David Merkel has a very interesting post up on where about how maximizing enhancing yield on fixed income investments.

Within that post is a very interesting discussion on who the equity/credit cycle works:

1. After a washout, valuations are low and momentum is lousy. People/Institutions are scared to death of equities and any instruments with credit exposure. Only rebalancers and deep value players are buying here. There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks. Liquidity is at a premium.

2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten. Equities may have rallied some, but the move is widely disbelieved. This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.

3. Slowly, but persistently the equity market rallies. Momentum is strong. The credit markets are quicker, with spreads tightening to normal-ish levels. Bit-by-bit valuations rise until the markets are fairly valued.

4. Momentum remains strong. Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures. Liquidity is cheap, and only rebalancers are selling. (This is where we are now.)

5. The market continues to rise, but before the peak, momentum flattens, and the market meanders. Credit spreads remain tight, but are edgy, and maybe a little volatile. This is usually a good time to sell. Remember, tops are often a process.

6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue. Some think that the problem is an isolated one, but search begins for where there is additional weakness. Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.

7. The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high. A few institutions and investors fail who you wouldn’t have expected. Momentum is lousy. We are back to part 1 of the cycle. Remember, bottoms are often an event.

The full piece is well worth your time thing morning . . .


Impossible Dream, Part 2
David Merkel
Aleph Blog May 13, 2011

Category: Cycles, Fixed Income/Interest Rates, Investing

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

6 Responses to “Investment Cycle for Equities and Corporate Bonds”

  1. mone9 says:

    This is true in the normal case. However, these years the Fed has been manipulating the market so that sometimes this doesn’t happen.

  2. Sechel says:

    Good points. I can see the influence of Hyman Minsky.

  3. MayorQuimby says:

    Tops weren’t really ‘processes’ in 2001 and 2008. 2003 was an entire year of ‘bottoming’.

    People love to categorize things and look for patterns (so do I of course) but in well over 15 years of market-watching I’ve never known the market to do what’s ‘expected’ or ‘typical’. Maybe 1 out of 10 times. The rest of the time, markets keep you on your toes.

    Also…WAAAAy too much attention gets placed upon the stock market when the bond market is what really matters.

  4. Orange14 says:

    The caveats at the end of the article are the key things for the individual investor (C’est moi). It is very difficult to find bond funds that have only Aaa corporate holdings. You end up at the mercy (or skill if that is a better term) of the fund manager. I’ve wrestled with this for my own modest portfolio where I really cannot find individual bonds worth investing in and rely the fund approach. The other way to approach this is to look at relatively high dividend yielding stocks and treat those as a “bond” investment, realizing that there may be a greater chance at loss of capital (but on the flip side greater chance of appreciation). As long as one focuses on the balance sheet and cash flow the approach is sound.

    Thanks for posting, this is an area that I’ve really wrestled with.

  5. victor says:

    Neatly categorized in seven clear stages; trouble is, at he depths of a bear market few have the cash or guts to step in and buy. I have done it in past bottoms but only by luck. I guess it’s the old story of market timing and our inability to do so. So, since they don’t blow a whistle to announce tops/bottoms and pundits are more wrong than right just buy John Bogle’s “The Little Book of Investing”on sale for $19.95 and follow his simple advice….

  6. cognos says:

    Nah, were still at stage 2,3.

    One famous hedge fund manager with awesome perf said recently, “the average recovery cycle is 30 quarters, we’ve had 6 so far.”