Risk in the markets has ballooned - blame private debt and equity

There will be a seismic event. When it hits and how hard is impossible to predict.

via Alamy/ CXNK1X

There is an old adage – the City and Wall Street are paved with old adages – that if you look around the table and you can’t see the fool, then you’re the fool. On Monday, the S&P500 closed for a second successive day on a new all-time high of 6,204.95 pts and the bulls are dancing in the aisles.

One of my recent play days on Friday took me to London where I ran into an Australian reader. He is a commodities hedgie who commented on my having recently written little about markets and plenty about politics. I asked him whether he himself had any strong views on markets which he agreed he did not have. Bingo! Yesterday, I was back in the Big Smoke to meet up and have lunch with the Chief Investment Officer of the investment firm on whose investment committee I serve as an external advisor. As it was the last day of the first half of the year and the quarterly meeting is around the corner – happy Q3 by the way - it was a very appropriate time for a catch-up and an informal exchange of views

Back to the fool at the table. Markets have a habit of focusing on data that supports the direction in which it is going, shamelessly disregarding releases that don’t match the mood. Another City chum kindly furnished me with an article from The Coastal Journal – not a publication with which I have been as far as I can remember previously acquainted – which looks at some of the miserable underlying economic data and asks how it can be that the economic bears are right but so are the market bulls. In the article, the writer points to Michael Lewis’s epochal work “The Big Short” which tells the story of some of those who ahead of the GFC saw the rapidly declining US mortgage market and who struggled to keep their bets on an imminent collapse. Who will ever forget Citibank’s CEO Chuck Prince and his catastrophically mistimed July 2007 assertion: “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance.”

The article runs through a list of statistics which would, were US stock markets not in a state of hubris, have the peasants fleeing the valley for the safety of the castle on the hill. Thus the writer observes: “Beneath the surface of this market rally lies undeniable madness—textbook signs of a speculative bubble accelerating at full speed. The gains aren’t being driven by strong fundamentals or real earnings growth, but by euphoric bets on hype-fuelled “meme” stocks with little to no profitability via call options. Shake Shack, a fast-food burger chain, is now trading at an eye-watering P/E ratio of 472—meaning investors are paying $472 for every $1 of earnings, a valuation more befitting a breakthrough company that discovers a cure for cancer than a business flipping burgers and selling $1 sodas. CrowdStrike has surged by 45% year-to-date despite NEGATIVE earnings of -$0.69 per share, and therefore no price-to-earnings ratio at all. Meanwhile, CoreWeave, which only went public in April is up over 300% despite reporting a staggering loss of -$2.54 per share – again, with NO P/E ratio because there are NO profits to speak of. When unprofitable companies triple in value and burger joints command valuations more absurd than dot-com stocks ever did, it’s not a market climbing on strength – it’s a bubble built on delusion”.

The author is of course not wrong but treating a clutch of meme stocks as a pars pro toto for the entire stock market might be pushing the boat out a tad too far.

What isn’t is when he looks at some of the more fundamental economic data and asks how, in light of such troubling weakness, the dancing is going on irrespective. The tariff regime might still be a work in progress but there is little doubt that it will in one shape or the other have a fairly fundamental impact on the US and the global economy. The article points to faltering trade, both in terms of US imports and exports. It also notes that new home sales have declined sharply, in May down by 14% annualised. There are of course arguments that any declines are only temporary and that in time the backlog will be made up by a string of above average monthly figures. Sceptics fear that the noise coming from the White House is specifically targeted at drowning out negative releases and that the ongoing sniping at the person of Fed Chairman Jay Powell is intentionally aimed at undermining his opinions and decisions concerning the conduct of US monetary policy.

The article cites a scad of poor statistics and wonders how it can be that stock markets don’t appear to have a care in the world. It is of course not entirely so. In the canon of adages can be found Peters’ Second Law. Peters’ First Law, the one that holds that risk is like energy, it can be converted but not destroyed, has been in and out quite a lot of late, especially as defaults in the commercial real estate sector are mounting but Peters’ Second Law has not had an airing for quite some time. It holds that nobody has ever been fired for being long of a falling market but that being short of a rising one is a career threatening error. Let me explain.

Around 90% of investors don’t look at 90% of their portfolios. They look at the number at the beginning of the reporting period, be that weekly, monthly or quarterly, and they want to see two things. The first is for the bottom figure to be bigger than the one at the top and a line from their investment managers confirming that they have outperformed their benchmark. That makes them happy. When markets fall, investment managers cannot but shrug their shoulders and it is hard for their clients to pinpoint what it is that they missed. Look at the risk appetite profiling that is undertaken periodically by investment managers and you’ll get the point. The risk of being long of a falling market is in the mandate without ever being mentioned. Why would it be? It is of course also emotionally much easier for clients to track their portfolio performance in a rising market than in a falling one. A fund manager can always take credit for what is in the portfolio that is going up but it’s hard to quantify the success of not holding what is going down. The net upshot is that in modern portfolio theory long is the new neutral.

There is another phenomenon that is rarely spoken of and that is the growth of the private markets. My dislike for them, debt even more than equity, is no secret. Much has been written about the dearth of IPOs and of the private equity firm’s struggle to exit many of their investments in the public market which is about what the private equity game is supposed to be. We are not quite in the state we were in 25 years ago where no publicly listed company was safe from corporate raiders as private equity firms used to be known who could for a while take out more or less any listed company they chose to, strip it down and flog it off again in several individual IPOs. The Barbarians really were at the gate. But each time a company is delisted from the public market, the universe of investments available to such investors who can for regulatory reasons not hold private and unlisted securities shrinks. Demand exceeds supply, prices rise.

Private debt and equity firms are not fools and have discovered that the best way out is to list their funds. If that isn’t the devil handing out free tickets to the Inferno what is for the key to a listed security is its accurate mark to market. The entire private debt and equity business is built on not having to mark to market. The Australian government is by all accounts toying with the idea of taxing unrealised capital gains. I am not acquainted with the details of the discussion paper, but I’d love to see how private and non-listed assets will be valued. High to prove how clever the private buyer has been or low in order to avoid a large tax liability? I digress.

An interesting measure to be looked at is the Nasdaq Oscillator. It summarises not only how the index as a whole performs but also at how many stocks in the index are participating in the rally. Is the rally broad-based or are just a few stocks whipping and driving it? I barely need to go on. There is enough economic and price action related material available that questions how and why markets are still hubristic. At the same time, however, and no matter how sceptical many professionals are with respect to the high price of financial assets, Peters’ Second Law applies. The one rotten apple in the barrel is the low volumes and limited liquidity within markets. Enter, stage left, J. Peter Steidlmayer, a commodities trader on the Chicago Board of Trade who tracked not only what prices were paid but how often the same price was paid. In other words, he tried to track to volumes at which certain prices traded which would then permit him to establish at what price market participants were most comfortable. His method was known as market profiling. I won’t bore you with the gory details. The Nasdaq Oscillator similarly tries to look not only at the what but also at the how and the why.

The total market cap of the Nasdaq Index is a tad above US$ 35.5 trillion and contains 3,324 stocks. The top five stocks are Nvidia, Microsoft, Apple, Amazon and Alphabet Inc. Their joint market cap is just above US$ 15 trillion. Continue on to the top 10, adding in the likes of Meta and Tesla and the joint market cap is US$ 22 trillion. The other 3,314 stocks between thar are priced – worth is a dodgy description – at US$ 13.5 trillion between them.

The upshot of the Coastal Journal article is that the author believes the stock rally to be standing on a platform of melting ice. Knowing what is likely to happen is easy. Knowing when it will happen is a different matter entirely and as my CIO pointed out at lunch yesterday, the opportunities missed by sitting on the sidelines waiting for the dip can be painfully expensive. As a cub banker in the foreign exchange department at Barclays International in Zurich in the late 1970s, I used to join the senior guys as after work they made their way to a bar by the name of Petit Prince where the forex community congregated for beers and boasting. It was there that I learnt at an early stage that those who made most noise about having picked the top and the bottom of the day regularly had the least impressive P&Ls.

Although post-GFC regulation has kept the banks relatively honest and the risk on their balance sheets contained, the aggregate quantity of risk in the markets as a whole has ballooned and much of that is lurking in private debt and equity. Irrespective of how much is written, and not only by myself, about the problems residing in the darker corners of both asset classes, pension funds’ and insurance companies’ enthusiasm seems broadly undiminished. There will be a seismic event. When it hits and how hard is of course impossible to predict. Markets have a notoriously short attention span and if it’s not going down it must go up; hence my observation above that long is the new neutral.