NEW YORK (Reuters) - An obscure corner of the stock market is giving strong warning signs even as the broader equity and corporate bond markets rally.
Equity derivatives indicate that although the stock market is turning in its best monthly performance of the year, investors are still fretting about the potential for another drop.
It’s not just equity options that are raising red flags.
U.S. Treasury yields reached new lows last week, signaling investors are willing to accept paltry returns on safe-haven securities.
But puzzlingly, credit markets, which were early indicators of trouble in 2000 and 2007, seem relatively unfazed.
Given the conflicting signals, it makes sense that America’s top economist, Federal Reserve Board Chairman Ben Bernanke, warned last week the economic outlook remains “unusually uncertain.”
Some U.S. portfolio managers argue that investors with an insatiable appetite for yield may be paying too little attention to the risks in stocks and corporate bonds.
Consider implied volatility skew from equity options. Skew indicates the difference in demand for put options, which investors use to bet on the market falling, and call options, which allow investors to bet on the market rising.
A standard measure of three-month volatility skew is around 11.39 percentage points, signaling much higher demand for puts than calls. Over the last five years, that figure has trended closer to about 9 percent, and skew has only been higher about 9 percent of the time.
“There’s a real market out there for protection against the market dropping,” said Scott Weiner, U.S. head of equity derivatives and quantitative strategy at Deutsche Bank in New York.
To be sure, three-month volatility skew has edged lower in recent weeks after reaching a record high in May, but it is still high by historical standards.
LIMITS ON GROWTH
The Treasury bond market would argue that it has known about the United States’ “unusually uncertain” economic outlook -- and other markets will play catch up.
The U.S. government is due to report on Friday that growth slowed to a 2.5 percent annual rate in the April-June period from a 2.7 percent pace in the first three months of 2010.
“Companies can only grow as fast as the economy grows. So if the economy grows at only 2-2.5 percent and you’re growing faster than that, you’re taking away market share from somebody else,” said Julian Koski, co-founder of Transparent Value, an equity asset management firm owned by Guggenheim Partners.
For many companies in the second quarter, profit growth came from cutting costs rather than rising revenue.
Industrial conglomerate General Electric Co GE.N posted its first quarterly profit increase in more than two years, but its revenue fell.
In recent weeks, yields on U.S. government bonds have dropped to alarmingly low levels, reflecting a growing concern of falling economic growth rates and inflation expectations.
Billionaire George Soros said at a conference less than two weeks ago that the Treasury bond market is suggesting “no inflation” and indicates “no growth.”
Last week, the yield on the two-year Treasury note hit a record low 0.56 percent and the yield on the benchmark 10-year note slid below 3 percent.
Treasuries have been investors’ favorite safe haven during periods of turmoil, as was the case during the depth of the credit crisis in Greece a few months ago, even overwhelming the $2 trillion of new government debt flooding financial markets.
More recently, they have become the security of choice for another reason: investors’ sinking feeling that U.S. economic growth has lost momentum.
“There is no growth to speak of and aggregate demand is falling -- this is what the bond market is telling you,” Koski of Transparent Value said.
By contrast, junk bond spreads -- a measure of the extra return that investors demand for taking credit risk from riskier companies -- are hovering near levels more typical of late 2007 or early 2008, according to Merrill Lynch indexes. To this market, it is almost as if Lehman Brothers and Bear Stearns never failed.
It may be that both markets are right. Companies might generate enough cash to meet their obligations to creditors but not enough to generate profit growth.
But one hedge fund manager said he is shorting junk bond credits because the market seems to have minimal potential upside and significant possible downside.
CASH NOT NECESSARILY KING
Mom and pop investors may be less concerned about the downside, having poured a total of net $138 billion into bond mutual funds during the first six months of 2010, with taxable bond funds taking in $120 billion, according to Strategic Insight.
“A huge percentage of investors want income because they are starving for yield and looking for it in junk bonds and corporate debt,” said Margaret Patel, the senior portfolio manager at Wells Fargo Funds who oversees both equities and fixed-income assets.
Overall, some investors have taken comfort that a double-dip recession won’t occur because of Corporate America’s solid balance sheets.
U.S. corporations, not counting financial companies, have socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26 percent from a year earlier, according to the Federal Reserve.
But cash levels could suggest less economic activity, not an economic sweet spot. “The cash is a reflection of large companies stepping up their ‘self insurance’ in view of the increasingly uncertain outlook,” Mohamed El-Erian, chief executive of bond firm PIMCO said.
Monday, the Dow Jones Industrial Average .DJI closed up 100.81 points, or 0.97 percent, to 10525.43, pushing the index back into positive territory for the year.
“There is cash out there -- people have to do something,” Koski said. “But does that mean this economy is growing? I don’t think so.”
Reporting by Jennifer Ablan and Dan Wilchins; Editing by Eric Walsh
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