Credit and Cost of Capital As Superior Predictors of Recession, Expansion and Stock Prices

October 18th, 2010 by hackel Leave a reply »

Kenneth Hackel, president of institutional investment advisor, CT Capital LLC, submits that the lessons related to the crisis of the credit markets during 2007-2009, including effects on the economic and financial markets, have been well constructed. What he believes is not as well-known, is  the equity market, as measured by the S&P 500, has lost much of its prowess as a forecaster of pending economic change, and therefore as a forecasting tool of pending recession and expansion.

In fact, everyone from Central Bankers to students of finance, and investors in between, continuously look to, quote, and believe that movements in the S&P 500, itself one of the ten leading economic indicators, to be a leading leading indicator.

In reality, the S&P 500 has been a poor future barometer of economic recession, with its merit becoming increasingly suspect over the most recent decades. On the other hand, credit analysis, including the dissection of the components of the cost of equity capital, has been an excellent leading (reliable) indicator, one which, if followed by investors of equities, would have placed them in a position to have avoided or mollified subsequent large price downdrafts. The data clearly shows the ability of stocks to predict economic slumps has only gotten worse since the 1960s.

Regardless of how the stock market is doing, there is always the fear of recession. Even during a strong, durable expansion, investors and investment strategists take part in the guessing game of “when will the next recession occur?” For if investors believed a recession were even a few years away, they would immediately begin to adjust their portfolios, which would impact current valuations.

Since 1957 (thru 2007), according to the NBER, stocks have dropped an average of 8.54% six months after commencement of recession.  Including the 50% equity plunge related to the 2007-2009 recession, and the recession’s ending simultaneously with the outset of the current bull market in stocks, equities have lost even more ground as a forecasting tool.

In the last (2007-2009) recession, whatever creditability stocks had as a forecasting tool evaporated. Despite ominous signals from the credit markets, stocks reached higher highs during the fall of 2007.  Credit metrics, by that time, were giving off unmistakable signals years prior to the outset of the December 2007 downturn.

Followers of the economy and individual company’s credit health would have permitted equity investors to escape the brunt of most post WW2 downturns, while placing them back into stocks as credit became looser and cost of capital fell.

The chart below visibly shows the relationship between the S&P 500 index and recessions going back to 1947.

The bottom of the S&P 500 does not generally occur until after the outset of recession.  On the other hand, with just one exception since 1946, the S&P has bottomed while still in recession. Meanwhile, credit markets began to rally prior to stocks, due to the actual or perceived change in Fed credit.

It is this change in credit that ultimately leads stocks out of slumps, which is the precursor of later fundamental change of corporate cash flows and balance sheet re-liquefaction.  The enhancement in valuation metrics cannot take place without the prior easing in credit, and for various reasons, to be explained in my text to be released next week, the credit markets both pick up and act on the upcoming policy change prior to the equity markets. It is up to the analyst to spot these potential and actual changes in credit posture.

This is all detailed in Security Valuation and Risk Analysis, McGraw-Hill. Credit markets are, in fact, the breeding ground for prospective change –to individual firms’ market values and for the economy as a whole. The variables (cost of equity capital credit metrics) in the book define and illustrate each point.

As an example, let us take a look at the five-year Treasury swap spread. As liquidity grew worse, housing weakened and banks’ balance sheets became questionable, swap spreads began to rise.  Although rating agencies did not acknowledge the potential extent of the problems, the credit markets were reacting.  The gap between the rate to exchange floating- for fixed- interest payments and comparable maturity Treasury yields for five years, known as the ‘swap spread’ began to rise at the end of 2006, about a full year before the outset of recession. By the middle of 2007, swap spreads were clearly signaling the economy was headed for a credit problem; by the Fall, spreads were at all-time highs.

Whereas recessions of brief duration could be a caused by any number of factors, such as labor costs or inventory corrections, most downturns are almost always credit related.

As McKinsey & Co. noted in its most recent Quarterly letter, credit  markets are a better place to look for impending trouble, “in no small part because they have been at the core of most financial crises and recessions for hundreds of years.”  So why do investors ignore this evidence?

Personally, I have no idea, but do know the credit work we use at CT Capital requires a very deep understanding of security analysis, accounting, finance and credit flows, which most analysts and investors are not trained to do.

Even today, financial reporters refuse to write stories on cost of equity capital and the credit metrics that are responsible for setting an appropriate discount rate which is used to value the likelihood of future free cash flows. “The readers won’t understand it” is their repartee. So they wait and quote those sources most familiar to their readers and viewers.

As McKinsey reported, the table below shows that most major downturns in the last 30 or 40 years have been driven by some sort of credit crisis.

US Crisis Federal Reserve inflation crackdown 1980
  S&L junk bond crises 1990
  US Subprime mortgage crisis 2007
Non-US Crisis Mexican debt crisis 1982
  Asia ((Thailand) debt crisis 1997
  Russia default 1998
  Argentina economic crisis 1999
  Greek Eurozone crisis 2009

Source: McKinsey & Co.

Unfortunately, if the US economy were to experience another crisis, equity investors should not expect historical patterns to change.  And if that were to occur, cracks would likely first be seen in the credit markets and metrics effecting cost of capital, including bids on bonds, credit spreads, adjusted cash flows and cash taxes. The book goes into 50 additional metrics geared to individual company analysis. For investors to maintain focus on earnings, revenues and cash flows, without a clear focus on risk, as determined by credit metrics, would be missing half the present value equation. This is why, despite the equity market’s most recent rally, the S&P is still down considerably over the past 3 and 10 years, while up less than 2% over the past 5 years.

The stock market, after all, isn’t what it’s all cracked up to be regarding it ability to forecast recessions and expansion.

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Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

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