Spanish bullfighter Miguel Angel Perera performs a pass on a bull during the last bullfight of the San Fermin festival in Pamplona, July 14, 2009. REUTERS/Susana Vera (SPAIN SOCIETY)

Leveraged Loans Betray The Rally In Stocks

I’ve written a fair amount about bond market risk appetites over the past year or so. Today, I’m watching the leveraged loan market even more closely because it’s moving in the opposite direction of the stock market across a variety of time frames.

Typically, risk appetites for leveraged loans (as measured by prices relative to same duration treasuries) and stock prices, especially small caps, are very highly correlated. Because leveraged loans are many times a key component of mergers and acquisitions, it makes perfect sense that waning demand for this type of credit investment could make for waning corporate demand for equities (not to mention buybacks). And this is exactly what’s happening right now.

“Where we are seeing it impact behaviors is at the smaller and middle size end of the market so the mid market. Deals are getting to be more expensive. The flex terms in financings have gone up significantly. And our pipeline in private credit so mezzanine, direct lending, and special situations opportunity are up significant as a result of some of the dislocation we’re starting to see…. What has become interesting more recently is what’s happening within the liquid part of the leverage credit markets. So the bank loan, leverage loan market the high yield market…there is a significant reduction in liquidity…if you see a screen price, it doesn’t necessarily mean that that’s achievable on any volume whatsoever and that is creating quite a bit of interesting tension in the markets.” -KKR Head of Global Capital & Asset Management, Scott Nutgall (via Avondale)

That reduction in liquidity is showing in the market right now as the Leveraged Loans ETF tests multi-year lows amid a modicum of selling pressure.


What I find striking is that even as risk appetites for leveraged loans (blue line in the chart below) have deteriorated, stocks have rallied this week:


But it’s not just this week. The entire rally that began in early October has not been confirmed by similar improvement in leveraged loan risk appetites:sc-2

In fact, leveraged loan risk appetites peaked over a year ago and have been falling since while stock prices went on to make new highs over the summer. That changed in August when stocks sold off pretty hard but the divergence is still very wide on this time frame:


Former Dallas Fed Chief, Richard Fisher, has warned about the growing risks in this area of the credit market for quite some time saying, “The big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.” As the only member of the Fed with any experience managing risk, I value his opinion highly.

The recent action in the markets suggests we may be getting closer to the point of, “tears.” And because leveraged loans are so highly correlated to stocks, I think equity investors would do well to take notice.

For more on the interplay between stocks and bond market risk appetites subscribe to The Felder Report PREMIUM.


History Rhymes: A Look At A Pair Of Popular Stock Market Analogs

There’s been a fair amount of discussion about stock market analogs in the financial blogosphere and on social media over the past few months. Traders are basically asking themselves whether the current correction is just that or is, in fact, something more… like the start of a new bear market.

The most popular bullish analog I’ve seen compares the current stock market action to the 2011 correction. And based purely on correlation, the current correction fits very well with that earlier one:


Still, there are major differences between today’s market and that one of four years ago. The most glaring of these is simply the earnings of the S&P 500. Back in 2011, the correction saw the index lose 22% from peak to trough. Earnings were also growing at a nice clip so the decline saw valuations dip to relatively depressed levels. At the lows, the p/e ratio on the index fell to 13 and change.

Today, in contrast, the peak to trough decline was only a bit more than half as deep as that earlier one was in percentage terms. Earnings are also declining today, rather than rising as they were back then. Finally the p/e ratio at the recent lows stood fully 45% higher than it did during the 2011 lows. So if investors are looking for another 100% gain over the next 36 months, as we saw after the 2011 correction, I think they’re misguided. The recent earnings trend and valuations now present major obstacles to this sort of outcome.


There are other problems with this analog including where we currently stand in the broader economic and credit cycles which will be made more apparent in looking at our next analog, which I’ve been following for some time now. I first learned of it when Ray Dalio presented it in a letter back in March of this year:

Interestingly, based simply on correlations the current market also fits very closely with that of 1937:


What makes this analog more compelling to me is the fundamental and historical comparisons Dalio makes between the two. And with the rising probability of a December rate hike, number 6 on the list is now possibly coming into clearer view.

  1. Debt limits reached at bubble top, causing the economy and markets to peak (1929 & 2007)
  2. Interest rates hit zero amid depression (1931 & 2008)
  3. Money printing starts, kicking off a beautiful deleveraging (1933 & 2009)
  4. The stock market and risky assets rally (1933-1936 & 2009-2014)
  5. The economy improves during a cyclical recovery (1933-1936 & 2009-2014)
  6. The central bank tightens, resulting in a self-reinforcing downturn (1937 & 2015?)

Now, I’m not saying (nor is Dalio, I believe) that the stock market is now going to crash because the current market is just like 1937. Effective use of analogs doesn’t rely on history repeating itself.

Investors who do so effectively, use analogs as just one tool among a myriad of others. And they do so in the belief that knowledge of market history is a great asset to an investors as history sometimes rhymes even if it doesn’t repeat.

Paul Tudor Jones famously used 1929 as an analog that helped him profit greatly from the 1987 crash. Less famously, Jim Rogers used 1937 as an analog to profit from that same event. And they both used these analogs merely as confirmation of a much broader trading process. And I’m certain Ray Dalio is now doing the same.

Ultimately, the 1937 analog looks much more compelling to me than the 2011 one because of all the supporting fundamental and economic similarities Dalio references. However, this is only one of many studies which tell me the risk/reward equation in owning the broad stock market is heavily skewed toward risk with very little in the way of reward.

Thanks to Nautilus Research for the analog charts presented above.


My 5 Favorite Sites, Services And Sources For Staying Plugged Into The Markets

I get asked a fair amount about my morning routine and the sites, services and sources I use on a daily basis to stay up-to-date with the markets so I decided to share a few of them here:

  1. Twitter has become an invaluable resource for me and a couple of the services I use are based on Twitter activity. It’s the first thing I check in the morning and I make a point to read every tweet from everyone I follow – I think that highly of them! See all 75 Twitter accounts I follow.
  2. A few months ago I found the Nuzzel app. It aggregates news stories shared by those I follow on Twitter and ranks them by popularity. It also has a section of popular articles shared by folks that I don’t follow which is probably even more helpful. Get the Nuzzel app here.
  3. StreetEye is a website I found a while back that is similar to Nuzzel in that it ranks stories by popularity on Twitter. The main difference is that they have independently determined the finance tweeps who regularly share the most relevant and valuable stuff and focus just on them. Visit I also prefer to read StreetEye through the Kite app which is sort of like Instagram for news. Get the Kite app here.
  4. I use Feedly to follow a number of blogs including Abnormal Returns, Avondale, Humble Student of the Markets, Meb Faber Research, Philosophical Economics, Short Side of Long, and many others. Get Feedly here.
  5. I enjoy the Zite app which was recently acquired by Flipboard, whose app I also use. Within Zite I’ve selected a number of categories that interest me including business, economics, finance, investing, stocks, etc. and by favoriting certain stories it’s really become nicely tailored to my personal interests and preferences. Get the Zite app here.

If you can’t tell by now I’m a news junkie. I use each of these at least once a day. And I thought it would never happen but, as a whole, they have now entirely replaced physical newspapers and magazines for me.


Amazon: The Dumbest Competitor In America’s Most Popular Commodity-Like Business

The strength in the FANGs (Facebook, Amazon, Netflix, Google) is what’s holding up the stock market this year. This is no secret. Everyone’s been talking about our new version of the “Nifty 50,” which is today something more along the lines of the “Nifty 4.”

In actual fact, it could really be considered the “Nifty 1” as Amazon has seen its stock price more than double this year, adding over $170 billion in market cap. Now at over $300 billion, the stock is now the 7th largest component of the S&P 500, making up 1.4% of the index. Coincidentally, that index is up just about 1.4% for the year right now so in some respects you could argue this one stock is responsible for essentially all of the gains in the index (I know this isn’t mathematically exactly accurate but the general point remains).


It seems the bullishness surrounding Amazon’s rise this year is due to the fact that it continues to take more and more market share from the likes of Wal-Mart, Target and others. This is partly evidenced by the fact these latter companies have seen their own stocks hammered recently to one degree or another. Yes, it’s once again “clicks versus bricks” in the financial markets.

To justify it’s current valuation, investors have talked about Amazon’s ability to one day, “turn on the profits.” Right now the company is simply focused on taking market share and during this process they don’t care about making any profit at all, as the story goes. But someday, this will change, investors say.

However, one thing Amazon investors may currently be overlooking is that the retail business, even for the best companies in the world, is generally not that profitable. In fact, these companies that Amazon is taking share from all have one thing in common: very thin net profit margins.

So I thought it might be interesting to run a little experiment to see when Amazon might actually grow into its current valuation assuming they do decide to turn on the profits at some point in the future. In doing so, I assumed Amazon would be able to continue to grow its revenues at 18% indefinitely (some might consider this a “heroic” assumption but let’s give Bezos the benefit of the doubt). I then applied the average profit margins of the company’s nearest “bricks and mortar” competitors along with those companies’ average profit multiples in the marketplace to come up with a valuation. Finally, I applied Amazon’s current average profit margin and these multiples just to see what it would look like if they decided to keep the profits spigot unchanged. The results can be seen in the spreadsheet below.

Screen Shot 2015-11-12 at 8.51.54 AM

With a Wal-Mart-like profit margin (3.5%) and multiple (14 p/e) it would take Amazon 11 years to grow into its current $300 billion market cap, assuming it continues to grow revenues at 18% as it has over the prior four quarters. With a Costco-like margin (1.83%) and multiple (25) it would take 12 years as it would with Target-like metrics (2.36% and 16p/e). Finally, if the company decided to simply maintain its current average profit margin of 0.42% and investors still afforded it a multiple like its peers it would take over 20 years to grow into its current valuation.

Now, it needs to be said that an 18% growth rate for perpetuity means the company will be doing over $6 trillion in sales 25 years from now. For a little perspective, Wal-Mart is already the largest company in the world by sales at nearly half-a-trillion. Personally, I don’t really doubt Amazon can become the largest by sales but it may be unrealistic to assume they can generate more than ten times the sales of the current largest in the world.

What’s more, I think the pertinent question investors must ask is this: ‘Even if Amazon does decide to, “turn on the profits,” at some point in the future what is the likelihood they can sustainably generate a profit margin similar to their top competitors while maintaining their current sales growth and market share?’

Now, I love the company. And, as a nation of consumers, the country clearly loves it, too. Over the past few years, I’ve started ordering more and more from Amazon. In fact, while writing this post my wife asked me if I wanted to see the new dress she’s ordering from the site (it’s gonna look great on her ;-). I’m sure many other Amazon customers are doing the same so the story, in this respect, is probably true.

Still, our loyalty to Amazon runs only as far as they offer the best price. As soon as someone offers a better price, consistently and with the same ease of purchase, our business will shift to them and away from Amazon just as quick as it shifted to Amazon and from its, “bricks and mortar,” competitors in the first place. To me, this suggests Amazon’s ability to, “turn on the profits,” is almost perfectly inversely correlated to their ability to generate sales growth and take market share.

Ultimately, the reason retail margins for all of these companies are so low is that it really is a commodity-like business. They don’t sell anything proprietary to any significant degree that gives them the ability to charge a greater margin.

As Warren Buffett has famously said, “In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.” And I’m sure Amazon CEO, Jeff Bezos, know that Wal-Mart, Target and Costco all look at Amazon right now as their, “dumbest competitor,” willing to sell the same products at essentially no profit margin.

So again, we have to ask: ‘What is the likelihood that, should Amazon decide to, “turn on the profits,” a new, dumber competitor sees the opportunity to take share from Amazon by undercutting their raised prices?’ I’d say that it’s probably pretty high, especially considering what venture capitalists have been willing to fund over the past couple decades (see as the latest example).

It seems to me that a 10-year time frame for Amazon to grow into its current valuation may be closer to a best-case scenario than anything because it assumes the company can both, “turn on the profits,” and maintain it’s current sales growth and market share gains. If it’s unable to accomplish both of these at the same time, investors in the stock may be left in lurch for quite a long time as it will only become harder to justify the valuation as the company continues to grow.

Finally, the fact that this investment thesis can be considered the driving force behind this year’s stock market gains should tell you much about current sentiment towards equities generally. In my view, it suggests there’s a whole lot of hope driving the stock market and not a whole lot of reality right now.

UPDATE: Yes, I set aside the whole AWS discussion for now. At about 10% of company revenues it’s not a huge part of the business and my personal opinion is that it’s also just another commodity-like product. Someone could easily come in and beat them at their own game in this line of business. The question is, ‘How dumb to Google and Microsoft feel?’ So even considering AWS, the growth and profit margin argument remains.


Stanley Druckenmiller Growls

Druck gave an interview yesterday at the DealBook conference. There are two major takeaways for me from the video above:

  • The greatest hedge fund manager of all time is now operating under the assumption that a primary bear market began in July.
  • Due to the massive misallocation of capital in recent years and the long-term demographic headwind going forward, normal investors should probably be in cash.

Bonus takeaway: He’s very open-minded about all of his views and easily changes his mind. This is the sort of flexibility that underpins the success of all great investors. That said…