An interesting headline from the credit markets caught my eye
recently: "U.S. junk bonds post $417 million weekly inflows.""
Why does this matter to us in the option market? The first reason
is that money flowing in the credit market reduces volatility.
That's why the VIX drifted lower as the mortgage bubble inflated
between 2003 and 2007.
Even more importantly, it confirms that the current recovery isn't
merely a stimulus-fueled blip on the radar screen. Real healing has
taken place in the world of credit, and that improvement will have
knock-on positive effects across the market in coming months.
Having a healthy financial system is a bit like having technology:
It makes things possible that are otherwise unthinkable. For
instance, before the Internet and cheap communications, businesses
held huge amounts of inventory in warehouses because they never
really knew what customer was going to want which product. Nor was
it known when or where the items would be needed.
Now with devices such as bar-code scanners and cash registers
linked into central management systems, a company can control its
supply chain all the way from China to Middle America to ensure the
right merchandise is in the right place at the right time. Advances
such as these are one of the main reasons that companies have been
able to deliver huge profit margins despite big drops in revenue.
A functioning credit market has a similarly positive impact because
it enables things that couldn't have been imagined in March 2009.
For instance, if a company wants to borrow money to buy a
competitor, that's now possible. If a company is facing a $500
million bond maturity in six months, it no longer needs to trade at
A lot of the stock market's gains over the last 13 months have
resulted from the return a leverage, which has brought debt-heavy
companies such as Ford Motor, Dana Holdings, and Boise back from
The week ending April 9 was the seventh in a row that money moved
into high-yield bonds. Also noteworthy is that bank-loan funds had
seen inflows for 19 straight weeks. Junk bonds and bank loans are
the mother's milk for takeover artists, so we very well could be
gearing up for a whole new cycle of leveraged buyouts.
The other good thing about releveraging is that the process is
clearly not over yet. Sure some stocks have rallied back more than
1,000 percent, but plenty more companies are still trading far
below their 2008 levels. That's why I think we've seen so much
bullishness in regional banks such as Regions Financial, Popular,
Look at the recent call roll on Synovus and the takeover
speculation on DryShips. What do these two companies have in
common? They're both leveraged, and they're both trading at less
than half their price before Lehman Brothers went down.
For much of 2009 the story was tech, which was rallying on true
fundamentals. But as a bull market progresses, investors look for
lower-quality "me too" names. This is exactly what happened in 2004
when second-rate junk stocks saw big run-ups because all the easy
money had been made on higher-quality names.
In 2010 the story is likely to be a hunt for value among companies
that are still trading at deeply discounted levels. Investors will
look for those to regain some of the lost ground. After all,
strength in junk bonds means the "down in quality" risk trade is
Just as the calamity in credit during 2008 took a few weeks to
leak into equities, look for these junk-bond inflows to continue
manifesting themselves in the stock market.
Potential ideas could also include a company like Georgia Gulf,
which is still about 75 percent below its pre-crisis levels. Others
I have liked on the same thesis include Patriot Coal and Century
I own DRYS and PCX shares.
(A version of this article appeared in optionMONSTER's Open
Order newsletter of April 9.
Chart courtesy of tradeMONSTER.)
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