A tale of a missing bonds rally

US markets have seen some strong rally momentum in recent days. Here is a good piece on bond markets in the US.

"If there really are signs of financial recovery, nobody told the bond market. Treasury Secretary Timothy Geithner's plan to rescue the financial system sent the S&P 500 soaring 7% on Monday alone, bringing its gains from March 6 to an impressive 19% through Wednesday. But credit markets have hardly budged. Corporate debt is still priced for disaster... Until investors recover confidence in financial assets, credit spreads are unlikely to tighten significantly. And without a sustained improvement in the credit market -- the seat of the crisis -- it seems irrational to expect a durable move higher in equities."

Yes, pretty much on the money. Here's how the numbers work: in my post on personal income by states - California is overdue a democratic party payoff and it will come, so the municipals markets and TIPS are going to be a good bet for some time to come. But the stock market is running too hot on absolutely nothing new - US Treasury's latest plan is a net transfer to
shareholders, which, obviously, first reduces any possible haircuts for bondholders, thus giving a fundamentals support to bonds ahead of shares.

What does this mean? If shares rises in the last 20 days is justifiable by fundamentals, there
should be at least a noticeable rally in bonds (although not as strong as in stocks, since bonds have already priced in all seniority over equity, thus a boost to equity holders yields is not going to be translated into 1:1 gains on bond prices).

My estimate would be as follows: for a 19% rally in equities, were the new valuations to set a new 'floor', we we will see a 5-6% gain on equity yields (including cap gains) over the next 3 years.

This would imply a yield differential compression to comparable corporate bonds relative to underlying equity. Assuming average yield differential for equity relative to corporate bonds of 8-10% in favour of bonds prior to equities rally, our post rally differential is ca 7.5-9.5% range. So bond prices have an upside potential of ca 16%. This is just straight math.

Now, take a cautious assumption that a part of equity rally is due to a fall in the perceived risk of default on equities (the recovery rate priced in CDS stays put, but expected recovery rate rises). Say 1/2 of the rally is just that. Then, price upside on corporate bonds is in the regions of 8-11%, holding YTM fixed. Until we see at least such a movement, the equity markets are overshooting the floor. And they are doing so pretty dramatically.

Market view

US dividends are being cut at a record pace (see here) and this is a welcomed news as it marks the beginning of a turning point in the market. I do not mean the turning point for an upward swing in equity prices, at least not yet. I mean a turning point from the relentlessly accelerating down trend and into a flattening section of the U-curve.

Here is the logic - corporate profits are lagged at the very least one-to-two quarters from real demand. This suggests that an accelerating fall in the dividends reflects the economic reality of Q3-Q4 2008. Assuming the real side of the US economy is going to start settling into the bottom section of the U-shape correction sometime in February-March, the current reporting season will be pricing exactly this forecast. Any pick up in growth from the low figures of December-January will be a bonus point to Q2 dividends.

Regardless of such a pick up, equity markets downgrades in the next few weeks will bring share prices down to reflect dividend cuts.

This will set the stage for the next move. End of Q2 is likely to see some upturn in the US economy. Real GDP growth is likely to stay negative in annual terms, but the latter part of Q2 will be marked by a rise in growth from the lows of Q1.

Equity markets will lead this trend with a potential rally in late Q1 - early Q2. Dividend cuts anticipations for Q2 will already be priced in by then, so aggressive cost cutting measures - implying lower sensitivity of Q2 profits to any further economic slowdown in Q1 2009 - will provide some additional potential mid-Q2 boost to the share prices.

A late Q1-early Q2 rally will be a payoff to today's realism...