Should You Fade the Plunge?

Many market cycles are marked by disproportionate investment in one sector.  That sector, post financial crisis, was energy, particularly oil.  The oil price fell with the crisis, bottomed at the end of 2008 and rallied to post crisis highs in April 2011 and March 2012. It  has fallen precipitously since June of last year. Energy stocks and bonds have both plunged along with oil.  If you are an investor, the question you might be asking yourself is whether you should buy energy stocks or bonds now or whether you should avoid them for some time yet.

Historically, the answer has been to buy the bonds, but avoid the stocks. Bonds have the advantages of known maturity dates, assuming solvency, and higher position in the capital structure, assuming insolvency or great stress.  If an energy company is solvent, but its bond prices have plunged, prospective returns will be high relative to similarly rated companies in other industries. If companies are  highly stressed, the bonds will reprice to a level that reflects the risk of a debt restructuring.  Debt taken out under one set of assumptions, like a high oil price, may not be serviceable, but cutting debt via an exchange offer or exchanging it for new debt and/or equity through bankruptcy often leaves companies viable due to the adjusted capital structure.

Equity in the previously favored sector typically underperforms broader indexes for some years.  This can be due to overvaluation, too much capacity, writedowns of that excess capacity and the poor returns on book equity resulting from the investment mania.

Note that this is a top down analysis. It  applies at the sector level, but may not apply to individual stocks or bonds.  Post selloff high yield investing is best done by or through specialists; there is a lot of security specific analysis involved.

Some background:

Here is the price of Brent from its bottom in late 2008 to the end of January 2015.

Brent012915

The next chart shows cumulative returns of the energy sector of the MSCI all country world index (left axis) and of the Bloomberg high yield energy sector index (left axis), along with the Brent oil price (right axis). The chart begins a year prior to the 2011 peak in the Brent oil price.  Energy stocks hit a high when Brent hit its high in 2011 and attained a slightly higher peak in June 2014 just before the plunge. High yield (HY) energy bonds experienced a smoother uptrend, until they too were caught in the Wile E. Coyote plunge last year.

Oil&Sectors

Below are charts from the aftermaths of the 2 previous market cycles, the financial crisis and the tech boom.

Financials were the focus of the last boom along with housing. Here is the post crisis performance of HY financial bonds against Bloomberg’s overall HY index from early 2010 on.* HY financials have outperformed the overall category by 74% to 50% over the last 5 years.

HYfin

Now we have equity performance from the beginning of the financial crisis until the present.  Financials have not reattained their pre-crisis peak. They are down 35% cumulatively from the chart’s inception, while the SPX is up 34%.  It is likely to be a long time before financials outperform the SPX.  Their dynamics have changed due to the higher capital requirements of Basel 3 and other regulatory changes.  Banks’ returns on equity in the developed world should probably stay muted as long as the global financial crisis is within living memory, but you can never say never.

s5FinlwSPX

The final chart shows the aftermath of the tech boom.  Both tech and telecom stocks were the objects of desire prior to March 2000.  From the tech boom peak through the birth of the financial crisis neither info tech nor telecom did well versus the SPX.

SPX&tech

*  I don’t have access to other HY indices so I cannot take the analysis back to the global financial crisis as I would like, nor can I show the performance of HY telecom bonds post tech boom. Desculpe.

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1 Response to Should You Fade the Plunge?

  1. Pingback: The Experts, the Oil Price and the Wisdom of the Market | Global Investment Strategy…

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