We are barely out of the gates in 2018 and the S&P 500 is up over 4%. From just looking around me it is clear entrepreneurs and consumers are optimistic about the future. For much of the last decade the general public wouldn't touch equities with a ten foot pole. Now people are taking on debt to buy as much cryptoassets as possible. I don't share this optimism and primarily look for investments outside of the U.S. and in special situations and investments that may have low or negative correlation to the general direction of the market. Seven reasons why I want to be very careful going into 2018:
1. Possibility of accelerating rate hikes
The Federal Reserve just raised rates for the fifth time since December 2015. This is an extremely measured approach given historical precedents. The previous full cycle of rate increases occurred between June 2004 and June 2006 with rates up from 1.00% to 5.25% within a few years.
Over the last thirty years there have been 4 historical tightening episodes in 1988, 1994, 1999, and 2004. On average the fed funds rate went up by 300 basis points during either one or two years.
The policy isn’t just an anomaly but FED Chairman Janet Yellen is leaving office early in 2018. It seems foolish to bet with confidence on this unusually slow advance of rates as the new normal.
The FED could take a much more aggressive approach by choice or because of being forced by a surge in inflation. More on that later. If inflation surged it would be a shock to the market and could easily result in a major sell-off in both stocks and bonds.
2. Hedge funds
According to recent Goldman Sachs research hedge funds are extremely bullish. Gross exposure has not been higher since the financial crisis. When hedge funds are levering up, increasing gross exposure and crowding into the same names this means a sell-off could be further exacerbated when it occurs. The funds will get margin calls if these names go down and have to sell-off shares of the same names which sets off a virtuous cycle.
3. Corporate debt levels
Companies are levering up as well. Corporate debt is at 45% of GDP. The highest level since the financial crisis. It is likely the economy will remain sound for a while. I don’t see any signals that indicate otherwise. When the economy slows earnings go down. There are a lot of companies with precarious balance sheets that will struggle mightily to survive a recession. To add insult to injury the tax reform makes it harder to deduct interest which handicaps the highly levered further.
4. Private corporations
There is no doubt private corporations are levering up as well. Perhaps not to the same extent as they are predominantly owner-operated. Owner-operators tend to be more careful as opposed to hired guns who can get rich quick of option packages. One “fun” I occasionally try is to get quotes on a business loan by a bunch of providers at once. It gives some insight into the rates and who’s extending themselves the most. The ones providing the lowest rates could be the best short targets. A lot of fintech money went into this space and I’m getting the best quotes through smallbusinessloans.co from Fintech darlings like Lending Club, OnDeck, BlueVine and Kabbage. With the data I provided I probably shouldn’t qualify for any loan but I did, although the rates were admittedly extremely high.
5. In Europe Insanity Reigns
The iShares € High Yield Corp Bond UCITS ETF trades at a weighted average yield to maturity of 2.38%. To put that into context the current 10 year yield on U.S. treasuries is 2.6%. To get that 2.38% people are taking considerable credit risk. I mean just a few selections from the top 10 positions are SoftBank, Valeant Pharmaceuticals, Altice and Unicredit. SoftBank, Altice and Valeant are loaded with debt and Unicredit is an Italian bank. It seems crazy to take this kind of credit risk for a yield that’s available on 10 year treasuries.
6. Stock market valuations
The S&P 500 (SPY) trades at a high P/E multiple in a historical context and a high Shiller P/E multiple only exceeded in 99’. If you measure valuations by GDP to total stock market capitalization it is at the upper end of its historical range as well at 149% according to Gurufocus stats. The measure is famously called the Buffett indicator as, arguably the greatest investor of all time, said it is the best single indicator for general stock market valuation.
The absence of any violent inflation in the wake of various iterations of QE and historical low interest rates surprised me. Over the past years circumstances have been perfect to allow for low inflation except for the unprecedented central bank interventions. Think of the cost inputs for corporations. Credit has been and still is extraordinarily cheap. The dollar has been relatively strong. With increased offshoring and outsourcing this depressed inflation. Oil prices have been low, commodity prices have been low, agricultural commodity prices have been low, people were happy to have a job and didn’t push their luck by demanding a raise, pensioners were content while institutions reneged on promises. The crisis confronted people with the need to buckle up. And they did.
Saudi Arabia and Russia have been surprising many by their effective campaign for higher oil prices. Brent is up 22% over the past year. Commodity prices have been going up rapidly. Copper and zinc are up between 22%-25% over the past year. The grain price is at the lower end of its historical range. Wage inflation is back. If corporations want to have a shot at hitting the earnings expected out of them we will see prices going up.
If inflation surges we can get to a scenario quickly where the FED sees itself forced to raise rates more quickly as currently anticipated. If you go over my earlier points it is obvious how that’s problematic given the many highly levered zombie companies that also see their cost inputs rise in this scenario. It will wreak havoc among the companies with the weaker balance sheets. In turn that may cause problems for levered funds with concentrated investments in such companies and setting off a vicious cycle of selling.
The saving grace could be strong consumer demand. However even if the consumer is able to come to the rescue, while both stocks and bonds decline because of an accelerated hike cycle, companies in at-risk categories that do not benefit from commensurate increased demand during upcycles are still dead.
The FED could surprise by tightening faster than expected. Either because they decide to do so or because their hand is forced due to inflation surging. Corporation have enjoyed an unusually easy environment to generate profits. Virtually every cost input has been on the low side of possible ranges. In addition corporation have had access to easy money and took full advantage as confidence returned. The result is that we have a highly levered corporate sector. Hedge funds are optimistic and using leverage to make concentrated bets on U.S. large caps. When cost inputs rise and the FED accelerates tightening that would cause profit margins to shrink rapidly. Under such circumstances it would be impossible for corporations to hit the lofty earnings expectations imposed by the market and stock buybacks would come to a screeching halt. A -20% drop in the S&P 500 is not a move that I have difficulty envisioning even without a recession.