What happens when the credit bubble breaks?

T

thriftybob

Where is the opportunity? What might go up or down significantly? They are saying it happened before. Exactly when so I can look at charts?

May 9 – Bloomberg (Warren Giles and Mark Pittman): “ Bank of America Corp. Chief Executive Officer Ken Lewis said a so-called credit bubble is about to break after six years of historically low interest rates and relaxed lending criteria. ‘We are close to a time when we’ll look back and say we did some stupid things,’ Lewis said… ‘We need a little more sanity in a period in which everyone feels invincible and thinks this is different.’ Lewis isn’t the only U.S. bank executive who expects that credit conditions will change. Wells Fargo & Co. CEO Richard Kovacevich said in December that ‘I am not a forecaster of the future; I’m a historian. And history says this will blow up. It always has. And there will be some blood on the street.’”
 
here's your signal to get short (or out):

1- long (10/30 yr) US treasury bond/note market breaks (aggressively) out of its current range to the upside in yield (ie sells off hard) past 5%.

and/or

2- oil at $90-100+ from Iran and Hurricanes

and/or

3- Chinese spending done (2008 olympics)


That simple. Until then buy, and don't waste your time worrying about negatives. Its all priced in. The credit bubble won't burst unless a recession hits, which comes from #2 and #3, and/or cheap money disappears which is #1. Remember there is no credit bubble when earnings yield on most of these equity markets by average meets or exceeds #1 (long yields).

Whats fascinating to me is 12 months ago homebuilder stocks were very hypersensitive to long yields. When the long yields start seriously moving, the same thing will happen to the broad equity markets. It'll be interesting ... a new pattern to watch for.

Simply put, if you were an oil or steel company (ie X), and had a P/E of around 10, that gives you an earnings yield of 10%. What stops you from leveraging all of your earnings against long term debt at 5.5%-6% either buying back your stock or acquiring other equally high yield companies and making a 'risk free' 4.5-5% ? Suddenly you've turned your company from a 10% yielder to a 15% powerhouse. Thats what is going on right now.

The credit bubble will burst when a recession hits, earnings stop, and the overleveraged credit users won't be able to make that excess 4.5-5% return, and instead the net cost to float their leverage/debt is negative. Then companies go on sale, stock gets diluted (reversal of buybacks) to pay off leveraged debt, etc. Like a guy losing his job and not being able to pay his credit cards. Publicly traded companies have a safety net, unlike some guy losing his job ... they can sell off stock to raise funds as a bailout, if the weakness is viewed as cyclical. That could mean X -> 110 -> 40, but they are still there nonetheless, with their debt liabilities reigned in.

It'll take halted growth to burst it. When does that happen? I say it all lies in some freak event in energy with strong inflationary and recessionary forces (imagine what $200 oil would do to the economy?) or China just slowing its GDP growth down significantly. And of course, an end to the cheap money (#1) stops the bid under the equity markets as well.

But none of that is happening now, so why the doom and gloom? A bus could hit you tommorow morning ... are you going to stay inside?
 
Quote from thriftybob:

Where is the opportunity? What might go up or down significantly? They are saying it happened before. Exactly when so I can look at charts?
More...

Year 1929.

<img src=http://www.wallstreetantiques.com/sentineloct29.jpg \img>

I remember reading about the bank panic of about year 1907 in "Reminiscences Of A Stock Operator". I recall about 1981 interest rates increasing and greatly slowed economic pace. I remember Russia defaulting on government debt year 1998.
 
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