there is always the chance of a violent reversal in sentiment.

TO BE NOTED: From the FT:

"Expect plenty of mood swings before optimism returns

By Tony Jackson

Published: March 8 2009 14:22 | Last updated: March 9 2009 05:41

At a recent session with investment bankers and pension consultants, the arresting question arose of whether credit is the new equity. Specifically, might today’s asset of choice for pension funds be not stocks, but corporate bonds?

This reminded me of the depths of the bear market in late 1974. Then, too, there was much talk of the death of the equity. Sure enough, at the turn of the year the market took off like a rocket.

Similarly, I would not be greatly surprised if equities staged a revival shortly. Whether that would represent more than another bear rally is, of course, the central question.

But consider first the bond-equity thesis, since it is relevant. Fund managers, I am told, are now putting most of their new money into corporate bonds, and buying equities only when obliged to by cash calls.

The argument for that is clear enough. Bond yields are high and guaranteed, while equity dividends are now painfully unpredictable. And while both get wiped out by insolvency, equity goes first.

Official policy is also powerfully biased towards bonds at present. Internationally, there is a clear presumption that bank creditors will be protected while shareholders are cannon fodder.

Similarly, various countries plan to buy corporate bonds directly as part of their bank rescue efforts. Just when and how much remains unclear, but every little helps.

It might be objected that there are not nearly enough corporate bonds around to substitute for equities, and that they are highly illiquid. The answer to the first is that any such shift would have to be gradual anyway, since buying bonds heavily would mean selling equities and incurring huge writeoffs.

As to liquidity, one fund manager tells me he regards illiquidity as a distinct problem in equities as well. This is because, in pre-crisis days, the lion’s share of liquidity came from hedge funds and proprietary trading desks.

Both are now mostly gone, and the survivors have nothing like the old leverage at their disposal. Those investors impatient for a return to “normal” liquidity in equities may have a long wait.

It is of course possible, as some maintain, that corporate bonds are now in a serious bubble. But that, the cynic might say, does not invalidate the broader argument. If the institutions could not hold assets which are subject to boom and bust, what price equities or real estate?

The much bigger objection, obviously, is the threat of resurgent inflation in a year or two’s time. These days, the sophisticated fund manager will guard against that with inflation swaps. But in the post-Lehman world, these are only as good as the counterparty. Precisely the same holds for insuring against default through credit derivatives.

Mention of credit derivatives brings us back to the wider argument. Last week, the cost of insuring European non-investment grade bonds against default rose to a new record.

The fact that such insurance now costs marginally more than in the depths of the banking panic last year – when it was unclear how governments would respond – is significant. It tells us the crisis is now systemic at the corporate level, and that the outlook for defaults is still getting worse.

So much the worse for the banks, whose bad debt provisions may prove correspondingly inadequate. The risk is thus of a vicious circle, whereby bank capital is further weakened and there is even less lending to the corporate sector.

In which case, one might ask what chance there is of an equity rally. After all, Morgan Stanley last week raised its estimate of peak-to-trough falls for UK corporate earnings to 60 per cent – compared, it reckons, with a 57 per cent fall in the Great Depression.

But it is just such extreme propositions that should give hope to the optimist. I am by no means saying Morgan Stanley is wrong – merely that when such ideas can be seriously entertained, there is always the chance of a violent reversal in sentiment.

The same thought is prompted by the astonishing spectacle of General Electric selling on under four times earnings. Suppose, for the sake of argument, that GE’s hugely indebted finance business can indeed drag down what was once American’s most-admired company. But it would probably take a while, and there would be plenty of room for mood swings in the meantime.

Or consider the big UK insurers, which dropped by between 20 and 33 per cent on a single day last week. If the market were to turn, so would their capital ratios, and the result would be galvanising.

And above all, markets worldwide have collapsed to the point where even the US is somewhat cheap by long-term criteria. My bet is it will get cheaper still before we are done. What happens in between could be another matter."

"Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Yesterday, I disputed the notion that Low-Information Assets allow more Trust than High-Information Assets. I said that Trust, which Banks need to survive, is never to be taken for granted, and that investors always need to be aware of a Bank' s financial status. Here's Tony Jackson in the FT:

"What are banks for? In normal times, the question would seem redundant. But, with the banks now drifting rudderless in a sea of popular resentment, the answers are alarmingly vague.

Precisely to whom do banks owe their first duty of care? Is it to their shareholders, their depositors or their borrowers? Or all of those?

The thought was partly prompted by a recent letter to this paper from a retired British banking grandee, Sir Ronald Grierson. “A bank is a bank,” he wrote, “and, if the security of its depositors is not its main concern, it should be required to adopt another name. Members of the public are entitled to take this for granted.”

I do not agree with this. We have just learned that such an attitude is not wise. But, together with this notion of Low-Information assets engendering more Trust, I can already see where many of us went wrong.

"Under UK law as it presently stands, Sir Ronald is, strictly speaking, wrong about that. At present – though this is to change – a UK bank is just another company. As such, its primary duty is to its owners."

Is this a surprise?

"More of that in a moment. First, how has the banks’ duty to shareholders been discharged in practice?

In two words, stunningly badly. UK bank shares are almost all below their level of five years ago, in most cases disastrously so. Many may never recover previous peaks."

Job well done.

"To be fair, shareholders sometimes tried to exercise their own duty of control, if ineffectually. For years, they resisted the acquisitive ambitions of Royal Bank of Scotland, only to lose their resolve at the top of the cycle. RBS’s resulting ABN Amro purchase is one main reason for its subsequent collapse into state ownership."

Job well done.

"The same recklessness characterised many borrowers. A depressing number of now-bankrupt companies made big debt-financed acquisitions at the peak of the boom. Others, such as Chrysler and EMI, are in crisis because the banks lent vast sums at the last minute to an equally reckless private equity industry."

Job well done.

"So, in general, you might think, let the borrower beware. The snag is, of course, that too much lending leads inevitably to too little, thus posing systemic threats to the economy – a problem now being urgently addressed by various governments."

If it's inevitable, how come people seemed unprepared? Of course, I don't believe that many were that surprised.

"Nor are all borrowers in the same category. I recently found myself perusing the personal ads on a supermarket notice board in the English Midlands. A striking number were for “house sharing” – seeking other families to move in and share the financial burden.

There is the plain sense here of a duty foregone. Most people know little or nothing of finance. But banks are accredited experts. If a bank says you are good for a loan, it is putting that expertise into practice.

To borrow Sir Ronald’s phrase, you are entitled to take that for granted. And, if the result is a choice between sharing your home with strangers or losing it, you are entitled to feel aggrieved."

You cannot take anything for granted. You should assess the competence of the bank that you put money in, or borrow money from. You are legally and morally entitled to your business with the bank being on the up and up.

"Let us now revert to the depositors. It might seem extraordinary that the UK has no special provisions to protect them from collapse, as opposed to insuring them after it. Most other countries, from the US and Japan to Mexico and South Korea, have had such provisions for many years."

I'm assuming he means the FDIC. Can we imagine how much worse this crisis would be without it? I assume that many free market followers would end it, although I don't hear many calling for it in this crisis.

"The usual method is a so-called “resolution regime”, whereby, if a bank seems in danger, the state intervenes and takes it into protection. It is then sold on, usually to a healthier bank. The implicit assumption is that the interests of depositors trump those of shareholders or creditors."

I believe that this is true.

"In the UK, as Sir Ronald also observed, that task was performed by the Bank of England until its independence in 1997. In the ensuing reshuffle of responsibilities, that part got left out. It is now being reinstated under legislation due for completion in February. But it took the collapse of Northern Rock to bring it about."

I believe that we have that here.

"This is the more extraordinary because, as Professor Julian Franks of the London Business School observes, the UK has had just such a regime for its utilities ever since they were privatised in the 1980s. And a bank is nothing if it is not a utility.

Both the electricity and water regulators, for instance, have powers of last resort to protect customers. If an electricity supplier goes bust, the regulator takes it over and sells it on. This happened in October to a small supplier with some 40,000 customers, Energy4Business. There was no fuss, no publicity. It was routine."

Are Banks like a Utility?

"This all leaves a worrying sense of muddle. In both the UK and US, the response of the authorities to the banking crisis has been piecemeal and uncertain, at least partly because there is no clear sense of priorities. It all badly needs sorting out."

This is true. There is a difference between Pragmatism and Trial and Error, and lurching backwards and forwards in a manner that signals unpreparedness and incompetence.

"Let the last word on this go to the Victorian banker and commentator Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Ditto for the legal framework. Lawmakers take note."

As per usual, Bagehot is correct, and his statement is simply a version of Searle's Sagacity.

"The gap between bond and equity yields is becoming a critical issue in financial markets.": Is Anything Not Critical?

Here's an interesting post on the FT by Tony Jackson:

"The gap between bond and equity yields is becoming a critical issue in financial markets.

For half a century, equities have consistently yielded less than bonds. But the reverse is now starkly true in both the US and UK. Something is badly wrong."

Yields: For The Last 50 Years

Bonds: Higher

Stocks: Lower

This has changed? Can we tell yet if it's a positive or negative change?

"The obvious place to look for clues is Japan, which has had a reverse yield gap on and off for years. So do investors think the Japanese disease of deflation and economic contraction is coming to the west?"

Yields: Today

Stocks: Higher

Bonds: Lower

This means:

Economic Downturn

Deflation

In Japan, this meant an economic downturn and deflation. Does it mean that here?

"The short answer is probably yes. But, to clarify the logic, we should first consider the relationship between bond and equity yields more closely."

Yes, and he'll tell us why.

"Until 1959, the norm was for equities to yield more than bonds in both the UK and US. This was a simple expression of what is now called the equity risk premium."

Previous to the last 50 years, we had the following:

Yields: More Than 50 Years Ago

Stocks: Higher

Bonds: Lower

Reason:

Equity Risk Premium

This sounds like it means that stocks involve more risk than bonds. Let's see. Words can be awfully deceptive at times.

"Just as in a horse race, where the odds are better on an outsider than on the favourite, it seemed obvious that risky equities should promise a higher return than safe bonds. But, from 1959 onwards – until today – the formula reversed. Why was that?"

A gambling reference. How interesting. You'll win more if the underdog wins in a horse race. In the horse race between stocks and bonds, stocks were considered the underdog. The underlying theme is that you expect a higher return for more risk.

"Financial theory – which, not coincidentally, had its origins in the 1950s – has an answer to that. As Professor Paul Marsh of the London Business School explains, it allows us to state that the yield gap equals the expected risk premium on equities minus the expected growth in dividends."

You figure out the risk premium for a stock, and then subtract it from the dividend yield of a stock.

"Before the reader’s eyes glaze, let me hastily say this expresses a fairly simple concept. To arrive at the equity yield, investors notionally add a risk premium to the bond yield. But they then adjust for the fact that equity dividends grow in real terms and also tend to rise with inflation, whereas bond dividends do neither."

The yield of a stock dividend =

1) The Bond Yield +
2) Some Extra Money To Compensate For The Fact That Stocks Are Riskier +
3) Since Stock Dividends Can Go Up ( Or go down ) , Whereas Bond Yields Are Often Fixed, You Have To Fiddle With The Figures A Bit. In this scenario, it sounds like stocks can be less risky over time, since they can figure in inflation, for example.

"It follows that inflation and growth are both crucial in determining whether the yield gap is positive or negative. The higher each of them is, the more equity yields will tend to fall below bond yields."

On 3, the higher inflation and growth is, the less risky stocks are as compared to bonds, so the yield of stocks will fall in relation to bonds.

"The Japanese example supports this.
Peter Eadon-Clarke of Macquarie has a chart comparing the Japanese yield gap with nominal GDP growth over the past decade. Broadly speaking, when nominal GDP is negative, the yield gap tends to be too."

3 happened in Japan, only in reverse. As GDP went down, stocks got more risky.

"The GDP figure here may be taken as a rough proxy for dividend growth. And the essential point is that it is nominal, thus including inflation. Generally, for nominal GDP to shrink, both inflation and growth must be negative. Japan is the one country to have displayed that malign combination so far."

In economics, nominal value refers to any price or value expressed in money of the day, as opposed to real value, which adjusts for the effect of inflation.

GDP = Dividends : in this example

"I should add that the historic record is rather less tidy. Prof Marsh has data* showing that both dividend growth and inflation were higher in the second half of the last century than in the first."

What about the first 50 years? Why did it change 50 years ago?

"But I calculate that, in the five years to 1959, US inflation and GDP growth were both higher than in the five years following. So why the crossover should have happened just then remains problematic.'

"Problematic" means "Unexplained". One question is whether investors came to simply value dividends less, or were there changes in the tax laws, etc. ?

"In addition, a crucial part of Prof Marsh’s equation is the equity risk premium. But, as he puts it, the premium is unobservable – that is, it can be measured only in retrospect, not at the time."

Oh dear. That's a serious problem for looking forward.

"All that suggests that, when we come to the present situation, we should proceed with due caution. That said, what do we think is going on now?"

No one knows exactly what's going on, but:
1) I need to post a column, and this is pretty interesting.
2) Since no one knows exactly what's going on, there's room for me to speculate without fear of being clearly refuted. Unless, of course, I use fallacious reasoning, misread graphs, etc.

"In essence, the steep fall in Treasury bond yields across the developed world does indeed suggest strongly that investors fear deflation while the steep rise in equity yields suggests they fear a sustained collapse in dividends. And they are presumably also pricing in a higher risk premium for equities. So all the parts of the equation are heading the same way."

Before, wasn't it a kind of inverse ratio?

"That said, the reality is slightly more complex. Today’s low bond yields represent a tension between opposing forces. On the one hand, investors crave security. On the other, an enormous amount of new bond issuance is likely on both sides of the Atlantic."

The tension sounds like supply and demand.

"And, with another part of their minds, investors do not regard bonds as all that safe. The cost of insuring UK government bonds against default has risen from eight basis points in February to 110 basis points today – still quite a modest level but not reassuring."

It reminds me of the song line, "Trying To Make It Real, Compared To What?".

"In fact, bond yields could prove the vulnerable part of the equation. In the bubble years, risk was ludicrously underpriced. Quite reasonably, we should now expect it to become overpriced by a similar amount."

That's what I basically expect, except that it isn't an exact equation, although "similar" might be fine.

"When that eventually corrects itself, bond yields should rise. Equity yields might also fall – to the extent that investors recover their risk appetite. And indeed, fears of deflation might prove unfounded, as might the prospect of an extreme collapse in dividends.

But not just yet, I think. In the meantime, the old-style pre-1959 yield gap could become part of the landscape."

Let's see: 3 mights, 1 should, 1 to the extent, 1 not just, 1 think, 1 could. Thanks for going out so far on a limb. We'll keep track of all of your hedged bets, to use a gambling phrase.

This isn't the first post I've read about this. It is, however, among the clearer and more interesting. In fairness to Tony Jackson, I've laid off this topic precisely because they have to include a lot of speculation.