David Einhorn: Scrap the official ratings agencies (Moodies, S&P, Fitch)

From Bloomberg:


Einhorn has shorted S&P and Moodies. Some take-aways:

Rating agencies are a “public bad,” not a public good.

We need a systemic change to reject the idea of centralized official ratings.

The market would adjust if we didn’t have them.

On Buffett: “He still made a very nice investment for himself.”

“The brands are ruined.”

The companies may lose their equity in (much-deserved) lawsuits.

Margins during boom reflected compromised objectivity, competing for market share.

Without official ratings the market would adjust to risks itself. Official ratings create an arbitrage opportunity: real credit risk is often higher than ratings imply (look at BP: downgraded by just “1/2 notch or something like that.” Ratings allow sharpies to front-run downgrades or prepare to take advantage of depressed prices following downgrades.

Agencies add little value. Market spreads are a much better indicator of risk.

Goldilocks is back, better watch out

It’s official: Goldilocks is back, at least for junk bonds, according to a JPM analyst quoted in Bloomberg:

March 29 (Bloomberg) — Junk bond sales reached a record this month as rising profits and record low Federal Reserve interest rates foster lending and investment to the lowest-rated borrowers.

Companies worldwide issued $38.3 billion of junk bonds in March, passing the previous high of $36 billion in November 2006, according to data compiled by Bloomberg. Yields fell 0.95 percentage point to within 5.96 percentage points of government debt, the narrowest gap since January 2008, Bank of America Merrill Lynch index data show.

This is “an almost ‘Goldilocks’ environment for leveraged credit markets,” JPMorgan Chase & Co. analysts led by Peter Acciavatti, the top-ranked high-yield strategist in Institutional Investor magazine’s annual survey for the past seven years, said in a March 26 report to the bank’s clients.

Sales soared as investors plowed a record $33.6 billion into speculative-grade funds this quarter, according to Cambridge, Massachusetts-based research firm EPFR Global. Bonds of Stamford, Connecticut-based Frontier Communications Corp. and Consol Energy Inc. of Pittsburgh, which sold a combined $5.95 billion of debt last week, rose about 2 cents on the dollar to 102 cents.

That’s a turnaround from February, when companies canceled sales at the fastest pace since credit markets began to freeze in 2007 amid concern that the inability of European governments to trim their budget deficits will threaten a global recovery.

Loan Revival

About $20 billion of high-yield, or leveraged, loans have been completed in February and March, compared with $38 billion for all of 2009, according to New York-based JPMorgan. Speculative-grade securities are rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.

Elsewhere in credit markets, yield spreads for company bonds shrank by an average 3 basis points last week to 151 basis points, or 1.51 percentage points, the narrowest since November 2007, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields rose to 4.02 percent from 3.98 percent. …

Looks like credit investors are “all-in” again, just like the stock market crowd. This never ends well.

…“Appetite is definitely there,” said Joel Levington, director of corporate credit for Brookfield Investment Management Inc. in New York, which has $24 billion in assets under management.

Sales of high-yield bonds in March more than doubled last month’s total of $16 billion, driving issuance this year to $78.5 billion, the busiest quarter on record, Bloomberg data show. High-yield companies, taking advantage of the lower borrowing costs, said they planned to repay debt with proceeds from at least $20 billion of this month’s sales.

“The mindset of investors is that this spread product is ideally situated for this kind of macro environment,” said Charles Himmelberg, the chief credit strategist at Goldman Sachs Group Inc. in New York.

Just what macro environment might that be? Silly me, I thought we were sliding down the backside of a credit bubble.

Urge to speculate not as rampant as it seems

The recovery of the US stock indexes and big new highs in the Russell 2000 and Nasdaq seem to have convinced a lot of people that we are either entering the next phase of a sustainable bull market, or about to at least crawl up another 10% before finally exhausting. I don’t see it that way. This feels to me like October 2007, when the market had smartly recovered from a hard break on the leadership of the secondaries, but the trend had been broken and stocks were strenuously overbought on extreme complacency.

This rally has mostly been a small-cap, tech stock and speculative affair. Larger stocks are not getting the same kind of bid, nor are commodities.

I have turned very short-term bearish this week on the extreme low in the equity put:call ratio. You can see here that the 10-day moving average is lower than at any point in the last three years, which at 0.51 might actually be the lowest ever (since this includes the Goldilocks spring of 2007):


How could you possibly be long given a reading like this?

Before concluding that we are blasting off here, take a look at oil, which has gone nowhere for five months, with each advancing impulse weaker than the last, and the latest looking particularly anemic:


Even gold and silver, which have dependably found a strong bid whenever stocks have rallied and even when they have not, have stalled out well under their fall highs:


Silver is weaker than gold, and this measure of risk appetite (silver:gold ratio) peaked all the way back in September:


Perhaps the greatest beneficiary of the risk impulse has been the junk credit market, which by one measure is actually showing the narrowest spreads in history over quality. This is absolutely astounding given the economic conditions, and only explainable by the notion that the investing public, twice burned by stocks in the last decade, has decided that bonds are safe, without making any distinctions among them. You can see this trend here in the ratio of the price of JNK (junk bond ETF) to LQD (investment grade bond ETF), though this chart appears to show waning momentum:


I’m not calling for an immediate crash, but certainly at least for a smart set-back, which may in retrospect turn out to be the start of a decline to new secular bear market lows. With the credit system still clogged with bad debt at the personal, corporate and state level, the economy simply has no ground from which to launch a new phase of business growth. What we have seen for the last year is simply unsustainable government spending and an overeager investing public that still trusts Keynesian economists and bogus statistics like GDP.

We are not out of the woods. We are entering a long phase of write-downs, defaults, bankruptcies and generaly frugality. We are not going to get away this time without our Schumpeterian event.

Keep an eye on the junk:quality ratio

Put this down in the list of no-fuss, no-brainer, long-term trades. Simply buy 10-year Treasury notes and short junk bonds. There is no purer deflation play than this. It doesn’t even matter if Treasury yields rise (unlikely anytime soon IMO), since you’re playing the spread and junk yields will always include Treasury yields plus a risk premium.


What are some other such no brainers for deflation? The closer something is to cash, the better.

- Long gold, short stocks. (Remember, I’m a gold bear for 2010).

- Long gold, short a basket of commodities (silver, platinum, copper, zinc, lead, oil, sugar, lumber, grains, etc).

- Long Treasuries (2, 5, 10), short stocks. This bet is safer the shorter the duration of the treasuries, but to make it work with short-dated notes, you’d have to go long a greater notional value of Treasuries than stocks. This is easy with futures: for example, for every $1M short in ES (S&P500), go long $3M ZF (5-year notes).

- Long US dollar, short hot “developing nation” or commodity nation currencies (Brazil, Australia, Canada, Russia, India, South Africa, etc).

- For later, not just yet: long 5-year treasuries, short 30-year.

- The most hard-core deflation trade of all: long stacks of $100 USD notes, short everything else, or safer yet, don’t even bother with the trading. Just wait for the market to make you an offer you can’t refuse, like a 10% dividend yield on the S&P, or $0.30 copper, $20 oil or $0.05 sugar.


To make the spread trades work, you’d have to watch your margins, set loose stops and then just leave the trades to do their thing for the next 2-5 years.

Another good week for bond spreads

Bonds are a key indicator of the health of the risk trade. So long as treasuries are shunned and junk is bid, it is likely that stocks and the commodity complex hold up. This week, long-dated Treasuries have gained a couple more points as junk bonds continued to lose their mojo:

Source: google finance

Here are the same ETFs going back to the start of the bear market in stocks. You can see that despite a huge correction in 2009, treasuries are still over 20% ahead of junk:


The collapse of the long bond has been eagerly awaited since 2007, and TBT (the 2X short bond fund) is still often mentioned in online chatter. The crowd is almost never right about these things, so I suspect that T-bonds will remain strong for the next leg down in stocks.

2008 was just been the “first look” at what can happen in the aftermath of a debt bubble — why couldn’t the same price action continue as risk in priced in again? Even if 2008 turns out to have been the “Prechter point” of greatest recognition and panic (and not what is coming), I doubt that many final price extremes were set last year.

For the yeild on the long bond, at the very least I expect another dip into the sub-3.5% area (it’s 4.5% now, and it touched 2.5% a year ago). Then we can talk about setting up long-term short positions for a secular (15-30 year) bear market.

At any rate, if think yields are going up from here, you’ve got much better odds with shorting corporate or municipal bonds, since those things are priced for perfection and defaults are going to be rampant. Even if treasury yields stay flat or go up, weak credit should collapse.

Oh, and if you just can’t wait to short long-dated sovereign debt, how about Japan at 2%? Or Greece at 6%? Or Spain, Italy, Ireland… all of this stuff is in trouble. Why pick the senior currency?

She’ll be comin’ round the corner when she comes…

Here’s a roundup of the usual markets, plus a look at grains. This topping process is frustrating, but the action remains encouraging for those waiting to profit from a resumption of the deflation trade. Even as some stock indexes make new highs, they have been revealing their weakness with low volume and advance/decline ratios. The currency and metals markets are signaling exhaustion, and Treasuries have refused to participate in this summer’s nonsense. To the charts:

The dollar to stock inverse relationship is still strong:


With only a few % of traders (DSI) bullish on the dollar and about 90% bearish on stocks last week, and respective 20-day averages similarly extreme, a big reversal is imminent. We first entered this condition in early August, and we have not had a significant correction to relieve it, but it has grown even more extreme, so when the break comes it is likely to be very large. My theory is that the more extreme sentiment gets, the sharper the reversal, and the longer extremes are maintained, the larger the degree of that move.

From a trading perspective, I prefer dollar longs (via euro, pound, CAD and AUD shorts) and gold and silver shorts as optimal short-term plays right now. This is where the single-digit DSI readings and exhaustive spikes are to be found. Short entries from this level allow for tight and well-defined stops.

Risk appetite remains very robust across the board, with investment-grade corporate bonds back to the kinds of yields we saw near the peak of the credit bubble. Here is the LQD ETF:


The above is sure to end very badly, since corporate revenues are off a whopping 25% since last year.  Treasury traders are holding up a big red flag and are not participating in this summer’s risk binge, but keeping a steady bid under the entire yield curve. Bonds made their bottom in June (TLT and IEF here — 30 and 10 year proxies, respectively).


I almost never mention the agriculture markets, but I have been watching them all summer, and I think there may be an opportunity coming up for a short-term play on the long side of grains. Wheat, corn and oats have been in a downtrend for much of the last two years, and their slides may be approaching termination as DSI readings enter the 7-18% range. This is similar, though not yet as extreme as what occurred in the natural gas and hogs markets recently, and those went on to violently reverse to the upside. The grain charts are not yet as pretty as those, and sentiment has some room to allow for an exhaustive plunge, but if it happens that would be a very nice buying opportunity, especially if we get a few consecutive days of single-digit readings. Here’s a weekly chart of wheat, my favorite:

source: http://futures.tradingcharts.com/chart/ZW/W

Corn here:


That about wraps it up. In summary, I’m feeling good about my long-term equity puts, but even more excited about the set-up in the currency and precious metals markets. I always like to able to go long something relatively uncorrelated, so it’s nice when a random commodities like grains provide such an opportunity.

Still rolling over?

At the moment, everything is still up in the air, so to speak. The rollover into the sub-950 range is still on the table, since a bounce like the last 24 hours on weak internals (such as an advance:decline ratio of well under 2:1) should surprise no one. Despite the lack of oomph here, it is still possible we drift to new highs. I’m sticking with a bearish stance until we see some more strength and breadth on the upside. A sharp drop to fresh lows in late US trading today or tomorrow would not surprise me, and this chart provides a nice stop in case that does not pan out:

Interactive Brokers


Meanwhile, the zig-zag action in the dollar since Monday looks corrective, maybe a wave 2. Sentiment remains highly bearish on the dollar in the face of a pretty sharp rally. Silver completed a brutal $1.70 drop over 5 days, but everyone still loves it. Oil is conspicuously not making new highs here with that storm out there. Nice short set-up there, since you’ve got a ready-made stop just above these levels.

Copper also seems to be losing its mojo, and is potentially on the verge of a very sharp fall after this sideways correction. Also a nice stop there. Did you read about how pig farmers and other Chinese are taking out bank loans to stockpile tons of the stuff? Now if that isn’t a productive use of credit, I don’t know what is.

Credit spreads (junk vs. quality and corporate vs. Treasury) continued to widen yesterday, further undercutting the integrity of the bounce in equities.

What should worry the bears a bit is the oversold condition in Chinese equities, down 20% from their peak a few weeks ago. But then India’s bubble is just as big and they’ve not dropped nearly as much.

Safest route here is to short with a tight stop or sit in cash. Longs are just tempting fate.

Can’t get no relief

Though this chart doesn’t show it, the TED spread has made a new all-time high, 412 basis points:









Click image for sharper view. Source: Bloomberg

Bloomberg reports that interbank lending rates around the world in all different currencies are at or near their highs of the year. This fact, along with the lack of oomph in any of the equity markets’ attempts at bounces, suggests that even this stage of the Panic of ’08 may not be over.

Central banks are being humbled because this is not a liquidity problem, but a solvency problem on a scale much greater than their combined, newly-expanded balance sheets. Not only that, but the market knows that solvency is the issue and is unwilling to resume borrowing and lending as though nothing has happened.

The only cure is time and lower prices. The banks have been propped up, but the real economy cannot be.