Meinung

A Bubble in a Depression?

Markets have seen a brisk recovery since their March lows. Some pundits angrily claim that central banks are inflating a new bubble. We've seen this story before, and it won't end well – but I don't think we're quite there yet.

Dylan Grice
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A popular narrative in the current rally in risk assets states that markets are drunk on central bank liquidity and failing to price risk rationally. I don’t think this is true. For weeks now, the market has shown evidence of clear discrimination in the pricing of assets deemed likely to be affected by Covid-19 versus those which were not.

In early May, I told my clients the following: «Rational market discrimination combined with the widespread conviction that this rally cannot last are the very reasons it will.»

Where are we today? One thing is sure: Risk pricing has tightened in the past weeks. It’s difficult to argue that any particular markets offer compelling value today. This, in combination with the emergence of a second Covid-19 wave is likely enough to push markets to give back a chunk of their recent gains.

Nevertheless, I don’t expect to retest March’s lows. I also believe that the underlying medium-term trend for risk assets remains up.

Let me explain why.

The credit opportunity is over

A good place to start is in the number of distressed fixed income issues trading on the Trade Reporting and Compliance Engine (TRACE). Although these have declined meaningfully during the rally, the level of distress remains elevated. This is consistent with what we observed for a while now, that markets are not behaving as though they’re oblivious to current problems.

Are enough problems priced in? Maybe not. Risk spreads have definitely tightened in the past month. We follow the CLO market very closely and it’s notable that in recent weeks the lower quality tranches most exposed to the impending wave of credit defaults (e.g. the sub-investment grade BB debt tranches) and hitherto left behind in the risk rally, have since caught up. Markets are continuing to price out much of the default severity priced in during the March crash.

The high yield market tells a similar story. Implied break even annual defaults in the high yield market peaked at around 20% during March’s market panic. Today that rate is just 10.6%.

It’s worth reflecting on that for a moment. The break even default rate tells you what annual default rate you can bear without losing any money (calculated as: spread / [1-recovery rate]). If we assume that most investors don’t deploy risk capital in order to just break even, we must also assume that investors buying High Yield at these levels expect to make a positive return. Therefore, investors at these levels are pricing in a default rate which is somewhat less than 10.6%.

S&P expect default rates to reach 10% by the end of this year. The default cycles of 2001 and 2008 saw annual defaults peak at that level too. High Yield markets are implicitly therefore pricing in a milder cycle than the two previous ones, which doesn’t sound very attractive (or prudent) to us.

The opportunity to buy high yield bonds (like that for more junior CLO tranches) has passed. For now credit market pricing seems on the tight side.

It is very tempting to conclude that markets have run ahead of themselves and are too optimistic about the likely strength of the recovery. Last week’s new Covid-19 infections in the U.S. reached an all time high and the long-feared second wave is happening as we write. According to the National Association of Business Economists’ June outlook, 87% of economists agreed that exactly this scenario is the biggest risk faced by the US economy right now.

The «anger rally» of 2020

I remain sanguine for equity markets, though. If 87% of economists expect something, it’s unlikely the rest of the market doesn’t. This might have been why markets barely budged last week as new infections exploded anew across the US.

It would admittedly be very surprising if the gains made in the last few months weren’t partly eroded as a second wave takes hold. Markets would then begin to price in a third wave, and a fourth, and maybe even a never ending rolling crisis. Last week’s ambivalent price action was probably similar to the lagged response we saw the first time around.

But markets are also likely to anticipate further stimulus, which if push comes to shove, they will get. Therefore, we don’t expect to get close to the March lows.

Not everyone likes this conclusion, and I understand why. Large parts of the investor community blame the central banks for propping up prices, as though in doing so central banks have spoiled their fun. Exasperated outrage is expressed as pundits rail against central banks for overriding market prices, doing the bidding of politicians and allowing enterprises which should be failing to continue.

I actually share many of these sentiments. I’m no fan of today’s central bank dominated financial system. But while I’ve seen market craziness many times in my career, from being giddy with greed to paralysed by fear, I’ve never seen a rally which has given way to so much anger.

It should be remembered that the market doesn’t care how you think the world should work. As investors, our job is not to conflate that with a view of how it does work.

Central banks do what they always do

Central banks’ reaction functions are well understood – and shouldn’t therefore come as a surprise. Blaming the Fed, or any other central bank, for doing what they always do seems to be borne more out of frustration with missing this rally and falling into the consensus trap than it is with anything else.

I think that pessimistic consensus trap remains wide open today.

First, influential commentators such as Paul Krugman and Larry Summers are bearish. Though they're not investors, they give a good indication of the market observing consensus. Second, the people in charge at the Fed are bearish too. And we know what they do when they are bearish.

Third, everyone is a seller. Legendary investors – such as Warren Buffett, Sam Zell and David Tepper – are as bearish as more ordinary ones. According to the latest Fund Manager Survey of Bank of America, four in five managers think stocks are overvalued.

But are they? Compared to bonds, they’re currently valued on the cheaper side of their historical range. The following chart plots the excess expected return of equities over bonds for the S&P 500 going back to 1950:

It’s true that equities don’t look as attractive relative to bonds as they did during WW2 or its immediate aftermath (US bond yields were suppressed by the Fed during WW2 and the chart period starts just as those price controls were being removed). Neither do they look as attractive as they did in the 1970s (when inflation ripped bonds were in a bear market, but equity valuations bore the brunt of the OPEC recessions). But they look much more attractive than they did in the 1990s, or in the run up to the Global Financial Crisis of 2008.

Equities are the least ugly duckling

One might complain that this «cheapness» (if it is even that) is a mirage, since it depends on the «compared to bonds» caveat, and we all know that the government bond market is egregiously distorted by a global central banking community which is in implicit yield suppression mode.

Sure. But why will this suddenly stop? What indication is there that central banks are about to let yields rise?

If anything, the Fed are priming markets for a move to explicit yield control. Portfolio construction is fundamentally relative and if yields are kept at close to zero, it's likely that equities valuations will ultimately anchor around that.

Equities are the least ugly duckling. We don't have to like it. But we do have to invest according to the way the world is, not the way we want it to be.

Is David Portnoy a sign of the top?

To many, the clearest indication of a market top is that the day traders are back. Their talisman, David Portnoy, founder of Barstool Sports, captivates his Twitter followers with live streams of him venting his emotions at the screen as he day trades live: «I’m sure Warren Buffett is a great guy but when it comes to stocks he’s washed up. I’m the captain now», he once proclaimed.

As Portnoy assembled his portfolio live on Twitter by picking scrabble tiles from a bag, Hertz, which had just filed for bankruptcy protection, saw its stock price rise inexplicably 15x in the space of a few days (the company even wanted to rush through a stock market raise before the SEC intervened).

Ill informed, gullible, stuck-at-home millennials with nothing better to do than to trade on Robinhood are copping the blame for making stock markets today feel like crypto markets in 2017.

It’s a familiar story with a familiar ending. «Doesn’t sound likely to end well» sneered Krugman to his followers on June 9th.

I agree with Krugman (there’s a first time for everything!). It won’t end well. I just don’t know when it will end. Indeed, I suspect it won’t be any time soon. I’m less sure that Portnoy signals a market top than he does a sign of things to come.

Market froth like this in the midst of the greatest economic contraction in recent history? Just think what it will be like when things recover for real.

Dylan Grice

Dylan Grice is co-founder of Calderwood Capital Research, an investment company specialising in portfolio construction and alternative investments. Prior to founding Calderwood, Dylan was the Head of Liquid Investments at Calibrium, a prominent private investment office based in Zurich. There, he was responsible for the management of the firm’s liquid portfolio, the research underpinning that portfolio, and the teams involved in the effort. Prior to joining Calibrium in 2014, Dylan was a part of the consistently top-ranked Global Strategy team at Société Générale, and was individually ranked first in the Extel Survey of institutional investor opinion in 2011 and 2012. Dylan started his career at Dresdner Kleinwort Wasserstein as an international economist and later prop trader. He is a graduate of Strathclyde University and the London School of Economics.
Dylan Grice is co-founder of Calderwood Capital Research, an investment company specialising in portfolio construction and alternative investments. Prior to founding Calderwood, Dylan was the Head of Liquid Investments at Calibrium, a prominent private investment office based in Zurich. There, he was responsible for the management of the firm’s liquid portfolio, the research underpinning that portfolio, and the teams involved in the effort. Prior to joining Calibrium in 2014, Dylan was a part of the consistently top-ranked Global Strategy team at Société Générale, and was individually ranked first in the Extel Survey of institutional investor opinion in 2011 and 2012. Dylan started his career at Dresdner Kleinwort Wasserstein as an international economist and later prop trader. He is a graduate of Strathclyde University and the London School of Economics.