As some high-risk assets take a hit, investors fear worse is to come

[July 14, 2014]  By David Gaffen and Jennifer Ablan

(Reuters) - World financial markets became reacquainted with fear last week, and even if it was short-lived, the ructions in some riskier assets looked to some like a precursor to a much rougher ride down the road.

Concerns that Portugal’s largest listed bank, Banco Espirito Santo was badly exposed to its owners’ accounting problems raised eyebrows in Europe and the U.S., getting investors to ask whether there were more shoes to drop in European banking.

Also some excess speculation that has been building up in various corners has bubbled over. Examples included the halt in trading in the stock of a company, Cynk Technology, with no assets or revenue, that had soared to a $6.4 billion market value, and the sudden collapse of Spanish wireless provider Gowex after a massive accounting fraud.

Add in the big reversal in fortunes for some companies who recently did U.S. IPOs, plus Puerto Rico's increasingly troubled debt picture, and it was tempting to remember Warren Buffett’s old saying: “Only when the tide goes out do you discover who’s been swimming naked.”

Billionaire investor Carl Icahn said he has become very wary. "In my mind, it is time to be cautious about the U.S. stock markets," he said in a telephone interview on Thursday. "While we are having a great year, I am being very selective about the companies I purchase."

It all comes against a backdrop of anxiety about whether global markets and economies are resilient enough to cope when the U.S. Federal Reserve takes the punch bowl away by ending its bond buying program and then starts to raise interest rates – probably next year - for the first time since 2006.

The sense of complacency that had set in among many investors has begun to disappear. Small-cap U.S. stocks fell more than 4 percent last week, their worst one-week performance in more than two years, while Spain’s Banco Popular postponed a bond offering and Greece could only place about half of what it wanted in a debt sale.

What's unclear is whether this is all about a short-lived, modest correction in some high-risk assets that had gotten out of control, or if its a harbinger of something more dramatic to come. Some are confident there will be a correction.

"I don’t care if it's Portugal, Ukraine, Russia or the Fed, markets are due for at least a pause or potentially a 10 to 12 percent pullback on a trading basis," said Jeffrey Saut, chief investment strategist at Raymond James Financial in St. Petersburg, Florida.

A correction of about 10 percent would generally be welcomed by large institutional managers, as the S&P 500 has not dropped by that amount in about three years. In recent weeks it has come within range of the 2,000 mark for the first time ever, having nearly tripled from its lows in 2009 during the financial crisis.

FAR FROM PANICKING

The concerns about Banco Espirito Santo may have crystallized fears some investors have about overheated credit markets but panic is far from setting in.

European government debt is still trading at levels not far from U.S. debt. Italy last week completed a sale of 7.5 billion euros, with the three-year and 15-year debt sales hitting their lowest yields in the euro's lifetime.

And while some of the optimism in the junk debt market has started to fade, the bears are far from taking over. The spread on the riskiest U.S. high-yield corporate bonds, those rated triple-C or less, has widened by about 0.35 percentage point against benchmark Treasuries since June 23, according to Bank of America-Merrill Lynch data, but the levels are still not far from their tightest since 2007.

“This correction only serves as a reminder that nothing is yet fixed in the euro zone and that, no matter how much money the ECB (European Central Bank) ends up printing, it will not jump-start the euro zone’s economies," said Phoebus Theologites, chief investment officer at SteppenWolf Capital in Lucerne, Switzerland. “But this does not mean we will get contagion or a crash,” he added.

Low borrowing rates across the globe, balance sheets that are in generally good shape for deal making or stock buybacks, and profits that are growing modestly in the U.S. and beyond are all reasons not to get too scared. Even valuations aren’t that stretched on some historical measurements.

Brian Reynolds, chief market strategist at Rosenblatt Securities, pointed out that pension funds and others have been steadily pouring money into corporate credit, even in what's usually a slow month of July.

High-yield issuer General Motors Financial borrowed $1.5 billion last week while U.S. power company Calpine Corp refinanced $2.8 billion in high-yield bonds. Overall, 2014 has seen high yield issuance of $183.6 billion so far, on pace for the busiest year ever, according to Thomson Reuters.

"Credit booms are littered with defaults," Reynolds said in reference to some recent problems. "So it's not a big deal. But the last five years has shown that if people want to panic for a few weeks, they may."

He says the S&P 500 could undoubtedly correct in coming days, pulling back to 1950 or even 1900, but the steady flows into corporate credit that has funded stock buybacks should keep the stock-market rally going for several more years.
 

David Joy, chief market strategist at Ameriprise Financial in Boston, where he helps oversee $771 billion in assets under management, says the jitters evinced in equities may be an early taste of the kind of reaction investors should expect when the Fed reaches the point of raising rates.

He attributes the recent modest uptick in market volatility to statements from Fed officials concerned about the need to normalize Fed policy, by starting to raise rates, while they also expressed concern about "complacency" in the markets.

He expects the Fed could start raising rates about six months after the expected end to bond buying in October of this year.

OVERHEATED PRICES

The easy money from the Fed and other central banks has helped lubricate more than just the equity and bond markets in recent years – whether the prices of sports teams and players, art or high-end apartments around the world.

Some investment strategists are concerned that the “smart money” is getting out of some areas, leaving others to face potential losses. Jason Goepfert, founder of Sundial Capital Research, points out that about 60 percent of IPOs in the last six months have involved some sort of exit for venture capital or early-stage investors, a higher percentage than any time in the last several years.

There has been notable underperformance from some U.S. companies that only first sold shares in the past year. Storage products retailer Container Store Group, which only went public in November, last week warned of weak forthcoming results; its stock has now lost almost half of the price it reached at the end of last year. Sandwich chain Potbelly Corp also disappointed investors after the initial euphoria there was during its October debut. It has now lost about two thirds of the value it reached then.

Twitter Inc, which sold shares to great fanfare in November, and saw its stock price almost triple in about seven weeks, has since dropped 48 percent.

"I wouldn’t hesitate to take profits here. I wouldn’t get out of the markets by any means, but there is a correction on the horizon somewhere," Joy said.

(Reporting By David Gaffen and Jennifer Ablan; Additional reporting by Sudip Kar-Gupta; Edited by Martin Howell)

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