Why The Mario Put is Bullish for Stocks

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It’s taken many observers including me longer than it might to comprehend, but ECB chairman Mario Draghi has done something that should be very bullish for U.S. stocks. Floyd Norris noted some of the ramifications in today’s New York Times. The Long Term Repurchase Operation (LTRO) in effect is an extension of credit from the ECB to EU sovereigns.

How can this be, when Mr. Draghi said all along he would not lend directly to governments? Because of the symbiotic relationship that exists between EU governments and their banks. The banks own most of the debt. If the banks can’t afford to roll over maturing bonds governments will default. If governments default banks will go with them. Both are locked together, and we believed that the ECB was holding off from proving needed sustenance while the politicians showed some evidence of imposing fiscal austerity. They (sort of) did at the last summit, and now the ECB has taken a path from which it will be difficult to turn.

Eurozone banks took down 489 billion Euros of three year loans at 1% this week. Whether they choose to buy sovereign debt or not is really not the point. They can, and now whenever the banks appear sufficiently shaky that they won’t be able to finance what their sovereigns need, the ECB can be relied upon to provide it. There will no doubt be more brinkmanship and dire warnings about delaying needed economic reforms in the south, but the problem has always been the absence of a credible punishment to wavering countries. The Maastricht Treaty incorporated enormous fees (1% of a country’s GDP) that were soon shown to be implausible when Germany and France were among the first to breach the 3% deficit/GDP criteria. Forcing a country to default is clearly unacceptable. The Eurozone’s countries are all roped together, and the ECB recognizes that pushing one off the cliff endangers them all. The ECB is the lender of last resort to banks. It has become the lender of last resort to EU governments as well, and Germany as a guarantor of the ECB’s balance sheet is now part of this solution.

This is not necessarily bullish for the Euro, although the tail risk of a disorderly collapse has been removed. But it is assuredly bullish for U.S. equities. By far the single biggest question mark hanging over stocks has been Europe, and now the roped-together have stepped away from the cliff. Equities are attractively priced compared with bonds and have been for some time. This may just be the development that nudges investors off the fence.

Dislocure: Author is long diversified equities equivalent to SPY, and is long EUO

Bond Buyers Drive with the Rear-View Mirror

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Charles Evans, Federal Reserve Bank of Chicago President, was on CNBC yesterday and nicely illustrated why bond yields could stay low for a considerable time. At times sounding as if he was running in a Democratic primary campaign, Evans commented repeatedly on the pain out there in the economy and the chronic unemployment. Interestingly he maintains that the “natural” rate of unemployment remains at 6% even while the numbers of long-term unemployed remains high. The Pew Research Center recently reported that nearly 32% of those out of work haven’t worked for a year – over time leading to an atrophying of skills, reduced employability and ultimately less excess capacity in the labor force as the jobs market moves on. It is no doubt a terrible human tragedy – if only Washington could stumble on the right policies to fix it. But the familiar partisan gridlock remains.

Therefore, since low interest rates are the time-honored solution to economic distress, we face more of the same. It is a recurring irony of recessions that while excessive exuberance and debt generally precede if not cause a slump, much pain is also borne by those whose affairs were managed altogether more prudently. So it is that bond investors today are paying for the sins of their more profligate neighbors through miniscule interest rates that erode the purchasing power of their savings. The over-indebted are helped with a transfer of real wealth from the frugal. Managing your own affairs carefully carries less reward than it might.

A consequence is that dividend yields on a number of blue chip stocks are higher than the yields on their own bonds. This used to be far more common in the early 20th century when bond coupons were regarded much more favorably than uncertain dividends, and you can’t rule out that this state of affairs could persist for many months. It maybe even turn out that this yield advantage of stocks is appropriate for the risk, if we endure a period of protracted slow growth or recession that sees no dividend growth. High dividend yields can indicate corporate stress. Transocean’s stock  (RIG) currently yields 6.4%, but the market recognizes some risk this will be cut, either through continued poor execution by management or following a larger than expected settlement with BP on last year’s Macondo spill. On the other hand, Johnson & Johnson (JNJ) stock yields 3.5%, comfortably above its twelve year bond yield of 2.6%. JNJ is not a stressed company and has raised its dividend annually for 49 years. They’re likely to earn close to $5 per share this year and consensus expectations are for 5% EPS growth in 2012. There are numerous other examples in this article for instance. Pepsi (PEP) and Kimberly-Clark (KMB) probably belong in the same category – companies whose stock is highly likely to outperform its own debt.

Falling and low bond yields have so far not dulled retail investors’ appetite. Strong returns on fixed income in recent years, for those who buy securities because “the chart looks good” reduce their return potential as assuredly as night follows day. The most you can earn on JNJ 6.75% corporate bonds maturing 11/15/2023 and yielding 2.6% is, well, 2.6%. That doesn’t even cover inflation, never mind taxes for the eager, momentum-driven buyer. If that return beats stocks over the next ten years it’s unlikely that most types of corporate risk (credit or equity) will have been comfortable places to be. Is it possible the buyers are actually expecting still lower yields and therefore some capital appreciation? Ben Bernanke has surely demonstrated that yields can always go lower. But if you like JNJ bonds at 2.6%, surely treasury bills for a couple of years at 0% with the retained option to invest on better terms later on must be a viable alternative? With a modified duration of just under 9, if the yield rose to 2.9% the capital loss would eliminate the coupon income. A portfolio of reliably growing, dividend paying stocks either in combination with a beta-neutral hedge or cash is far more attractive than high-grade bonds.

 

Disclosure: Author is Long RIG, JNJ, KMB, PEP

Reining in the Rating Agencies

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Through the ongoing and mind-numbing complexity of the European sovereign debt crisis, the bureaucrats in Brussels can be relied upon to introduce some absurdity into their deliberations. The latest is a report in the FT that under certain circumstances  the EU will suspend the ability of rating agencies to evaluate sovereign credits. Now it’s true that markets are generally too reliant on credit ratings issued by S&P, Moody’s and Fitch. The basic business model of charging the issuer for the rating is fraught with conflict, as catastrophically revealed during the sub-prime crisis. However, alternative models are hard to identify – increased competition among rating agencies would likely cause a “race to the bottom” in which issuers would flock to those with the most forgiving standards. And charging investors, the actual users of the ratings, is regarded by many as unworkable.

But the downgrade of U.S. debt that occurred in the Summer highlighted the absurdity of the rating agencies evaluating sovereign debt. Unlike a corporate issuer where a detailed financial analysis encompasses most of the necessary work, sovereign credit analysis incorporates a political judgment as well. The U.S. downgrade in the Summer illustrates the rating agencies straying beyond their expertise. U.S. creditworthiness is based to a large degree on a willingness to repay debt, and an opinion on which is as much political as it is financial. The rating agencies have no more insight on the politics than many other informed observers, and as such their opinions ought to be irrelevant except for the fact that so much bond investing is rules-based driven by the ratings that these agencies issue. Many bond investors are required to hold issues with minimum ratings from the three Nationally Recognized Statistical Rating Organizations (NRSROs), otherwise known as S&P, Moody’s and Fitch.  But really, since sovereign issuers have the ability to tax, their credit ratings are by nature not simply financial. The ratings frankly shouldn’t carry any more weight than other sell-side research on bonds.

As sensible as it might seem to ditch the legal support for NRSRO-issued sovereign credit ratings, the EU bureaucrats in Brussels have revealed their own muddled thinking in the latest proposal. No doubt France’s impending loss of its AAA rating, a possibility the French regard with horror but which financial markets have already moved past, is the catalyst. The FT reports that under proposed EU regulations ratings will be suspended during times of financial stress. So good ratings are fine, but bad ones are not. And presumably the EU’s credit experts will anticipate trouble by suspending ratings prior to a downgrade, therefore providing an eloquent and informed signal to investors that perhaps those bonds are not quite as safe as previously thought.

In the U.S. we can be grateful that we don’t subsidize such entertaining idiocy with our tax dollars. It must be more frustrating for those sitting in Europe.

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