The Falcon and the Snowman

“We build statues out of snow, and weep to see them melt.” -- Walter Scott

Kevin Cassidy, a senior credit analyst at Moody’s, recently referenced the $700 billion in risky high-yield corporate debt on the horizon and offered, “An avalanche is brewing in 2012 and beyond if companies don’t get out in front of this.”

Minyanville offered a similar assessment entering September 2008 as $871 billion of corporate debt was set to mature into year-end. We opined there were two plausible scenarios; a credit cancer that would chew through the financial body, or a car crash that would crack the system under the weight of an indebted world. Read more in Pirate’s Booty.

I agree that another avalanche is building atop Credit Mountain; while risk transferred from corporate coffers to sovereign strongboxes, the magnitude is cumulative in cause and effect. And despite scary parallels between the 2008 financial crisis and our modern day sequel, savvy investors continue to monitor corporate credit as a timing mechanism for an equity downturn.

As stocks grind to fresh 18-month highs, we’re left to wonder if the upside window of opportunity will remain open until corporations are again forced to pay their bar tabs. Credit markets are exhibiting surreal strength and through that lens and that lens alone, the equity market has plenty of room to run.

The question is therefore begged -- will this singular proxy again ring the bell when a crimson tide is about to turn?

Raptors Await

There’s no denying the bulls have captured the year-over-year crown. While you can agree or disagree with the synthetic catalysts, price is the ultimate arbiter of variant financial views. The market is never wrong; we should never let an opinion get in the way of making money.

As investors key on corporate credit, there is a litany of causal risks waiting in the wings. With a conscience nod these could conceivably create building blocks in a wall of worry, I humbly submit ten reasons why we’re witnessing a cyclical bull market in the context of a prolonged and painful secular bear stretch:

1. Questions remain on a Greek aid package in front of €20 billion in debt that comes due in April and May. This dynamic is not bound by borders; should an accord be reached, as expected, the approach will be tested when the next “lifeguard” begins to drown. See A Five-Step Guide to Contagion.

2. New health care legislation could add hundreds of billions of dollars to already yawning budget deficits. That chasm can only close through upward taxation or austerity initiatives; neither is pro-growth and both drain consumption. This, of course, comes at a time when the “interconnectedness” of governments and markets has never been higher.

3. State budgets are cracking and a recent report from the Pew Center estimates unfunded pension liabilities are an eye-popping $452 billion. While I expect a Federal bailout package, as discussed in January, it’s akin to moving money from one pocket to the other. For more, read Ten Themes for 2010.

4. Social mood is tenuous at best and deteriorating at worst. As The Great Divide continues to evolve -- Red States vs. Blue States, Main Street vs. Wall Street, Have’s vs. Have Not’s -- societal acrimony has evolved into social unrest in some parts of the world, and economic hardship is pointing an unfortunate needle towards geopolitical conflict.

5. Complacency abounds, as measured by traditional volatility measures such as the VXO. While we’ve witnessed prolonged periods of subdued volatility (2004-2006) and healthy debates rage regarding the indicative validity of this measure, risk premiums are at levels last seen in June 2008 -- a few short months before the financial crisis arrived.

6. From Google (GOOG)-China to USA-Toyota (TM) to EU-Greece, the seeds of protectionism continue to sow. That posturing is on the opposite end of “globalization” on the prosperity spectrum. 7. While the “stated’ unemployment rate hovers just below 10%, almost one-in-five Americans is underemployed; that means they’re not working, stopped looking, working below their abilities or working part-time because they can’t find full-time employment.

8. From an economic perspective, interest rates have one way to go, price-to-earnings multiples never troughed, and debt-to-GDP ratios will approach or exceed 100% in all G7 countries by 2014, with the exception of Germany and Canada, according to John Lipsky at the IMF.

9. The Congressional Oversight Panel warns that commercial real estate losses at banks alone could reach $300 billion starting in 2011. Almost half of those loans are concentrated at smaller institutions with total assets under $10 billion, and those are the same banks that account for almost half of all small business loans. See also What to Expect from the Commercial Real Estate Crisis.

10. It’s easy to forget about the housing crisis; in terms of “what matters now,” this concern almost feels passé. We must remember that massive amounts of residential mortgage backed securities are mis-marked at best and toxic at worst, sitting on the balance sheets of private and public institutions and by extension in bank accounts across America. This is in addition to the manifestation of under-water mortgages (negative equity) and foreclosure trends throughout the land.

Total Recall

Do I think the system is broken beyond repair? No, I believe there will be massive opportunities once we’ve taken the medicine of debt destruction so long as calmer heads prevail. Also read The Great Expression.

That could take another five to seven years but it’s difficult to foretell; a lot depends on how we navigate a multi-linear dynamic that includes currency readjustments, the evolution of credit, $500 trillion of global derivatives, two-sided regulatory reform, the shifting social mood, geopolitical fragility, and trade relations.

Is it possible we “echo” higher before that comeuppance arrives? Sure; these aren’t natural markets anymore and we must respect both sides of the financial equation. Given the path we take trumps the destination we arrive at, there’s only one way we can reconcile these seemingly disparate data points: Carefully, and one step at a time.

With quarter-end bearing down and performance anxiety picking up, market psychology is emerging as the most important of our four primary metrics. The last round of fundamental data points (earnings) beat expectations on the aggregate, the bulls have the technical baton above S&P 1150 and BKX 50 (resistance comes into play at S&P 1200). And while stateside structural dynamics are currently steady, we haven’t heard the last of sovereign situations on the other side of the pond.

If you asked me for my near-term opinion, I would offer that the tape tops out before quarter-end under S&P 1200, consistent with the path of maximum frustration as fund managers reach for performance. Remember, when S&P 1150 was surmounted, a lot of shorts covered, removing a natural layer of forward demand. From there, we’ll monitor the second quarter flows, which should help shape the tape into the beginning of April.

We each have unique time horizons and risk profiles, which is why blanket advice is so very dangerous. I don’t believe in punditry, I believe in proactive preparedness and individual responsibility for our financial choices. It’s my hope that by painting the big picture landscape -- and adding color by numbers in the near-term -- I’ve added some value as we together find our way.

R.P.