According to the Bank of International Settlements, there are now more margin loans supporting buying in the US stock market than during the tech boom of 1999/2000. And those loans are chasing an ever-narrowing band of tech stocks on the back of a ‘fear of missing out’. This is just one of the many red flags making us nervous right now.
When I started down the list of NASDAQ 100 companies and their price to earnings (PE) ratios, I quickly counted a dozen on multiples of more than 200 times earnings. Think about that for a minute. More than 12 per cent of companies in the NSDAQ are on PEs of more than 200 times – companies like Netflix, GoDaddy, Yelp and Salesforce. And some are on PEs of 250 times.
At the pointy end you have companies like Tesla, Uber (unlisted) and Twitter with an aggregate market cap of US$140 billion but an aggregate profit of…wait for it…zero.
Idiosyncratic risk, sector risk and concentration risks seem to be ignored in what Howard Marks has described as “the pursuit of the new untrammelled by knowledge of the past”.
That we could be in the midst of the largest ever margin loan debt bubble may come as a surprise. But so might the fact that the returns for simply buying the index are extremely rare and unsustainable.
Since the lows of the Global Financial Crisis (GFC) in March 2009, the S&P 500 has delivered a total shareholder return of almost 18 per cent per annum. By itself this return is exceptional, but what makes it extraordinary is that the returns have come with a measure of risk, or volatility, of just 12 per cent.
In other words, over 100 months, the S&P500 has delivered a Sharpe Ratio (a measure of risk adjusted returns) of 1.4. To put that in perspective, it has not happened since 1959 and the world’s very best hedge fund managers would give their right eye to produce numbers that the broad stock market index is delivering now.
Ultra low volatility and ultra high returns is not a function of an enlightened world and smarter investment products such as Exchange-traded funds (ETFs) and index funds. It is a function of very cheap money, avoiding the punitive returns offered by cash, and chasing a narrowing pool of opportunities. I am once again reminded of the quote by renowned US economist, Herb Stein, who said: “if something cannot go on forever, it must stop”.
On the subject of low interest rates, it is worth noting that stocks only appear cheap because interest rates are low. The US 10-year Treasury bond is trading on a yield of 2.27 per cent as I write this column. That’s equivalent to a PE ratio of 44.1 times earnings and the earnings don’t grow. Therefore, if you can find a stock with a lower PE than 44 times and offering a little growth, the stock must be cheap.
But as you can also see, such a game is a dangerous. It relies entirely on rates staying low. If rates rise, the apparent ‘value’ vaporises.
The Bank of International Settlements made this precise point in its latest quarterly report, observing: “Valuations seem to be aligned with historical benchmarks only after account is taken of the level of bond yields” and “equity markets continue to be vulnerable to the risk of a snapback in bond markets, should term premia return to more normal levels”. (Term premia refers to the level of compensation investors require for taking on risks in bond markets.)
And let’s not forget the debt picture if ‘term premia’ does indeed rise. US corporate debt as a percentage of gross domestic product (GDP) is near all times highs. On all of the past three occasions that debt hit this level, a recession ensued.
Meanwhile corporate bond spreads – the premium that lenders demand for lending to a company instead of the US government – are at record lows, as is Moody’s Covenant Quality Index, which measures the quality of conditions lenders impose on junk borrowers.
In other words, lenders are lending a lot, for very low returns and with very few requirements imposed on the borrower.
Red flags are everywhere and perhaps the most crimson flag is the recent issue of a 100 year bond by Argentina. Anyone with any knowledge of Argentina’s history knows that in the last 90 years the country has endured three periods of hyper inflation – with the worst, of 5000 per cent occurring as recently as 1989. It has experienced dozens of military coups and civilian uprisings and as recently as 2001 the country declared the then largest-ever sovereign default.
In fact, it was only last year that Argentina emerged from that default, and 12 months later it issues a 100 year bond at a 5 per cent premium to a US government bond, and after offering $2.75 billion at the final yield, it received $9.75 billion in bids. It was massively oversubscribed.
Do you think there could be, or will be, a period of inflation, a credit event or rising interest rates in Argentina in the next 100 years? If you do, then you don’t want to be holding those bonds.
Such is the disdain that investors have for cash, it appears they will buy almost anything and at any price. And that’s the biggest red flag of all.
Spot on, Roger!