Diary of a Financier

Bull v. Bear: Bubble checklist edition

In Capital Markets on Mon 23 Jun 2014 at 08:51

In this exercise today, I wanted to leverage another great checklist Barry Ritholtz (The Big Picture) likes to utilize.  Barry tracks 14 bubble indicators to objectively identify exuberance/euphoria before a market crash.  To wit, I thought I’d quickly evaluate each to give myself an appraisal of the stock market’s secular standing…

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14 bubble indicators

  1. Extreme valuations (NO)- traditional valuation metrics (PE/PS/PCF/etc.) rise 2 or 3 standard deviations (sigmas) above historical meanSPX valuation metrics 2014q2.
    • SPX valuation metrics: SPX fundamentals have just reached their long term (20-year) averages — not even close to multiple-sigma premia.
    • Return after fair value: Secular bull markets never end at fair value; they always ride momentum’s wave and overshoot.  In the postwar-era, the average SPX return after hitting fair value is +28.14% mean (+16% median) across 7 occurrences, with only 2002′s market reversing without material gain.
  2. Abnormal returns (PUSH) repeated, unsustainable growth rates.
    • SPX bull markets: SPX +122% (inflation-adjusted) over 5 years says this secular bull market is mid-stride compared to the 5 prior precedents, which averaged +424% (+396% median & 131.6% standard deviation) over 15.9 years (18.1 median & 8.8 year σ).
    • SPX long term regression: SPX +80% above its long term mean has reached almost 2 sigmas — a sign that this rally is over-extended; prior deviations were +85% before the Panic of 1907, +81% Great Depression, +150% Tech Bubble, and +89% Great Recession — all leading to crashes without any false signals.
  3. Tortured rationalizations (PUSH)absurd explanations or new valuation metrics to justify a new paradigm (e.g. “permanantly high plateau,” price compression/extrapolation, EBITDA, price-to-clicks, “Dow 36k,” “new normal”).
    • Nothing “absurd” is rampantly pervasive yet today, but there are some well-know, laughable examples to heed:
      • Corporate margin expansion: Street consensus assumes net margins will persist at these record levels.
      • Return of capital: Corporations have all resorted to shareholder value campaigns.  Stock buybacks have reduced share-counts and increased EPS in the face of lower net incomes.  Both these repurchase programs and dividend increases — one-time stimuli from an accretive standpoint — have been funded by long term debt.  These inorganic initiatives are a zero-sum if they don’t rear organic growth, and they won’t since they’re not investments — more so the dividends than the buybacks.  Further, they’ll only last as long as the Fed maintains its unconventional monetary policies, which have inverted the historical relationship between corporate bond yields and equity earnings yields. (See #12 below too)
      • Leverage: Analysts have resorted to citing “additional turns of leverage” (Debt/EBITDA) as bull case scenarios for certain equities, particularly latter-day LBOs (e.g. $DNKN $GNC).
      • Greater Moderation: Fed QE/ZIRP and coordinated central bank policy action warrant market stability, low volatility, and a perpetual “Bernanke Put” under markets.
      • New paradigms: Tech 2.0, Biotechnology, Energy renaissance, and Clean technology (e.g. $TSLA’s electric battery Gigafactory will engender a “Utopian Society“).
  4. Low volatility (YES)
    • $VIX: hit its lowest postcrisis level @ 10.34 last week, remaining persistently below its extreme low threshold of 15 and its long term average of 20.1.
  5. Trading/transaction volumes spike (NO)
    • Average daily volumes (ADVs): Equity share volumes are at secular lows due (in part) to structural changes in the marketplace and exchanges.
      • ETFs: Volumes and AUM in these new-ish products are, however, screaming (see #11 below)
  6. Excess leverage (YES)for rampant speculation.
    • Margin debt: descending from record levels, but at extremes nonetheless.
  7. Credit expansion (NO)- the investing public (households & individuals) is invited to overleverage.
  8. Tight credit spreads (YES)- high yield spreads ($HYG).
    • High Yield: HY absolute spreads @ 343bps are at postcrisis lows vs. the alltime record 240bps from 6/2007; relative spreads are at record lows; junk bond yields @ 4.94% are at record lows
  9. Low & falling lending standards (PUSH)
    • In aggregate, standards are modest, despite some nuances:
      • Leveraged loans & institutional bank loans:  Junk issuance and valuations at exuberant levels, including floaters and PIK toggles for M&A/LBOs.
      • Traditional bank lending:  Credit extension is modest in aggregate; loans to the real economy (C&I loans) are in an upswing after years of weak demand; lending to households is cooling-off after the postcrisis refinancing scramble; CRE loans are moderating after a multiyear boom.
  10. Low default rates (YES)excess liquidity creates a false sense of securityHY spreads & defaults (1988-2014).
    • HY default rates: currently 0.6% vs 4.0% average are extraordinarily low and on par with exuberant stretches 1995-99 and 2005-08.
  11. Financial product innovation (PUSH) new products encourage bubble inflation (e.g. derivatives).
    • In the US alone, nothing pervasive enough has proliferated enough,but some burgeoning WMDs to watch include:
      • Exchange Traded Funds (ETFs): Providers are dreaming-up new indices for new products that’re linked to ever more illiquid underlying indices; we saw a sample of their destructive potential  during 6/2013’s emerging market and muni bond selloffs, in which FMVs unhinged from NAVs (i.e. tracking errors spiked)
      • Shadow banking: With Dodd Frank regulating the traditional banking system with Glass Stegall-esque prohibitions, the shadow system has assumed much of the cast-away products and services (e.g. Capital Relief Trades, Venture Capital, Crowdfunding & Peer-to-peer lending), taking “financial weapons of mass destruction” (WMDs) like derivatives into an unregulated corner.
      • Master Limited Partnerships (MLPs): Not a problem yet, but it’ll be interesting to see how more companies might abuse drop-downs and the tax benefits of this unique business entity structure, particularly as oil & gas rates of return slow in coming years.
      • Cryptocurrencies: We know very little about the potential of digital currency like Bitcoin ($BTC) or Dogecoin — for better or worse.
  12. Misincentives  (YES)
    • Repurchase programs: Extraordinary monetary policy (QE/ZIRP) has created perverse incentives for corporations, and executives’ models nominate buybacks as the optimal capital allocation — rather than Capital Expenditures — a myopic focus forgoing long term sustainability.
    • MLPs: General Partners (GPs) have a strange conflict of interest regarding governance and dropdown valuations unto Limited Partners (LPs). (see above too)
  13. Unintended consequences (YES) ripple effects from reformed laws/legislation/(de)regulation.
    • Dodd Frank: see #11 above.
    • QE/ZIRP: Not only has the Fed’s unconventional monetary policy created perverse incentives for domestic entities (see #3 and #12 above), but a somewhat coordinated, developed market, central bank response to the crisis has engendered hot money flows into Emerging Markets.
  14. Concentrated employment boom (PUSH)an asymmetric spike in particular jobs or professions (e.g. daytraders, real estate brokers).
    • The booms that exist are infantile relative to historical precedents, but worth watching to see if they grow unruly:
      • Computer programmers & software developers: Employment boom part of a “technology revelation,” which is the more constructive echo of yesteryear’s Tech bubble.
      • Energy: North Dakota (!?) is a high income, high employment state now due to the hydrofracturing (“fracking”) boom and its technical jobs.

~~~~

I count 6 affirmations (YES), 5 maybes (PUSH), and 3 negations (NO), which tells me no bubble, crash, or crisis is drawing near at this time.  Broadly, the environment isn’t delusional yet.  Narrowly, I do see Energy ($XLE) appear throughout this list, so I’m sure a correction — hopefully isolated — is warranted to revalue that sector and temper its excesses.  No idea when that’ll happen or what the catalyst will be, especially since a rolling Arab Spring’s geopolitical tensions keep a bid under the raw commodity.

Clearly, a number of these items are close to pushing toward affirmation, so I’ll keep returning to this checklist, and when I find more unanimity among the items, there will be more cause for concern.

–Romeo

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