Oil and credit

Markets are trading with a lack of conviction characteristic of recent P/L distress and an upcoming event risk of the type that generally emasculates risk appetite.   Funny enough, that's exactly the situation we're in, so a bit of meandering to and fro isn't the most surprising (or worst) thing in  the world.

Equally funny was PIMCO's announcement that they had brought on as advisors Messrs. Bernanke, Trichet, and Brown- or, as many might call them, the Three Stooges.   Putting aside the issue of public sector figures criticizing the financial industry whilst in office and then accepting its filthy lucre afterwards, one can only hope for PIMCO investors that they're not using Bernanke to call the housing market, Trichet for developing optimal policy models, and Gordon Brown for market timing gold.

One market that is not meandering and clearly bears watching is crude oil- not just for commodity punters and high yield owners, but also for those friendly macro analysts who've been expecting an uptick in inflation once the y/y change in crude oil stops dropping like a stone.  The problem, of course, is that if crude itself does not stop dropping like a stone, neither will the y/y change.   If that happens, then there will doubtless be a few sneaky views on upside inflation surprises for next year that will have to get tossed out of the window.   The chart below plots the dynamic, including forward projections based on three scenarios: unchanged WTI, WTI goes to $30/bbl by mid-year, and WTI goes to $50/bbl by mid-year.

As you can see, over the next four months or so base effects will be very favourable almost regardless of the spot price; thereafter, however, there could be trouble again.  What seems close to indisputable, however, is that monetary policy cannot "solve" this "problem", since it's a function of good old supply and demand.   Indeed, if we look at the IEA estimates, we find that the one year average level of daily oversupply is the largest 1999, just after the infamous drop to $10/bbl.

Small wonder energy sector equities and credit have been mullered!  Speaking of credit, it seems like we're now at the stage where it becomes important to think in terms of the relative value of equities and credit, insofar as in the US the latter remains on the back foot while the SPX and NDX at least sail merrily along.   Such divergence can persist for a while, particularly insofar as the components of credit and equity indices are far from identical.   That being said, there is a wealth of historical precedent to suggest that where credit leads, equities generally follow.

While the IBoxx credit indices are nice because they offer an easy way to track the total return of investment grade and high yield, unfortunately they only go back to 1999, which is a relatively small sample size.   In the absence of a subscription to credit indices with a longer data history, Macro Man jury-rigged his own index by creating synthetic bond prices from the Moody's BAA index, which goes back to the mid-80's.   The synthetic index generally mirrors the IBoxx index quite well:

This in turn provided another decade-plus worth of data to compare with the S&P 500 total return index, which started in January of '88.  If we start at that date and plot the relative performance of stocks and credit since, here's what it looks like:

Now, there is certainly nothing special about a ratio of 1.00, since there is no guarantee that each asset class was fairly valued at the arbitrary starting date.  Still, it is instructive to note that according to this metric at least, equities are comfortably more expensive to credit than they were at the peak of the last cycle.   (Note that there is a large beta to the indicator, given the relatively higher volatility of equities.)

Now, what's really interesting is when we try to identify some sort of boom/bust line.  Over the entire sample, the average annual total return of the SPX has been 9.78%.   When this relative value metric is below 2, the average one year forward return is 15.4%.   When the metric is above 2, that average forward return is -0.84%.  We currently sit at 2.58, which is in the 92nd percentile of all observations over the last 28 years or so.

(Note:  The threshold value of 2 was arbitrarily chosen based on an eyeballing of the chart.  It was the only value tested.   1 year forward returns are not yet available for all dates less than one year ago, because the Magic 8-ball is still not working.)

This is far from an exhaustive analysis, and there are of course industry- and company-specific nuances that can impact relative pricing.   Nevertheless, at first blush the analysis seems to confirm the unease that Macro Man and perhaps others have felt about the ongoing resilience in equities in the face of the retreat of credit.  It might be a little early to suggest owning credit at the expense of equities; at the moment, in the US at least, Macro Man is hard-pressed to find compelling reasons to own either one.