A good friend whose opinion I respect wrote a comment that deserves space in the front page.
Thursday, October 23, 2008
The CDO unwind waiting to happen (Bloomberg)
The CDO unwind waiting to happen
Are the days of CDO carnage behind us?
Apparently not. Bloomberg reported on Wednesday:
Oct. 22 (Bloomberg) — Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.
The article is referring to synthetic CDOs: that is, CDOs which are not backed by tangible collateral (RMBS, CMBS, for example) but CDS contracts which reference some form of collateral.
In this case, CDS on corporations.
All of which may sound dreadfully esoteric. Until you ratchet up the numbers. On Friday last week, Barclays analyst Puneet Sharma put out a report on a possible synthetic CDO unwind, and what can be expected to happen to the market as we move through a recession in the coming months.
In graph form, here’s what would happen to the ratings on prime and high-grade tranches of the trillion dollar synthetic CDO market:
It can get worse (FT Alphaville)
It can get worse
Granted, this was written by UBS’s Jeffrey Palma on Oct. 21, and things have deteriorated since then.
Year to date, global equities are down 36.2%, on a total return basis, the worst year ever since MSCI World began in 1970. Before that, 1974 was the worst returning year, when equities fell 24.5%.
At today’s prices the MSCI World is back to its September 2003 levels, erasing 61 months of gains so far. This is more than the gains erased at any other time since the 1970s. In 1990 the index erased 24 months of gains, and then a further 15 months of gains in 1992. Between 2000-2003 the index erased its prior 53 months of gains.
Peak to trough things have been worse in the past. From their October 2007 peak, global equities are now down 43% in price terms compared to 48% between 2000 and 2003.
On the plus side, that means equities are trading on an average price/earnings ratio of 11.1 — the cheapest PE since 1982, according to UBS. FT Alphaville notes, however, that might not be so good when you consider the stocks are at their lowest level since before 1970 (as above).
On the other hand, over 50 per cent of companies are now offering dividend yields above 3 per cent — greater than the long-term average of 2.8 per cent since 1974, UBS says.
Opportunity to buy then? Not quite.
There’s still the coming recession.
In previous earnings cycles, global earnings have fallen 30-40% from their peak. So far EPS is down around 15%, suggesting earnings weakness is likely to persist well in to next year.
What’s worse is that while analysts are just starting to revise their earnings estimates for 2008 (almost over anyway) downwards, 2009 and 2010 still have a long way to go.
… while 2008 numbers have come down significantly, 2009 and 2010 estimates still look too lofty. As a result, forecasts for growth in these years will need to fall sharply.
What’s an investor to do then? Palma has the answer:
Stay defensive. Against an uncertain landscape we retain our defensive sector allocation, as investors continue to manage cyclical risk. Our largest overweights are in Consumer Staples and Telecoms as we encourage investors to search for yield and companies with stable earnings and less relative downgrade risk. These sectors are trading at a premium to the market because of these characteristics, but we don’t expect a reversal while uncertainty prevails.
Not surprising then that UBS have Campbell’s Soup on their preferred stock list.
Subscribe to:
Posts (Atom)
Posts
