Why The Bears Are (Temporarily) Wrong

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Includes: AAPL, DIA, QQQ, SPY
by: Long/Short Investments

Summary

Central banks are now largely perceived as the de facto risk managers in the market.

Equity markets are going up in mostly linear fashion and low-risk/high-risk asset spreads are compressing.

This is not limited to US or developed markets generally, and is also observed in emerging markets as well.

While skeptics can point to overvaluation and poor risk/reward asymmetries, central bank policies, credit expansion, and economic optimism are likely to keep the market going.

General argument: Shorting the US equities market(s) (NYSEARCA:SPY)(NYSEARCA:DIA)(NASDAQ:QQQ) on the basis that the market can't sustain its current clip is a poor bet when there isn't an immediate catalyst on the horizon.

Overview

With the way the stock market and high-yield bond markets have been going up - with very little volatility along the way - it begs the question whether the level of complacency observed in the market is a consequence of the perception of central banks will not allow financial markets to become overly chaotic. When central banks have such profound oversight, the risk appetite among investors is keen on increasing.

I think most would agree that forward returns expectations in the stock and bond markets are well below historical norms. Even if the markets were at middle-of-the-road valuations, I would expect this to be the case. As countries develop, their demographics age, people consume less, innovation slows, and economic growth moderates in conjunction.

The Federal Reserve adjusted its long-run real growth projection for the US economy at 1.8%, a figure I think is fairly accurate. The US could outperform this in the near-term because of both good and bad reasons.

The good reasons include corporate tax cuts, which should theoretically free up more of companies' earnings to be pushed back into organic growth initiatives, such as the creation of new jobs and worker development programs to enhance productivity. Either way, it's an objective boost to earnings, which is a large component that feeds into how stock and bond markets are valued.

Incentivizing corporations to repatriate their overseas cash is also positive, as current corporate tax penalties are deemed too punitive for many companies. For example, Apple (NASDAQ:AAPL), despite its massive store-hold of offshore cash, has turned to debt issuances in the past to repurchase shares, given the effective cost of repatriating this cash is greater than going toward the debt markets instead.

Deregulation can be positive if it rolls back genuine inefficiencies. Some regulation doesn't work as intended and can create perverse incentives by merely shifting corporate actions elsewhere. Some of it is overly punitive and restricts optimal business functioning. And some of it is positive and genuinely mitigates risk. US banks look very healthy with their current levels of capitalization. Although the US banking sector is larger than it was back in 2008, gone are the days where equity merely takes up 4% of a bank's capital, wherein a small fluctuation in the value of its assets would present a large risk to shareholders.

The main "bad" reason why growth could continue to outperform is through the continual overexpansion of credit, both at the government and corporate level, which allows economic and financial entities to spend more than they should during the "boom" phase of the economic cycle. If credit growth exceeds the rate of nominal GDP growth, it's unsustainable long-term but can help fuel economic performance in the short-run.

Wasn't 2017 Supposed to be a Year of Risk?

There's always risk in the market, so it's somewhat ridiculous to assert that 2017 is supposed to be a year characterized by uncertainty. But anxiety over how the change in power in US politics and upcoming elections in Germany, France, the Netherlands, and possibly Italy (a group inclusive of 3 of the largest 8 economies in the world) would impact the market were expected to leave markets in more wait-and-see mode. Not to mention the prospective influences of increasing protectionism, a stronger dollar and its likely adverse effect on emerging markets, and multiple rate hikes from the Fed for the first time in over a decade.

Yet risk-asset markets (i.e., stocks, high-yield bonds, commercial and residential real estate) have continued to go up in essentially linear fashion. A big portion can be attributed to continued accommodative measures by central banks.

Namely, the general line of thinking is that if there is no foreseeable catalyst to reprice markets and a dearth of higher yielding alternatives, it only makes sense to plow more capital into these asset classes if everything else is unattractive. Rate hikes are generally bearish for stocks in that it increases the discount rates at which cash flows are valued (leading to lower valuations). But the market has interpreted the notion of several rate increases as a vote of confidence regarding the strength of the US and world economy. Despite the common acknowledgment that valuations are lofty, central bank optimism and a lack of quality alternatives to put capital has contributed to a steady appreciation in asset without much in the way of corresponding volatility.

The appetite for risk is higher than it's been, in many respects, since 2007. Tight spreads and poor valuation metrics we're seeing in a variety of assets - e.g., 10-year US Treasury vs. forward stock returns, 10-year vs. high-yield, capitalization rates in commercial real estate, various emerging market credit spreads - continue narrowing at breakneck speed.

Below is an emerging market credit spread metric used by BofA Merrill Lynch, which takes into account the option-adjusted spreads between an emerging market bond index of a particular rating category and the spot Treasury yield rate at a comparable duration.

(Source: BofA Merrill Lynch; modeled by fred.stlouisfed.org)

Over the past year, this has fallen by 330 basis points and the spread is the lowest since November 2007.

I should note that emerging markets are more stable than they were ten years ago, so some portion of this spread tightening is attributed to this factor. Nonetheless, this demonstrates that the phenomenon isn't solely limited to US markets, which have seemingly swelled upward via expectations of deregulation and tax cuts. And the phenomenon hasn't been contained to developed markets generally. The high degree of risk-taking is observed at a global level in places where these policies could partially hurt emerging markets via a stronger dollar (thus make a large portion of emerging market debt more expensive) and for general "flow of funds" reasons (i.e., the US market becomes more attractive at least in relative terms).

Part of the euphoria may be justified with reflationary measures expected to be fulfilled in time to go along with ultra-accommodative central bank policies. But when spreads between high-yield credit and stocks are being bid down all the way below 350 bps, it shows an unquenchable appetite for risk that simply doesn't make sense in terms of what spreads indicate in practice (differences in recovery rates upon default).

Considering the default rates between the "risk free" 10-year US Treasury and junk bond of a comparable duration, it is very difficult to rationalize a spread of merely 330 bps.

Below is a bit of an older table from Moody's (financial crisis data aren't included, which would skew up default rate statistics), but the average junk bond over time will have expected loss values over a ten-year period that come out greater than just 3.3%. (Junk bonds are rated below Baa3 on the Moody's scale. An interesting surfeit of statistics can be found here.)

With that said, I want (and expect) the spread to narrow further before I'd feel comfortable taking this trade (i.e., long Treasuries, short high-yield).

At the same time, the market's not quite as over-exuberant as it was in June 2007, shortly before the first overt signs of a crisis began to manifest on August 9, 2007 with BNP Paribas' now-infamous "evaporation of liquidity" statement with respect to subprime lending. Back then, now nearly ten years ago, the spread between CCC (or worse) yields and comparable-duration US Treasuries was just 423 bps, which is patently absurd. At the moment we're still "only" at 841 bps, though it's still nonetheless a 27-month low.

(Source: BofA Merrill Lynch; modeled by fred.stlouisfed.org)

Conclusion

Much of this risk-taking, in my view, emanates from the perception that central banks are reluctant to let markets fail to any appreciable extent. Thus, the notion of internal risk management seems to have slackened in practice and many traders/investors have hopped on the bandwagon for fear of missing out on the rally.

Even so, I think that this sentiment is at least temporarily justified. When there is economic optimism, more capital flows into the markets and these funds have to be put to use somewhere. Low-risk bond markets have been perpetually unattractive due to low yields, so much of it naturally goes into riskier assets that provide the best returns (at the expense of the highest risk), with a lot of it wrapped up in passive index funds due to active management's underperformance over the past decade. Not so ironically, hedge funds have continued to underperform this year due to their cautiousness of the current situation, while passive indexers have reaped the benefits of the ongoing rise in the market.

For now, the momentum remains to the north side. Even if the market becomes even more overvalued (note that "overvalued" is a subjective term), I don't believe in a pure short of the stock or high-yield bond market as a whole. Overvaluation by itself is a tremendously weak thesis. I don't believe the market will correct until we get a substantive credit-related event that forces a repricing. When and where (sector, country) the music will stop is uncertain.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.