Trade in Groups

We noted previously that during the worst of days in October, Campbell Soup (CPB) was the only stock in the S&P 500 to rise. Add another distinction to the soup maker – traders have more confidence in its credit than in the US government. Via Bloomberg, it’s noted that the price of credit default swaps on Campbell Soup are lower than CDS on US Treasury debt (which would pay the holder in Euros) – meaning that Campbell Soup is viewed as one of the most creditworthy entities in the world right now.

With CDS prices on US Treasuries at 67 basis points for a 5-year contract, subtracting that amount from the current yield on 5-year Treasuries (1.61%) means that the “adjusted risk free” 5-year borrowing rate is a meager 0.94%.

With returns on cash so low, does that mean it’s time to aggressively buy equities? Hardly. Above all, we have been advocating a focus on capital preservation and prudent risk management the last few months, and see no reason to depart from that. This means owning puts under long equity positions, and/or matching short equity positions (or long puts) against them. Some dividend yields look appealing, but they must be judged on their safety – no point in buying something with a 10% dividend, only to see the dividend cut and the stock drop 20%.

Be particularly wary of dividends from financial companies, as their leverage ratios make paying out capital more costly. Credit protection costs on commercial mortgages continue to rise, and the prices of leveraged loans continue to fall. The top tranche of AAA asset-backed securities are likewise down 25-30%, and it will be interesting to see where banks mark their assets next quarter; I believe many of them would be technically insolvent if the marks were based on the cost of credit protection. Likewise, leveraged loan prices in Europe have fallen off a cliff; the tracking indices ended September at within a point or two par (100), and now trade in the 70-75 range. Because those banks actually run higher leverage ratios than American banks and comprise a disproportionate share of their home country’s GDP, we could see some interesting accounting – or bailout attempts – to come.

The S&P 500 has rallied about 20% from its last bottom in November, but during that time the Transport index has underperformed despite sharply lower oil, and FedEx (FDX) has gotten crushed after slashing guidance on continually deteriorating economic activity. And this rally has occurred despite an easing in credit fears – while there has been some stabilizing and even slight easing in investment grade credit indices, the riskier assets continue to be dumped across the board, and even sovereign credits have raised concerns judging by the CDS market.

One of my better professors taught me in a quantitative modeling course; he was very practical and always made us step back from the numbers and analyze why our model could fail to represent reality. The equity market has diverged (positively) from the credit indices, has outpaced the transports (a measure of economic health) and has been led by a nearly 40% rally in financials that appear to have very sick assets on their books. Yesterday we noted the signs this rally appears to be getting tired and complacent, and overall this assessment makes us nervous. Yet our model of what “should” be happening does not square with what reality is showing us – what to do? Staring at the chart below and pondering whether it means a bottom has been put in seems like a good place to start.