Convincing Traits Of A Market Bubble - Part II

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Includes: CRF, DB, DDM, DIA, DOG, DXD, EEH, EPS, EQL, EWSC, FEX, FWDD, HUSV, IJR, IJS, IVV, IWL, IWM, JHML, JKD, LLSC, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSCO, RSP, RWJ, RWL, RWM, RYARX, RYRSX, SAA, SBB, SBUS, SCAP, SCHX, SDD, SDOW, SDS, SFLA, SH, SLY, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TNA, TQQQ, TWM, TWOK, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UWM, VFINX, VIOO, VOO, VTWO, VV
by: Mark Bern, CFA

Summary

Global debt has surged again.

Troubling signs in the non-U.S. financial network.

The Fed is raising interest rates again, which generally does not end well.

Market cap to GDP is at nosebleed levels again and market breadth is beginning to appear unhealthy.

Don't let this be you!

Back to Part I

Global Debt is towering above levels attained in 2007

The following chart should be scary enough, but it does not include the whole picture. It excludes financial sector debt. Another shortfall of this chart is that it only extends through the end of 2015. I could not find more recent updates without spending enough to pay for the last year of college for my daughter. But I believe we can add some data from other sources to put things into perspective.

First, according to a McKinsey report on the global debt crisis that includes all debt (even financial institutions), I found that global debt had risen by $57 trillion from 2007 through the end of 2014. See the graphic below from that report. We can see below that financial debt stood at $45 trillion at that time. I suspect that with all the QE continuing to flood into the markets in Japan and Europe, the number today is certainly no lower and probably higher. But, if we just assume that it has not moved at all over the last two years and add that number to the more recent figure from an IMF (International Monetary Fund) report that was up to date as of October 2016, we get a much clearer picture of "total debt."

According to Bloomberg the "IMF is worried about the World's $152 trillion debt pile." In that report, the IMF stated that total debt has surged to 225 percent of global GDP (Gross Domestic Product). Again, the amount and ratio reported in the IMF report do not include debt held by financial institutions. So, if we add the 2014 financial institution debt of $45 trillion to the non-financial institution debt total of $152 trillion, we get a total of all world debt of $197 trillion. Of course, that would assume that total debt has fallen since 2014, when it stood at $199 trillion. Somehow, I do not think this to be likely.

According to the IMF, as reported on statisticstimes.com, World GDP in 2016 stands at $75.2 trillion. The other IMF report mentioned by Bloomberg linked in the previous paragraph stated that total debt (sans financial institution debt) stands at 225 percent of GDP. These two numbers do not jive. The first report indicates World GDP of $67.6 trillion ($152 trillion divided by 225 percent). But if the real number is more like the actual number (instead of the implied number) reported in this more recent report and debt remains at 225 percent of that total, then total debt (not including financial institution debt) would be about $169 trillion. Now add the $45 trillion in financial debt and we get total world debt of $214 trillion. This is not completely accurate but it makes more sense when compared to the $199 trillion total in 2014.

Now compare that $214 trillion to the total world debt reported by McKinsey at the end of 2007, which amounted to $142 trillion. This would mean that total world debt (including financial institution debt, or at least most of it) has increased by 51 percent since just before the last bubble burst. This does not leave me feeling all warm and fuzzy inside. This is a real problem. But now I want to dive a little deeper into why it is a problem.

Three legs of the global financial network stool

This is just one way to look at the global financial network, but it makes sense to me even though I have not seen this picture drawn by anyone else. If we think of the network as a three-legged stool, my three legs would be the North American (U.S. and Canada) financial industry, the financial industry represented by all other developed countries (Europe, Japan and Australia) and the financial industry in developing and emerging markets (led by China, India, Korea, Brazil, Russia and Mexico).

If the health of any one of these groups (legs) is broken, it can have adverse effects on the other two and lead to a mild global recession. If two or more legs are broken, then the effects are far more severe and the resulting recession is likely to be much stronger (read: really bad for stocks). Today, there is evidence that two of those legs are ready to break and that if either one gives way, the other will crumble with it.

The first leg, U.S. financial institutions appears to be in good shape. So far, so good. But the next leg, consisting primarily of Europe, is another story.

According to press from Reuters (picked up by CNBC here) the total of nonperforming bank loans in Europe amounts to 990 billion euros ($1.05 trillion) and, of that total, 286 billion euros ($303 billion) is on the books of the 14 largest banks in Italy. Italy has GDP of $1.85 trillion as of 2016. This is a serious problem.

According to KPMG LLC (as reported by Bloomberg here) the total of bad loans (nonperforming) is 1.2 trillion euros ($1.3 trillion). One of the factors that has created this problem is that the net interest spread earned by banks in Europe averages only 1.2 percent compared to about three percent in the U.S. This is killing the banks' ability to turn a profit. And, as it should be obvious, the problem is not contained to just Italy. It may be the focal point of news stories on the subject, but it represents only about 29 percent of the problem. The toxic loans in Europe represented only about 1.5 percent of lending on the continent in 2008 (just before the financial crisis), but represent more than five percent now, most of which is held by a relatively small number of very large banks across Europe. So, this is a widespread problem in several countries, even Germany (think: Deutsche Bank (NYSE:DB)), and appears to be getting worse (not better) due to the policies of the ECB (European Central Bank). Liquidity may be helping to stave off the end, but sub-zero interest rates (and the narrow spreads that result) are constraining the banks' ability to earn their way out of the problem. So, it just keeps getting worse; until the bubble bursts.

Japan, with its central bank imposed negative rate interest policies, is following the same path. Australia may be taking a different road, but I hardly think it can save the rest of its peer group.

The third leg of the stool is a mixed bag. The problem in many EM (emerging market) countries is that of weak currencies relative to the USD (U.S. dollar) and other major currencies. When these governments, or corporations located within the respective EM borders, need large loans, it becomes necessary to look outside the country. A great number of these loans are denominated in USD as a result and many of those loans are originated by large, multinational financial institutions from the U.S. The problem arises when the USD strengthens against local, EM currencies. The revenue is coming denominated in the local currency, but the loan payments must be made in USD. As the USD strengthens, these loan recipients must pay out an ever rising portion of revenues to service these USD-denominated loans. The USD has gained almost nine percent against other major currencies. The results by country vary widely, but I believe it is safe to assume that currencies in many EM nations have fallen by more against the USD than the average of major currencies. Over the last three years, the USD has surged by more than 26 percent. You can check my calculations by using this interactive DXY charting tool at Marketwatch.

As interest rates rise in the U.S., the result is often a stronger USD, especially against EM currencies. There are a number of articles I found that make a good case for EM debt to be safer now than it appeared a year ago. Commodity prices, especially oil, have rebounded some and there seems to be more political stability in Latin America. Those are positives for EM debt, and the situation is steadier for the moment. But that could change quickly.

Does anybody remember the "Taper Tantrum" of 2013 when EM bonds fell off a cliff? That nosedive was the result of the Federal Reserve announcing that it planned to tighten monetary policy. Rising interest rates in the U.S. is just another version of tightening. A month ago, the consensus called for no rate increases until June and no more than two for all of 2017. Now an increase is expected this coming week and consensus seems to think that three increases this year are more likely. This may seem like a small change to the casual observer, but in EM-land this could prove much more problematic. I am not trying to be prophetic, but I am attempting to raise the caution flag. This article from Bloomberg provides a good explanation of the situation, in my opinion. The spread between EM bonds and U.S. high-yield bonds is the narrowest it has been since, well, 2013. This is not a red flag yet, but it is definitely a yellow flag from my perspective and something to keep an eye on.

Now, here is the real problem with the debt in Europe and EM economies. The global financial network is more interconnected today than at any time in history. All big banks claim that most risk exposures are insured against by derivatives designed to offset the risk. The real problem is that the big banks are also the issuers of that same insurance. If the U.S. banks are the primary issuers of such derivatives to European banks (very likely) and the U.S. banks have bought derivatives to offset their own respective risks from each other or from European banks, or Japanese banks, or Chinese banks, and so on, the problems are interwoven into the fabric of every major bank on the planet. There really is no place to hide. This may make the U.S. banks just as vulnerable to problems in European banks or EM banks as if the problems resided domestically.

Derivatives trading (mostly by big banks) has expanded since before the financial crisis of 2008 from $500 trillion (notional value) to over $700 trillion now, according to sources cited by a Forbes article. Bank balance sheets are just as opaque now as in 2008 when the global economy froze up since banks would not lend to each other because no one knew what the real value of assets were or what assets were held by each bank. The risk appeared too high and it will again if we have another meltdown.

The argument that the notional value is meaningless comes up a lot. But, according to bis.org, the gross market value of derivatives held at banks is "only" over $20 trillion. I do not know about you, but that still seems like a lot. I suspect that it is enough to cause a lot of damage to the financial system if it begins to unravel. And U.S. banks are right in the middle of it all so, irrespective of how strong our banks may appear, the risk is such that we (the American Taxpayers) will not be spared the next time either. Remember: the problem is bigger now than it was in 2008.

If another crisis hits EM bonds again, as in 2013, U.S. banks will again not be spared since much of that debt was issued by none other than our own big banks. Once again, we are subject to the global interconnectedness of the global financial economy and financial network. If things start going downhill, the slope will be slippery and there will be nowhere to hide.

I have spent more time on debt than intended, so I will try to keep the remaining sections more succinct.

The Fed is raising rates again and how this usually ends

The following graph show movements in the fed funds rate by the Federal Reserve since 1954. As we look at the graph, it should be clear that, more often than not, once the Fed begins raising rates, the U.S. economy falls into recession or an already initiated recession continues to get worse. Since 1954, there were 15 instances in which the Fed raised rates multiple times. In eleven of those instances, the U.S. economy fell into recession or a recession continued unabated until the Fed began to reduce rates.

The recessions that began in 2000 and 2008 did not start immediately after interest rates peaked but, in both instances, a recession did occur when rates were at peak levels and had to be reduced to provide liquidity to slow recessionary pressures. Rate reductions alone worked to curb recession after 2000 but the Fed needed to do much more after 2008. With rates at such depressed levels and the Fed balance sheet already more than 4.5 times larger than before the financial crisis, how much can the Fed do to support the economy should it fall into recession?

The point of this chart is not to support the idea that the economy is about to fall into recession again because of rate increases. It is more of an attempt to demonstrate how fragile the situation is and that the Fed may not be able to rescue us the next time when it comes. However, it does tell us that once the Fed begins to raise rates, eventually bad things tend to happen.

Warren Buffett's indicator of market value: Market capitalization to GDP

There has much written about this next chart, and many dispute its continued relevance, but I still believe it has value. Market capitalization of equities to GDP; in 2001, Buffett remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment." Where does this ratio stand at year-end 2016? Let us take a look.

Source: dshort.com at Advisor Perspectives

Well, it is not at the highest level ever and it was even a little higher a year ago, but we are still at nosebleed levels, in my opinion. Valuations did not get this high in 2007 and only surpassed these levels in 2000. We all know what happened in those instances. Since 1950, this ratio has not been higher with one exception (assuming 2015 as part of the current rally). It has only risen above 100 two other times. Of course, the market has rallied strongly since the end of 2016, so when this chart is updated again to show where we stand at the end of Q1 2017, barring a major disruption to the rally, the ratio will be even higher than it stands today, probably higher than it was a year ago. Year to date, the S&P 500 has rallied 5.9 percent while the ratio is only 3.5 percent off 129.7 percent level of a year ago. The ratio has probably risen to over 130 percent at this juncture.

One more nice chart to chew on is the breadth of small capitalization stocks as represented by the S&P 600 SmallCap Index (NYSEARCA:IJS). The chart below shows the plotted daily index value (black line) along with the net number of new 100-day highs vs. 100-day lows (green line).

Source: IndexIndicators.com

Notice the stark divergence (gap) that has formed between the two. Valuations are trading in a range while the breadth indicator is trending lower. This is not an indication of a healthy market. Small capitalization stocks are being left out of this late period rally of the current bull market. And that is being caused by another characteristic of a bubble, which I will dive into in the final installment of this series: investor euphoria.

I have not yet been able to reconcile the huge rally in valuations relative to EPS (earnings per share) for the S&P 500 (NYSEARCA:SPY) which remain below 2007 and 2011 levels on a GAAP basis. In case you missed my explanation and unveiling of this dilemma, you may want to click this link to check out Part I.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge. Don't forget to hit the "Follow" button at the top of the article next to my name to keep up to date on my next moves and full accounting of results for the strategy.

For those who would like to learn more about my investment philosophy please consider reading "How I Created My Own Portfolio Over a Lifetime."

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.

Additional disclosure: Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the Disclaimer at the end of this article. Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.

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