Risk Assets: 'Nothing Can Go Wrong'

Includes: DIA, IWM, IYF, QQQ, SPY
by: Acting Man

Commercial Banks Increase Lending to Business

Ever since the Fed's "QE tapering" began, the annual growth rate of broad US money TMS-2 has actually not declined further (that may however change, as there have recently been two back-to-back monthly declines). The main reason for this is that commercial banks have "taken the baton" from the Fed and have expanded their lending to corporations at an accelerating rate. Thus we find that commercial and industrial loans have recently expanded at a more than 11% pace year-on-year (not seasonally adjusted: we prefer to look at actual numbers instead of statistically smoothed ones. As Lee Adler often mentions, this is the best way to ascertain what is really going on).

Commercial and industrial loans, year-on-year growth, not seasonally adjusted.

In early May, we already wrote about the blistering business in CLOs (see: “Embracing Leverage Again”), describing how banks are eagerly helping investors not only with buying the corporate equivalent of sub-prime CDOs, but enabling them to do so at up to 1:10 leverage. We also commented on the enormous surge in leveraged loan issuance in March, and have frequently discussed how PIK bonds, "frontier market" debt and other junk securities are gobbled up by yield-chasing investors as if they were the best thing since sliced bread. As of yet, there seems to be no let-up. Zerohedge has just discussed the topic as well, in the wake of a Bloomberg article that describes how banks are getting around the limitations imposed by the so-called "Volcker rule" so as to continue CLO production to their hearts content. It is worth excerpting the first paragraph of the article:

“The business of bundling junk-rated corporate loans into top-rated securities is booming like never before following the implementation of regulation aimed at making the financial system safer.

More than $46 billion of collateralized loan obligations have been raised this year in the U.S. through the end of May, after $82 billion were sold in all of 2013, according to Royal Bank of Scotland Group Plc. JPMorgan Chase & Co. boosted its annual forecast to as much as $100 billion, which means 2014 may end up as the biggest year on record, while Onex Corp. said yesterday it will expand its CLO business.”

(emphasis added)

So here we have packages of junk loans that are masquerading as highly rated securities, just as in the last boom. Only this time, the focus is on corporate junk instead of sub-prime residential mortgages.

Creditworthy borrowers have actually little need to borrow from banks, as there is a) great demand for corporate bonds and b) most of them have rearranged their financial affairs after the 2008 scare and have amassed large cash hoards. Capital expenditure is already far too high relative to sales and relative to recently falling profits (as Albert Edwards has pointed out, economy-wide profits are actually falling if one adjusts them for the accounting-related allowances provided by accelerated depreciation schedules – see this recent write-up by Mish). We also keep hearing of a "coming capex boom". However that boom may already be largely behind us, as the US production indexes for business equipment and consumer goods indicate.

Business equipment and consumer goods production in the US, long term.

Thus, creditworthy corporate borrowers probably mainly borrow for purposes like share buybacks, as they don't want to repatriate their overseas profits (in order to avoid paying US taxes on them).

This means that potential borrowers are probably mainly those engaged in some form of financial engineering (apart from share buybacks, mainly LBOs), or those who are actually not really creditworthy to begin with.

Similar to sub-prime securitizations, banks can employ CLOs to transfer the credit risk associated with lending to low grade borrowers to yield-chasing pension funds, hedge funds, insurers, etc., making money on fees, spreads and margin loans to more adventurous investors in the carry trade, so they now have a great incentive to lend to borrowers they have hitherto tended to avoid. In other words, we believe that the increase in business lending is probably a result of yield chasing by investors, and that much of this credit will eventually prove to be unsound.

Measures of Risk Perception

We have recently discussed the markets with a few good friends we regularly meet to exchange ideas, and one of them made the interesting observation that the stock market may well be on the verge of a blow-off move. This cannot be ruled out: consider that the Fed has only just begun tightening in baby steps, and that as noted above, banks are filling the void so far. While the annual growth rate of money TMS-2 has fallen from a former high at close to 16% to just above 8% today, it remains elevated. Lagged effects of the massive monetary pumping to date are likely to continue to play out. With regard to the many divergences appearing in the stock market we have mentioned in these pages, our friend pointed out that similar divergences were also in evidence on occasions preceding blow-off moves in the past, such as e.g. in late 1986, prior to the 1987 blow-off (which was followed by a rather memorable crash).

However, it must also be pointed out that various measures of risk perceptions have been in lala-land for quite some time. While there is some evidence of negativity on an anecdotal level (mainly expressed by members of the broader public, but also by a few prominent fund managers like e.g. John Hussman), quantitative sentiment and risk measures are quite stretched, to put it mildly. There is of course also plenty of anecdotal evidence that indicates that investors are throwing caution to the wind (see this crop of articles from yesterday: “Get your money ready for a big rally” one proclaims, “Stop worrying, the "new normal" is over” another informs us, followed by ”No need to worry about rising jobless claims”). While the scenario discussed above cannot be ruled out, it would require a few noteworthy records to be broken. A number of positioning measures are already at the most extreme ranges observed in all of history – including even the year 2000 tech mania. We show a few examples below.

The first chart illustrates Rydex related data: money market funds, bear assets and the raw ratio between bull and bear assets. These series have recently handily exceeded the extremes of the year 2000 peak – which is something we never expected to see again. The most striking thing about the Rydex data is the complacency evidenced by a 25 year low in money market assets and the almost complete capitulation of bears – which we also see echoed in some surveys.

Rydex money market fund assets, the SPX, bear assets and the ratio of bull to bear assets. Every record established in early 2000 has fallen by now.

We also see extremely high levels of conviction among stock market newsletter writers tracked by Investor's Intelligence.

The Investor's Intelligence survey of stock market newsletter writers.

The "risk appetite index", an average of measures of risk appetite published by three major banks, also remains near a record high:

The willingness to take on risk remains quite pronounced.

Lastly, here is a chart of a cyclical technology stock that is always getting a lot of love from investors when bubble conditions obtain. The stock is Sandisk (SNDK). We want to stress that we are not trying to pick on SNDK here; it merely serves our purpose in illustrating the point that risk aversion has essentially disappeared. This is inter alia shown by the fact that investors are currently paying about 20 times of what they are willing to pay for the stock near recession troughs, resp. bear market lows. The chart also happens to illustrate how strenuously overbought many technology stocks have become (the urge to own cyclical tech stocks such as semiconductor stocks and the stocks of data storage device makers like SNDK has recently become especially pronounced).

Note that the chart below is a monthly chart, which means that RSI is now at more than 80 on a monthly basis. The only time when even slightly higher overbought readings occurred was, not surprisingly, in February- March of 2000.

SNDK, a deeply cyclical technology stock, which in the past has oscillated between about $4 and $80, has recently climbed to a new high near $100 – almost 20 times its 2008 low.


We certainly live in an extraordinary time period. It is fascinating that after two major bubbles that have collapsed rather spectacularly in the not-too-distant past, yet another, in many ways even bigger bubble has emerged. As discussed above, investors certainly continue to pile into risk assets at a frenetic pace.

This is supported by the "ZIRP" policy pursued by major central banks and the vast and still ongoing money supply growth that has gone hand in hand with it. It is unknowable for how much longer the bubble will expand, mainly because every boom is historically unique; one can compare certain characteristic features with past experiences, but this cannot tell us how extreme things may become this time around. All that is certain is that just as risk aversion seems de minimis, actual risk continues to increase ever more.


Charts by: stockcharts, sentimentrader, decisionpoint, St. Louis Fed.