Some of you may remember Michael Milken.  He was The Bad Boy from the 1980s leveraged buyout (LBO) craze and the father of modern junk bond debt financing to conduct LBOs.  He ran the Drexel Burnham Lambert high yield bond desk until 1989 at which point, he ran it into the ground and in 1990, DBL out of business.  For this and other mischief and overreaching, he earned himself a one-way ticket to Federal prison for SEC violations in his dealings with client and fellow Bad Boy, Ivan Boesky.  Milken served a two year prison sentence and apparently came back a changed and philanthropic man.

So, if anyone can speak with authority on the national bond market and what it means to business, it should be Michael Milken.  How refreshing he has turned his formidable analytical powers to helping the rest of us understand the bond market. 

Today (Tuesday, August 21)  in the WSJ, Milken published an editorial on the corporate bond market drawing parallels to the mid 1970s.  Those of you that are loyal "Wealth-Ed" readers know that I am of the opinion that history is a prelude to the future, that is history (almost) repeats.  I have also noted the market similarities between now and the mid 1970s as well as the late 1930s.   Milken puts some specific analysis behind that speculation.

In Milken's opinion, we are working through the worst of times and not far from much better times.  I have been recommending investments in the high yield bond market as the spreads (TED spread) between high yield and Treasuries were until recently at record levels.  The fact those spreads are improving shows healing in the market.  The bond market almost always gets the story right before the stock market.  So an improving high yield market is a good indicator for stocks and the economy.

• OPINION
• APRIL 21, 2009

Why Capital Structure Matters

Companies that repurchased stock

By MICHAEL MILKEN

Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors who said, "I'll never own a stock again!" Meanwhile, some state and local governments as well as utilities seemed on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved for capital.

Chad Crowe

If that all sounds familiar today, it's worth remembering that 1974 was also a turning point. With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged, two-year rates of return approaching 100%.

The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That's 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations are now raising capital through new issues of equity, debt and convertibles.

This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations with strong capital structures started acquiring others. In a single recent week, Roche raised more than $40 billion in the public markets to help finance its merger with Genentech. Other companies such as Altria, HCA, Staples and Dole Foods, have used bond proceeds to pay off short-term bank debt, strengthening their balance sheets and helping restore bank liquidity. These new corporate bond issues have provided investors with positive returns this year even as other asset groups declined.

The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company's securities or the risk of investing in them.

My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it's happening again.

Overleveraging in many industries -- especially airlines, aerospace and technology -- started in the late 1960s. As the perceived risk of investing in such businesses grew in the 1970s, the price at which their debt securities traded fell sharply. But by using the capital markets to deleverage -- by paying off these securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt -- most companies avoided default and saved jobs. (Congress later imposed a tax on the difference between the tax basis of the debt and the discounted price at which it was retired.)

Issuing new equity can of course depress a stock's value in two ways: It increases the supply, thus lowering the price; and it "signals" that management thinks the stock price is high relative to its true value. Conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price generally rises.

The decision to increase or decrease leverage depends on market conditions and investors' receptivity to debt. The period from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late '80s, equity market values rose above the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal to deleverage.

In this decade, many companies, financial institutions and governments again started to overleverage, a concern we noted in several Milken Institute forums. Along with others, including the U.S. Chamber of Commerce, we also pointed out that when companies reduce fixed obligations through asset exchanges, any tax on the discount ultimately costs jobs. Congress responded in the recent stimulus bill by deferring the tax for five years and spreading the liability over an additional five years. As a result, companies have already moved to repurchase or exchange more than $100 billion in debt to strengthen their balance sheets. That has helped save jobs.

The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market's recent fall. These purchases peaked at more than $700 billion in 2007 near the market top -- and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world's largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy's, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

The current recession started in real estate, just as in 1974. Back then, many real-estate investment trusts lost as much as 90% of their value in less than a year because they were too highly leveraged and too dependent on commercial paper at a time when interest rates were doubling. This time around it was a combination of excessive leverage in real-estate-related financial instruments, a serious lowering of underwriting standards, and ratings that bore little relationship to reality. The experience of both periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real estate is a good loan, and that property values always rise. Fact: Over the past 120 years, home prices have declined about 40% of the time.

History isn't a sine wave of endlessly repeated patterns. It's more like a helix that brings similar events around in a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.

It doesn't matter whether a company is big or small. Capital structure matters. It always has and always will.

Mr. Milken is chairman of the Milken Institute.

 

I have spent some time during recent days in remorse. "How did I not see all of this coming and get into cash?", I ask myself. But I am being unfair to myself, because I did see all of this coming, but could not bring myself to believe that it would actually happen or pull the trigger to sell out and get 100% into cash.

I looked to see what I was saying in January 2004, and low and behold, I thought all of this was a possibility, though in early 2004 I did not yet fully appreciate how much the real estate bubble would affect the future. By the end of 2005, I understood that was the true danger. But if our financial system was not so inherently weak prior to that bubble, it would not have brought the system down. Looking back on this advice, it sounds as relevant today, as it did almost five years ago.

Here is what I said in my annual letter, January 2004:

REAL ASSETS

This category was not mentioned in previous reports, but is an area of great interest. The base materials (natural resources) markets have outperformed many equities and all bonds in 2003. Gold, like oil and other natural resources, has reversed a 25 year downtrend. This is very significant. It was only two years ago that many central banks decided to liquidate gold reserves, pressuring prices with the anticipation of increased supplies. Now, gold has gone from $250, to well over $400/oz. in 18 months. What does this mean? Is it a portent of things to come? Gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar) went off the gold standard and onto a paper based standard (the USD). Gold prices went from $35 in 1971 and eventually to $850 in 1980, during the height of inflation. Then as now, gold strengthens when the dollar (and other paper currency) weakens, as gold is the alternate form of world financial exchange.

Gold and other commodity prices are considered by many economists to be predictors of future inflation. Inflation is created by excess debt leading to declining currency valuation. If government and consumer debt and money supply is again in excess, then inflation and declining purchase power of the USD is on the way (Boy, sure got this one right!!). The deficit spending of the past 3 years rivals the late 60s, during Johnson’s “Guns and Butter” program, as a percent of GNP. But the story is really worse this time. Unlike the 60s, when the USA was still the world’s creditor nation coming out of World War 2, with positive balance of trade, now, the USA has severely negative balance of trade. Continued build up of national and personal debt is doubly troublesome. Unlike the 1970s, now have nothing to offset our debt, except more paper.

Potential “Doomsday” scenarios come out of this ominous situation. At best, as hoped for by me, the large national debt will result in a price inflation, a stagnant economy, flat stock market, and declining bond prices in concert with increasing interest rates. See the 1970s for an example. I believe this is what the Fed is now trying to engineer: dollar devaluation and price inflation. The dollar devaluation makes exports more attractive and imports less attractive, helping our trade balance. Price inflation reduces the impact of long-term debt for both government and consumer at the expense of the creditors: mortgage holders in the case of consumer debt and foreigners in the case of government Treasury bonds.

In the worst case scenario, the dollar’s value will disintegrate taking the USA and many other dollar-denominated economies with, leading to a global financial crisis and depression that could last for 10 or more years. From this depression will emerge a new global financial power, China, which would de-link its currency from the USD, and make the China Yuan as the new global currency standard. As the new creditor power, replacing the USA role from the 50s and 60s, China will dictate world policy.

The end result of these concerns is the need to own either commodities in the form of mining, energy or other natural resource companies, and rare metals: gold, silver, platinum, etc, in certificate or in fact.

Energy stocks are another commodity that would do well in an international financial crisis. Asia (China) continues to increase consumption of energy products, like oil and coal. Supply is limited and requires years of effort to expand. Commodities will also do well during a period of global inflation, or deflation, as during the 30s. Raw material values may not increase in absolute terms during periods of deflation, but they do not decrease much, either. So, if currencies increase in value, as they do during a period of deflation, then commodities appreciate in relative terms.

On Friday, at the market close, and less than 6 hours after the Financial stocks tanked on the bad employment data from August, Treasury Chairman Hank Paulsen let leak that the Feds would be taking over Fannie and Freddie on Sunday.

My reaction was: DARN! or something close to that. I had been waiting for this to happen and knew it would create a trading opportunity on the financial indexes that I have been trading. But unlike the Bear Stearns bailout in March, where the rumor was on the net a couple days before the event, this one was very well guarded. Some people must have known as after the financials tanked Friday, they worked their way higher all day from about 10am on. Then, at the close, when the press release about the meeting on Sunday was announced, the UYG popped by 10% and I knew my goose was cooked, at least for a few days.

I would have loved to have been on the right side of this trade, but the financials had not dropped enough for me to cover my short position (SKF) and take a new long position (UYG). I was close, but about 5% away from pulling the trigger. And, as I have a day job, I did not have a chance to watch the financials move higher all day long into the close and the Fed press release. Had I been a full time trader, I would have looked into that counter trend movement (against the backdrop of the bad employment data in the morning) and might have found enough information to get me to switch direction.

But all is not lost! This is NOT the proverbial "other shoe dropping" signaling a change in direction for the financials, the stock market and the economy. In fact, I was stunned that the market reaction was so dramatic this morning. The fact that the Fed would have to intervene in Fannie and Freddie has been known for many weeks, really since the July 15 bottom when Paulson asked for and received authority to make this move. Most market followers expected this move sooner than this, so there should have been no "surprise factor" here.

In fact, the deal went down just about as expected. Fannie and Freddie common share is basically wiped out. This was necessary to eliminate concern of "moral hazard" where investors get taken off the hook by taxpayers. But Paulsen did not stop at common shares, he also took out the preferred shareholders. He did not actually bankrupt the company, but by giving warrants to the US government / taxpayers that give 80% of the equity to the government, with no dividends until Fannie and Freddie get profitable, for practical purposes, the stock is worth very near zero.

Worse for the financial market, many banks hold Fannie and Freddie preferreds as part of their capital structure. This was an arrangement with the bank regulators where FNM and FRE stock was considered as safe as cash, so avaiable as collateral for capital. But, it was not so safe and has now been written down to nothing. In fact, the preferred was not convertible to common, so its only value is for the dividend, which has now been eliminated for the forseeable future.

This is a material surprise. And it has a materially negative impact on many banks. That information will get back into the stock price in the next few days. I still think the Financials will continue to go down, with bounces along the way. I would use this opportunity to get short on Financials, which I am doing by selling more puts on SKF.

Jeff asked me yesterday to keep an eye on a few key charts for signals to buy or sell within that sector, or the sector itself. So, I will monitor the S&P; 10 sectors plus a few other specialty sectors like Materials and Mining. I will post them here regularly, as there are changes to report.

We talked about Technology. After hearing the Cisco news yesterday, it seems like Tech might be taking a little turn for the better. Tech is a good sector to buy as a sector since there are a lot of casualties in that sector. The chart for the S&P; Tech is XLK. It does show a recent breakout where the third green arrow was made two days ago, so now is a time to buy the sector, or good stocks within the sector. I hope this change in trend helps out Microsoft, which I have in a big way:

Another sector to monitor is the Energy sector. We recently looked at the OIH (yesterday it was in a report I sent out). Jeff was concerned about the prospects of equipment builder RIG, which has been declining steadily along with the entire sector. You can make the comparison yourself, but both charts are down about 25% from their high and are trending lower.

RIG is getting very cheap by all measures (P/E, P/CF, Book Value, PEG, etc). But what about the overall Energy Sector, XLE? It is in a downturn and should be watched for a break to the upside. But there is no rush. When a chart is in steep decline as this one is, it can continue quite a bit lower. Don't try to catch the falling knife, is the saying. A cheap Value guy like me, has been stabbed numerous times by not heeding this advice. The 12 month low in XLE is 10 points lower than where it is today (62.50). Don't fight the tape is another of the oldest sayings in investing. We should wait till we get three Green arrows, before we commit new money to Energy stocks.

Just picked this up off the E-Trade News. The article from this PM confirms the points I have made recently regarding a rotation from the commodities to the financial equities. It sure is nice to see someone independently come up with the same technical indicators that I have identified ;o) The rotation may not be long term in nature, but it sure looks tradeable over the next few months (today's action notwithstanding).

The chart below compares the Financials index, XLF with the oil index, OIL. The relationship between the two is almost perfectly inverse the past month. So, as oil and commodities decline, financials and other related equities will increase. This makes sense because oil / commodities are a reflection of inflation denominated in the home currency. Higher inflation must mean higher interest rates, which must damage financial equities.

"Goodbye commodities, hello financials" 1:01 PM ET 7/24/08 Marketwatch

NEW YORK (MPTrader) -- It seemed as though there was no place to hide when Apple and the technology sector, along with Bank of America and the financials, got clobbered with the rest of the market at Tuesday's open. Though by mid-day, the market did recover in a big way and left behind another significant low within a "rolling bottoming process."

Tuesday's action in the Standard & Poor's 500 Index (SPX) established a low of 1248 and high of 1277. That dwarfed Monday's daily range, closing well above Monday's close and high, so from a strict technical prospective the blue chip index had a key upside reversal.

In addition, unlike the rally off of last week's July 15 low, Tuesday's rally did not have the feel of a temporary oversold rally. The morning sell-off wasn't as dramatic, with the S&P; 500 only down 11.5 points from its previous close as opposed to nearly 28 points on July 15. So it was a higher, secondary low -- more corrective looking than that of the previous week, and less susceptible to a mere reactive bounce.

Driving the S&P; 500, which has now recovered 6.8% from its July 15 low (through Wednesday's close at 1282), are the financials, which have room to go higher. Over the last several months the percentage that the financials make up of the S&P; 500 has diminished just by virtue of the price deterioration, while the energy sector percentage of the index has increased. But institutions in the last week, in particular, appear to have begun to shift their money out of the once high-flying energy sector into equities.

One way to play this trend is through the Financial Select SPDR (XLF) or its sister ETF, the Ultra Financials ProShares (UYG), which moves two times that of the XLF. Since its low of 14.08 on July 15, the UYG is up 68% through Wednesday's close at 23.67.

Traders should look this week for a break of 26.40. That's where the major resistance trendline from Sept. 30 of last year cuts across the price axis, a break of which would be the first major signal of damage to the downtrend that's transpired since the fourth quarter of last year. Beyond that, if the UYG can sustain above 33.75, it would indicate the end of the bear market in financials.

Likewise, the Ultra Short Oil & Gas ProShares (DUG) provides an opportunity to play the downside move in energy shares. The DUG has put in a rounded bottom at around 25.30, closing Wednesday at 36.16, up 42% from its low, as oil prices have declined 15% from their $148 high. Its chart points to 39.50-41.00 next.

Another way to play the trend is through the iShares Dow Jones Transportation Average (IYT), which for obvious reasons is getting a major lift from declining energy prices. The IYT chart shows it made its bear market, corrective low on January 6 at 72.86, and went to new highs after that at 99.09 on May 18. The July 15 low at just under 82 was the pullback low after that new high, and from there it's gone to just above 92 as of Wednesday's close, a 12% gain in just a week. Tuesday was the first time it closed above its 50-day moving average since the first week of June, suggesting the IYT is in a new upleg and heading directly back to 99 to test that high.

Other commodity indexes are confirming what the IYT is suggesting, like the PowerShares DB Agriculture ETF (DBA), which closed below its 200-day moving average for the first time in a year on Tuesday. The PowerShares Commodity Index Tracking Fund (DBC) closed for the second day in a row below its 50-day moving average and looks like it has considerable room to go down as well.

In addition, the streetTRACKS Gold Shares (GLD) looked like it was on its way to retest high levels at around 98 early Tuesday but instead ran out of gas at around 96.20 in the pre-market hours and then reversed in a big way and closed at 93, falling to 90.57 as of Wednesday's close. Chances are the GLD now will move back to below 90, and possibly towards a full-fledged test of its rising 200-DMA, now at 86.80, which must contain any further sustained weakness to avert a total breakdown in gold prices towards $800 ($80 in the GLD).

The financials, transports and stock index ETFs are turning up, while we have sell signals in the, energy, agricultural and precious metals sectors. For people who have followed markets for a long time, this inverse relationship between equities and commodities makes intuitive sense and suggests there are trading opportunities developing that will last longer than a few hours!"

Mike Paulenoff is author of MPTrader.com, a diary of his intraday technical chart analysis and trading alerts on ETFs for gold, oil, equity indexes and other major markets. (mptrader.com)