Risk assets continue to rally as investors chase everything that moves in the quest for yield; we’ve seen this movie before and it doesn’t end well
“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” – Alan Greenspan, December 1996
It’s been a very strange few days. Everywhere you look, risk assets are hitting new highs – like the final squeeze is on and investors are grasping at straws. Are we in the final days of bull market? I wish I knew the answer; if I did I’d be running a hedge fund in a paradise tax haven. However, it certainly feels to me like the markets are becoming frothy and others might say “irrationally exuberant”. Call me crazy, but I’m going to ring the bell calling the top of the equity markets.
Step forward exhibit one. Last week, Macquarie Group printed USD750m Additional Tier 1 notes (otherwise known as a CoCos, contingent convertibles, or hybrids) at 6.125%. Bloomberg reported that the demand was about USD12bn and the initial price talk was about 7%. According to the article, more than 500 investors were trying to get their paws on the bonds. This succinctly highlights the insatiable appetite for risk at almost any price.
Exhibit two is this chart from Bloomberg that asks, “are junk bond yields getting ahead of themselves?”
This chart shows the very normal spread compression – between CCC (Caa) and BB (Ba), and BB (Ba) and B (B) – that occurs when positive sentiment rises; investors require less additional yield/return to move down the credit spectrum. However, at some stage this will usually reverse, especially as the chart indicates credit fundamentals aren’t improving, with net leverage remaining relatively high at approximately 4.0x.
Our clients, both institutional and private, have plenty of cash to invest – but given the recent rally it can be argued that the high yield rally has gone too far.
For exhibit three we note the S&P500 price earnings ratio is currently expensive on a historical basis - trading over 19x, a level not seen since the dotcom boom and bust. Now, there are reasons why this may persist for a while – share buybacks and potential M&A activity – but history shows that over time it will typically revert to the median (16.5x from 1999 to 2017).
Lastly, exhibit four saw the Dow hit its twelfth record close last week, which is its longest streak since 1987. Those with long memories will know what happened in 1987, but for those who don’t, take a look at Figure 2: There was a 36% correction.
All I’m saying is that we’ve had a good run – and profits have been made – so maybe now is the time to show some caution. At the very least, we need to acknowledge how far and how quickly we have come.
“Caution is preferable to rash bravery.” – Falstaff, part one of King Henry the Fourth, William Shakespeare