In 2003, the equity markets finally broke a three-year losing streak and the corporate bond market continued a strong rally that began in late 2002. Many pundits argued that the stock market recovery heralded a new bull market; others pointed out that the underpinnings of the rally were weak. In the credit markets, a lot of noise was made about a “bond bubble” as the Federal Reserve kept U.S. interest rates at record lows, while consumers and businesses continued to borrow at unprecedented levels.
As 2003 progressed, two things became increasingly clear:
Investors were prepared to ignore evidence of long-term economic problems and put money to work in stocks and bonds. Significant financial imbalances simply were not being taken into account, including a burgeoning U.S. current account deficit, a sharp deterioration in U.S. government finances, an overvalued dollar, huge corporate pension shortfalls, continued structural weakness in the European and Japanese economies, increasing protectionist noises, and geopolitical risk in the Middle East and the Korean peninsula.
Investors also jumped for joy (and dug into their pockets) at every hint of an economic revival — despite the fact that evidence of real recover was inadequate until the fourth quarter of 2003 (by which time the markets already had rallied impressively). By December, there were promising signs that the economy was on the road to recovery (just in time for the 2004 presidential election). Living up to the dictum that “bull markets climb a wall of worry,” market participants chose to believe that Herculean efforts at monetary and fiscal stimulus finally would succeed in reviving the U.S. economy from three years of doldrums. All of the major equity indices rallied strongly throughout the year. But one worrisome indicator was that the most speculative Nasdaq stocks rallied the most. The stock of companies like Amazon.com, Inc., eBay Inc. and Yahoo! Inc. were approaching the kind of stratospheric multiples last seen before the Internet stock bubble burst in 2000.
These astronomical share prices called to mind the words of a participant in the 18th century South Sea Bubble (England's scheme for privatizing its debt through the South Sea Company, whose shares became valued beyond all reason): “The additional rise above the true capital will only be imaginary; one added to one, by any stretch of vulgar arithmetic, will never make three and a half, consequently any fictitious value must be a loss to some person or other first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.”1
For investors eager to buy last year's inflated stocks, there were plenty of insiders eager to sell them. This was an ominous sign. Once again, those who knew the most were selling to those who knew the least. Insider sales, particularly at the most egregiously overvalued technology companies, reached record levels as the year progressed. Insiders made certain that somebody else would be left holding the bag when stock prices returned to earth.
The corporate bond market experienced similar exuberance as bond prices recovered from the unjustifiable low of the summer of 2002. The wireless telephone operator Nextel Communications Inc. saw its two most widely traded issues — the 9.5 percent bonds due 2011 and the 9.375 percent bonds due 2009 — rally from the high 40s in the summer of 2002 to over 110 by December 2003. The average spread on BB-rated bonds shrunk from 607 basis points on Dec. 31, 2002 to 326 in mid-October 2003, according to Credit Suisse First Boston. This was both the quickest and sharpest bond rally in the history of the less-than-investment grade markets, and investment-grade bonds followed suit.
The high-yield bond market enjoyed its best performance in a decade as investors still smarting from the equity market collapse poured money into high-yield mutual funds. High returns are not unusual in the wake of years like 2001 and 2002, when the corporate default rate exceeded 10 percent. But just as the most speculative stocks rallied the most, so too did the most speculative bonds. According to Lehman Brothers, CCC-rated bonds (almost 50 percent of which end up defaulting) returned 51.17 percent, while BB-rated bonds returned 15.9 percent during the first three quarters of 2003.
Of course, looking at a longer period, returns on BB-rated bonds were superior to those for lower-rated bonds, on a risk-adjusted and liquidity-adjusted basis. Collateralized debt obligations, previously the buyers of last resort for new bond issues, were replaced by the high-yield mutual funds as issuers lined up to sell debt with extremely low coupons. An insatiable demand for bonds created the opportunity for many companies seen as weak credits in 2002 to come to market to refinance their existing debt, extend maturities, and lower their interest costs.
In the deregulated energy sector, previously considered on life support, companies such as Calpine Corp., El Paso Corp. and Dynegy Inc. were able to avoid bankruptcy and sell billions of dollars of bonds to yield-hungry investors. These sales did nothing to solve the long-term problems facing these companies — not the least of which was low electricity prices — but did allow them to live to see another day. The same phenomenon occurred in many industries, as companies met a welcoming party at virtually every turn in the markets.
One of the rare examples of a company forced to withdraw (and refile months later) a new bond offering was Charter Communications, Inc., Paul Allen's highly leveraged cable television company. In this rare instance, investors apparently remembered that high-yield bonds are not true bonds — they are “equities in disguise” and carry all the risk of equities but none of the profit potential.
Corporate bond prices and spreads did not reflect the underlying credit risk associated with owning high-yield bonds. The default rate did drop from over 10 percent in 2001 and 2002 to the range of 5 percent to 6 percent in 2003, but that rate still exceeded historical norms and hardly indicated a robust credit environment. The corporate bond market has set itself up for a sharp reversal when the Federal Reserve begins to raise interest rates. The question is whether that will occur early in 2004 or after the Presidential election. Either way, 2004 will be a much more difficult year for bond investors than 2003, and 2005 is likely to be ugly by any standard.
The leveraged bank loan market also was a friendly venue for corporate borrowers. As confidence in an economic recovery increased in the latter half of 2003, borrowers returned to lenders in droves to request that their interest rates be lowered. This had little to do with improved corporate financial performance — in most cases, nothing of the kind occurred. But lenders, who today consist primarily of institutional investors as opposed to banks, acquiesced to these requests anyway.
As a result, this market — like any market that doesn't properly price risk — set itself up for a reversal in 2004 if corporate profits don't revive. The seeming strength of this market facilitated the reappearance of a number of large leveraged buyouts toward year-end as private equity firms dipped their toes back into the water after several years of poor returns.
The problem with all of these rallies is that they were built as much on hope — and lack of alternatives, with interest rates at record lows — as on reality. In most cases, improved corporate profitability only seemed impressive compared to the unduly depressed levels of the last two years. In virtually all cases, manufacturing companies continued to experience deflationary pressures resulting from the price-deadening combination of technology and globalization.
Corporate profitability was only modestly improving, and continued to fall short of the performance needed to justify the high stock valuations and tight credit spreads that characterized the market by year's end. Just as in the late 1990s, stock prices were divorced from underlying value, as a surfeit of liquidity resulting from lax monetary policy provided fuel for a rally that corporate financial performance couldn't support.
Moreover, like all statistics, the government economic numbers that bulls were relying upon were complex and subject to different interpretations. Much-touted second quarter growth in the computer sector was largely a result of hedonic pricing adjustments included in the government numbers. These adjustments are intended to capture quality improvements — but without them, computer spending was not as robust as it seemed to be.
The numbers also contained less-technical cause for concern. Much of the economic strength seen in the third quarter of 2003 was attributable to inventory destocking, not new production. Defense spending associated with the “war on terror” and the war in Iraq provided $40.6 billion of the reported second quarter gross domestic product growth of $73.1 billion. Such spending is unlikely to stay at these high levels despite the ongoing costs of the Iraqi occupation. The labor markets' continued weakness through the early part of the fourth quarter of 2003 suggests that consumer spending could trail off in 2004.
It will take several more quarters of data to determine whether the apparent strength cited in reports on productivity and GDP growth is genuine and sustainable. But today's momentum-driven financial markets don't have the patience to wait for confirmation. Today's motto is, “buy now and ask questions later,” even though it then will be too late to sell.
Overall, the markets appeared to have gotten ahead of themselves as the fourth quarter unfolded. There are two critical, and inter-related, pieces of the economic puzzle that investors should watch as the year unfolds. The first is whether the Federal Reserve finally starts to raise interest rates in 2004, or waits until after the November election. If the Federal Reserve believes the economy is truly reviving and inflation is again a threat, it will raise rates, in which case fixed-income securities will suffer. If the Federal Reserve leaves interest rates unchanged, this could suggest that the economy is not as strong as it seems; then stocks and bonds could descend from the lofty perches they've been occupying.
The second thing to watch is the U.S. dollar, because that will be the field upon which continuing global imbalances will play out. A dollar crash — which the authorities will do everything in their power to avoid — would be catastrophic for the global economy and financial markets. A slow but steady decline in the dollar is probably the most likely scenario.
As we enter 2004, the financial markets and the global economy are at an inflection point. The imbalances created by the late 1990s stock market bubble have yet to be fully corrected; instead they have been kept on life support by the Federal Reserve (through low interest rates) and President Bush (through two rounds of tax cuts).
In short, investors should proceed with extreme caution. Bond portfolios should be kept short in duration. The most speculative stocks — those sporting price/earnings ratios in the high double or triple digits — should be sold as soon as possible. Investors should plan for higher interest rates, a lower dollar — and all that brings in 2004 and 2005.
- John Carswell, The South Sea Bubble (Cresset Press, London, 1960) cited in Roger Bootle, Money for Nothing (London; Nicholas Brealey Publishing, 2003), p. 16.