Page 1 of 3 CREDIT BUBBLE BULLETIN Financial euphoria
Commentary and weekly watch by Doug Noland
Tepper stokes the melt-up: "I am definitely bullish. The budget deficit is shrinking massively. Guys who are short, they better have a shovel to get out of the grave" - hedge fund manager David Tepper, CNBC, May 14, 2013.
Mr Tepper has every reason to be euphoric. His US$7 billion estimated net worth places him at number 53 on the Forbes US billionaires list (and ascending briskly). Few have profited more
from central bank monetary largess and attendant asset inflation. Few are currently benefiting as much from the Federal Reserve's $85 billion monthly quantitative easing program.
I'll view Tepper's Tuesday CNBC appearance as confirmation of the US stock market officially attaining "financial euphoria", so it's an opportune time to reread John Kenneth Galbraith's little gem A Short History of Financial Euphoria. There is a long history of manias and, as Galbraith points out, there are common themes and common conclusions.
The commonly accepted view sees manias as episodes of irrational crowd behavior (that is, a bunch of lunatics running around trading tulip bulbs). Galbraith sees the "mass escape from sanity by people in pursuit of profit". Fair enough, though I tend to view perfectly rational behavior as the more typical yet unappreciated theme of major financial bubbles. Bouts of irrationality would be far less dangerous.
Sure, speculative episodes do in fact appear irrational, though, I would argue, mostly in hindsight. Tepper doesn't seem to be a raving mad speculator. Now a full-fledged market legend of our gilded age, Tepper is a bit manic, sort of annoying, incredibly successful at speculating and definitely rational. He and those of his fortunate ilk are at the precipice of potentially adding billions more to their colossal treasure troves.
And what if they're wrong about the markets and the all-powerful cadre of global central banks? Well, they could lose an enormous amount of money and survive with more than ample resources for the "good life" (with, perhaps, fewer collectables and trophy properties). The point is, at this stage of a long inflationary asset market boom, it's perfectly rational to double-down with the "house's money" and play for the spectacular big win. They're just electronic chips, for heaven's sake.
Today, with markets at all-time highs, Tepper exudes unequivocal financial genius. Having enjoyed years to master their craft, it's perfectly rational for the successful market operators these days to use this bout of unprecedented ultra-loose finance and government backstops to accumulate as much financial wealth as possible.
That's the norm for speculators going back centuries. It's worth noting, however, that when filthy rich market speculators were in the past celebrated for their brilliance and extraordinary market acumen - well, it proved a decent juncture to start worrying about the future. This spectacular cycle of speculator wealth accumulation has been going on for so long now that everyone has simply stopped worrying.
Understanding the dynamics of market euphoria and crowd behavior remains a fascinating and worthwhile endeavor. From an analytical perspective, however, I've always focused more on the finance underpinning the boom. Show me a manic bubble period in the markets and I'll show you underlying monetary disorder. And perhaps it's easy to see and perhaps it's not.
Throughout about every historic bubble episode, there inevitably reaches a manic point of financial euphoria that corresponds to an unsustainable manic expansion of suspect finance. Financial euphoria and unstable finance make dicey bedfellows.
Euphoria has reached the point where the markets have become largely immune to bad news and negative fundamental developments. Actually, negatives are nowadays welcomed to the party. On a macro basis, weak economic data ensures a longer period of aggressive global monetary stimulus. On a micro stock basis, deteriorating fundamentals equate with larger short positions. And right now, nothing has the equities markets more ebullient than squeezing the shorts.
No reason to fret stagnant earnings, a stronger dollar, faltering global growth and myriad developments that could bring this party to a rapid conclusion.
Yet bullish market pundits these days argue that market speculation has not yet reached dangerous levels. Some admit to "pockets of froth". "No sign of public exuberance." Heck, the public hasn't even succumbed yet. Market excess is "certainly not at 1999 levels".
Well, one has to go all be way back to 1999 for an environment so rife with short squeezes. Indeed, no game in the markets these days is as remotely profitable as buying heavily shorted stocks and forcing the shorts to buy back their borrowed shares (and bonds?) at higher prices. Squeezing shorts has become the hot topic on day-trading discussion boards. It has become popular sport throughout the leveraged speculating community. And I suspect that buying baskets of heavily shorted stocks has become a hot venue for algorithmic ("algo") trading. Why not just buy a basket of heavily shorted stocks at the open and then gun the S&P futures?
Short squeezes can play a major role in destabilizing markets - equities and fixed income. On the one hand, widespread buying (short covering) provides a powerful boost to marketplace liquidity. This is the proverbial "throwing gas on a fire" - for markets already gorging on liquidity and speculative excess.
As for market psychology, having the bears on the run helps jolt sentiment past optimism to exuberance and then euphoria. With the depleted bears largely out of the way, a potential source of selling pressure is removed from the marketplace. And as market dislocations see an increasing number of stocks experience spikes and upside gaps, long sellers are prone to think twice before selling. A short-seller panic and attendant sellers' strike is the stuff of financial euphoria.
Why did Nasdaq collapse in 2000? Because of several years of excess that culminated in a historic market squeeze and speculative free-for-all in 1999. It's "funny" how market dynamics work. With industry fundamentals turning increasingly problematic in 1999 and stock prices diverging markedly from underlying fundamentals, short positions were expanding. But in the post-Long-Term Capital Management bailout backdrop, the Federal Reserve was incentivizing long-side speculation, while impairing the bears.
With short positions in "weak hands", a Fed-induced market rally evolved into a powerful short squeeze and precarious bout of financial euphoria. Along the way, myriad hedging strategies combined with leveraged long-side speculation in a bustling derivatives marketplace. As the market broke loose on the upside, those on the wrong side of derivative trades were forced to buy stocks into a frantically advancing market.
Deteriorating fundamentals were easily disregarded, as stocks marched ever higher on an almost daily basis. When the speculative bubble eventually burst, the crisis of confidence in the market was exacerbated by virtually collapsing fundamentals. The gulf that had widened dramatically during financial euphoria was quickly rectified by a panic collapse in stock prices.
Abruptly, buyers disappeared and sellers were left wondering how the liquidity backdrop had been so transformed almost overnight. Well, the liquidity surge from short squeezes and panic covering had set the stage for payback time. Derivatives trading that had helped fuel market melt-up suddenly was fueling meltdown. And as it has accomplished so often in history, financial euphoria ensured that virtually everyone found themselves with too much long (not enough short) exposure come the inevitable abrupt market reversal.
The technology stock crash was then exacerbated by shorts pouncing on what were clearly unsustainable stock prices and a bursting industry bubble.
Investors, the equities marketplace, corporate debt, the technology industry and the US economy were in a much weaker position because of 1999 market euphoria. And at risk of blasphemy, it's worth noting that some of the most sophisticated market operators were punished by a bubble that had somehow burst prematurely.
I don't mean to imply that today's environment is comparable to 1999. The US economy was sounder in 1999 - and the global economy was a whole lot more stable. Global imbalances in 1999 were insignificant compared to the present. The US economic and credit systems had yet to be degraded by a doubling of mortgage debt and a massive misallocation of resources.
The federal government hadn't doubled its debt load in four years. Europe had not yet terribly impaired itself with a decade of runaway non-productive debt growth. China and the "developing" economies had not yet succumbed to historic credit booms, over-investment and economic maladjustment. Central banks hadn't yet resorted to really dangerous measures.
In I>A Short History..., Galbraith so eloquently describes the rebuke and vitriol lavished upon naysayers during periods of financial euphoria. These are the despicable folks who not only dare to challenge conventional wisdom - they simply refuse to accept that they've categorically been proven wrong.
I will temporarily remove the dunce cap and calmly place it over in the corner - and then move to explain that I see nothing in this environment inconsistent with my view that this is the biggest, most precarious bubble in history.
I've briefly addressed excesses that led to the 2000 collapse. Well, there's a bevy of relatively recent (from a historical perspective) booms and busts to compare to: the stock market crash of 1987; the late-eighties Japanese bubble; the 1992/3 bond bubble; Mexico; Southeast Asia; Russia; Argentina, Brazil and Latin America; Iceland; US mortgage finance; European debt, etcetera. Nothing, however, even remotely compares to the current global bubble environment.
From my perspective, the global nature of excesses and fragilities is the most worrying aspect to the current financial euphoria. Essentially, the entire world faces acute financial and economic instability. The entire world suffers from a widening gulf between inflating asset prices and mounting economic vulnerabilities. Seemingly the entire world suffers from an increasingly protracted period of near-zero rates, aggressive central bank monetary stimulus and a desperate search for market returns. The entire global financial "system" is an over-liquefied speculative bubble - stoked by central bankers responding desperately to acute financial and economic fragilities.
As noted above, find a speculative bubble and there will be an underlying source of monetary disorder. From my perspective, bubbles are at their core about a self-reinforcing over-issuance of mis-priced finance. Major market misperceptions are integral to fueling bubbles - and these misperceptions are often associated with some form of government support/backing of the underlying credit financing the boom.
These days, the dynamic of over-issued, mis-priced finance is a global phenomenon - in the US, Europe, Japan, China, Asia and the "developing" economies. The perception that central bankers will ensure ongoing asset inflation is an unprecedented global phenomenon. The collapse in yields and risk premiums in debt markets across the globe is unlike anything I've ever witnessed or studied historically.
These days, asset inflation, speculation and bubbles prevail virtually everywhere. Moreover, the gulfs between inflating assets and weakening economic fundamentals seemingly widen everywhere, as financial euphoria engulfs debt and equity securities markets around the world. As noted last week by the great market watcher and historian Art Cashin: This market is unlike anything we've ever experienced.
The S&P500 jumped 2.1% (up 16.9% y-t-d), and the Dow rose 1.6% (up 17.2%). The Morgan Stanley Consumer index advanced 1.9% (up 23.3%), and the Utilities added 0.7% (up 14.2%). The Banks surged 4.4% (up 19.2%), and the Broker/Dealers jumped 4.6% (up 32.7%). The Morgan Stanley Cyclicals were 1.9% higher (up 18.1%), and the Transports jumped 2.7% (up 23.4%). The S&P 400 MidCaps gained 1.8% (up 18.7%), and the small cap Russell 2000 jumped 2.2% (up 17.3%). The Nasdaq100 increased 1.6% (up 13.8%), and the Morgan Stanley High Tech index advanced 2.3% (up 12.8%). The Semiconductors gained 1.0% (up 22.5%). The InteractiveWeek Internet index jumped 2.9% (up 18.8%). The Biotechs added 0.4% (up 29.7%). With bullion hit for $89, the HUI gold index sank 12.1% (down 44.6%).
One-month Treasury bill rates ended the week at one basis point and 3-month rates closed at three bps. Two-year government yields were up slightly to 0.24%. Five-year T-note yields ended the week up two bps to 0.83%. Ten-year yields increased 5 bps to 1.95%. Long bond yields increased 7 bps to 3.17%. Benchmark Fannie MBS yields jumped 12 bps to 2.69%. The spread between benchmark MBS and 10-year Treasury yields widened 7 to 74 bps. The implied yield on December 2014 eurodollar futures increased two bps to 0.49%. The two-year dollar swap spread increased one to 14.5 bps, while the 10-year swap spread declined about one to 13 bps. Corporate bond spreads were mostly narrower. An index of investment grade bond risk declined 2 to 70 bps. An index of junk bond risk fell 8 to 341 bps. An index of emerging market debt risk rose 3 to 267 bps.
Debt issuance remained extremely strong. Investment grade issuers included Merck $6.5bn, Morgan Stanley $2.0bn, American Express $1.85bn, Toyota Motor Credit $1.5bn, Total System Services $1.1bn, ING $750 million, American Honda Finance $750 million, Fifth Third Bank $600 million, Wynn Las Vegas $500 million, Lorillard Tobacco $500 million, Consumers Energy $425 million, Northern States Power $400 million, Kimco Realty $350 million, Golondrina Leasing $311 million, DDR $300 million, Hershey $250 million, and Nstar Electric $200 million.
Junk bond funds saw outflows of $403 million (from Lipper). Junk issuers included Dish $2.6bn, Tenet Healthcare $1.05bn, Cequel Communications $750 million, AES Corp $750 million, First Data $750 million, Univision Communications $700 million, Select Medical $600 million, DCP Midstream $550 million, Freescale Semiconductor $500 million, SM Energy $500 million, Hawaiian Airlines $450 million, Supervalu $400 million, Murray Energy $350 million, Builders Firstsource $350 million, Bon-Ton Dept Stores $350 million, Magnetation $325 million, Earthlink $300 million, Jefferies Loancore $300 million, Harland Clarke $285 million, SugarHouse Gaming $240 million, Amkor Technology $500 million, Cooper Standard $200 million, Stonemor Partners $175 million and Neehan Paper $175 million.
Convertible debt issuers included Tesla $600 million, Shutterfly $270 million, Ryland Group $250 million and Vivus $220 million.
The long list of international dollar debt issuers included Petrobras $11.0bn, Pertamina Persero $3.25bn, Kommunalbanken $2.0bn, China State Grid $2.0bn, Inter-American Development Bank $1.6bn, Stadshypotek $1.25bn, Sberbank of Russia $1.0bn, Kazagro National $1.0bn, Seagate HDD $1.0bn, Thomson Reuters $850 million, Covidien $750 million, Pacific Drilling $750 million, NII International Telecom $700 million, Far Eastern Shipping $550 million, BRF $500 million, Ukrzaliznytsya $500 million, AGL Capital $500 million, Ukraine Railways $500 million, Barminco $485 million, Alere $425 million, Golden Eagle Retail Group $400 million, and Nitrogenmuvek $200 million.
Italian 10-yr yields were little changed at 3.89% (down 61bps y-t-d). Spain's 10-year yields were unchanged at 4.18% (down 109bps). German bund yields declined 5 bps to 1.33% (unchanged), and French yields fell 10 bps to 1.85% (down 15bps). The French to German 10-year bond spread narrowed 5 to 52 bps. Ten-year Portuguese yields dropped 21 bps to 5.17% (down 158bps). Greek 10-year note yields sank another 130 bps to 8.06% (down 242bps). U.K. 10-year gilt yields slipped a basis point to 1.88% (up 6bps).