The Heroic Assumptions Behind The Current Stock Market Rally

It’s fascinating to watch our stock market here in the US rally back near its all-time highs even as other major markets around the globe remain well below their own. As CBS News reports:

America’s stock market rally stands alone. Markets around the planet are much less ebullient, with the MSCI World Index (minus the U.S.) down nearly 15 percent from its high last summer. That suggests caution is warranted.

Why would that warrant caution? Well, let’s take a look at what’s driving the run higher here at home yet failing to inspire investors abroad. FT reports:

It’s all about the second half of the year. Forget the troubling signs that asset prices have rebounded sharply on the back of no real improvement in underlying fundamentals. There appears plenty of faith in the idea that bad debts related to the energy sector are contained and that the present S&P 500 earnings recession will fade, justifying rising valuations by the end of the year.

Those are some pretty optimistic assumptions, in my view (see this and this). What FT doesn’t mention but I believe is also built into investor assumptions at this point is that the US will be able to avoid being pulled into a global recession, a growing possibility reflected in the prices of global equities.

Historically, it appears that equities around the world regularly cycle together. As we become more of a globalized economy with each passing year, this makes perfect sense. And if we enter a global recession, driven by weakness in these other countries, it might be heroically optimistic to believe the US can avoid a similar fate.


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Investing, Trading

Trader Mentality Interview

I recently did an interview with Trader Mentality in which I discuss my personal investing discipline and the major influences who helped me develop and continue to shape it. I also share some advice for those new to the markets:

Economy, Investing, Markets

More Signs Of A Possible Reversal In The ‘Wealth Effect’

A couple of weeks ago I proposed the idea that the Fed’s efforts to stimulate a wealth effect in recent years could now be at risk of a reversal. There are growing signs that the ultra-wealthy in both Silicon Valley and on Wall Street are beginning to feel a bit of a pinch on their massive pocketbooks.

Maybe the best sign I’ve seen recently is in a new bond issue from Spotify. The company decided to issue debt rather than equity in order to avoid a down round that would be discouraging to the company’s equity investors. However, the terms of the deal are so onerous that it’s very possible it may hurt the company’s equity investors even more than a new equity offering would have. I would be hard pressed to find a better anecdotal symbol of the shift we are now seeing in risk appetites toward both startups and corporate debt.

Certainly, Spotify is not alone in seeing pressure on its equity valuation. Most unicorns now find themselves in that unenviable position.

And their investors have to be feeling a bit less optimistic about their ability to realize their gains as prices begin to reverse and the public market begins to shun them like never before.

This is only reinforcing the cycle of risk aversion in the sector.

Even Google, it seems, is now succumbing to the broad change in sentiment.

As I wrote in the earlier piece, this weakness in Silicon Valley appears to be taking a toll already on the high-end real estate market there. It’s probably only a matter of time before this is reflected in the broader real estate numbers.

The shut down of the IPO market not only hurts Silicon Valley, it hurts Wall Street, as well. And there’s another force working against these fat cats’ bank accounts: The market for mergers and acquisitions. Between the IPO and M&A markets, investment banking fees look to be hammered recently.

In the prior piece, I highlighted the slowing market for high-end homes in the Hamptons as a reflection of this weakness on Wall Street and as a clear risk to the wealth effect. We are now seeing a very similar pattern in the city, as well.

This sort of weakness is also showing up in high-end Miami condos that recently sold for as much as $850 per square foot. No longer.

And that other financial capital across the pond is also starting to see its high-end real estate market begin to weaken in very similar fashion to the Hamptons and Manhattan.

As I wrote last time:

If the Fed’s efforts in recent years were primarily focused on creating a, “wealth effect,” to stimulate the economy, they should be increasingly concerned now to see these growing signs of a reverse, “wealth effect.” Because if the economy does operate from the top down, as this theory proposes, these could be very important leading indicators.

Is the Fed paying attention? I would guess so and this could be one reason why we recently saw one of the most dovish Fed meetings in history.

Economy, Investing

How The ‘Wealth Effect’ Could Now Shift Into Reverse

A couple of weeks ago I wrote a post asking, “is this the real estate ‘echo bubble’?” Today, it looks like this potential ‘echo bubble’ may be in the slow-motion process of popping.

High-end real estate in the Bay Area is starting to show real signs of weakness.

This is mainly due to the fact that the startup boom, which created a massive wealth effect in the area, looks to be in the process of peaking and rolling over. Many large investors have been writing down the value of their startup investments for months now and new investment in the space is drying up. It only makes sense, then, that real estate prices, which benefitted from the boom, would now begin to suffer accordingly.

At the same time we are now seeing weakness in another ultra-high-end market. The most expensive segment of homes in the Hamptons is seeing pressure on prices as sales begin to slow and inventories rise.

Similar to the slowdown in Silicon Valley, the weakness in the Hamptons can largely be attributed to the slowdown on Wall Street. Trading revenue in the first quarter has been disappointing, negative interest rates around the world pose a unique challenge to banks, and hedge funds are finding it very difficult to profit in the current environment. All of this adds up to pressure on prices of the most valuable homes in the Hamptons.

I should also note that all of this fits with what we have recently heard from some other companies serving the ultra-wealthy like Sotheby’s. The auction house has seen a dramatic slow down in business recently with at least one large buyer becoming a forced seller.

And If the Fed’s efforts in recent years were primarily focused on creating a, “wealth effect,” to stimulate the economy, they should be increasingly concerned now to see these growing signs of a reverse, “wealth effect.” Because if the economy does operate from the top down, as this theory proposes, these could be very important leading indicators.

Economy, Investing, Markets

Margin Debt’s Message For Investors Couldn’t Be More Clear

The January margin debt figures were released earlier in the week and there are a couple of interesting things to note. First, though it is still very elevated, margin debt-to-GDP has now fallen to its lowest level in over two years.

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I prefer to look at this measure rather than the aggregate level of debt on its own because this ratio is highly correlated to future 3-year returns in the broad stock market.

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There are only two prior occasions where margin debt-to-GDP rose above 2.5% and then fell to a 2-year low. Those were March of 2001 and October of 2008. Now it’s hard to glean anything from just two prior occurrences but they would suggest, at a minimum, that we are at risk of falling into another major bear market if we haven’t done so already.

To explain, I view margin debt as one of the best indicators of potential supply and demand for risk assets, namely stocks. Very low levels of debt suggest there is a great deal of potential demand for equities out there should investors feel inclined to borrow and buy. Early in a period of rising risk appetites, this can be a very bullish catalyst for higher equity prices.

Conversely, very high levels of margin debt suggest just the opposite. Should investors feel inclined to buy they have very little ability to borrow more to do so. However, during a period of risk aversion, high levels of margin debt suggest there is a great deal of potential supply that could come to market. It makes no difference if this potential supply becomes real supply as a function of investors own volition or at the insistence of their brokers it always means the same thing: rapidly falling prices.

The trend in risk appetites, then, is the key to this supply/demand puzzle presented by margin debt. The fact that the major equity indexes are below their 200-day moving averages and corporate spreads have been widening for nearly two years suggests the trend in risk appetites has shifted from risk seeking to risk aversion. And this is now confirmed by the trend in margin debt. Because margin debt as a percent of economic activity is now reversing lower from the highest level recorded over the past few decades, the “risk” in risk assets like equities may be as high or higher today than any other time during that span.

And speaking of credit, my friends over at Hedgopia discovered another fascinating correlation this week between the trend in margin debt and that in commercial lending:

Turns out, margin debt tends to strongly correlate with U.S. banks’ commercial & industrial loans. In fact, R between the two over the last 35 years is 0.96 (Chart 3). Damn tight!


As noted in the chart above, margin debt peaks have led peaks in commercial lending by about a year. The absolute level of margin debt peaked April of last year. If this relationship holds, commercial lending should begin to peak any day now. And we may already be seeing signs of the peak right now.

As the economy has become even more finance-centric in recent years, it only makes sense that credit, which drives both asset prices and economic activity, would be correlated in this way. And the message for investors couldn’t be more clear: Pay very close attention to the larger credit cycle.