Markets & Finance

Markets: What You Should Be Watching Now


What signals should investors pay attention to as financial markets gyrate? Here's what the pros are looking at

Big financial companies appear to be falling like dominoes as the credit crisis intensifies. In just the past two weeks, Fannie Mae (FNM) and Freddie Mac (FNM) were made wards of the state, Lehman Brothers (LEH) filed for bankruptcy, and Wall Street's signature brokerage, Merrill Lynch (MER), rushed into a hastily arranged marriage with Main Street mainstay Bank of America (BAC).

Market players have anticipated further asset writedowns and credit-rating downgrades for other big industry players by whacking their stock prices sharply lower.

Individual investors worried by all the turmoil may wonder what they should be watching as Wall Street quakes (BusinessWeek.com, 9/14/08). BusinessWeek offers five signals in the equity and credit markets that investors should keep an eye on to gauge whether the clanging chimes of doom are tolling louder for individual financial firms.

CREDIT DEFAULT SWAPS

The first barometer of market sentiment toward certain companies is what's happening with their credit default swaps, which protect the buyer by transferring the credit exposure of bonds from the purchaser to the seller. Prices for these instruments, which aren't regulated by the U.S. government, have spiked in recent weeks as the creditworthiness of certain financial firms has been severely damaged.

Credit default swaps on the widely followed Markit CDX North America Investment Grade Index jumped as much as 34 basis points to 229 basis points above the London interbank offered rate (LIBOR), an all-time high, at 11 a.m. on Sept. 16, according to Phoenix Partners Group, On Sept. 12, the index traded at 152 basis points above LIBOR.

Investors who want to check credit default swap spreads for individual companies can ask their brokers to look them up on a Bloomberg terminal or can find them in regular quotes in the financial press.

Investors also need to monitor the price and yields of new issues in the corporate bond market, says Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass. On Sept. 16, the high-yield bond spreads over comparable Treasuries had widened to 9.05%, while the investment grade bond spreads widened to 3.80%—levels that haven't been seen in quite a while, he says. The higher yields signify lower prices on the notes, which means companies are paying more to raise capital.

For a general sense of where high-yield spreads are trading, investors can go to Yahoo Finance and look up the SPDR Lehman High-Yield Bond (JNK), an exchange-traded fund normally comprised of at least 80% of the total securities included in the benchmark Lehman Brothers High Yield Very Liquid index. They can also track the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), which generally invests in at least 90% of the securities in the iBoxx $ Liquid High Yield index.

Monitoring the bond prices of individual companies requires access to a broker's trading platform such as those provided by Charles Schwab (SCHW) or Fidelity Investments. "If you see a lot of the same issuance, be advised that may be another flag you need to research," says Larkin.

Uncertainty about the extent of the fallout from whatever happens to American International Group has caused more stagnation in the credit markets, with investors "hoarding cash right now and building up for the rainy day," he says.

OPTIONS VOLATILITY

Besides the credit market, activity in stock options can reveal a lot about the magnitude, if not the direction, of anticipated moves in stock prices.

A key number to keep an eye on is implied volatility, a forward-looking measure of expectations within the options market for impending stock moves.

The higher the implied volatility, the bigger the anticipated move in the stock price.

So how does an investor gauge whether the implied volatility of the front-month options contract is particularly elevated? The best way is to compare it with the 30-day historic volatility, which can be found on a number of options-related Web sites, including those of the International Securities Exchange, the Chicago Board Options Exchange, and the Options Industry Council, says Joe Cusick, senior market analyst at OptionsXpress (OXPS) in Chicago.

Each of these sites, as well as that of OptionsXpress, provides a toolbox that allows visitors to calculate the implied volatility for any given stock option.

In a sector under as much scrutiny as financials, implied volatility will be higher across all names in sympathy with the biggest losers, says Cusick. In that case, investors need to look for "remarkably higher" numbers, on the order of three or four times historic numbers, he adds.

Once there has been a major move in the stock price, the implied volatility of the nearby options typically declines, reflecting the better visibility the market has. Despite a more than 15% decline in Goldman Sachs' (GS) shares since Sept. 11, its implied volatility remained high on Sept. 16, suggesting that options traders are expecting further moves, whether lower higher or lower. The fact that twice as many put options as calls were purchased on Sept. 15 was a bearish signal, since puts enable but don't obligate holders to sell the underlying stock at a higher price after the price has dropped below that price.

The implied volatility on Morgan Stanley's (MS) September and October options spiked to around 200 on Sept. 16 from 120 the prior day and 80 before the weekend, says Cusick. There was also an explosion of options volume in the stock on Sept. 15 to over 262,000 options contracts, vs. 59,000 options contracts bought on Sept. 12. "We still don't know what's going to wash out from this. We still have AIG, and the Lehman situation is not resolved," says Cusick. "Implied volatility is going to stay high until we have more visibility [on the extent of the damage to the financial system]."

ACCESS TO CAPITAL

What ultimately spelled doom for Lehman Brothers was an inability to obtain the capital it needed to continue to operate in the face of huge asset writedowns stemming from its real estate holdings.

Doug Roberts, chief investment strategist for ChannelCapitalResearch.com in Shrewsbury, N.J., suggests you also keep abreast of news about how much access companies have to capital.

For Roberts, the seeds of Lehman's failure were sown last fall when the Federal Reserve extended the discount window to primary dealers and investment banks to quench their short-term liquidity needs. Many investment banks mistakenly interpreted this as gaining similar protection as commercial banks with access to a backup line of credit that wouldn't be pulled. But government officials are now rethinking this move on the premise that these banks don't have federal insurance and aren't submitting to regulatory oversight as commercial banks do.

Believing he had indefinite access to the Fed's discount window, Lehman's chief executive, Richard Fuld, refused offers to sell the firm at $25 a share only to be told by the government that it didn't intend to backstop a bailout by a larger firm. "The flip side of that was Merrill Lynch, which clearly understood [its circumstances]," says Roberts. "They saw a partnership with Bank of America as putting them under the regulatory umbrella" and by getting stock for deal, felt comfortable waiting for a recovery in Bank of America's shares.

Another aspect to track are downgrades to the credit ratings on these companies' corporate bonds, although some market watchers have argued that the ratings agencies have lost much of their credibility by being so far behind the curve in their ratings actions. Ratings downgrades further impede companies' access to capital and give short sellers more confidence to look for ways to cut off all avenues of access to cash.

One key trigger for Lehman's endgame was rumors that Standard & Poor's Ratings Service was going to lower the bank's debt ratings, says Roberts.

(S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

"There's an inflection point that once you cross it you're worth more dead than alive," says Roberts. He cites Barclays' decision last weekend to pull out of a deal to buy Lehman's brokerage business due to uncertainty around the potential for further writedowns and instead wait for the company to go into liquidation so the assets could be bought for much less. AIG seems to have crossed the point of no return on Sept. 16 as it appeared that the government would have to take the lead in arranging funding for the floundering firm.

Banks like Barclays and Bank of America, which have huge amounts of capital within grasp or the ability to pull together with other institutions to form an investment vehicle, are anomalies, says Alex Moglia, president of Moglia Advisors, a financial and operational advisory firm in Schaumburg, Ill. "Most companies have to explore a network of lenders and investors who work in distressed markets, and most of them aren't acting in this environment," he says. "They're waiting for even worse times to come before they deploy their assets. Most of the lenders we do business with are not planning to deploy a penny until 2009."


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