Category Archives: asset bubbles

15/6/18: Italian High Yield Bonds and Markets Exuberance

Nothing illustrates the state of asset valuations today better than the junk bonds tale from Italy. Here is a prime example from the Fitch ratings note from June 7:

"...longstanding Italian HY issuer and mobile operator WindTre sequentially refinanced crisis-era unsecured notes at 12% coupons into 3% area coupons by January 2018, despite losing cumulative revenue and EBITDA of 30% and 25%, respectively, and re-leveraging from 4x to 6x."

Give this a thought, folks:

  1. We expect rates to rise in the future on foot of ECB unwinding its QE, the Fed hiking rates and monetary conditions everywhere around the world getting 'gently' tighter;
  2. Euro is set to weaken in the longer run on foot of Fed-ECB policies mismatch;
  3. WindTre issues replacement debt, increasing its leverage risk by 50%, as its revenue falls almost by a thirds and its EBITDA falls by a quarter;
  4. WindTre operates in the market that is highly exposed to political risks and in an economy that is posting downward revisions to growth forecasts.
And the investors are piling into the company bonds, cutting the cost of debt carry for the operator from 12 percent to 3 percent. 

Per FT ( "Lending to corporates rose 1.2 per cent in the year to February 2018, according to the Bank of Italy, and the average interest rate on new loans was 1.5 per cent — a historic low."

Say big, collective "Thanks!" to the folks at ECB, who worked hard to bring us this gem of a market, so skewed out of reality, one wonders what it will take for markets regulators to see build up of systemic risks.

7/4/18: Markets Message Indicator: Ouuuuch… it hurts

An interesting chart from the VUCA family, courtesy of @Business:

'Markets Message Indicator', created by Jim Paulsen, chief investment strategist at Leuthold Weeden Capital Management, takes 5 different data ratios: stock market relative performance compared to the bond market, cyclical stocks performance relative to defensive stocks, corporate bond spreads, the copper-to-gold price ratio, and a U.S. dollar index. The idea is to capture broad stress build up across a range of markets and asset classes, or, in VUCA terms - tallying up stress on all financial roads that investors my use to escape pressure in one of the asset markets.

Bloomberg runs some analysis of these five components here: And it is a scary read through the charts. But...

... the real kicker comes from looking back at the chart above. The red oval puts emphasis on the most recent market correction, the downturn and increased volatility that shattered the myth of the Goldilocks Markets. And it barely makes a splash in drawing down the excess stress built across the 'Markets Message Indicator'.

Now, that is a scary thought.

22/10/17: Leverage risk and CAPE: Why Rob Shiller Might Be Wrong

Rob Shiller recently waxed lyrical about the fact that - by his own metrics - the markets are overpriced, yet no crash is coming because there is not enough 'leverage in the system' to propagate any shocks to systemic levels.

The indicator Shiller used to define overpricing is his own CAPE - Cyclically Adjusted PE Ratio - and the indicator does indeed flash red:

CAPE is defined by dividing the S&P 500 index by the 10-year moving average of index components' earnings. The long-run average of CAPE is 16, and the index currently sits above 31, making the current markets valuations trailing those of the bubble peak (using recent/modern comparatives).

So the markets are very expensive. But what Shiller says beyond this mechanical observation is very important. His view is that these levels of valuations are 'sustainable' in the medium term because there is very little leverage used by investors in funding these levels of stock prices. In the nutshell, this says that if there is any major correction in the markets, investors are unlikely to be hit by massive margin calls, triggering panic sell-offs. So any correction will be short-lived and will not trigger a systemic crisis.

All fine with the latter part of the argument, if we only look at the stock market brokerage accounts leverage, ignoring other forms of leverage.  And we can only do this at a peril.

Investor is a household. Even an institutional one, albeit with a stretch. When asset prices correct downward, income received by investors falls (dividends and capital gains are cut) and investor borrowing capacity falls as well (less wealth means lower borrowing capacity). But debt levels remain the same.  Worse, cost of funding debt rises: as banks and other financial intermediaries see their own assets base eroding, they raise the cost of borrowing to replace lost income and capital base with higher earnings from lending. Normally, the Central Banks can lower cost of borrowing in such instances to compensate for increased call on funds. But we are not in a normal world anymore.

Meanwhile, unlike in the bubble era, investors/households are leveraged not in the investment markets, but in consumption markets. Debt levels carried by investors today are higher than debt levels carried by investors in the and pre-2007 era. And these debts underwrite basics of consumption and investment: housing, cars, student loans etc (see Which means that in an event of any significant shock to the markets, investors' debt carry costs are likely to rise, just as their wealth is likely to fall. This might not trigger a market collapse, but it will push market recovery out.

An added leverage dimension ignored by Shiller is that of the corporates. During the crises, cash-rich and/or liquid corporates can compensate for falling asset prices by repurchasing stocks. But corporates are just now completing an almost decade-long binge in accumulating debt. If the cost of debt carry rises for them too, they will be the unlikely candidates to support re-leveraging necessary to correct for an adverse asset prices shock.

I would agree with Shiller that, given current conditions, timing the markets correction is going to be very hard, even as CAPE indicator continues to flash red. But I disagree with his view that only margin account leverage matters in propagating shocks to a systemic level.