Stock market vs. Junk spreads

This chart comes via David Stockman’s blog:


The chart plots the evolution of the S&P (blue) vs. Junk Bond Yields (red).  The S&P hasn’t seen a major correction for almost three years. I do not remember such a dull market environment – even in the 2004-07 period there were occasional shakeouts. Both markets are in “uncharted territory,” as they say.

I have written about how the stock market is linked with frothy credit markets via buybacks. I admit that buybacks really occupy my from a theoretical perspective (charts are nice, but I prefer to have a sound theory behind it). However, conventional theory is of no help  – the market is efficient and the buybacks vs. dividends decision is a function of tax rates. This is consistent with Eugene Fama’s view that the Fed’s policy has a negligible impact on the markets. In short, if you are an efficient market guy the above chart is merely noise.

As a value investor, however, I think that “Mr. Market” – one of Ben Graham’s favorite metaphors – is prone to over-and under valuations. Under such circumstances issuing debt to buy back stock at overvalued levels is a phenomenon that CAN occur and that CAN destroy value.

The view of the Austrian school is consistent with Graham’s view: it shows that in a world with non-constant money supply (M), money prices of capital goods (stocks and bonds) are distorted in such a way as to induce entrepreneurs to make errors in a systematic way (i.e. they do not cancel out). “Wrong” prices send wrong signals to market participants as to the future profitability of certain projects (think skyscrapers in Dubai, or bulk carriers). Sooner or later, the true economics of these investments will come to the fore and are classified as malinvestments. These malinvestments are value destructive for the economy.

In the same vein, falling bond yields and rising markets can signal management that it is more profitable to buy back stock on margin. After all, stocks are a very long-term asset (being a residual claim on the companies operating assets). It’s therefore no wonder that their attractiveness increases with falling long-term rates. Buying back stock is a long-term investment decision, akin to building a skyscraper or increasing spending on iron-ore capacities . In a world with steadily increasing M we should not be surprised to see all these phenomena happen at the same time…


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