the asset or how well loved.  What we see in the numbers is as follows (Source: First Boston):

High yield investing is an exercise in focusing on total rate of return.  Especially in today's world.  In the current environment with the Merrill High Yield Index showing a 13% cash yield, the key question for investors is not in trying to guess future default rates, but rather in assessing whether one is being compensated for assuming above average default rate risk.  The current 13% income return being shown by the Merrill number combined with Moody's very high projection of an 8% default rate would academically leave one with a 5% total rate of return if both of these assumptions proved valid.  The 13% income cushion allows a 13% default rate to just break even.  A 20% default rate yields a loss of 7%.  You can do the math.  We'll tell you one thing right now.  An actual 20% default rate on high yield debt would most likely mean an absolute implosion in the stock market from here.  Remember, the Fed is on the other side of the equation here.  They simply have no choice except to try to stop the world from coming to an end if indeed we were heading in that general direction.  An interest rate ease somewhere in the future is nothing short of a guarantee.  The Fed will ultimately reliquify a system under extreme stress.  To bet on an extreme implosion in the high yield market from here is to bet on an extreme outcome.  Possible, but a low probability bet.

We'll have much more to say on this topic moving into next year.  We are not recommending junk bonds.  The time to buy is when we are at or very near recessionary levels in the general economy.  We're not there...yet.  We are recommending homework.  We expect loss selling in high yield to be extreme at year end.  We expect "things" to get worse before they get better.  We are not putting any investment money on the line right now.  We are simply stepping up our monitoring activities in the junkyard.  Isn't this what contrarian rigor is all about?

Are We Oversold?...We're quasi-oversold, semi-oversold, the margarine of oversold, the Diet Coke of oversold, one-calorie oversold.  At least that's what the fast stochastics are suggesting.  Have a look:

Watch the charts we have been showing you recently of the NASDAQ potential consolidation zone in the 2500-2750 range.  That may be the first stopping point near term.  We'll keep you updated.