Home > Behavioral, Bond Market, Credit Spreads, Investing, Stock Market > Signs of a Top, OR that I am a Grumpy Old Man

Signs of a Top, OR that I am a Grumpy Old Man


I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.

This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.

That’s borderline crazy.

It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.

There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:

  • In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
  • In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.

It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.

After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.

Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.

I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.

I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.

However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.

  1. CharlesD
    June 20, 2018 at 11:02 pm

    Michael not everything is frothy e.g. consumer debt burden (payments) to disposable income is near a 40 year low. Business investment still low. Both ot these almost always pick up prior to a recession/bear market. Never, to my knowledge, have fiscal deficits been increasing meaniingfully at this stage of the expansion. But because of tax cuts, spending increases and demographics – apparently trillion dollar deficits are ahead – up from $700-800MM. As you know, perhaps 70-80% of the higher deficits feed right into profits. I believe profits run around a couple of trillion in total – so that’s a big boost.
    In brief, yes, a bit late to get too bullish. At the same time, though, may be a bit early to
    get too bearish. Just my opinion which, of course, is worth its cost!

    • June 21, 2018 at 8:20 am

      Thanks Charles. Yes, the tax cut fed into profit growth…but that’s all past now! However, you may well be right. Although I will also say that the market almost never begins its decline when everyone knows there’s a recession. It almost always begins prior to the recession being generally perceived, and usually before there are any overt signs of it. So I’m not sure we’ll get a bell ringing at the top.

  2. CharlesD
    June 21, 2018 at 5:37 pm

    Michael thanks. My point on the deficits is that they may continue to grow in the next couple of years so not necessarily all in the past. You are definitely right though. When the bull market tops, there will no apparent reason – at the time – to get out. Best

  1. June 24, 2018 at 8:13 am

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