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.


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…



Bond Market To Stocks: “Last Call!”

Bond market risk appetites hold the key to the stock market right now. It is normally the case that equity and debt markets are very closely intertwined but today this true more than ever. And the bond market is signaling the party is nearly over.

I say that the relationship between bonds and stocks is more important today than ever because mergers and acquisitions activity and stock buybacks have been a major source of demand for equities over the past few years. And, to a very large degree, these have been financed by debt. So companies’ ability to access the credit markets currently has a huge impact on stock prices.

This is evident in the fact that, after shunning corporate bonds in September, investors rushed back into the sector in October. Stocks clearly benefitted, seeing one of the largest one-month rallies in quite some time.

The Wall Street Journal reports that the rebound in October puts the corporate bond market back on track for another record year of issuance.

Despite the record investor demand for these funds, however, the interest rate spread between corporate bonds and treasuries hasn’t narrowed very much at all over the past month. This means that the cost of pursuing buybacks and M&A through new debt issuance is still more expensive than just a few months ago, let alone a year ago.

The persistence in spreads may simply be a sign that companies are reaching the limits of their ability to borrow and spend on buybacks and M&A. The ratings agencies are clearly signaling their concern in this regard.

Indeed, corporate leverage has soared far past the peak seen prior to the financial crisis. What’s more, after falling to very low levels defaults are now starting to grow again.

And with the global economy slowing, in many ways back to recessionary levels, it’s hard to imagine how these trends will reverse themselves.

Finally, it appears that the stock market may have overreacted to the rebound in the corporate bond market. Bonds, as measured by risk appetites, are still pricing in much more fear than stocks currently do.

When this has happened in the past, it’s not been a good sign for the stock market.

Ultimately, it looks like we are in the very late innings of this credit cycle. Companies have now levered up to an unprecedented degree and downgrades and defaults are rising from very depressed levels. Spreads have also now been widening for over a year. Should these trends continue, more and more companies will begin to find it difficult to access the credit markets. And because buybacks and M&A have become such a critical component of the bull market in equities, the potential end of the credit cycle could mean precisely the same for the equity cycle.


The Latest Margin Debt Figures Send An Ominous Signal For Stocks

The NYSE margin debt numbers for the month of September were released today revealing a very significant milestone for the stock market. As of the end of September, both stocks and margin debt have seen their 12-month rate of change turn negative after margin debt-to-GDP had risen above 2.5%. The last time this happened was April of 2008, as the stock market crash during the financial crisis was just getting started. The time before that was December, 2000, the very beginning of the dotcom bust.


What’s more, the level of margin debt relative to the economy is now contracting from an all-time high. In other words, financial speculation as a percent of overall economic activity looks to have possibly peaked from one of the most extended levels we have ever witnessed.

Screen Shot 2015-10-19 at 12.10.52 PM

I like to look at this measure because it’s been highly (negatively) correlated with forward 3-year returns in the stock market for at least the past 20 years or so. Right now this measure forecasts a 45% decline over the coming 3 years.

Screen Shot 2015-10-19 at 12.11.00 PM

Based solely on these measures, stocks have already likely entered a major bear market that will not end before significant wealth destruction is accomplished. Obviously, this is only one measure, however, so it can’t be relied upon on its own. Still, I believe investors would do well to respect the elevated risk in U.S. stocks right now and position themselves accordingly.

UPDATE: I updated the first chart to include the qualification that margin debt-to-GDP had risen above 2.5%.