In a follow up to last week’s discussion of financials in context, we revisit several of the points we made in the context of last week’s sell-off. We were invited to discuss some of our findings on CNBC’s Strategy Session this morning and the link above has the embedded video.
We include the notes we wrote for the discussion (please bear in mind they are notes – apologies), but the key takeaways are that financial credit is catching up to equity’s weakness (driven by macro-economic, domestic residential/commercial real-estate balance sheet impacts, and expectations for higher cost of capital going forward – TLGP rolls) and what we will be concerned about is when spread decompression starts to lead equities as it did in 2007.
While equity prices for many financials, and specifically US banks and the XLF ETF, have lost significant ground recently, we have been pointing out the considerable divergence between our expectations for where CDS should trade and where equities are trading – especially adjusted for volatility and skews.
We believe US financial CDS are due for considerable widening pressure and this post is designed to provide some contextual evidence and fundamental thesis for why this is the case.
Our institutional clients are able to take advantage of this view via a capital-structure-arbitrage (name-by-name selection and deltas available via our professional services group) but we think there are potential ways to benefit individual investors (by underweighting financial sectors broadly or potential pairs trades via insurance firms and the credit ETFs).
The S&P lost 18pts in May as IG credit spreads were stable. HY widened a worrisome 25bps, notably underperforming on a relative basis.
May proved the Almanack and every other old-wife right as it saw underperformance in equity and credit markets. Most interestingly for us is the relatively large underperformance of the HY market relative to IG and equity markets which were much more sanguine despite worsening macro situations globally.
‘Good is good and bad is better’ seems to have been the trading theme of the last week or so as performance for the month was saved from a far worse fate thanks to forward-looking expectations of renewed growth or QE3 – whichever fits your long-only investing bias better.
We sound a little jaded in that comment but as should be clear from the chart above, the excitement in the S&P of the last week or so seems considerably more ‘standalone’ than in the credit markets – which we are told are so critical to the continued performance of this ‘recovery’.
In context, comparing the relative HY and IG moves to their 50-day rolling beta, we see that HY underperformed by around 25bps. Interestingly, based on short-run empirical betas between IG, HY, and the S&P, stocks outperformed HY by an equivalent 7.6bps, and stocks underperformed IG by an equivalent 2.8bps which fits with the up-in-quality and up-in-capital-structure theme that has been so evident all month (and in fact since late March).
With 497 of the 500 stocks in the S&P500 reported their Q4 earnings, we take a step back to highlight some of the more notable trends among valuation and credit metrics and highlight where our C-RANKs are positioning weightings going into Q2 2011.
Overall, EPS grew 36.3% YoY, a rise from the 30.13% growth of Q3 2010 while top-line growth was 7.85% YoY relative to 8.9% previously and has no fallen three quarters in a row. Prior to that, we had seen three consecutive drops in YoY growth rates in EPS. Going forward this growth rate is expected to drop dramatically, to around 11% EPS growth concensus. While this is cornerstone of so many talking-heads buy-the-dips theories, we bring two things to your attention: 1) ex-FINLs (more on this below) there is a dramatic difference in EPS, and 2) Free-Cash-Flow metrics are dropping notably – a much tougher to manipulate valuation metrioc as we discussed recently.