April 9, 2021
By Steve Blumenthal
“Irrational exuberance is the psychological basis of a speculative bubble.
I define a speculative bubble as a situation in which news of price
increases spurs investor enthusiasm, which spreads by psychological
contagion from person to person, in the process amplifying stories that
might justify the price increases, and bringing in a larger and larger class
of investors who, despite doubts about the real value of an investment,
are drawn to it partly by envy of others’ successes and partly through a gamblers’ excitement.”
– Robert J. Shiller, Economist and Author
At the beginning of March, investors had borrowed a record $813.7 billion (margin debt) against their portfolios. (Source: FINRA data.) The prior high occurred during the dot-com bubble in March 2000. Today, margin debt is up 49% vs. a year ago, the largest jump since 2007.
When one believes that the Fed will do whatever it takes, conviction, confidence, and margin debt grow. Costs are low, so belief is the stock market has nowhere to go but up – put up $100,000 and buy $200,000 worth of stock. It is important to remember that there is a life cycle to markets and investor behavior plays a key role. It looks like this:
At some point, we reach euphoria. I recently wrote, “This is Euphoria” and I think it is, but the truth is no one knows exactly when that point is reached. You and I will eventually be able to look back and point to a specific moment that marked the top. Along the way, we can measure the level of risk and the probability of future reward.
Over long periods of time the markets will do just fine. It’s those once or twice a decade challenges that present. Generally, those occur when euphoria is reached.
Euphoria can be measured in terms of leverage and crazy speculation, such as occurred with GameStop. For most investors, the problem isn’t so much that markets cycle from bull to bear, though the swings can be emotional, the problem is a question of how much time you have to recover and the level of need for your wealth to produce for you. If near or in retirement, you may not have the 5 to 15 years that may be needed to recover from loss. That is, unless Mauldin is right on the coming scientific advancements’ ability to slow the aging process. And I hope he is!
If we look at data from 1877 to the March 2009 low, we see that:
- Secular bull gains totaled 2075% for an average of 415%.
- Secular bear losses totaled -329% for an average of -65%.
- Secular bull years total 80, versus 52 for the bears–a 60:40 ratio.
This last bullet may come as a surprise to you. The finance industry and media have conditioned us to view every dip as a buying opportunity. If we realize that bear markets have accounted for about 40% of the highlighted time frame, we can better understand the two massive sell-offs of the 21st century. And we can better prepare for the opportunities such declines present.
Source: Advisor Perspectives
What’s driving the market today is trillions in Fed QE and zero-interest-rate policy. It’s fueling things we can see and things most of us can’t see (shadow banking, leveraged derivative structures, etc.).
In the next chart, take a look at the spike in the Fed’s balance sheet since last March (the orange line). Currentmarketvaluation.com put it this way: “The Fed’s balance sheet expansion in early 2020 very clearly aligns with the S&P 500 crash and subsequent recovery. This suggests that the economy isn’t actually doing as well as the S&P 500 suggests, and raises serious concern over the sustainability of the current stock market performance. Is additional QE possible?”
What everyone believes that everyone believes with complete conviction is that the Fed (and Biden and the legislators) are going to keep sending money our way. And for now, that appears to be right. You’ll see in Trade Signals that the price indicators remain bullish, high yield is back in a buy signal, and the spreads are at all-time lows.
Good friend David Kotok sent a note this week. It read, “HY is important because it has strong correlation with the stock market. Essentially, the spread is a proxy for stocks because it is the debt-issuing, publicly held American companies that populate the database from which these spreads are derived. Spread levels are important, as is the direction of change and the rate of change (delta). We combine these elements in order to help with strategic investment decisions. Right now, the message from the various spreads and their attributes is straightforward. Spreads are saying, ‘Stay bullish.’”
Loosen the reins, there is likely more run in the run.
Last week I shared a quote attributed to president of Seabreeze Partners Management Doug Kass, “There is no vaccine for over-leveraged.” Mauldin and I were prepping for a webinar when he shared his friend’s words with me. How perfect, I thought as I was digesting the Archegos hedge fund blow-up.
Things happen that seem little at the time but turn out to be not so little. The common denominator is always too much leverage. Tell Credit Suisse there is no vaccine. And there was no vaccine in 2007 for Bear Stearns.
In early 2007, a Bear Stearns hedge fund manager was privately emailing his associates about the highly rated mortgage product he was buying, which he knew was inaccurately rated and at face value was really junk. Package a bunch of no-down-payment, no-doc mortgages issued to uncredited borrowers and then sell those mortgages to unsuspecting investors whose eyes bulge at the higher yields and high credit ratings, and what you end up with is leverage on leverage on top of leverage.
Banks issue a mortgage, get a few points for issuing the loan, and then sell it to a Wall Street firm who pools a bunch of mortgages together, creating a mortgage-backed security. They then sell the security to investors. The liquidly drove home prices higher. What investors did not see were the layers of leverage and derivative products tied to price movements of the mortgage market. As interest rates rose, demand for housing fell, and so did home prices. These mortgage-holders found they couldn’t make the payments or sell their houses, so they defaulted.
“Most important, some parts of the MBS were worthless, but no one could figure out which parts. Since no one really understood what was in the MBS, no one knew what the true value of the MBS actually was. This uncertainty led to a shut-down of the secondary market. Banks and hedge funds had lots of derivatives that were both declining in value and that they couldn’t sell. Soon, banks stopped lending to each other altogether. They were afraid of receiving more defaulting derivatives as collateral. When this happened, they started hoarding cash to pay for their day-to-day operations.” Source: Role of Derivatives in the Financial Crisis
All was good until it was not.
Ultra-low interest rates and massive amounts of liquidity are present again today. Have you been watching what is happening in the housing market?
In hindsight, the blow-up of the Bear Stearns mortgage-backed hedge fund top ticked the equity market. It was sold as a safe investment approach. It wasn’t. There is no vaccine for over-leveraged.
- The S&P 500 Index peaked in October 2007 and crashed in late 2008 into early 2009. Now, it’s known as the Great Financial Crisis. I wrote a lot about sub-prime, CDOs, structured products and derivatives in 2007 and 2008. “Steve, you are so bearish,” I was told.
- I thought it would be a $400 billion problem. Turns out, I wasn’t bearish enough.
To get a sense for the size of the Fed rescue, take a look at the next chart. The large dark grey “other” spike (’08 and ’09) is the Fed bailing out the banks. The dark blue “MBS” spike is the Fed buying up much of the garbage mortgage debt to stabilize the housing market.
I’m not saying what they did with QE1 was wrong. It saved us from a great depression. I’m simply pointing out that Fed policy enabled cheap money and incented the system to leverage up. Leverage was the problem then and it’s the problem again today.
When you drive interest rates down from 6.50% to 1%, investors step out on the risk curve. The problems surface when the Fed pulls the punch bowl away (stops buying financial assets and tightens policy by raising rates). They do this to stem excess speculation. They do this to keep inflation from getting out of control.
Note the Fed raised rates from late 2004 to August 2006. From 1% to 5.25%. They held rates steady until the first cut to 5% in July 2007. Then they cut: 4.75% in October, 4.50% in November, and 4.25% in December. By January 2009, the Fed Funds rate was 0%.
Source: St. Louis Fed
Zero bond interest rates incentivize risk. We can measure it in valuations, leverage and behaviors. Free money incentivizes bad behavior. Margin debt has never been higher:
Note that when margin debt is going up, it is bullish for equities. That’s the case today.
A Bear Stearns-Like 2021 Warning
Forget the two-to-one leverage you and I can borrow on margin in our brokerage accounts, give me five-to-one via a swap contract (think of it as a made-up contract between Credit Suisse and its client). Bill Hwang’s Archegos Capital Management experienced the forced liquidation of $30 billion worth of positions on Friday, according to The Wall Street Journal. Credit Suisse will absorb a $4.7 billion write-down in the wake of the Archegos blow-up.
CEO Brian Chin and risk boss Lara Warner are leaving the bank in April. “The Board of Directors has launched two investigations, to be carried out by external parties, into the supply chain finance funds matter and into the significant US-based hedge fund matter,” the bank said in a statement. No bonuses this year…
From Seeking Alpha:
- Archegos provides yet another anecdote that the expansive global derivatives marketplace is at the epicenter of leverage and speculative excess.
- From numerous reports, it appears Archegos had fund equity of around $10 billion. Positions have been estimated in the range of $50 billion to $100 billion, meaning a leverage ratio between five- and 10-to-one.
- Why would Archegos employ such a risky strategy––basically reckless leveraging of volatile equities exposure? We can only assume the firm was emboldened by the hyper-loose policy and liquidity backdrop.
Who in their right mind would leverage individual stock positions up five-to-one? And what would lead a bank (several banks actually) to issue the leveraged SWAP contracts?
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others’ successes and partly through a gamblers’ excitement.
– Robert J. Shiller
A Minsky Moment
A Minsky Moment refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. Minsky Moment is named after economist Hyman Minsky and defines the point in time when the sudden decline in market sentiment inevitably leads to a market crash.
- Minsky Moment crises generally occur because investors, engaging in excessively aggressive speculation, take on additional credit risk during bull markets.
- A Minsky Moment marks the tipping point when speculative activity reaches an extreme that is unsustainable, leading to rapid price deflation and unpreventable market collapse.
Over time, memory fades, confidence grows, and leverage is back in play. Warren Buffett once said, “It’s only when the tide goes out that you learn who has been swimming naked.” As we learned last week, one of the naked swimmers just surfaced.
I have no idea if this is like the Bear Stearns hedge fund signal in 2007. But my spidey senses are tingling with similarities. The Fed aggressively cut rates, which incented a lot of bad behavior, and began to raise them from 2004–07. That tripped the switch.
The Fed dropped rates to 0% from 2009–15, and then raised rates to 2.50% by September 2018, the market sank sharply in late 2018 and Powell made his famous Powell Pivot at Christmas. By March 2020, rates were back to 0%.
The pandemic has vaulted the Fed into a whole new level of creativity. Look back up to the Federal Reserve Balance Sheet chart above. Specifically, the $3.45 trillion in additional QE4 spend.
I’m not arguing that it’s right or wrong, I’m thinking about what this means in terms of leverage and investor reaction. Bear Stearns in 2007 and Archegos in 2021? Worth noting…
I did a webinar this week with partners John Mauldin and Kevin Malone for clients and potential clients. During the webinar, John said something I think is really important. He said, “The stock market could go up 10%, 20%, or 40% more because of central bank activity, the $1.9 trillion in COVID relief and the trillions in coming infrastructure spending… and the stock market could go down 10%, 20% or 40% for the same reasons.”
Nobody knows, and that’s not the answer clients want to hear. If QE4 continues, we likely get more run. However, if inflation runs away due to the very same policies, we’ll get the bear. I think John’s right.
Just a few more charts, and then we’ll put the coffee down and get on with our day.
Traditional bonds are a broken asset class:
The S&P 500 Index is extremely overvalued by most every measure including the “Buffett Indicator:”
The Buffett Indicator is the ratio of total US stock market valuation to GDP. It’s named after Warren Buffett, who called the ratio “the best single measure of where valuations stand at any given moment”. (Buffett later walked back those comments, hesitating to endorse any single measure as either comprehensive or consistent over time, but this ratio remains his namesake).
In March 2000, the Buffett Indicator ratio was 155%, or 2.2 standard deviations above trend. Five years later, the total real S&P 500 Index return was -30%. On August 31, 1995, the Buffett Indicator was 78% or 0.4 standard deviations below trend. Five years later (August 2000), the total real S&P 500 Index returns were +139%. Note the red “we are here” arrow I inserted.
(Charts are from www.currentmarketvaluation.com, a website I recently discovered.)
One more chart––one of my favorites. It looks at the value of the stock market (Stock Market Capitalization) as a percentage of gross domestic income (what we collectively earn). Ned Davis Research sorts the data into five categories (quintiles), ranging from overvalued to undervalued. The bottom section of the chart plots the current reading (light blue line with a red arrow pointing to most recent reading) and shows how far above or below the ratio is from its long-term trend. Bottom line: we sit in the “Top Quintile.” Actual returns achieved the following one, three, five, seven, nine, and 11 years later were negative, with the exception of the 11-year performance. In that case, $100,000 grew to $100,090. Up $90 after 11 years is not good.
Trade Signals – Zweig Bond Model Buy Signal
April 7, 2021
S&P 500 Index — 4,074 (open)
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators. Market trends persist over time and stem from changes in risk premiums or the amount of return investors demand to compensate them for the risks they take.
Risk premiums vary a great deal over time in response to new market information or changes in the economic environment or even changes in investor sentiment. When risk premiums increase or decrease, stocks, bonds, and other assets have to be priced again. Investors react to the changes gradually and this creates trends.
Rules-based trend following strategies don’t predict, they react to what prices are telling us about supply and demand. More buyers than sellers, price moves higher and more sellers than buyers, price moves lower. Trend-following strategies seek growth opportunities while maintaining a level of protection in down markets.
Notable this week:
Interesting trade setting up for high-grade credit. Past performance does not guarantee or indicate future results, and this is not a specific recommendation for you to buy or sell any security but do take a look… the Zweig Bond Model just moved back to a buy signal. The process is a trend-based process as spelled out in the top left-hand corner of the following chart. The signal score ranges from +5 to -5. A positive number is a buy signal and a negative number is a sell signal. The model had been on a sell for the majority of the time since last summer. This week it moved back to a buy signal.
Next is a look at the 10-year Treasury yield. Yields hit a high of 1.75% last week and are now at 1.65%. If the buy signal is correct, best guess is to look for yields to fall back down to 1.33% or 1.43%. A 38.2% to 50% retracement of the up move since January 1, 2021. Remember that when rates fall, bonds gain in price. I’m not bullish on bond yields longer term but, with the overvalued and euphoric nature of the market, a stock market decline from this level of extreme optimism supports a trading opportunity in bonds.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
Personal Note – The Masters
Ok, I’m going to share with you something I should not share. Son Matthew sent me a text yesterday prior to the start of the Masters. It was about a bet. If any player gets a hole-in one on the par three 16th hole, it paid off four to one. Matt put $10 toward the bet and I texted him back to see if he could put me in alongside him. It was too late.
Sitting in my office with golf on my TV, I turned my head just in time to watch Tommy Fleetwood hit a hole-in-one. I immediately called Matt who was walking to his girlfriend’s house to cook dinner. I gave him the good news.
If you missed it, here it is:
I’ve watched the Masters for years. Dad got me into golf when I was young, and we use to sit and watch the tournament together. It’s the beginning of spring and maybe between that and the time with dad, the beauty of Augusta National, the challenge of the course, somehow it became different for me this time. I planted myself on the couch, watched the evening replay, and will be watching this weekend.
I lost dad to prostate cancer in 2011. For his last Masters, I laid next to him in his hospital bed. He woke, looked at the TV and drifted back to sleep. He had Parkinson’s-related dementia, and sometimes it was lights on, sometimes lights off.
That day, daughter Brianna sprang into the room with a smile on her face and three Starbucks lattes in hand. She offered one to Pop and he looked at me like a young boy and asked if it would be OK if he drank it. I smiled and said yes. It must have been the caffeine that kicked his lights on then, and boy were we grateful for that.
He sat up in bed, quickly recognized the Masters tournament on TV, and we watch Charl Schwartzel beat Jason Day and Adam Scott by two strokes. Tiger finished four strokes back in a tie for fourth place. Dad, Brianna, Matthew, Kyle, and I finished first that day too. So did sister’s Amy and Sheryl and their kids.
We asked him what he wanted for dinner. He answered, “pizza and beer.” We ate the pizza but he passed on the beer. Dad graduated two days later. It was so nice to have that last weekend together.
I was lucky enough to play Augusta National a few years ago. What I didn’t share with my host was that I had a small container of dad’s ashes with me in my golf bag. After I finished the 11th hole, I discretely rushed to the area behind the 12th tee box, pulled out the ashes, and spread them on the grass. I said a prayer, wished him well and went on to par the hole (a bonus).
I tell my kids that when I pass over, I want some of my ashes at the top of Snowbird; some at Stonewall; and, if they are every lucky enough to play Augusta, to put a few ashes next to Dad. Each time I watch the 12th hole, I remember the big guy.
The trip to San Diego was productive and fun. From there I flew to Utah and met my kids. Pictured is the view from Torrey Pines looking down the California coastline. What you can’t see are the hang gliders circling above the cliffs. Insane. I’ve added a few photos from Utah as well. Hope you don’t mind me sharing.
I am going to enjoy my weekend and I hope you enjoy yours as well.
Have a great week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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