“I’ve been in the markets for more than 30 years and I have never seen such a complete dislocation between the equity and debt markets,” says Citigroup’s head of investment research Bruce Rolph in today’s Financial Review. It’s the most intriguing question in finance now…does the collapse of the credit bubble mean falling stock prices or not?
“It’s like we are all on the Titanic headed towards the iceberg. Except the bond guys are in the engine room trying to figure out if there are enough life jackets in case we hit an iceberg, while the equity guys are on the fourth floor sipping martinis,” ads Kumar Palghat, the managing director at Kapstream Capital. “One of the two markets is wrong,” he adds.
Are life jackets normally kept in the engine room?
Mr. Palghat’s point is well-taken, jokes aside. It’s the question no one quite knows the answer to right now. It’s like that tree falling in the forest bit. If no one hears it, does it make a sound? If the credit market continues to implode, will it matter to stocks?
The answer, we think, is that it will matter to some stocks more than others. Lehman, Bear, Goldman, and Morgan all report earnings this week. They will tell the markets how much money subprime has cost them. Hopefully they will be honest. They will probably own up to trading losses.
Whether or not they are willing (or can) mark down the value of securitised assets…we’ll see. Goldman is up 16% from its 52 week low, Lehman 15%, Merrill 8.2%, and Morgan a healthy 23%. The market reckons the worst is behind us. A nasty surprise could change that reckoning.
By the way, of course a tree makes a sound when it falls in the forest. An event doesn’t require an observer in order to be a fact. In our younger days, we’d spend most of Saturday morning in a room secured against the invasion of all natural light. But just because we couldn’t see the sunrise didn’t mean the sun was still asleep too. Things happen all the time which we neither see nor have any knowledge of. It’s what we do when we find out they’ve happened that matters anyway.
Take stock picking going forward. Knowing what we know about credit conditions, it’s safe to say that businesses that don’t rely on the capital markets for their funding are less vulnerable than investment banks. It’s funny if you really think about it and break down what it means.
Businesses that don’t borrow a lot of money in order to make money should be relatively better off. Pretty simple, isn’t it? Business models built on low-borrowing costs may be “selected against” in this new credit environment, if you don’t mind us using Darwinian terms.
What we’re seeing is the collapse of a whole era of fictitious capitalism built on debt. Thank god. But it isn’t over yet. Not by a long stretch.
Meanwhile, anyone who owns assets that went up because credit was cheap should be prepared for falling asset values. This is what we call debt deflation. Gold might deflate too. But the money supply is rising faster than the supply of gold, which is bullish for gold investors.
Markets and Money