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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

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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.

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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.

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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.

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5 Reasons You Should Avoid Bank Stocks Right Now

Josh Brown, blogger extraordinaire, wrote a post the other day about the breakout in the financials which argued that investors should overweight them. All due respect to Josh (who I think highly of), here’s 5 reasons why I think that’s a bad idea, especially in regards to the bank stocks:

  1. The yield curve has been falling all year and lately more like a brick. Because banks borrow at the short end and lend at the long end this always leads to pressure on profit margins. That’s why, until this year, banks’ share prices were so sensitive to changes in the curve. I don’t know why their share prices haven’t noticed yet this time around but I’m thinking it’s just a delayed reaction:sc-14
  2. The default cycle is about as low it can possibly get and now looks to be turning upwards again. The 40% crash in the price of oil over the past few month raises the real prospect of rising defaults in the energy sector. Canadian and Texas banks are especially vulnerable and their share prices have taken a hit recently. But if there’s one thing we’ve learned from the financial crisis it’s that these things are never isolated. They are all closely and inevitably intertwined.
  3. Everyone and their mom is overweight the banks and has been for quite some time. And if everyone already owns them where’s the incremental demand going to come from to push prices even higher or at least faster than the broader market? That’s a tough question to answer.BAML Allocations Nov 14
  4. What if these breakouts everyone is watching are nothing but a head fakes? False breakouts are one of my favorite chart patterns to trade because they are visual evidence of the crowd become overly euphoric for something. They are a text book example of price getting ahead of fundamentals (exactly where I think the banks are today). The resulting fall back to reality of sentiment usually brings with it a pretty dramatic price reversion, as well. (JPM, C, WFC all look vulnerable to me and BAC is merely working on a double top.)sc-15
  5. They are impossible to value. If the companies themselves can’t even determine how much money they made or lost in a given quarter how can anyone else be expected to? In fact, since FAS-157 was repealed (or “relaxed”) who knows if they’re even solvent? You just can’t possibly “invest” in something you can’t begin to understand (but speculate away; that’s your prerogative).

Ultimately, I think the banks might be the most vulnerable sector to a cyclical downturn and there are plenty of signs (global economic weakness, interest rates, commodities and bond market risk appetites) we could be headed in that direction fairly soon.

Disclosure: I am short financials.

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Can Gold Regain Its Gleam?

Over the past few months I’ve been looking at gold and particularly the gold mining stocks for signs of a bottom. To be clear, I don’t own either… yet.

But here’s why I’m intrigued by the opportunity:

  1. Central banks are competing to devalue their currencies. The longer this goes on the more likely gold will benefit.
  2. Gold miners are extremely cheap relative to gold.
  3. This might just be the most hated asset class in the world right now.

The reasons I haven’t taken a position yet are:

  1. If we are, in fact, currently experiencing a global deflation this is not good for gold (or oil, copper, etc.).
  2. The trend is super-fugly.

So basically, I’m waiting for the chart to confirm or deny the above. As it stands, the long-term uptrend broke last month:

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So unless we see a major reversal soon (or at least some sort of attempt to form a bottom) I’ll have to assume deflation trumps money printing. However, if gold can manage to find a bottom it could end up being a helluva trade. Stay tuned.

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Obscene Risk Hidden In Plain Sight

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.”

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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.

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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.

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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.

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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.

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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.

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“The Dominant Risk For Wall Street” May Be Manifesting In Small Caps

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.

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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.

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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.

Until now…

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.

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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:

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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…

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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.

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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.

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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.

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