What Makes a Market Top?

by Pater Tenebrarum

A New Report by Variant Perception -  What Few Are Focused On Our friends at Variant Perception have published an interesting report entitled “Understanding Market Tops” (please note: the article can be obtained for free here, but requires registration). Readers will probably recall that we have frequently mentioned that the current 'echo boom' is more diffuse than previous booms in terms of bubble activities that can be easily identified. There is no focus on a specific sector of the economy (such as the tech boom of the late 90s, or the real estate bubble thereafter). Instead, the bubble is more broad-based, but there is one broad category of activity which we have indeed frequently singled out, and that is the dangerous growth in debt of all stripes, but especially in low quality debt. It has been ten months since we wrote about the frenzy of debt buyers reaching even Rwanda, a nation that had never before been active as an issuer in international bond markets. Since then, there has been some regret in emerging markets on the currency side of things, but emerging market debt has largely weathered the storm (we have not kept tabs on Rwanda specifically). However, the credit bubble as such has continued to expand at a dizzying pace, with junk bond issuance reaching record highs, while both the yields and the quality of the debt issued have never been lower. Leveraged loans have recently also exploded into the blue yonder, and their yields have collapsed as well.  Mind that we are talking about quality in a very specific sense here: default rates have also never been lower, but that is mainly because plenty of money for refinancing purposes is available, so that even companies that would normally have long passed on into the eternal corporate hunting grounds can easily continue to Ponzi on. What we mean by 'low quality' is especially the lack of investor protection in terms of debt covenants. The hunt for yield has blinded people completely to risk; there has never been a smaller margin of error in corporate debt than there is today (issuance of 'payment in kind' bonds has also soared to a record – this is debt that obviously offers very little protection to investors). Currently, 'suspicion is asleep', but one of these days, it will wake up, and the lowest junk default rates in history will likely become the by far largest. In fact, we hereby predict that this will be one of the characteristics of the next bust: there will be at least one year when an all time record high in junk bond defaults is going to be set. Our friends at Variant also argue that the corporate debtberg is one of the major Achilles heels of the current bubble. Their report contains inter alia the following chart that shows two sectors exhibiting especially egregious debt growth:

Net debt per share in the US energy and consumer staples sectors – click to enlarge. Here is a chart documenting the trend in junk bond issuance:

US junk bond issuance - click to enlarge.

The dangers posed by the corporate credit bubble are something few people think about, because they constantly hear the refrain that 'corporations hold record cash'. Of course that is technically correct, but the devil is in the details. First of all, gross debt has grown even faster than cash, so that net indebtedness is at a record high as well. But there is an additional wrinkle to this which is mentioned in the Variant Perception report: “The largest corporations in America are sitting on all the cash. The top fifty companies have 65% of all cash. This would include companies like: Apple, Berkshire Hathaway, Microsoft, Oracle, etc. (Furthermore, almost all of this cash is sitting offshore and cannot be repatriated without significant tax penalties.) Once you strip out the extremely large cash hoards of the biggest companies, US corporate leverage is now much worse than it was in 2007. The last crisis was a mortgage crisis, while this crisis will much more likely be a corporate debt crisis that investors are barely focusing on.”

The distribution of corporate cash is heavily skewed – click to enlarge.

We should add here, the size of debt issuance as such is actually not a reason to worry. What gives rise to apprehension is how and why it has grown so much, namely by the issuance of fiduciary media, in the current cycle mainly directly by the Federal Reserve. We know for a fact that much of the flood of money will have been unwisely invested, as the structure of relative prices has been distorted and economic calculation has been falsified as a result of great gobs of money ex nihilo having been introduced into the economy in recent years. By definition, all debt that has been invested unwisely is unsound debt. Creditors just don't know it yet. Valuation and Margin Debt Another point made in the Variant report is that while valuations were nominally higher overall in the late 1990s bubble (in terms of the trailing P/Es and CAPE of capitalization-weighted indexes), the high valuations were also far more concentrated: tech stocks and a few big cap growth stocks were absurdly valued, but many so-called 'value' stocks really did represent good value. If we recall correctly, value was extremely out of favor. In fact it had been going down since at least 1997 and earlier in the case of some sectors. Julian Roberts' “Tiger Fund” e.g. closed at the peak of the tech bubble because its focus on value had cost it a lot of relative performance.

So when the tech mania burst, there was actually something to rotate into. This is no longer the case. This time, almost the entire market is overvalued – in fact, valuation dispersion has never been lower. If we had to name market sectors that offer a contrarian buying opportunity at present, only gold and coal would come to mind off the cuff, and perhaps the odd shipping company (but we don't like the large debt loads many of them carry). Back in 2000, there were entire swathes of the market that could be regarded as cheap, or at least as reasonably valued. The market is driven higher by growing leverage and a maniacal surge in stock buybacks (which also increases leverage, as companies often borrow to buy back their shares), even while insiders are cashing out like never before. IPO issuance is the second highest since the tech bubble (in terms of number of IPOs – in terms of dollars it is at a record high), with the percentage of money losing IPOs issued closing in on the February 2000 record high (the share of IPOs of money losing companies has recently surged to 74%). However, as Variant points out, there is another factor that is garnering far less attention and that is the follow-on secondary selling of shares in the wake of successful IPOs, which has gone parabolic last year, and far exceeds anything seen previously. There has been a record in IPO dollar volume of $33.38 bn. in 2013, but secondary selling of shares amounted to $72.68 billion, far eclipsing the previous records of 2006 (just below $30 billion), and 2012 (about $42 billion).  So buybacks are surging, but insiders are at the same time getting out of Dodge at warp speed (see also in this context: “Insiders Become Extremely Pessimistic”, which discusses a different aspect of insider activity).

NYSE margin debt, via sentimentrader: another new record high. However, it is investor net worth that is the most interesting statistic – click to enlarge.

Lastly, you probably won't be surprised to learn that margin debt has just hit another new record high, with investor net worth hitting a new record low concurrently. This amounts to 'feeling rich while actually being poor', because not all of them will be able to exit with their gains anywhere near intact. The very situation that will bring about a reduction in margin debt will ensure that many traders up to their eyeballs in margin will see their gains turn to losses. Besides, if the market should eventually crash (we are referring to a very large percentage decline in a very compressed time frame), which is a possibility that can certainly not be ruled out a priori, then a very large portion of the population of market participants burdened by margin debt could see its net worth wiped out entirely, as there would not be enough time to plan and execute a clean get-away (e.g. on 'Black Monday' 1987, the market opened with a 10% gap down and closed down 22% in just one day). Conclusion: The Variant Perceptions report is far more detailed than this article – we merely picked out a selection of the topics it presents. It is well worth checking out in its entirety. We should perhaps also mention here that the authors do not yet see any evidence in leading indicators that the economy is about to fall into recession, so they argue that a major market peak is probably not at hand just yet. However, they also point out that numerous other measures of market risk (such as the incredible extremes in bullish sentiment we have often discussed in these pages) are well into red alarm territory even so. We are also focused on money supply growth in this context, and on that front there is no clear alarm signal discernible yet either, but the trend is clearly unfavorable.

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