Fed Sounds The Alarm On Overvalued Stocks, Hedge Fund Leverage, "Cov Lite", And Junk

Back in November we reported  that when combing through the hedge fund Q3 13Fs, Goldman Sachs cautioned that even as smart money turnover had tumbled to all time lows, net hedge fund leverage - both net and gross - had hit all time highs.

Today, in its latest quarterly "hedge fund tracker" this time for Q4 Goldman doubled down (we will have more on the full report shortly), and made the same observation:

LEVERAGE: Hedge funds entered 2018 with near-record leverage and maintained risk despite the correction. Funds added nearly $20 billion of net exposure in two index ETFs alone (SPY and IWM) as ETF exposure rose to 3% of long portfolios. Although the S&P 500 suffered its first 10% decline in two years, funds maintained conviction in their positions. Portfolio turnover rose slightly but remained near recent record lows at 28%.

David Kostin then notes that while "net leverage dropped briefly during the correction", Goldman's Prime Services attribute the decline to mark-to-market dynamics in options positions, in other words hedge funds were not actively deleveraging, something Kostin confirms, stating that "both gross and net exposures currently remain close to recent highs."

We bring this up because in a section in the just released Monetary Policy Report, entirely dedicated to "financial stability", the Fed makes an explicit warning about precisely this: "there are signs that nonbank financial leverage has been increasing in some areas—for example, in the provision of margin credit to equity investors such as hedge funds." The Fed continues:

... there is some evidence that dealers have eased price terms to hedge funds and real estate investment trusts, and that hedge funds have gradually increased their use of leverage, in particular margin credit for equity trades.... such easing of price terms has taken place against the backdrop of building valuation pressures.

And speaking of building valuation pressures, this time the Fed does not mince its words, and makes a clear warning just how overvalued risk assets have become:

Over the second half of 2017, valuation pressures edged up from already elevated levels.

Visually, the Fed's lament is shown below:

What is just as surprising is the Fed's admission that equities are overvalued even if look at just relative to Treasury yields, i.e. the "Fed model":

In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields. In part reflecting growing anticipation of the boost to future (after-tax) earnings from a corporate tax rate cut, price-to-earnings ratios for U.S. stocks rose through January and were close to their highest levels outside of the late 1990s; ratios dropped back somewhat in early February.

Another way of stating this: US stocks no longer yield more than treasuries.

Then there was the now traditional CRE warning:

In a sign of increasing valuation pressures in commercial real estate markets, net operating income relative to property values (referred to as capitalization rates) have been declining relative to Treasury yields of comparable maturity for multifamily and industrial properties. While these spreads narrowed further from already low levels, they are wider than in 2007.

In its litany of warnings, the Fed did not spare corporate credit, and especially focused on junk bonds:

In corporate credit markets, spreads of corporate bond yields over those of Treasury securities with comparable maturities fell, and the high-yield spread is now near the bottom of its historical distribution.

For the first time, the Federal Reserve even took aim at covenant lite loan and CLO deals:

Spreads on leveraged loans and collateralized loan obligations—which are a significant funding source for the corporate sector—stayed compressed. In addition, nonprice terms eased on these types of loans, indicating weaker investor protection than at the peak of the previous credit cycle in 2007.

And in the most bizarre admission, the Fed said that risk appetite is so elevated - thanks to the Fed of course - it helped unleash the cryptocurrency bubble.

Consistent with elevated risk appetite, virtual currencies experienced sharp price increases in 2017

Looking forward, the Fed warned that rising rates could result in a serious hit to bank P&Ls:

If interest rates were to increase unexpectedly, banks’ strong capital position should help absorb the consequent losses on securities. About one-third of the losses that could be experienced by banks would affect held-to-maturity securities. While these losses would not reduce regulatory capital, they could still have a variety of negative consequences—for example, by worsening banks’ funding terms. The large share of deposits in bank liabilities is also likely to soften the effect of an unexpected rise in interest rates on banks.

Depositors, you have been officially warned: you are first on the hook when banks start suffering trillions in paper losses to the tune of $1.2 trillion for ever 100 bps...

The full report can be found starting on page 24 of the Fed's report - link.

 

Comments

Quivering Lip GETrDun Fri, 02/23/2018 - 14:30 Permalink

As we approach year end, we believe it is appropriate to sound a warning to public companies and other registrants who present to the public their earnings and results of operations on the basis of methodologies other than Generally Accepted Accounting Principles ("GAAP"). This presentation in an earnings release is often referred to as "pro forma" financial information. In this context, that term has no defined meaning and no uniform characteristics. We wish to caution public companies on their use of this "pro forma" financial information and to alert investors to the potential dangers of such information.

"Pro forma" financial information can serve useful purposes. Public companies may quite appropriately wish to focus investors' attention on critical components of quarterly or annual financial results in order to provide a meaningful comparison to results for the same period of prior years or to emphasize the results of core operations. To a large extent, this has been the intended function of disclosures in a company's Management's Discussion and Analysis section of its reports. There is no prohibition preventing public companies from publishing interpretations of their results, or publishing summaries of GAAP financial statements.

Moreover, as part of our commitment to improve the quality, timeliness, and accessibility of publicly available financial information, we believe that - with appropriate disclosures about their limitations - accurate interpretations of results and summaries of GAAP financial statements taken as a whole can be quite useful to investors.

Nonetheless, we are concerned that "pro forma" financial information, under certain circumstances, can mislead investors if it obscures GAAP results. Because this "pro forma" financial information by its very nature departs from traditional accounting conventions, its use can make it hard for investors to compare an issuer's financial information with other reporting periods and with other companies.

For these reasons, we believe it is appropriate to alert public companies and their advisors of the following propositions:

First, the antifraud provisions of the federal securities laws apply to a company issuing "pro forma" financial information. Because "pro forma" information is information derived by selective editing of financial information compiled in accordance with GAAP, companies should be particularly mindful of their obligation not to mislead investors when using this information.

Second, a presentation of financial results that is addressed to a limited feature of a company's overall financial results (for example, earnings before interest, taxes, depreciation, and amortization), or that sets forth calculations of financial results on a basis other than GAAP, raises particular concerns. Such a statement misleads investors when the company does not clearly disclose the basis of its presentation. Investors cannot understand, much less compare, this "pro forma" financial information without any indication of the principles that underlie its presentation. To inform investors fully, companies need to describe accurately the controlling principles. For example, when a company purports to announce earnings before "unusual or nonrecurring transactions," it should describe the particular transactions and the kind of transactions that are omitted and apply the methodology described when presenting purportedly comparable information about other periods.

Third, companies must pay attention to the materiality of the information that is omitted from a "pro forma" presentation. Statements about a company's financial results that are literally true nonetheless may be misleading if they omit material information. For example, investors are likely to be deceived if a company uses a "pro forma" presentation to recast a loss as if it were a profit, or to obscure a material result of GAAP financial statements, without clear and comprehensible explanations of the nature and size of the omissions.

Fourth, we commend the earnings press release guidelines jointly developed by the Financial Executives International and the National Investors Relations Institute and we encourage public companies to consider and follow those recommendations before determining whether to issue "pro forma" results, and before deciding how to structure a proposed "pro forma" statement. A presentation of financial results that is addressed to a limited feature of financial results or that sets forth calculations of financial results on a basis other than GAAP generally will not be deemed to be misleading merely due to its deviation from GAAP if the company in the same public statement discloses in plain English how it has deviated from GAAP and the amounts of each of those deviations.

Fifth, as always, and especially in light of the disclosure that we expect to see accompanying these presentations, we encourage investors to compare any summary or "pro forma" financial presentation with the results reported on GAAP-based financials by the same company. Read before you invest; understand before you commit.

Companies with questions about the use of "pro forma" financial presentations in earnings releases are encouraged to call John M. Morrissey, Deputy Chief Accountant, at 202-942-4400, or Paula Dubberly, Chief Counsel of the Division of Corporation Finance, at 202-942-2900. Investors are encouraged to read our investor alert on "pro forma" financial statements (available at http://www.sec.gov/investor.shtml).

By the Commission.

Jonathan G. Katz 
Secretary

Dated: December 4, 2001

 

Oh the good old days when fraud was sort of illegal.

In reply to by GETrDun

Alchemedes Fri, 02/23/2018 - 12:11 Permalink

Tyler headlines: Fed Sounds The Alarm On Overvalued Stocks, Hedge Fund Leverage, "Cov Lite", And Junk

 

MarketWatch headlines:Stock market climbs as Fed report suggests no need for 4 rate hikes in 2018

adr Fri, 02/23/2018 - 12:18 Permalink

Real fair value of the S&P is around 850-900, anything above that is bubble territory. 

But yeah, let's value near revenueless unprofitable companies in the billions of dollars.

Are we really going to have Peleton go out with a $2-5 billion valuation? The market for exercise equipment above $1500 is less than 10% of the market. The ENTIRE global fitness market including gyms and home equipment is $10 billion. 

Peleton has ONE product and is working on a treadmill, which will be the most expensive treadmill on the market. A $3 billion valuation would represent Peleton taking over 220% of the exercise bike market.

DO YOU SEE A PROBLEM THERE???????

Nobody For President Fri, 02/23/2018 - 14:15 Permalink

Careful Bunga - the Fed is useless to you and I, but is very useful to a small club that you and I ain't in.

(And yes, zh english majors, I ended the fucking sentence with a proposition.)