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Is Credit Quality Peaking?

By Lewis Johnson | August 06, 2014
"Formal education will make you a living; self-education will make you a fortune."
-Jim Rohn

The U.S. stock market just suffered its worst week in more than two years.  Is this just short term volatility, or is there a deeper message in this sell-off?  We write Trends and Tail Risks to explore questions like this, because we are believers in the merit of self-driven, life-long learning.  Writing this publication helps our research because it forces us to clarify our thinking, while hopefully helping investors understand our core principles. This week’s Trends and Tail Risks integrates a few of the simple principles we have explored so far to answer a very important question: could credit quality be peaking? While we will only know the answer for certain in retrospect, our initial answer is ‘yes.’

The paragraphs that follow outline our increasing concern that global credit quality may be peaking.  Over the past few weeks, we have been taking the necessary steps to further fortify our portfolios, which frankly were already defensively positioned to begin with.  We note our reasons below. Our goal is not to try to time the market; rather, our goal is to allocate capital prudently, which we strive to do by thoughtful study of where we are in the cycle.  We join this cyclically aware view to our own proprietary valuation analysis to create our highest conviction investments and to guide our asset allocation.

Our work on the inventory cycle, (Making Volatility our Friend: Trading the Kitchin Cycle, May 28, 2014 ), has suggested that we are in the expected time frame when we would start to see evidence of an inventory driven slowdown.  As such, we have been especially vigilant for any signs of weakness.  Bonds, especially long duration U.S. sovereign bonds, have had their best start to the year since 1987.  We have considered what these yields were suggesting (What Does the Bond Market Know, May 7, 2014  and Bond Market Clues, May 14, 2014) and reiterated our view that the highest quality, long duration debt market should still be in a secular bull market (What Does the Bond Market Know, May 7, 2014). 

The relative value of gold, (Gold: Price vs. Relative Value, July 23, 2014) has been showing signs of a turnaround especially in Europe, which our research tells us often signals a change in credit fundamentals.  Equities are the junior tranche in a company’s capital structure (Big Problems Start Small, May 21, 2014) subordinate to claims of credit, so a downgrade in credit quality should by definition weaken equities.  We have written many times about our ongoing concerns over the European credit markets (Big Problems Start Small, May 21, 2014, Ghosts of Invergordon?, June 4, 2014, and Gold: Price vs. Relative Value, July 23, 2014).  Last week, our concerns intensified with the collapse of the largest bank in Portugal, Banco Espirito Santo, which fell 78%.  In the last few days, U.S. mortgage insurance companies, which are some of the most highly leveraged equities to inflections in credit, have started to buckle.  Today, after all our early credit indicators pointed  to growing credit stress, the Bloomberg news service announced that Italy has officially fallen back into recession.  In terms of size and significance, Italy has the world's third largest sovereign debt market which nearly failed in 2011 before the European Central Bank stepped in with extraordinary measures.

A peak in global credit quality does not necessarily mean that the equity market has peaked.  For instance, global credit quality peaked in early 2005, but the US and many other global stock markets continued to rally through late 2007 and into 2008.  However, a peak in credit quality shows that after five strong years in the US equity markets, that the cycle has now progressed to a more complex and challenging phase.  This is an excellent time to continue the steps we have been taking, in particular by raising cash levels, extending duration in very high quality bonds, and adding to our highest conviction equity holdings, such as gold royalty companies.

Based on the confluence of credit indicators, we see this as an especially important time to closely study the markets to trace the ultimate source of unfolding credit weakness.  Such focus helps us identify the weak link in the credit chain, for it will be that very link that will break meaningfully at the ultimate peak of the cycle.   As always, we use our trusted indicators to observe the markets closely.  Thankfully, experience has taught us that there is always a bull market somewhere. We combine our bottoms up fundamental valuation work with our top down view of the greatest trends and tail risks in today’s markets to identify the best investments.  We are confident that over time this discipline is the best way to grow and protect capital. •


CWA Asset Management Group, LLC is an SEC-registered investment adviser, doing business as Capital Wealth Advisors (“CWA”) and as blueharbor wealth advisors.  This material is for informational purposes only, as of the date indicated, is not complete, and is subject to change. Additional information is available upon request. Any opinions expressed herein represent current opinions as of the date of publication only and may change based on market or other conditions.  This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual results will not be materially different from those described here.   Certain information herein has been provided by and/or is based on third-party sources and, although believed to be reliable, has not been independently verified, and CWA is not responsible for third-party errors.  No representation is made with respect to the accuracy, completeness or timeliness of information or opinions herein and CWA assumes no obligation to update or revise such information or opinions.
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Lewis Johnson
Co-Chief Investment Officer

Author of Trends & Tail Risks

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