What more can I say that the chart doesn’t already?
Recently there have been numerous major economic agencies warning of the growing and severe risks in the debt markets. Investors have shrugged them off as they seem to think that their bond fund is immune as are equities. They’re not.
The Geneva Report, released last month, revealed that there has been no progress made in reducing debt levels around the world in the years since the financial crisis. In fact, debt levels have only grown over that time, even here in the US. This should be worrisome, they report, because, “there is considerable evidence that a high stock of debt increases vulnerability to the risk of a financial crisis.”
Chart via Geneva Report
Clearly, the BIS is looking at the same research because back in July they warned these growing debt levels could kick off ‘another Lehman.’ BIS General Manager, Jaime Caruana, told the Telegraph, “We are watching this closely. If we were concerned by excessive leverage in 2007, we cannot be more relaxed today.”
This week, the IMF joined the chorus:
…Prolonged monetary ease has encouraged the buildup of excesses in financial risk-taking. This has resulted in elevated prices across a range of financial assets, credit spreads too narrow to compensate for default risks in some segments, and, until recently, record-low volatility, suggesting that investors are complacent. What is unprecedented is that these developments have occurred across a broad range of asset classes and across many countries at the same time.
For all of these bankers, economists and regulators, there’s just too much debt for their liking and much of it carries too much risk – and it’s spread beyond the debt markets to a broad variety of other asset classes. That’s funny because even the Fed has been warning about the very same thing lately! And they’ve pointed their finger directly at the leveraged loan market.
There’s not really one definition for these things but leveraged loans are typically floating-rate loans made to companies that carry an above-average amount of debt and, for this reason are labeled, “high-yield” or “high-risk.” The “high-yield” might actually be a misnomer because lately these things have been issued at a rate of around 5%. Many of these loans are used for leveraged buy-outs and the “high-risk” label is right on the money.
Back in 2012, the volume of these sort of loans rebounded to a new all-time record as investors, hungry for yield in a zero-interest rate environment, couldn’t get enough of them. Last year blew 2012 away and this year is on track to do even more than last.
Chart via Dallas Fed
What’s more troublesome than just the sheer volume of these loans is the quality. Although the Fed has advised bankers not to loan an amount greater than 6 times EBITDA to any given borrower, in the third quarter of this year new LBO debt levels ran 6.26 times EBITDA. This amount of leverage would normally be very risky but it is especially troublesome today because current EBITDA for these companies is based on record-high profit margins. Should margins contract at all, it would make these borrowers less likely to be able to service their debt. In other words, a simple reversion in profit margins closer to their historical average level would probably mean rising defaults, maybe dramatically so.
With yields currently at 5%, investors in these loans currently don’t need to worry about defaults hovering around the 2% level (unless you think a net 3% return is silly for the amount risk you’re taking, as I do). But prior to the financial crisis, before the s*** even began to hit the fan, default rates were nearly twice that level. At the height of the crisis defaults soared to nearly 13%. Now consider that these companies are more highly leveraged than ever and a huge portion of their debt floats at rates that are now near record lows.
On top of that, the share of “covenant-lite” loans has soared. These are loans that place fewer restrictions on the borrowers and give lenders less recourse in the event of a default. So when (not if) defaults rise again lenders will feel more pain in these sorts of loans than they ever have before.
Chart via Dallas Fed
Richard Fisher summed it up fairly well recently 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.” And this time it will be more than just bankers’ tears. Shadow bankers will be affected, too. And by “shadow banking,” I mean your bond fund (among other things).
From the IMF:
While banks grapple with these challenges, capital markets are now providing more significant sources of financing, which is a welcome development. Yet this is shifting the locus of risks to shadow banks. For example, credit-focused mutual funds have seen massive asset inflows, and have collectively become a very large owner of U.S. corporate and foreign bonds. The problem is that these fund inflows have created an illusion of liquidity in fixed income markets. The liquidity promised to investors in good times is likely to exceed the available liquidity provided by markets in times of stress, especially as banks have less capacity to make markets.
This may be why the Fed has been chastising the banks so much lately. Maybe they know how much more difficult a “shadow banking” crisis would be to deal with than just your run-of-the-mill “banking crisis.”
Anyhow, what is troublesome right now is that it looks like profit margins might have already begun to revert. This puts pressure on all of these highly leveraged companies and makes the prospect of defaults more likely. This is probably why credit spreads have recently widened to their highest levels of the year, breaking the multi-year downtrend that inspired the boom in the first place. All in all, this could be the beginning of the end of the “reach for yield” in this cycle.
Chart via St. Louis Fed
What I find most fascinating about the whole thing, however, is that the demand or appetite for leveraged loans is so closely correlated to the stock market. The black line in the chart below tracks the PowerShares Senior Loan Portfolio, a leveraged loan ETF with $6.5 billion in assets, relative to the 5-Year Treasury Note price (roughly the average weighted duration in the ETF portfolio). The S&P 500 Index is also overlaid. Clearly, the risk appetite for leveraged loans is nearly perfectly mirrored by the stock market.
Chart via StockCharts.com
Now I don’t know if this correlation will hold up going forward but it sure looks like risk appetites across asset classes are currently dancing to the same beat. And if this credit cycle is going to end in tears then it may be hard for equity investors to avoid a similar fate.
A good deal of attention has already been paid to the growing divergence between small cap and large cap stocks so far this year. The former have seen a small decline while the latter have risen about 8%. But I’ve seen very little commentary regarding WHY this might be happening. Of the many divergences the market has seen recently I think this one may be the most significant as the small caps could be the “canary in the coal mine” for the broader market.
It all comes back to what I have argued amounts to a bubble in corporate profit margins. Jeremy Grantham has used a 2-standard deviation event as one benchmark for a bubble. Using that definition, it’s hard to argue that profit margins are not currently in a bubble.
Warren Buffett also weighed in on unsustainably high margins back in 1999:
In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen.
Note that margins are now nearly twice the 6% level that Buffett considered a long-term upper threshold. Now I haven’t heard him say anything about current levels of profit margins (and I’d love for somebody to ask!) but I think his logic is still valid. At some point, the pendulum will have to swing the other way and profits will revert to some extent.
Like the price divergence between small and large caps, the forces behind the scenes here have also been the subject of much ink. It’s that 99% versus the 1% thing. You see over the past few years as the economy has slowly recovered in the wake of the financial crisis companies have seen their revenues grow but have been reluctant to add to their employee base. The result is that a larger and larger portion of these revenues fall to the bottom line. This goes on for a period of five years and, voila! Record profit margins. The 1% (owners of these companies) celebrate while the 99% stagnate.
There are signs recently that this dynamic is shifting. After all, you can only milk your current employee base so much before they become overextended and your product or service suffers or you can’t meet the growing demand, etc. At some point in the recovery or expansion process you have to start adding employees AND paying your current employees a little better in order to retain them.
And it’s beginning to look like this is exactly what’s starting to happen. As the BLS reported a couple of weeks ago, job openings are improving pretty dramatically. July saw a 22% gain year-over-year. And as we learned today, real wage growth spiked in August by the largest amount in years.
This is fantastic news for the 99%. It looks like more jobs and better pay are finally on the way. And it’s exactly the result the FOMC, with their albeit super-blunt tools, have been trying so hard to create. As Pimco’s Paul McCulley writes:
But as Martin Luther King intoned long ago, the arc of the universe does bend toward justice. And as I wrote in July, I think it will do so with the Fed letting the recovery/expansion rip for a long time, fostering real wage gains for Main Street. This implies that the dominant risk for Wall Street is not bursting bubbles, but rather a long slow grind down in profit’s share of GDP/national income.
But do bubbles usually unwind in a “long slow grind down”? Maybe. But sometimes they burst. Either way, this is not so good for the 1% and those record-high profit margins. And we’re seeing this happen already in what area of the market? You guessed it – the small caps and “middle market” companies. Sober Look reports:
While over 50% of [middle market] companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.
It’s been six consecutive quarters now that these smaller companies have experienced, “margin compression.” UBS recently confirmed this data noting the recent plunge in EBIT margins at small cap companies.
Chart via Business Insider
Make no mistake, this epic stock market rally has been built on the back of this profits boom. It’s been the source of much of the earnings growth we’ve seen and inspired investors to bid valuations to what has historically been rarified air. Should profits decline it would mean already extended valuations are even more inflated than they currently appear and would remove a major underpinning of the bull market.
What I worry about even more, however, is the amount of risk that has been assumed recently based upon the expectation that profit margins will remain at these record levels indefinitely. As Sober Look recently reported, leveraged buy out valuations are at heights not seen at any other time during the past 14 years. More importantly the amount of debt in relation to targets’ EBITDA is also at a record:
Chart via Sober Look
If EBITDA at more than half of these companies is actually declining now these multiples will soon look even more inflated than they already do and the massive amount of debt used in buying them is at risk even greater risk of becoming unsustainable than it originally appears.
Speaking of the “massive amount of debt,” It’s important to note that the volume of leveraged loans has far surpassed it’s highs of 2007…
Chart via Dallas Fed
…and the risk controls embedded in these loans has fallen dramatically as covenant-lite’s share of overall issuance is now twice what it was prior to the financial crisis.
Chart via Dallas Fed
So it looks as if we may have more built up risk on the debt side of things than we did prior to the financial crisis. If margins are actually beginning to revert, as the small cap/middle market is suggesting, at 2-standard deviations above their long-term average, they potentially have a very long way to fall. And with so much risk betting against this possibility the fallout could be dramatic.
Perhaps this is why spreads have finally begun to widen just a bit over the past few months in the high-yield market.
Chart via Charlie Bilello
All in all, this is clearly a very complex system with various intermarket relationships. But we are seeing some signals that point to the fact that the Fed may be close to achieving it’s goals of increasing employment and wages. While this is good news for the labor force, it’s bad news for companies and investors because the resulting margin compression would remove the main driving force of this bull market along with causing potential problems (defaults) in the high-yield bond market. So keep your eyes on the small caps; there are big implications in that divergence everyone’s looking at.
Below is a compilation I put together using excerpts from Richard Fisher’s speeches this year (emphasis mine):
There is no greater gift to a financial market operator—or anyone, for that matter—than free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call “beer goggles.” This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy. Here are some of the developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat:
- Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth.
- Dividend payouts financed by cheap debt that bolster share prices.
- The “bull/bear spread” for equities now being higher than in October 2007.
- Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s.
- The price-to-earnings (PE) ratio of stocks is among the highest decile of reported values since 1881. Bob Shiller’s inflation-adjusted PE ratio reached 26 this week as the Standard & Poor’s 500 hit yet another record high. For context, the measure hit 30 before Black Tuesday in 1929 and reached an all-time high of 44 before the dot-com implosion at the end of 1999….
- Margin debt that is pushing into all-time records.
- In the bond market, investment-grade yield spreads over “risk free” government bonds becoming abnormally tight.
- “Covenant lite” lending becoming robust – surpassing even the 2007 highs – and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when “junk” companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk. I may be too close to this given my background. I have been involved with the credit markets since 1975. I have never seen such ebullient credit markets. From 1989 through 1997, I was managing partner of a fund that bought distressed debt, used our positions to bring about changes in the companies we invested in, and made a handsome profit from the dividends, interest payments and stock price appreciation that flowed from the restructured companies. Today, I would have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy. 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.
The former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability. We must watch these developments carefully lest we become responsible for raising the ghost of irrational exuberance.
Why isn’t anyone listening?
The most critical asset class in the world right now might just be the US bond market, as represented by the 10-year treasury note yield. So far this year bonds have performed very well as this rate has declined – foiling the best laid plans of all the bond bears (and there have been loads of them). But the bulls can’t quite plan their victory parade just yet because right now this critical interest rate is sitting at a critical technical level, a crossroads, actually.
The downtrend for this rate is well-established. It might be the longest tenured trend, in fact, of any major asset class out there right now. Here’s a look a the monthly chart:
Clearly it’s not even close to breaking above that upper downtrend line that dates back to the mid-1980’s. So anyone making the case for higher interest rates is swimming upstream.
But take a look at the weekly chart and it’s a little bit different story:
After briefly breaching the 2.25% level during the height of the financial crisis and then testing it again in the fall of 2010 this rate finally broke down to new lows during the summer of 2011. It wallowed below that key level for a couple of years before regaining it during mid-2013 – along with breaking the downtrend line on that time frame – in a year that amounted to a walloping for long bond holders.
Much has been made of the weakness in rates/strength in bonds since then but, in actual fact, the action over the past few months has only amounted to a 50% retracement of the surge in rates from last year. And that area between 2.25% and 2.4% serves once again as key technical support. A closer look at a daily time frame shows what might be described as a bull flag (for the price action year-to-date) that has taken the rate right to the 50% retracement of the 2013 rise:
In any case the action this year has been corrective rather than implusive, as Elliott Wave aficionados would say, suggesting yet higher rates are in order. However, the trend is still pointing lower on all of these time frames so there’s something both bulls and bears can point to right now.
All in all, this 2.3%ish level serves as a technical line in the sand. Until it breaks meaningfully one way or the other bulls and bears are at a stalemate. Once it does break out, though, it could have major implications for both the stock market (in terms of relative valuations) and the economy (in terms of leading indicators).
If you couldn’t already tell I’ve been thinking about cognitive biases and logical fallacies a lot lately. And while I’ve been fairly bearish for quite some time now I haven’t been, “sell everything and hide your cash in the mattress bearish.” Those who are that bearish are suffering from clear biases or fallacies I’ll get to in a minute. By the same token, those who are rip-snorting bullish right now are also suffering from a similar condition.
By being overly bullish right now, you’re simply in denial over a plethora of evidence that suggests the risk/reward equation is heavily skewed toward the risk side without much potential for reward at all. But what I really think bulls are relying on most heavily right now is a little something called “recency bias” or, as the Fed likes to put it (emphasis mine):
If asset prices start to rise, the success of some investors attracts public attention that fuels the spread of enthusiasm for the market. New (often less sophisticated) investors enter the market and bid up prices. This “irrational exuberance” heightens expectations of further price increases, as investors extrapolate recent price action far into the future. – “Asset Price Bubbles” FRBSF
That’s all “recency bias” is: investors ‘extrapolating recent price action far into the future.’ In other words, Mr. Market has been flipping a coin that just keeps coming up heads (big gains) so investors begin to believe that it’s just going to be heads forever. Tails (corrections or bear markets) are a thing of the past.
Obviously, this is just faulty logic. But when BTFD becomes so ingrained into the broader market psyche it just becomes painfully clear that investors are relying on nothing but the trend. Which is fine, of course, until the trend comes to an end. Just don’t pretend there are any other reasons to be bullish aside from the trend because there just aren’t.
On the flipside, uber-bears are suffering from a similar ailment called “gambler’s fallacy.” They believe that because Mr. Market has flipped heads so many times in a row (how long have we gone without a 10% correction?) that the likelihood of him flipping tails is now much greater which is also bogus logic but something people do all the time. The likelihood of flipping heads or tails is still 50% no matter what sort of streak has come before this flip of the coin.
Despite the fact that the odds haven’t changed at all, bulls believe there’s a near 100% chance the next flip is gonna be heads once again (because it’s just persisted so long) and bears believe there’s a near 100% chance it will be tails (because the ridiculous streak of heads just can’t persist). Both are wrong. So what’s an investor to do?
To me the fundamentals, sentiment and the macro backdrop are clearly bearish right now. But I grant that these are not timing mechanisms. These are just the shade of the lens we should be looking through right now. In 2009, you wanted rose-colored glasses because all three of these indicators were flipped. Today, you want the opposite, whatever that is (brown-colored glasses?).
Still, you probably don’t want to express that view in your investments to any great degree simply because Mr. Market is still, in fact, flipping heads… for now. So don’t get me wrong; I’m bearish. Clearly. But I’d recommend waiting until Mr. Market flips a tails or two to before jumping feet first into your bear costume.
Next week I’ll post the third in my “market timing” series which will make this much more clear.
Fed policy “makes no sense from a risk/reward perspective” and it will “end badly.” -Stan Druckenmiller
Druckenmiller went on to say, “every ounce of intuition in my body is that the potential costs have crossed the potential benefits in Fed policies.” I think what he is referring to here is that the tools available to the Fed are not precision tools. They are blunt instruments that are not very effective in their mission and their use comes with all sorts of side effects and consequences. I wrote a bit about this yesterday. We’re seeing the majority of the effects ZIRP and QE appear in stock and bond prices rather than in employment and wages. But so what?
“We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.” -Raghuram Rajan
When you push up asset prices in an effort to stimulate the economy you also subject the economy and financial markets to the risk of asset bubbles – which, when they eventually pop (as they all do sooner or later), can undo all the work the policies or tools did in the first place. Anyone remember the financial crisis? We were well on our way to the Great Depression, part deux, as the Fed would have us believe. But have we reached “bubble” levels yet?
“Yellen’s comments suggest, and I agree, that we are in an asset bubble.” -Carl Icahn
Carl sure thinks so and evidently believes the Fed is doing it consciously. But how can we determine if we’re in a bubble?
Corporate bonds and junk bonds “have never been more over-valued in history.” -Jeff Gundlach
Oh, that’s how. Junk bonds valuations are sky high (not to mention other asset classes like stocks, farmland or office towers)…
“It is worrisome that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.” -Richard Fisher
…and the riskiest sort of bonds are being issued at a record pace. Didn’t we learn our lesson after the financial crisis? That this sort of thing is not a fix at all but just exacerbates the problem? Will we ever learn?
Maybe somebody ought to teach the Fed Albert Einstein’s definition of insanity: ‘doing the same thing over and over again and expecting different results.’