by Amit Kumar
Table 5.1
Major corrections in the S&P 500 since 1929
Source: S&P Dow Jones indices, Bloomberg.
It was déjà vu all over again in 2011, when the S&P 500 fell 80 points on the Monday after S&P stripped the United States of its AAA rating. Over the week, the S&P 500 followed the same price chart as each consecutive day after the Lehman bankruptcy in 2008, falling and rising by almost the same number of points. The S&P 500 rhymed.
The S&P 500’s wild moves in 2008 and 2011 were triggered by similar events. On September 15, 2008, markets were hit by more bad news: S&P downgraded AIG’s credit rating, following through on its prior threat to downgrade AIG. Likewise, S&P made no exception in 2011 when it followed through on its threat to downgrade the U.S. credit rating from AAA to AA+. History rhymed, but was this as deep a crisis or a black swan event like the Lehman bankruptcy?
Takeaway
If the AIG downgrade was a prologue, it seemed probable that S&P would downgrade the United States’ rating as well. Ex-post, it was reasonable to speculate wild swings in the S&P 500. History often repeats itself—when it does, past performance in the stock market can offer clues to what may result from current events.
Was the U.S. Credit Downgrade a Black Swan Event?
In theory, the U.S. credit downgrade should have caused the cost of capital to go up because the risk-free rate was now based on the yield of a AA+ security. Consequently, the price multiples would have been expected to shrink. In reality, the impact of the U.S. credit downgrade on credit and stock markets was a tale of two cities: the S&P 500 declined by 80 points on the news as one would expect; however, U.S. Treasury and bond prices soared.
The U.S. downgrade was not a normal economic event; however, it was not quite a black swan event either. What were the odds of a credit crunch, liquidity crunch, or a 50 percent correction in the stock markets given that the U.S. Federal Reserve (“the Fed”) was on standby to continue quantitative easing (QE) and keep interest rates low for an extended period of time? Low odds indeed.
The S&P downgrade had not yet led to a funding and liquidity squeeze or any liquidation or fire sales remotely close to what transpired after Lehman, and the Fed seemed well prepared to provide liquidity this time around. Stock markets had corrected ~13 percent in a knee-jerk reaction during the week of the downgrade; however, credit markets showed few signs of distress, with treasury yields hitting an all-time low. Continued gloominess from Europe, poor economic indicators in the United States, and fears of a China slowdown could tip the U.S. economy into recession, but no black swan event was in sight.
A U.S. default on its obligations or the breakup of the Euro had a greater chance of being a black swan event; however, both the cans were kicked down the road after the compromise on the U.S. debt ceiling and the bailout of Greece. The Fed delivered on expectations, announcing that it would keep rates at zero until 2013.
U.S. Downgrade in 2011 Versus Japan Downgrade in 2001
S&P had downgraded the United States for the first time in its history, and the longer-term impact of the downgrade remained a question. If we looked in the rearview mirror at Japan’s downgrade in 2001 for cues, we would find some similarities. For starters, the Japanese yields declined as an initial reaction to the credit downgrade in 2001, just like U.S. treasury yields.
In this context, Japan’s central bank policy actions also offered clues for the markets. Japan’s rates were already near zero in 2001, just like the U.S. rates in 2011. The Bank of Japan (BOJ), Japan’s central bank, chose the path of QE or balance sheet expansion, increasing the circulation of yen banknotes after the downgrade. The BOJ could not have lowered rates below zero.
Over the next five years, BOJ assets as a percent of Japanese gross domestic product (GDP) nearly doubled, from 15 percent to ~30 percent. During these five years, the yen lost value and the Japanese economy showed abysmal signs of growth. Japanese stocks jumped in response to BOJ policy actions, and BOJ began to tighten its balance sheet at the end of 2005. However, the financial crisis in the United States forced BOJ to reverse course and restart balance sheet expansion.
We could follow these cues in history to infer that the U.S. economy was headed nowhere, while the bulls argued that the U.S. economy was inherently stronger than the Japanese economy and did not suffer from structural issues, such as the aging population in Japan. Despite the dissimilarities between the United States and Japan, it seemed evident that U.S. equity and credit markets would continue to be focused on the central bank’s policy actions.
While you are left to wonder if the U.S. economy would follow a course similar to Japan’s over the next ten years, you could turn to a more predictable variable: Ben Bernanke, the chairman of the U.S. Federal Reserve.
Ben Bernanke on Japan’s Lost Decade and the U.S. Great Depression
Bernanke had indicated in the past that an early end to expansionary monetary policies and/or a lack of expansionary policy were key reasons behind the Great Depression of the 1930s and Japan’s lost decade of growth in the 1990s. He had studied both events at length and published reports that had been analyzed to death by economists, investors, and analysts.2
In his 1994 paper, “The Macroeconomics of the Great Depression: A Comparative Approach,” Bernanke compared the behavior of selected macro variables in countries that left the gold standard during the depression to those that did not. He concluded the following: “(1) monetary contraction was an important source of the Depression in all countries; (2) subsequent to 1931 or 1932, there was a sharp divergence between countries which remained on the gold standard and those that left it; and (3) this divergence arose because countries leaving the gold standard had greater freedom to initiate expansionary monetary policies.”3
Later, in 2003, Bernanke remarked on BOJ:
I would like to consider an important institutional issue, which is the relationship between the condition of the Bank of Japan’s balance sheet and its ability to undertake more aggressive monetary policies. Although, in principle, balance-sheet considerations should not seriously constrain central bank policies, in practice they do. However, as I will discuss, relatively simple measures that would eliminate this constraint are available.4
As his simple measure suggested, “The BOJ might have to scrap rules that it has set for itself; for example, its informal rule that the quantity of long-term government bonds on its balance sheet must be kept below the outstanding balance of banknotes issued.”
If Bernanke did not find BOJ’s decision to increase the balance sheet assets by 30 percent to be aggressive enough, it was safe to infer that he would not hit the brakes and continue with the grand expansionary policy in the United States that began in 2007.
Did the Lenders of Last Resort Have Room to Lend?
Central bankers (also known as lenders of last resort) at the Fed, BOJ, and the European Central Bank (ECB) printed currencies to expand balance sheets, funding nearly 20 percent of respective GDPs and remaining committed to lending more. It seemed in line with Bernanke’s earlier suggestion to eliminate constraints on expanding the balance sheet.
Chronologically, Japan was first among equals: Japan had increased its balance sheet from 20 percent to 30 percent of its GDP over five years since the 2001 downgrade, while keeping their benchmark rates below 1 percent. It was déjà vu a decade later as the Fed renewed its commitment to lend at zero percent over the next two years and fueled the speculation of further expansion of the balance sheet or QE.
The U.S. Federal Reserve was in a similar position as Japan with zero interest rates, two rounds of quantitative easing, and assets at 20 percent of GDP. The Federal Reserve had not held such a high level of assets since World War II. If Bernanke used his own prescription to eliminate constraints on expanding the balance sheet, another round of QE would have been no surprise.
The impact of the Eurozone crisis on U.S. markets had turned the spotlight on ECB. ECB always had a larger balance sheet than the Federal R
eserve since the formation of the Euro in 1999. They had expanded the balance sheet just like the Fed (figure 5.1), to above 20 percent of the GDP after the Lehman crisis.
Despite criticisms of ECB’s large balance sheet, ECB had room to further expand its balance sheet in response to more market fear. ECB’s monopoly on issuance of Euros and other policy tools could allow them to act swiftly if Germany and France were willing. After the 2011 Greece crisis, ECB saw its balance sheet soar to almost 25 percent of the Eurozone GDP. ECB was essentially following the lead from BOJ and the U.S. Fed.
FIGURE 5.1 Fed balance sheet expansion after two rounds of QE. Source: Federal Reserve.
If BOJ monetary policy was a guidepost, ECB and the Fed balance sheet still had room to grow in terms of balance sheet assets as a percent of their GDP. Central banks had expanded their balance sheets to all-time highs; however, their monopoly to print unlimited currency made them seem unstoppable. Central banks had diminished the possibility of a liquidity crunch.
Central Banks Flushed Out Liquidity Risk but Left Credit Risk Lingering
Without any hawkish signals from the central banks, the case to short sell based on liquidity issues was weak. However, a U.S. credit downgrade could still lead to credit issues and raise funding costs for companies that were heavily dependent on credit markets. Banks are especially vulnerable to issues in the credit market and rising funding costs because they depend on the wholesale funding markets. Banks with poor loan quality and regulatory capital issues are even more exposed to a drop in profitability. Let us look at Regions Financial, a short idea that I published in July 2011.
CASE STUDY:
REGIONS FINANCIAL (RF)
On June 23, 2011, Regions Financial reached a $200 million settlement with the Securities and Exchange Commission for charges that Morgan Keegan, a brokerage unit of Regions, defrauded customers during the financial crisis.5 Regions is a diversified commercial bank operating in the southeastern United States, with a majority of operations in Florida, Tennessee, Alabama, Georgia, and Mississippi (figure 5.2). Regions also announced to sell Morgan Keegan to raise money to repay its government Troubled Asset Relief Program(TARP)-preferred stocks from the 2008 financial crisis. I had followed Regions in the past and decided to look at any funding issues.
While Regions was not exposed to a rise in funding costs with $4 billion in short term borrowings and a loan-to-deposit ratio below 100 percent, it needed to boost its Tier 1 regulatory capital. Because Regions had more than $50 billion in assets, it could also face potential systemic risk capital burden, which could be introduced under the new Basel III banking regulations.6
Regions was adversely exposed to home equity loans secured by second liens in Florida, which accounted for ~8 percent of their total loan portfolio. Their nonperforming assets (NPAs) or loans past due by 90 days or more had stayed stubbornly high at 4 percent and its Texas ratio (percent of NPAs covered by equity and loss reserve provisions) was at 57 percent. Poor-quality loans could erase half of the book value of the company’s equity. I had stumbled onto a potential short idea.
Regions had $1.4 billion in net deferred tax assets, of which $424 million was disallowed for Tier 1. Region’s decision to sell Morgan Keegan would have eased the pressure to raise capital, but Regions also wanted to repay their $3.5 billion of government TARP preferred stocks. Morgan Keegan’s estimated sale at $1.5 billion would not have fetched even half the capital to repay TARP and tough market conditions could lower the sale price. Regions shareholders faced a dilution risk.
FIGURE 5.2 2010 revenues $6.5 billion. Source: RF reports.
Morgan Keegan’s sale would have also resulted in a loss of revenues in excess of $1 billion per year and $70–100 million lower net income, and Regions’ reliance on interest income would increase significantly after the sale. In addition, Dodd-Frank regulation changes could result in a loss of $150–170 million in debit card income.
Regions faced an overhang from its TARP-preferred stocks, poor asset quality, reduced normalized earnings power, and other short-term negative catalysts, such as headline risk of their ongoing board investigation into their credit practices that could result in additional settlement expenses. Regions should have traded below a price/tangible-book-value ratio of 1 or $5.9 per share. Potential share dilution and lower earnings outlook posed a 20–30 percent downside for Regions stock at 10× normalized earnings or 3× preprovision earnings.
How Did It Play Out?
Regions Financial stock fell nearly 40 percent after S&P downgraded the U.S. AAA ratings on August 5, 2011. The stock continued to trade around $4 per share as Regions failed to sell Morgan Keegan to Stifel Financial in 2011. On March 13, 2012, Regions announced a public offering of approximately $900 million of its shares toward the plan to repurchase its $3.5 billion in TARP-preferred stocks. On April 2, 2012, it sold Morgan Keegan for $1.2 billion to Raymond James Financial.
Passage of the Baton from Bernanke to Yellen
On October 9, 2013, Janet Yellen was officially nominated to replace Ben Bernanke as head of the Federal Reserve. As I began researching Janet Yellen, I stumbled upon an excellent blog from the Washington Post that listed all of her key academic papers.7 In a 2004 paper that she coauthored with her husband George Akerlof, her concern with underutilization of labor and policy response to high unemployment was clear:
Stabilization policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilization of labor and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level. The Federal Reserve Act thus wisely enunciated price stability and maximum employment as twin goals for monetary policy.8
The U.S. unemployment rate was still hovering over 7 percent and inflation did not seem to be a concern for the Federal Reserve. Janet Yellen’s background as a labor economist seemed to signal that her first priority would be to bring down unemployment to normalized levels and maintain a dovish stance. In other words, the low interest rate could stay put for the foreseeable future and the Fed “put” could encourage the U.S. stock market to continue to rise.
Keeping an Eye on the Economic Calendar
Investors watch for some key economic indicators other than the Federal Reserve calendar to gauge the state and outlook of the economy and the signs of economic downturn. The periodic release dates for economic data are important catalysts for the market.
Leading economic indicators:
1. Average weekly hours, manufacturing
2. Average weekly initial claims for unemployment insurance
3. Building permits, new private housing units
4. Index of consumer expectations
5. Interest rate spread, 10-year Treasury bonds less federal funds
6. Manufacturers’ new orders, consumer goods and materials
7. Manufacturers’ new orders, nondefense capital goods
Coincident economic indicators:
1. Employees on nonagricultural payrolls
2. Personal income less transfer payments
3. Industrial production
4. Manufacturing and trade sales
Lagging economic indicators:
1. Average duration of unemployment
2. Inventories-to-sales ratio, manufacturing and trade
3. Labor cost per unit of output, manufacturing
4. Average prime rate
5. Commercial and industrial loans
6. Consumer installment credit to personal income ratio
7. Consumer price index for services
8. GDP/Real GDP
Other industry-specific indicators include the S&P Case-Shiller Index, Mortgage Bankers Association (MBA) Mortgage Application Survey, and pending home sales for housing stocks. Monthly automobile and truck unit sales and monthly retail sales are impor
tant indicators for consumer stocks. Closely watched commodities data releases include Energy Information Association (EIA) crude oil supply and weekly natural gas storage report.
Market Fear Indicators
The three commonly watched fear indicators are TED spread, VIX, and CDS (e.g., CDX, iTraxx, Sovereign CDS, single-name CDS). These indicators are negatively correlated to the market and investors gauge the indicators to engage in tactical shorting to hedge their long positions.
TED spread (the difference between interbank loan rates and the risk-free treasury rate) measures the fear of systemic banking issues. VIX is the measure of 30-day expected volatility in the S&P 500. VIX crossed 80 during the Lehman crisis, implying that the S&P 50 could move 80 percent on an annualized basis. CDS is a measure of credit risk.
I have included some charts to show their negative correlation with the S&P 500. Aggregate money outflow for equities is also a closely watched indicator. Money outflow tends to have amplified impact on equities, especially in emerging markets with low liquidity. I have also included a chart to show the correlation of foreign institutional investor money flow with the S&P BSE Sensex, the Indian stock market index.