“A Bubble Bubble”

This last week has been fantastic in terms of news flow. Conscious I am in my own “bubble” there is an increasing choir of voices calling for caution as asset prices boil. So I thought I would summarize what I have seen heard this week. A curated cornucopia covering bubbles, bag holders, bankruptcy and bias.

Calling it Out – Grantham

This week we had Jeremy Grantham calling the recent rally in equities “crazy stuff” ,“It is a rally without precedence,” and most importantly he sees the rally is becoming the fourth “real McCoy” bubble of his career. Given his reputation for calling bubbles historically this is worth taking note of. Importantly he says the bubble “can go on a long time and inflict a lot of pain”.

“With the Fed Scattering Money around has created a favorable environment..with this amount of money slopping around and with the economy depressed it would be fairly typical for some of the money to find its’ way into the market. That in itself is unexceptional. It is the ignoring of the downside problems that is the exception ” Jeremy Grantham CNBC Jun-20

Calling it Out – Marks

Howard Mark’s June Memo “The Anatomy of a Rally” is worth a read if you have the time. In it he lists the reasons supporting the rally – FED, Low rates, FOMO, Buy the Dip Mentality and the entrance of retail investors (both Grantham and Marks point to Hertz as being a poster child for “speculative fever”). Against this are the varying degrees of Lockdown across the US, no vaccine for Covid til 2020, a potentially slow economic recovery, enormous unemployment and systemic changes to industries exposed to the consumer. What I like about Marks is that he focuses on the behavioral – so the question isn’t “is the rally legitimate” rather is the pace and enthusiasm reinforcing an increasingly over optimistic assessment when compared to the fundamentals? According to Marks :”The Questions to ask are:

Are investors weighing both positives and negatives dispassionately?
What is the probability of the positive factors driving the market will prove valid (or that the negatives will gain in strength instead)?
Are the positives fundamental(value based) or largely technical relating to the inflows of liquidity(i.e,cash driven)? If the latter, is the salutary influence likely to prove temporary or permanent?
Is the market being lifted by rampant optimism?
Is that optimism causing investors to ignore valid counter arguments?
How do valuations based on things like earnings, sales and asset values stack up against historical norms?”

“They lead me to conclude that the powerful rally we’ve seen has been built on optimism; has incorporated positive expectations and overlooked potential negatives;and has been driven largely by the Fed’s injections of liquidity and the Treasury’s stimulus payments, which investors assume will bridge to a fundamental recovery and be free for highly negative second order consequences” Howard Marks, The Anatomy of a Rally, June -20

Charts are worth a thousand words

In addition to Grantham and Marks there have been a significant number of investors, investment houses calling out the valuation disconnect – Crescat Capital’s June 17th note contained a great series of charts to back up their opening line “The US stock market should not be trading anywhere close to the multiples it is today given the enormity of the macro events that have already unfolded this year”

“illustration of how insanely disconnected equity prices are from their underlying fundamentals”

“Money printing does not fix the economy”

“These stocks have never been so indebted relative to EBITDA”

“Aggregate enterprise value to EBITDA for the S&P 500 has never been higher.”

“US labor markets unexpectedly improved last month but were not enough to support the bullish narrative of late”

“If the economy continues to prove incapable of growing organically, further monetary stimulus will be necessary and therefore only exacerbating the inequality problem”

“the largest net decline in Fed assets vs. government debt since the repo crisis started back in September of 2019. The government debt is more than crowding out all the new liquidity”

Looking at CFTC Commitments of traders (CoT) data shows that there is a growing position imbalance between dealers and speculators. The assumption is that Dealers are the “smart” money here. There is less of a contrast in the S&P 500, but the DIJA and VIX suggest we maybe topping out:

This Tweet by Pictet Asset Management’s Julien Bittel, CFA is a good reminder that you cannot diverge from economic reality for too long:

“The stock mkt is not the economy.” Hear it all the time; don’t hold your breath. US lead indicators have explained 97% of the variability in equities over this entire business cycle, & currently they’re diverging by a record amount. In the end, macro fundamentals always matter. pic.twitter.com/Gc76TCW8MJ

— Julien Bittel, CFA (@BittelJulien) June 18, 2020

Retail Investors – Beneficiaries or Bag Holders?

So – valuations are stretched, fundamentals far from healthy but there are some reasons for hope. No bubble discussion would be complete without mentioning Dave Portnoy or Hertz as the poster children for a Central bank led rally. Dave Portnoy has been a bucket of ice cold water over a lot of investor’s heads – his foray into day trading and his success glorifies and sensationalizes the “Fed Fuelled” rally. At first I thought he was trolling. I soon realized he is for real ” I’m the new Generation. You cant, there is nobody can argue that Warren Buffet is better at the stock market than me right now”. He is picking stocks by pulling letters out of a scrabble bag and he is making a killing. Hats off to him – “stocks are easy” is his mantra and certainly since March they have been. You could argue that Portnoy is not exhibiting “irrational exuberance” – after all he is smart enough to recognize there is money to be made. Soros’ famous quote “When I see a bubble forming I rush to buy, adding fuel to the fire” looks to be in play. The key to success is knowing when to get out – I imagine Portnoy has people rooting for him, hoping for disaster in equal amounts!

#DDTG: Grab your scrabble tiles and string some letters together. Everything is up a BAZILL. pic.twitter.com/iGyaXB4cs7

— Dave Portnoy (@stoolpresidente) June 16, 2020

Hertz -is best summarized by this chart:

Long story short – purchasing stock in a bankrupt company is beyond speculative. The ability to start a share sale process in bankruptcy is close to criminal in my mind. What it does tell you is there are a lot of people out there who don’t understand what Bankruptcy means for equity and there are professionals who would look to exploit that. Here the argument against “irrational exuberance ” is much harder to make!

Bubble in a Bubble?

So -clearly there is a lot to think about – “Bubble!” is being yelled from several quarters. So what does it mean? I think it means be extremely wary – bubbles can be a long time in the making. John Authers in Bloomberg wrote this week on the perils of timing a bubble:

“In extremis, a bubble can always get even more expensive. The critical metrics to watch are “technical” ones, concerning the move in the market itself. In a bubble, you aren’t investing in a company; you are instead placing a bet on the collective behavior of other investors. That behavior reveals itself in chart patterns, rather than in balance sheets and valuations.”

John Authers, “It’s Getting Harder to Avoid the Insanity Trade”, Bloomberg, Jun-20

When I look at my reading this week I do wonder is there is a bubble in a bubble. That is, investors are getting more vocal in highlighting the value dislocation , there is a paradigm bubble.

This paradigm or sentiment bubble is a consequence of what I read, the market taking its’ own temperature, fiscal and economic realities and how I then use all of this to formulate an opinion. The bubble grows when my individual conclusion marries with that of others and spreads. (Like writing this post).

Unlike the asset price bubble I don’t think we have reached an extreme in negative sentiment, but it is clear that sentiment is building for some kind of correction. The trigger that sees sentiment converted into action is likely to be Q2 reporting, reduced financial support for citizens, withdrawal of liquidity or a resurgence of CoVid. And the recent stock sell off tells you that broad conviction in the stock rally is low.

Looking at the BAML June Fund Manager Survey and Goldman’s summary of stock ownership, institutional positioning looks defensive and the proportion of equity in “retail bag holders” hands is not as large as the sentiment bubble would have you believe:

Investors are clearly aware of the risks they face, or put another way they haven’t bought into the future asset values imply.

A Bubble in High Yield?

The corollary of the rally in stocks in High Yield has been record issuance in the US markets, with European markets opening up in the past few weeks. Markets are functioning, Capital is being allocated (efficiently?), balance sheets are being shored up and restructurings are happening at pace. Spreads have tightened c300bps from their wides in Europe. Lower rates have translated into lower yields, government support schemes have allowed companies to defer and sometimes write off costs as well as providing liquidity – ensuring the survival of the vast majority of high yield issuers. Zombie issuers with earnings that are less than their interest cost still walk among us. Truly distressed names have to turn to private capital in order to survive or are opting to restructure when this fails. Bifurcation is something that is and will become increasingly relevant in high yield. For every article I see hailing the opportunities of fallen angels – companies moving from investment grade to high yield – there are at least 2 or 3 warning of the next bankruptcy wave. Importantly there is no linear transition from a good to a middling to a distressed credit in high yield. The transition ,like default rates, is exponential. Given those credits that have already accessed government support, capital raised or performed some kind of soft restructuring (amend, extend and pretend) any “second wave” is going to further split high yield into quality and stressed buckets – with fewer “middling” credits in between.

Spreads in Context

ING published a great piece this week “What credit spreads are pricing in is not realistic” . It highlighted the updated default expectations and then put them in the context of current spreads (the title of their article gives the game away):

“Reading the graph; the index and the accompanying 1yr default rate that is being priced into spreads shows that we are looking at a scenario where default rates are not EVEN expected to approach levels seen during the early 2000’s recession (dot-com bubble) and nowhere near those seen during the global financial crisis some 10 years ago.”

Moodys’ forecast the global speculative grade default rate to peak below 10% assuming a significant economic decline in Q2 and then slow recovery. Their worst case scenario has default rates at 16.3% higher than the GFC’s 13.3% due to reduced consumer spending being a drag on the economy. By Region the base case has defaults peaking in Feb 21 at 12.4% in the US and 6.4% in March 2021 in Europe. Standard and Poors see the European high Yield Default rate at 8.5% in march 2021, Its optimistic and pessimistic scenarios have the default rate at 3.5% and 11.5% respectively. ING think that the default rates “could well hit 10%, but the GFC peak at c.13% should be out of reach. The conclusion is that high yield spreads are pricing in a fair amount of optimism given the default outlook. ING also provide a chart of spreads historically for context:

Declining Recoveries

Lower recovery rates in default, translate into a higher spreads. One important thing to note is that both Fitch and Moodys have come out with expectations that the Coroana Crisis will result in lower recovery rates across the board in high yield. Another reason to argue spreads are optimistic. As I touched on earlier – bifurcation will increase further in High Yield as the market separates the haves and the have not’s. The ability of companies to weather a second economic stutter is key, having access to government support or private capital translates into survival. Moodys notes the following reasons to expect lower recoveries compared to prior crises:

Longer duration of default cycle – the longer the default cycle the lower the ability of the market to absorb/ deal with defaults – supply and demand
CovLite First Lien -First Lien only structures have increased (no subordinate debt to absorb losses) lender protections have declined due to a reach for yield
Distressed Exchanges – restructuring – 41% of the time companies will default having performed a distressed exchange- recoveries in these cases are significantly lower
Private Equity – the majority of lower rated debt is owned by private equity, historically recovery rates are lower when PE is the owner especially as a distressed exchange is more likely to have happened under PE ownership

POP!

The speed and magnitude of the rally in Equities and High Yield have rightfully got people calling out the disconnect between economic uncertainty, underlying fundamentals and valuations. High Yield certainly looks like it is ripe for some kind of correction. Factset’s Earnings Insight published on Friday shows Q2 may give the market pause for thought, although never estimate Mr Market’s ability to focus on an earnings “beat”. Given low expectations I would not be surprised!

In High Yield a “second round” requiring additional shoring up of liquidity and capital structures would be a huge source of stress. This, along with consumer data that normalizes below the initial recovery are likely to be the red flags that see a widening. Positioning certainly looks to be cautious, and the economy is opening up so there are reasons to be optimistic.

In the mean time the negative sentiment bubble has room to grow – until POP!

A Bubble Bubble?