Last week in this space, columnist Barry Ritholtz wrote that the five-year bull market on Wall Street isn’t about to end — it’s merely entering a more measured and mature stage after last year’s spectacular 30 percent stock market returns.
My message to you this week is that Barry is probably wrong because he’s looking at the history of stock market cycles rather than what we should be looking at in these unusual circumstances, which is the credit cycle. And right now the credit markets are in bubble territory, propping up stock and real estate values as well.
The signs of dangerous exuberance are both statistical and anecdotal.
The first place I check when looking for a credit bubble is in volume of corporate mergers and acquisitions and the amount of borrowed money they involve.
So far in 2014, the pace of deals has equaled or surpassed 2007, driven by megadeals in technology (Facebook’s purchase of WhatsApp for $19 billion), telecom (Comcast’s proposed $45 billion merger with Time Warner Cable; Altice’s $23 billion purchase of Vivendi) and biotech (Zimmer’s $13 billion purchase of Biomet; Actavis’s purchase of Forest Labs for $25 billion). Just this past week, venerable old General Electric is considering its biggest acquisition ever, $13 billion for France’s power plant maker, Alstom.
Among the most active sellers these days are private firms, which is a pretty good sign that the smart money thinks we are at or near a market top.
“Let’s just say it is easier to sell than buy right now,” said one private equity manager with a keen eye for value. Private equity deals, he reported, are getting done at nine times cash flow — not quite at 2007 levels, but getting close.
With a few exceptions, these deals are financed with lots of cheap and easy credit in the form of junk bonds or leveraged loans. The “easiness” of the loans is reflected in the lack of performance covenants and the right of borrowers to call in loans after only a few years. The “cheap” is reflected in the fact that corporate bond spreads — the difference between what companies pay to borrow compared to the risk-free U.S. Treasury — are at record lows.
Things have gotten so cheap and easy that bank regulators recently warned that takeover loans would get increased scrutiny (apparently without much impact, so far). So much money has been flowing into junk-bond funds that Black Rock, Pimco and a veritable herd of Wall Street analysts have recently warned that the high-yield market is overpriced.
As is always the case, cheap credit leads to expensive stocks. Anyone who says he can’t see a bubble in tech stocks ought to click his Prada loafers three times, say “Candy Crush, Tesla, Bitcoin,” and rush to an optometrist’s office.
But it’s not just tech. Robert Shiller, whose knack for spotting bubbles won him a Nobel Prize last year, came up with what’s called a cyclically adjusted price-earnings ratio for the S&P 500. And right now that ratio is 25, higher than at any time except the tech and telecom bubble of 1999 and, briefly, 1929. The historic average is about 16.
Some of this is driven by the flood of dumb money from individual investors into stock mutual funds over the past 16 months, encouraged by investment newsletters that are near unanimous in their market optimism — a classic warning sign. Much of the rest of the buying reflects momentum investing by hedge funds and day traders using plenty of leverage to boost their returns. The amount of outstanding margin debt — debt used to buy stocks — is near its mid-2007 peak.
Henry Blodget, editor in chief of Business Insider, knows a thing or two about frothy markets, as one of the chief cheerleaders of tech stocks during the late 1990s.
A wiser, chastened Blodget now calculates that stocks are 50 percent overvalued. He cites, among other things, the ratio of the market value of U.S. corporations to their revenues (1.6 compared to an historical average of 1.0) and the ratio of market value to the country’s GDP (1.27, double the historical average).
“A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla,” wrote Seth Klarman, the fabulously successful manager of Boston’s $26 billion Baupost Group hedge fund, in his annual letter to investors.
“The zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit . . . until they’re sure everyone else won’t stay on forever.”
Commercial real estate has also shown up at the party. “Risk is back,” declared the headline of one of those glossy commercial real estate publications I picked up on a recent trip to New York. The Real Deal reports that lenders are willing to finance purchase of prime Manhattan office buildings based not on the income the building is currently generating, but on the significantly higher rents that are anticipated once current leases come up for renewal.
The reason why credit is so cheap and easy is the Federal Reserve, which has kept short-term interest rates near zero while continuing to push down long-term rates, buying tens of billions of dollars in mortgage-backed securities each month. Such aggressive use of the Fed’s monetary printing press was necessary and effective in warding off another Great Depression. But this extraordinary stimulus is now providing only a small and diminishing boost to an economy that is well along the path toward a self-sustaining recovery, while having a large and growing impact on financial markets.
Last spring, then-chairman Ben Bernanke signaled that the Fed was about to begin winding down these extraordinary measures, only to call it off when Wall Street had a hissy fit. He later dismissed it as a “communications” problem. Even now that the Fed has finally taken the first tentative steps in that direction, Janet L. Yellen, the new chair, has felt the need to continually reassure the markets that cheap and easy credit will be available for years to come. The Fed’s upbeat message: Party on, dudes.
As it happens, one member of the Fed’s board of governors has quietly been pushing his colleagues to give financial market impacts greater consideration in how monetary policy is set. In a recent speech, Jeremy Stein argued, in effect, that the Fed should be willing to tolerate slightly higher levels of unemployment if the only way to lower it is for the Fed to create a credit bubble that eventually will burst, hurting the economy even more.
Unfortunately, Stein recently announced that he is returning to his tenured post at Harvard Business School. And Yellen, who seems to have learned little from the mistakes of her two predecessors, continues to frame the Fed’s thinking about monetary policy solely in terms of the traditional trade-off between higher unemployment and higher inflation.
Yellen also is reluctant to accept that there is little more that an aggressive Fed can do to reduce long-term unemployment that is mostly the result of technology, demographics, globalization and other structural changes in the economy. Long-term unemployment is indeed a serious problem, as is an apparent long-term slowdown in economic growth. But these are not problems that can be fixed in any sustainable way by more cheap and easy credit.
It’s only a matter of time before Yellen and her colleagues acknowledge that monetary policy has done as much as it can and rise toward a more normal level. And when that happens, given the forward-looking nature of financial markets, there will be a sharp downward adjustment in the price of stocks and bonds. It’s the unavoidable last stage of the recovery process that has involved the largest injection of monetary stimulus that the world has ever seen. And the sooner it is allowed to happen, the less damage it will cause to the real economy.
Which is why I part company with my columnist colleague. For investors, I think the better strategy is to take your gains now, put most of your savings in cash and wait for the market correction to play itself out. Given the inevitable increase in interest rates over the next two years, the risk of missing out on another surge in stock and bond prices looks pretty low. As Klarman once put it: “We prefer the risk of lost opportunity to lost capital.”