Monty Python's The Meaning of Life

Here’s Why Investors Should Be Worried About Waning Risk Appetites

I’ve spent a lot of time here and on social media drawing attention to the waning risk appetites in junk bonds and leveraged loans. What I haven’t done is fully explain why I think it’s so important to pay attention to. In short, all of the markets, whether you’re talking about stocks, bonds, commodities or currencies, are all interrelated and cyclical. What’s happening in the commodity markets has implications for currencies and vice versa. What’s happening in the bond market has implications for stocks and so on and so forth. Right now it looks to me, from the action in many of these markets, like the overall upcycle could be close to peaking and rolling over.

Why do I focus so intently on risk appetites? Because risk appetites are the main driver of the overall cycle. When investors are eager to take on more risk, riskier companies are more able to finance their endeavors. When investors become risk averse, it becomes harder for these companies to finance and those who overextended themselves during the upcycle face the prospect of failure during the downcycle.

This is why the Fed has made it perfectly clear that one of the goals, if not the main goal, of quantitative easing was to stoke risk appetites because this provides a boost to the credit markets. Hopefully companies use the easier credit to spend, invest and otherwise stimulate the economy. (In the current cycle, a lot of that money went to things like stock buybacks, though, so the direct impact on the economy wasn’t as great as the Fed probably hoped).

So the fact that risk appetites for high-yield bonds and leveraged loans are waning so rapidly should be a worrisome sign for all kinds of investors because it means the main driver of the cycle is now waning. Now consider the crash in the price of oil and other commodity weakness which is a deflationary sign. And also consider the surge in the dollar, or crash in foreign currencies depending on your geography, which could cause all kinds of problems for the folks who borrowed too much money in dollar terms. And finally consider the plunge in sovereign bond yields, including treasuries, in developed nations around the globe, a clear sign that not only inflation but future economic activity, here and abroad, may not be as robust as we thought a few months ago.

All of these signs are flashing red for both the economy and the markets, in my humble opinion. And at the very least, the drying up of liquidity in the high-yield and leveraged loan markets will have a negative impact, and possibly a very large one, on mergers & acquisitions, LBOs and buybacks, three significant sources of demand for equities. All in all, it looks to me like the boom in risk appetites which has driven the markets higher over the past five years could be in the process of reversing and the major implication for the markets is not bullish.

Related reading:

Bloomberg: Leveraged Loan Funds Seen Plunging 40% After Record Year

FT: Falling Oil Price Poses New Thread To Banks

Bloomberg: Carl Icahn Calls Junk Bonds A Bubble

Dr. Ed Yardeni: The Energy Bubble

Bloomberg: Hedge Fund Manager Who Remembers 1998 Rout Says Prepare for Pain


Everything But The US Stock Market Has Already Peaked

The new Z.1 report came out today so let’s update many of the indicators I’ve been sharing here over the past few months. What should be worrisome to market watchers here is that we now have a host of significant indicators that look like they may have formed important peaks and begun to roll over. We will need to see at least a couple more quarters worth of data to be sure but this is certainly something to keep an eye on.

First let’s take a peek at Warren Buffett’s favorite valuation yardstick. (See “How To Time The Market Like Warren Buffett” for a look at one way I use this indicator.) It actually peaked last quarter and saw a small retracement in Q3. This indicator is 83% negatively correlated with future 10-year returns in stocks (the higher the reading the lower forward returns) and its current reading implies a -0.88% annual rate of return over the coming decade. The 10-year treasury at 2.2% looks fairly attractive in comparison.

fredgraphNext we can take a look at the household percentage of financial assets allocated to equities. This indicator is even more negatively correlated to future 10-year returns at about 90%. It has also pulled back just a bit from the peak it made in Q2. Its current reading implies a forward return of about 2.8% per year over the coming decade, slightly better than the 10-year treasury.


Finally, comparing the current level of the S&P 500 to its long-term regression trend we can see that the only other time in history stocks were this overbought was at the height of the internet bubble. This measure is not quite as highly correlated to future returns as the other two but at 74% it not that bad, either. It also looks at the largest data sample of any of them so I believe it’s worth including. At its current reading it suggests stocks should return just 0.74% per year over the coming decade.

Screen Shot 2014-12-11 at 1.35.10 PMBlending the three forecasts together we get a 0.89% annual return forecast for the stock market over the coming decade. A straight comparison to 10-year treasuries at 2.2% shows them to be the more attractive of the two asset classes right now. Hell, even 5-year treasuries are paying 1.6%, nearly double our model’s forecast.* All in all, this looks to be the second worst time to own equities in history.

Still, the stock market’s uptrend remains in tact as all of the major indexes currently trade above their 200-day moving averages. But as I’ve noted recently there are plenty of signs that the trend is not as healthy as bulls would hope. The advance/decline line, new highs-new lows and the percentage of stocks trading above their 200-day moving averages are all diverging fairly dramatically from the new highs recently set in the indexes. This is a serious red flag.

And now that our market cap-to-GDP and household equities indicators have possibly peaked, along with high-yield spreads (inverted), margin debt and corporate profit margins, there seems to be a very good possibility that the uptrend could be tested in short order. In fact, when I go back and look at the times when all of these indicators peaked around the same time over the past 15 years or so they coincide pretty neatly with the major stock market peaks:

Stock Market Peak Q1-2000 Q4-2007 ???
Market Cap-GDP Peak Q1-2000 Q4-2007 Q2-2014
Household Equities Peak Q1-2000 Q2-2007 Q2-2014
Margin Debt Peak Q1-2000 Q3-2007 Q2-2014
High Yield Spreads Peak (Inv) Q3-1997 Q2-2007 Q2-2014
Corporate Profit Margins Peak Q3-1997 Q4-2006 Q3-2013

So the uptrend may still be in tact but I think we have a plethora (yes, a plethora) of evidence that suggests its days may be numbered. Foreign equities have mostly given up their uptrends over the past few months and commodities, led by the oil crash, look even uglier. How much longer can the US stock market swim against the tide?

Note: I’ve received many questions over the past few months since I first posted, “Seeing The Forest For The Trees,” about just how to go about doing this and here’s my recommendation if you don’t want to own stocks right now: Hold cash. It’s not sexy but it’s dry powder.

Now if you want to earn something rather than nothing on your cash and you’re worried about interest rates rising (and it seems everyone is) you can easily build a ladder of individual bonds rather than just buying a bond fund. The difference between owning a fund and owning bonds individually is when you own bonds directly you can decide exactly what maturities you are comfortable owning and you can always hold them to maturity if interest rates move against you. A bond fund, on the other hand, doesn’t give you that sort of flexibility.

Here’s how I would consider setting up a bond ladder right now if your goal is wait for a better buying opportunity in the stock market. Simply divide your investable funds into five equal buckets. Then invest each bucket into 1, 2, 3, 4 and 5-year treasuries, for example (you may want to choose shorter or longer durations based on your own goals). So if you have $50,000 in our example you would just buy $10k of each maturity. If the 1-year bonds mature before you find a better place to put the money then reinvest the proceeds into 5-year bonds again (as your original 5-year bonds will now be 4-year bonds and so forth). This way your blended yield on the bonds should come pretty close to the 0.89% our model suggests stocks should return without any of the heightened risk in owning equities right now.


Don’t Dismiss The Dire Message Of The Junk Bond Market

Junk bonds have been selling off rather dramatically lately and are now testing their October lows. This stands in stark contrast to the strength in stocks which are just off of their all-time highs. This divergence stands out because both asset classes are typically very closely correlated due to the fact that they appeal to similar risk appetites.

However, many market players are reacting to it by saying, ‘don’t worry about junk bonds; it’s different this time.’ They write it off to the energy sector saying that the weakness there will be contained and not extend to anywhere else in the economy. Or they say, ‘great! That’s bullish because it means the Fed will have to be more accommodating for longer.’ This just smacks of classic rationalizing to me. Folks want to stay bullish so they try to spin even the most negative data points that way.

I’d just like to point out a couple of precedents for the weakness we’re now seeing in high-yield. First, way back in 1999-2000, the junk bond market (as measured by yield spreads) diverged from the price high made in late March 2000 suggesting that stocks were missing something. Notice in the chart below that when the stock market (red line) made a new price high in March, high-yield spreads (blue line – inverted) had actually been widening (declining) for months. When stocks tried to make another new high in the fall of that year, high-yield again told a different tale, unable to show any sign of improvement. For those that don’t remember, this marked the beginning of the internet bust.

fredgraphAgain in 2007 we saw a similar scenario unfold. Stocks rallied to new highs during the summer of that year even while junk bonds began to roll over. In the fall, stocks made another new high yet high-yield couldn’t manage much more than a small rally. Once again, the bond market was telling a tale the stock market was deaf to. Then came the financial crisis.


Today, we’re seeing the very same movie. Stocks recently made new highs even while junk bonds have gotten slammed. This may, in fact, be the greatest disconnect between the two markets as that divergence is just gaping.


Maybe it is different this time. Maybe this weakness in the junk bond market is just, “full of sound and fury, signifying nothing.” But considering the past precedents I think that’s probably not the wisest interpretation.


The True Contrarian Is On An Island

“The further a society drifts from the truth the more it will hate those who speak it.” -George Orwell

It is both a blessing and a curse to be a true contrarian. It’s a blessing because you don’t follow the rest of the lemmings off of the cliff. It’s a curse, and a miserable one at that, because to be a true contrarian you consciously and completely ostracize yourself.

It might be the most poignant form of loneliness there is, intellectual and psychological solitude. And it goes against our most important need as human beings, community and connection to our fellow man. This is why almost nobody is willing endure it even if somewhere in their subconscious their rational brain is telling them it’s true.

I’ve felt this feeling many times before during my career in the markets. For the most part, I sat out of the internet bubble only committing capital to a handful of terrific value opportunities that went completely overlooked by the ravenous speculators of the day (read this for more). I ran a trading desk at a hedge fund at the time and watched a few of our individual clients triple and quadruple their accounts in a matter of months during 1999. They all thought I was the crazy one to not get in on the “free money.”

I started this blog, actually back in early summer 2005, at the height of the real estate bubble, primarily to warn of its inevitable consequences (read my first few posts here). Here in Bend, Oregon the bubble was magnified by limited inventory and mass immigration to the area primarily from California. In fact, we were named the most overvalued market in the country around the peak. Still, plenty of my friends literally “hated” to hear what I had to say about their speculative activities at the time.

In February 2009, at the tail end of the financial crisis, I was incredibly bullish (see my posts here), calling the stock market a “once-in-a-lifetime opportunity.” I was pounding the table but my powerful and persistent calls fell on deaf ears. Despite my shift from market skeptic to evangelist – pessimism to optimism – I found my views shunned yet again.

Today I find myself in, what’s become over the past 15 years, a very familiar position. I couldn’t be more vocal about the risks to investors in the US stock market than I have been here in these pages and across the internet, thanks to the likes of Business Insider and Huffington Post. And as a result I’m marginalized by the crowd who merely wants to know why stocks will double again over the next three years.

Maybe I’m wrong this time. I’ve certainly been wrong before. And I’ve been bearish and wrong for about a year now. I was also early (or wrong, depending on your time frame) at all of those earlier inflection points I described above. So I agree that you can’t buy the bottom or sell the top. That’s not what I’m trying to do here. But it’s not rocket science to effectively decide whether it’s time to be aggressive or defensive.

Everything tells me that it’s time to be as defensive as possible right now. And after all these years and various bubbles, the fact that I’m on an island in that regard only serves to confirm that conclusion.

Dow Jones Sets New Highs

This Is Probably The Second Worst Time In History to Own Stocks

This stock market is now the second most overbought, the second most overvalued and most most over-leveraged market in history.

Overbought: My friend, Dana Lyons, recently posted the chart below which shows the S&P 500 in relation to its exponential regression trend line. The only other time in history stocks were this “overbought” (traded more than 90% above the long-term trend) was back at the height of the internet bubble.


Chart via JLFMI

Overvalued: A glance at the chart below, of Warren Buffett’s favorite valuation metric (total market capitalization-to-GDP), clearly shows that there was also only one other time in history when stocks were priced so dearly as they are today: 1999.


Chart via FRED

Over-leveraged: Finally, investors have never been so highly levered to equity prices. Even 1999 can’t compare with today’s aggressiveness. As the next chart shows, net free credits (cash minus margin debt) in brokerage accounts have never traveled so far into negative territory as they have now.


Chart via

I think it’s pretty pointless to debate whether this constitutes another “bubble” or not. Label it however you want. But it’s hard to deny that this is, at the very least, the second most unattractive time to own equities in history. In other words, this is probably the second worst time in history to own stocks.


A Conversation

Imagine a financial adviser* approached you with an investment opportunity** without telling you specifically what it was. And right up front he tells you it’s likely to generate a zero to negative return over the coming decade. What would you say?

I imagine any investor with any common sense would respond by saying something like, “why in hell would I want to own something that will generate a zero to negative return over 10 years?!

And the adviser would likely respond with: “Well the outlook for other asset classes over the next 10 years is no more attractive than it is for this one.”

Common sense investor: “Well if it’s going to return zero or less wouldn’t even a savings account do better? Why not just own safe fixed income instruments? We can ladder them so we don’t have too much interest rate risk or opportunity cost. And it’s plain to see that plenty of asset classes offer returns better than zero over the coming decade. Why not just own them?”

Adviser: “There seems a reasonable likelihood that inflation will accelerate at some point over the next decade, and this asset class is a good hedge against inflation.”

Investor: “Okay. If runaway inflation is the only reason to own it wouldn’t TIPS or precious metals provide a better hedge considering this asset class’s extremely unattractive valuation?”

Adviser: “I have learned the hard way that market timing is very difficult and is generally a terrible idea. It’s better to just own this asset class all the time regardless of its prospective return.”

Investor: “Okay. So you’re saying you’re not confident in your ‘prospective return?'”

Adviser: “No. We’re confident. We have a variety of valuation measures that are highly correlated to the future 10-year returns of this asset class and they all say the same thing: that it’s very highly likely to return zero or less over that time frame.”

Investor: “So you’re saying that you have proven valuation measures that have been highly accurate in forecasting the return of this asset class for decades but you don’t think they’re very useful.”

Adviser: “That’s right.”

Investor: “Gotcha. I’ve got an even better deal for you. How about I sell YOU an investment that returns nothing over the next 10 years? That’s better than negative right? I’ll take the money and put it into risk-free treasuries, keep the difference between what they pay me and what I pay you (nothing) and then pay you your initial investment back at the end. How much would you like to buy?”

Adviser: “Only my employer (major bank) and the Fed can play that game, I’m afraid.”

*Thanks to Henry Blodgett for playing the “adviser.”

**US Equities


Dogma and Denial

“Don’t Be Trapped by Dogma – Which is Living With the Results of Other People’s Thinking” -Steve Jobs

There is a very strong and popular dogma out there that says, ‘you must own US stocks all the time no matter what.’ It’s really at the heart of the “buy and hold” mantra which is something I’ve railed against recently.

I’ve railed against it because it’s pretty plain to see that there are times when US stocks are attractive to own – the vast majority of the time, in fact. But there are also times when they really aren’t.

Right now just happens to be one of the very few times US stocks have offered investors a negative 10-year forecast return based on Warren Buffett’s favorite valuation metric (total market capitalization to GNP).

So I ask, “why in hell would you want to hold something that is likely to give you a negative return over the coming decade?”

I imagine these dogmatists would answer, “because you can’t time the market.”

To which I would answer, “On what time frame? Because it’s pretty clear that this tool is fairly good at predicting 10-year returns. (It’s about 83% negatively correlated).”

Admittedly, on a one or two year time frame it has little or no value in timing but is that your investment horizon? If so, you shouldn’t hold ANY stocks at all, US or foreign! On the other hand, if your time frame is 10 years or longer you should probably be very interested in what a measure like this has to say. And it’s not just this one. There are measures that are even more closely correlated to future 10-year returns that say essentially the same thing: stocks are extremely highly-valued/offer unusually low rates of return.

And there are plenty of other asset classes to own that offer more attractive prospective returns! Hell, the 10-year treasury bond, at a mere 2.2% yield may offer better returns than US stocks over the coming decade with FAR less risk (so long as you intend to hold to maturity). In fact, nearly ANY other country around the world offers better value/prospective returns than US stocks do right now.

So why the hang up? Why are investors (and their advisers) so stuck on dedicating the majority of their investable assets to US stocks despite the fact that they are so unattractively priced?

My best guess is they are simply in denial. They are so enamored with the returns they’ve witnessed over the past five years that they simply refuse to even entertain the possibility that stocks may serve up anything less going forward. And that’s just a shame because it’s precisely at times like these investors should question this sort of dogma, rather than near the end of a bear market when they usually finally do decide to abandon it.