More Bad News for Credit

The stock market continues to depict the wrong message to investors.

As financial stocks continue to rally this month, despite some horrid earnings released for the second quarter, the stock market is gradually discounting a recovery over the next several months. The dollar is strengthening, housing and bank stocks are rallying and volatility indexes are trading 30% below their highs over the last 12 months.

But the real truth lies in the credit market, not stocks, as it pertains to deciphering the extent of the economic problems still confronting the world’s largest economy.

I’ve got several updates I think you’ll find quite illuminating, suggesting the credit crunch is not over.

Since Tuesday’s big stock market rally the majority of credit spreads have actually widened, not tightened. A strengthening equity market should be accompanied by a rally in higher risk credits like high-yield bonds, corporate debt and mortgage-backed securities. Also, inter-bank lending rates are still elevated (see LIBOR above).

But on Tuesday, these credit markets posted losses. That’s not indicative of a broad-based rally in all markets. It suggests that although some confidence might have returned to the equity markets that is certainly not the case for credit. And credit is where the smart money lies on Wall Street.

Also, the number of companies with weak cash-flow and limited access to capital has risen to the highest level in five years, according to Moody’s. Speculative grade companies are now in the midst of a liquidity crunch; though many companies were fortunate enough to refinance ahead of the credit crisis last summer, many others didn’t.

Default rates for companies with the weakest liquidity ratios also jumped to 21.6% in June from 17% in May – above the 18.7% average since Moody’s launched this index in October 2002. And as liquidity tightens for distressed companies, default rates will start to rise.

Overall, default rates among junk-rated companies are running at 1.44% -- still below the long-term average of 4.35% between 1981 and 2007, according to Standard & Poor’s. I’ve got a hard time believing that default rates have stabilized, considering the extent of the hardship confronting the auto, airline, housing, financial and restaurant industries. Media and entertainment are also under pressure and will witness more defaults.

Until these and other credit markets at least start to stabilize, investors should remain under-weighted in stocks. It’s still too early to load-up on equities again. Credit markets don’t lie. Stocks do.

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