Volatility and Credit Spreads Likely to Rise

The vice chairman of BlackRock, Bob Doll, gave investors much to cheer about in his recent 2007 forecast. Having considered his projections, we conclude that we can basically toss investment research overboard this year and head out for a lengthy vacation. Why? Because his predictions for a return to quality and increased volatility means all we need to own are Dow futures and the index that measures expected volatility, the VIX. Mr. Doll, however, would probably not endorse that conclusion.Mr. Doll is the chief investment officer for the equities operation of BlackRock, formerly Merrill Lynch Investment Management. He is optimistic that equities in America will have another good year, mainly because of an expansion of price/earnings multiples. He expects slowing growth for the domestic economy, a consequent easing of inflation pressures, and a corollary move by the Fed to lower rates at mid-year. On the dark side, he also expects an increase in volatility and credit spreads.He points out the volatility of the stock market is at historically low levels. For instance, in 2006 (through 11 months), the Nasdaq experienced a price swing of better than 2% on only 5% of the trading days, compared to 40% in 2002. The CBOE’s VIX index, which effectively reflects investor’s expectations about volatility, closed Friday at 10.15, near the 52-week low of 8.6, and considerably below the trend line of the past decade. The index reached a high over the past 12 months of 23.8.Credit spreads, too, are unusually low. That is, the rates being charged for loans do not adequately compensate lenders for varying levels of risk. In both areas, Mr. Doll is looking for a return to more normal circumstances. Since his success rate over time has been considerably above average, his views resonate.There are certainly some aspects of the investment scene in the last couple of years which have been unusual, to say the least. The no. 1 oddity has been the extraordinary level of liquidity in the marketplace. You’ve read this everywhere, but what does it really mean?Bluntly, it means that just about anyone with a driver’s license can borrow a ridiculous amount of money at a low cost, for almost any sort of investment. The core reason for this is that corporations have experienced a huge boom in profits, while responding to the latest recession and to economic realities by cutting costs and outsourcing manufacturing. As a result, they have spent conservatively on plant and equipment, and instead have been paying down debt and otherwise boosting the economy’s available cash.Since the economy has been so happily expanding for the past five years, the incidence of default, or of companies getting into financial trouble, has been extremely low. If a corporation runs into a financial wobble, there have been plenty of lenders willing to step in to help. With a record-low occurrence of problem loans, lenders have become increasingly confident, and have been charging less and lowering premiums for riskier borrowers.This pattern is unlikely to continue. First, we have the beginnings of a credit reappraisal taking place in the mortgage markets. No matter where the housing cycle bottoms out, it is clear that the free flow of money to borrowers with no credit history, and who have divulged little financial information, is bound to come to a halt. Without a doubt, in the months ahead there will be a “What were they thinking?” moment, or maybe lots of those moments, as mortgage companies report rising losses, which are now beginning to surface.Second, corporations have begun to increase their plant and equipment spending as capacity utilization has increased, and third, the economy and profits will be growing more slowly. Thus, the overall liquidity in the system will decline, prompting an eventual return to more normal, and higher, pricing of risk.That doesn’t mean there isn’t still a lot of cash around looking for investment opportunities. The surge in liquidity has come at the same time that investors have been directing increased funds to alternative investment shops, such as hedge funds and especially private equity shops. These funds would traditionally have been invested in stocks and bonds, so their redirection could have been a negative for those markets.However, since alternative investment firms have traditionally taken advantage of low borrowing costs to leverage their holdings in listed securities, as well as in private investments or commodities, the overall impact on the stock and bond markets has been muted. Indeed, the equities markets have benefited from rising takeover activity in numerous sectors from the private-equity players.The buildup of cash in the hands of private equity firms and the need to invest it has added to the compression of risk premiums. We have heard of one instance when a lender put $10 million into a so-called “club deal”, a deal with several participants, without performing any due diligence at all because he was so eager to participate, and so confident of the investment opportunity. That can’t be good.Along with a rise in credit spreads, Mr. Doll also foresees a rise in volatility. These trends might be connected, in that a “credit event,” such as a major hedge-fund meltdown (and haven’t some of us wondered if the dramatic fall-off in energy prices might initiate a big fund collapse?), could cause jitters in both the stock and the credit markets. Other possible sources of higher volatility are a terror attack, or greater turbulence in the Middle East, according to Mr. Doll.Given these potential negatives, Mr. Doll is focusing on high-quality large-cap companies with solid balance sheets. As mentioned earlier, he anticipates an increase in overall price/earnings ratios, for the first time in six years. We are, he suggests, in the second phase of a bull market, and valuations are such that America is no longer likely to under perform other markets around the globe.Just as credit risks may widen going forward, the valuations on high-quality growth stocks should begin to rise relative to smaller, riskier companies. As of the end of November, according to data from Merrill Lynch, price/earnings multiples on the highest quality stocks (rated A+) averaged 18.4, compared to an average of 34.6 for stocks rated B-.Given these various factors, Mr. Doll expects to see the average stock under perform the broad averages. So, Dow futures may be pretty appealing going forward, and trading the VIX index from these low levels should pay off as well. Time for vacation?peek10021@aol.com

Volatility and Credit Spreads Likely to Rise

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