Retailing in America: Game Theory in Reverse

Game Theory, Danielle DiMartino Booth, Money Strong, Fed Up

Toro, toro? Hankering for Hamachi?

Have an urge for uni? In Midtown? Well then, head west, to 8th Avenue to be precise. And keep walking, west that is. But go easy on the sake if you’ve got a sushi crawl in mind. No fewer than six fine purveyors of some of the best raw fish on the isle of Manhattan await you. Clearly the law of game theory applies to more than just clusters of gas stations.

Not sure you’d agree, but game theory made the study of economics engaging. The brain teaser’s roots date back to the 1920s with the work of John von Neumann. His work culminated in a book he co-wrote with Oskar Morgenstern which delves into the oxymoronic theory in its most straightforward form – a ‘zero-sum’ game wherein the interests of two players are strictly opposed.

But it was John Nash who elevated the theory to fame. The eminent Nash Equilibrium added practicality to the theory and opened the door to nuance. The ‘players’ were numerous and shared both common interests and rivalries. Hence six sushi spots in one square block and a handful more a few steps in either direction.

But what happens when game theory hits reverse gear? Is such a thing possible? The answer may be coming soon to a mall near you, maybe even one with its theatre and Sears still standing. Huh?

Developed in 1973, Valley View Mall rose to be a retail darling on the 1980s Dallas shopping scene. Even its name worked well with an iconic mall-era film (Why Valley Girl, of course! (Retailing in America:  Valley Girl (Interrupted) Foley’s, Macy’s Bloomingdale’s anyone? All of these icons anchored Valley View at one point or another.

But that was then, in a pre-Amazon world, when people clearly got out more and discretionary spending was more discrete. In December 2016, the mall literally began to be bulldozed, albeit with two tenants still operating amidst the dust storm – Sears and AMC Theatres. On March 21st, the world learned that it could soon be just the theater left standing.

Though the Valley View Sears will still be open today from 11 am to 8 pm, odds are the retailer will not be with us in a year’s time. On March 21st, Sears Holding Corporation submitted a filing with its regulators that it has “substantial doubt” it can continue as a “going concern.”

Don’t recall companies being charged with making their own death throes’ announcements from your Accounting coursework? You are correct. Meet the new and improved U.S. accounting rules that have just come into effect for public companies reporting annual periods that ended after December 15, 2016, Sears included. The change shifted the onus to disclose from a given company’s auditors to its management.

It was telling that the Sears news fell on the very same day discount retailer Payless announced it could soon file for bankruptcy protection. That same day, the less ubiquitous Bebe female fashion chain said it too was ‘exploring strategic options,’ typically code for that same ill-fated Chapter in the court system.

Did Sears strategically time its disclosure? Not in the least according to the retailer’s CFO Jason Hollar. The day after the disastrous disclosure, he blogged out that the ‘going concern’ reference simply complied with regulators’ requirements that investors be apprised of any risks looming over the horizon. Hollar went so far as to say that Sears is a, “viable business that can meet its financial and other obligations for the foreseeable future.” Don’t shoot the messenger, but selling Craftsman, the last valuable jewel in the once encrusted crown, certainly doesn’t suggest that much of a ‘future.”

Unless, that is, the reassurances come down to CEO Edward Lampert trying his level best to play game theory in reverse. That would entail capitalizing on the dying chain’s real estate holdings before the rest of the players on life support clue in to just how dire the situation will soon be across the full commercial real estate spectrum. Lampert does, after all, run a hedge fund that happens to be the retailer’s second-largest shareholder. You would agree, the best managers excel at games.

One does have to marvel at the degree of denial among retailers when websites such as deadmalls.com actively track shuttering structures.

At the opposite end of the denial spectrum sits Boston Fed President Eric Rosengren, who is and has been publicly worried about an entirely different sort of challenge facing the real estate market.

It’s no secret that apartment prices are soaring. Over the past year, prices have risen 11 percent, leading the broad market. While that increase may seem benign in and of itself, consider how the sector has fared over the course of the recovery: prices have recouped an eye-watering 240 percent of their peak-to-trough losses. In sharp contrast, retail has performed the worst; it’s only recovered 96 percent of its losses.

Rosengren is rightly worried that the “sharp” increase in apartment prices could catalyze financial instability. He went on to say that, “Because real estate holdings are widespread, and the monetary and macro-prudential tools for handling valuation concerns are somewhat limited, I believe we must acknowledge that the commercial real estate sector has the potential to amplify whatever problems may emerge when we at some point face an economic downturn.”

If you would indulge a translation: The bubble in commercial real estate (CRE) could trigger systemic risk, which of course, no central bank can contain.

The ‘macro-prudential’ tools to which Rosengren refers include rules and caps on banks’ exposure to CRE. Odds are, however, that the horse has already fled the barn. Over the past five years, CRE lending has been running at roughly double economic growth, a dangerous dynamic. The result: banks’ exposure to CRE has reached record levels. Last year alone, bank holdings of CRE and multifamily mortgages rose nine and 12 percent, respectively.

More worrisome yet is that the most concentrated cohort – those with more than 300 percent of their risk-based capital at risk – is banks with less than $50 billion in assets; most have assets south of $10 billion. How exactly will small banks confront a systemic risk conflagration? That pesky potential presumably is what’s robbing Rosengren of sleep at night. He might just remember that small German lenders called Landesbanks were where subprime bombs detonated unexpectedly way back when.

Beginning to connect the dots? All of this lending has led to massive amounts of building. After troughing at an annualized rate of 82,000 units in late 2009, multifamily starts hit a 387,000-annualized rate last year – a neat 372 percent rebound. Permits data suggest 2017 will push an equal number of units onto the market while 2018 looks to be about three percent below these lofty decade-high levels. There are similar supply stories in the hotel sector, which has led to the beginning of the end for lodging. Indeed, prices across the full CRE market have begun to fall for the first time since 2009.

Take all of these moving pieces into account and ask yourself, is it any wonder retailers are rushing the exits, all but falling over one another to accelerate announcements of thousands of store closures? As ugly as the situation is today, if widespread panic promises to present itself, prospects for retailers will get that much nastier. Demolition specialists will soon forget what it was to have down time and headlines screaming about malls sold for $1 will lose their novelty.

Is Sears’ Lampert craftily capitalizing on a trend he saw coming first, giving new meaning to ‘first mover advantage’? Is retail on the receiving end of reverse game theory? John Nash would be so proud.

The American Dream: An Endangered Ethos

Few words are slipperier than ‘ethos’ to grasp.

Even the best translation of the word – essence – is hard to get your arms around. Perhaps that is why so many of us were blissfully unaware until recently that the very essence of the American Dream was slipping through our fingers. Though the phrase, which captures the very, yes essence, of the American thirst for adventure, dates back to the hopes and spirit that emboldened prospectors to ‘Go West,’ those who first engaged in California Dreaming, it was James Truslow Adams’ popularization of the term that cemented the ideal into our collective psyche.

“But there has been also the American Dream, that dream of a land in which life should be richer and fuller for every man, with opportunity for each according to his ability or achievement. It is a difficult dream for the European upper classes to interpret adequately, and too many of us ourselves have grown weary and mistrustful of it. It is not a dream of motor cars and high wages merely, but a dream of social order and in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable, and be recognized by others for what they are, regardless of the fortuitous circumstances of birth or position.”

It is sweeter still, in the annals of our proud U.S. history that these words were written in 1931, during the thick of the most ravaging economic devastation this country has ever known. And still hope defeated despair, reigning supreme, inviting the lowliest of street urchins to achieve greatness in this country of endless possibilities. Were that only still the case today.

The housing crisis has long stopped commanding headlines. According to ATTOM Data Solutions, the new parent company of RealtyTrac, default notices, scheduled auctions and bank repossessions slid to 933,045 last year, the lowest tally since the 717,522 reported in 2006. Is the final chapter written? Not if you live in judicial foreclosure states such as New York, New Jersey and Florida where ‘legacy’ foreclosures take years to clear. At the end of last year, 55 percent of mortgages in active foreclosure were originated between 2004 and 2008. Factor in what’s still in the pipeline and one in ten circa 2006 homeowners will have lost their homes before it is all said and done.

That helps explain one part of the chart below which was generously shared with me by one Dr. Gates. Longtime readers of these missives will recognize the nom de plume of my inside-industry economic sleuth. His first take on this sad visual, was that, “The heart of the American Dream has stopped beating.” Did that stop your heart as it did my own?

As you can see, after a steady 40-year build, owner-occupied housing has stagnated and sits at the lowest level since 2004. This has sent the homeownership rate crashing to 63.4 percent, the lowest since 1967. It would be nice to think that things were looking up for would-be homeowners. But it’s difficult to be overly optimistic when the local newspaper reports that house flipping in the Dallas-Ft. Worth area rose 21 percent in 2016, seven times the national rate.

In all, 193,000 properties nationwide were flipped for a quick inside-12-months profit last year, a 3.1 increase to a nine-year high. Moreover, the median age of a flipped home rose to a two-decade high of 37 years, about double the median age of homes flipped before the crisis hit. That translated into a median gross profit of $69,624 on a median selling price of $189,900 in 2016, a neat 49.2 percent margin, the highest on record. Awesome!

That is, unless we’re still talking about the American Dream. But then maybe homeownership isn’t all it’s cracked up to be.

At least you can still hang a shingle in this country. Right?

You may note that the decline in self-employed is appreciably more dramatic than the fade among the ranks of owner-occupied homes.

You see, it took more than even the cruelest recession to wipe out two decades of ingenuity, to decimate a trend, to shift a culture. Think of the financial crisis as merely the initial catalyst, the first nail in the coffin.

Then came access to capital, which was dealt a once in a century body blow. Seemingly overnight, credit cards and home equity lines of credit disappeared as a source of operating income. Arguably these two growth governors spread the lack of wealth evenly across the country. But it was the heartland that suffered the most as the number of community banks in the six years ending 2013 sank by 14 percent. Federal Reserve data found that this shrinkage resulted in a 40 percent decline in the number of people with access to community banks. (No, Dr. Bernanke, zero interest rates do not benefit the little guy. They just make it cheaper to borrow for those who have never and never will lose their entree to the credit markets.)

Note that neither ‘Dodd’ nor ‘Frank’ were mentioned in that last paragraph. The awful Act did indeed further impinge access to credit, but let’s say that falls under a different heading, the most insidious of the plagues unleashed on small businesses.

To that end, it’s the last nail in the coffin, the one that’s left behind the most difficult stain to eradicate, as we are beginning to find out the hard way as the GOP tears itself asunder on the public stage. Of course, we speak of the imposition of a regulatory burden that knows no precedent. It’s all but inconceivable to fathom an additional $100 billion in annual regulatory costs but that’s the reality, the legacy of the last administration.

More than anything else, even the Federal Reserve’s assigning of the have’s and have not’s among us, this suffocation of the ability to succeed that raised the hackles of middle-income Americans, bitter that they’ve lost the right to what once was every American’s birthright. The hope is that the nascent rebound off 2014 lows in self-employment continues as red tape is rightly slashed back to where it belongs, that is countries where capitalism doesn’t exist, that the 40-year low in new business formation is squarely in the rearview mirror. The prayer is that recession is not around the corner, an unwelcome development that would undo what little progress has been made.

“My hope is for our current President to turn this tide. Lord knows the last President didn’t do anything to get us back on track, and neither did the Fed,” Dr. Gates observed. “At least we still have baseball, hot dogs and apple pie.”

It goes without saying, ‘tis the season for all three of those National Treasures. Thank you, Dr. Gates.

As for yours truly…shall we dispense with the niceties for just a moment? Like it or not, part of what’s happened in housing is a natural Darwinian outgrowth of the ridiculous zero interest rate policy that’s set profit-seeking scavengers on one another. What we’re witnessing is a mere reflection of a world in which rational investments have been whittled down to nothing.

Still, might we at least raise an eyebrow to the schadenfreude that’s infected the housing market? Should we truly take pride in crowding out those who would rather own than rent a home in the name of hard-to-come-by profits in a low rate world? And what good have we done, allowing our feckless politicians to snuff out a proud history of entrepreneurship that put our country on the map? Will the one percent be capable of lifting all boats, or even care to do so, in order to reestablish our national pride?

It was later in life that James Truslow Adams placed a punctuation mark on his written legacy with the following:

“The American dream, that has lured tens of millions of all nations to our shores in the past century has not been a dream of merely material plenty, though that has doubtlessly counted heavily. It has been much more than that. It has been a dream of being able to grow to fullest development as man and woman, unhampered by the barriers which had slowly been erected in the older civilizations, unrepressed by social orders which had developed for the benefit of classes rather than for the simple human being of any and every class.”

No more elegant words were ever written to ensure our ethos would never be endangered. And yet it is at risk of extinction today. It is high time we stand up for what is rightly ours and take back the American Dream for one and for all.

In Case You Missed It

In Case You Missed It, Danielle DiMartino Booth, Money Strong, Fed UpDear friends,

These past two weeks rank among some of the most tumultuous in U.S. postwar history, not just for investors, but every group imaginable save young children who’ve the freedom to not pay attention, much less care. ‘Uncertainty’ has taken on new meaning as the news cycle contracts to a nano-range in which sentiment can turn in the space of a 140-charcater transmittal of an unexpected message.

Into this breach stepped the Federal Reserve on Wednesday. Rather than capitalize on the uncertainty of the moment, policymakers retained their relatively cautious stance, wasting the chance to prepare markets for 2017 being the most aggressive year of tightening in over a decade. Recall that there are but four FOMC meetings followed by a press conference. If FedSpeak can’t jawbone a March rate hike back onto the table, policymakers will have precious little room for error to make good on their promised three rate increases for the remainder of the year.

Of course, ‘data dependent’ remains the mantra. Following Wednesday’s ADP report, and despite the data’s unreliable predictive power, confidence in today’s January labor report skyrocketed. This echoed household’s healthiest prospects for the job market since Reagan was in office. That makes it a good thing headline job growth did not disappoint. Private job creation exceeded estimates by a healthy margin, coming in at 237,000, 62,000 more than expected. Meanwhile the unemployment rate ticked up for the right reason, as more able-bodied workers rejoined the labor force.

The one black eye in the report was wage growth. At 2.5 percent in the 12 months through January, average hourly earnings ticked down from December’s 2.6-percent rate. That’s something of a surprise given the minimum wage rose in 19 states at the start of the year. Add to this what Peter Boockvar pointed out – that 305,000 jobs were lost by those in the 25-54-year cohort. Those ‘prime earning years’ have just not delivered for far too many in the current recovery. Strong wage gains remain the missing link, a subject I will write about in the coming week.

As for the trading week we’re about to log into the history books, it was a very busy one for yours truly in chilly New York. I’ve pasted links to what you might have missed below. As always, your feedback is most appreciated.

With that, wishing you the best for a relaxing weekend. To capture that peace, you might want to pretend we’re back in medieval times and not being endlessly pinged. In other words, unplug, lest you’re constantly jolted back to the new news cycle and our collective newfound restlessness.

All best,

Danielle

Click through:

Debt and Deficits Are About to Matter Again for Investors — Bloomberg  

The Federal Reserve Has Squandered an Opportunity – CNBC 

Live Reaction to Release of Fed Statement — CNBC 

Federal Reserve Policy: The Cash Menagerie

Danielle DiMartino Booth, Money Strong, Fed Up, Cash Menagerie, Newsletter“Yes, I have tricks in my pocket, I have things up my sleeve. But I am the opposite of a stage magician. He gives you the illusion that has the appearance of truth. I give you truth in the pleasant disguise of illusion.” 

The next time you happen to find yourself at 111 West 44th Street in New York’s theater district, make it a point to gaze up at the haunting image of the illuminated sign for The Glass Menagerie, the play that launched the career of America’s greatest playwright. Maybe you too will recall the unsettling opening lines written in 1944 by Tennessee Williams, spoken by his protagonist, Tom Wingfield. Tom’s words promised to deliver the sort of truths few of us covet, though the play’s entertainment value has clearly withstood the test of time.

If you’re of the rip-the-Band-aid-off philosophy on facing life’s unpleasant realities, pivot on your heel and look across the street, to 110 West 44th Street. Your eyes will be immediately drawn to the less mesmerizing, but equally inescapable, signage gracing the edifice of that building, the U.S. debt clock, that live, unrelenting tally that is marching towards $20 trillion, be we all damned.

One must wonder if Broadway’s denizens see the theater in having these two facades stare one another down, as if taunting the other to wax more fatalistic.

This week, Federal Reserve policymakers will release a policy statement that paints an illusion of prosperity in cold monetarist verbiage that feigns the appearance of truth. The doves’ message will be uncharacteristically hawkish. They will flap their wings about accelerating underlying growth and inflation. They will allude to the time being upon us to normalize interest rates, to come in from a long, brutal winter of artifice.

The truth, you ask? Unconventional monetary policy in the form of zero interest rates and quantitative easing braced an economy that has been and remains fragile. And yet, as evidenced by the most recent bout of euphoria, animal spirits are out in full force.

There are other calendar years ending in the number ‘7’ associated with rampant speculation in asset markets and a strong Fed. Only one of the two proved to be a buying opportunity. The other stands as testament to one of the greatest monetary policy blunders in history.

As was the case in 1936, monetary policy had been manipulated to serve political needs. It’s noteworthy that the form assumed differed from that of recent years: it was huge gold inflows that were being monetized back then, but similarly, interest rates had been held closer to the zero lower bound for a protracted period.

In another parallel, measured goods inflation was conspicuous in its inability to achieve liftoff while that of asset prices was off the charts. (Has it really been 80 years of repeating the same mistake in gauging aggregate price behavior?) Then and now, investors exiled to a yield dessert justified their irrational approach to investing by rhetorically asking, “What’s the alternative?”

Commodities and stocks were the primary target of speculators in the recovery that took hold in 1933. Today, commercial real estate (CRE) and bonds have taken center stage while that of stocks is running a close third depending on your preferred valuation metric.

The latest Moody’s/RCA CPPI aggregate price index for CRE is remarkable. Prices through November, the latest on offer, are up nine percent over the past year. But they are perched 23 percent above their pre-crisis peak, which represents a vertigo-inducing 159 percent recovery of prices’ peak-to-trough losses. Morgan Stanley’s Richard Hill and Jerry Chen helpfully provide perspective on this figure: residential real estate, by comparison, has recovered a mere 80 percent of its losses. As for what’s driving the CRE train, office and industrial properties have taken the lead while, no shock here, retail property prices have begun to decline.

As was the case throughout the housing mania, loose underwriting standards can be credited with initially pushing prices upwards. Add to this lender behavior. Smaller banks, in particular, have aggressively reduced fees to garner market share, raising the ire of Fed regulators alarmed at the growing concentration of banks’ exposure to CRE loans. At last check, banks accounted for nearly half of CRE lending activity, up from 35 percent a few years ago. The good news, unless you’re a seller, is that lending standards have tightened for five consecutive quarters. In response, transaction volumes fell 21 percent in the final three months of last year. Hill and Chen observed that the sales slide, “was unusually high for a period that is typically very active.”

The prima facie evidence on extreme bond market valuation is equally compelling. Rather than delve into specifics on sovereign, corporate and emerging market bonds, we’ll let Deutsche Bank’s math speak for itself. It took a mere eight weeks through early January for the global bond market to rack up $3 trillion in losses. The swiftness of the move placed in stark perspective how hyper-sensitive bonds had become to interest rate moves. Investors should consider themselves warned.

As for stocks, the broadest valuation measure compares the market capitalization of all stocks to gross domestic product. Anything north of 100 percent denotes overvaluation making today’s reading of 127 percent disconcerting. That said, it has been higher – the ratio peaked at 154 percent in 1999 and was 130 percent in late 2015. It was, though, appreciably lower shortly before the stock market tanked. Just before the 2008 crisis, the ratio was at ‘only’ 108 percent. So make your own determination on this count. Does a relatively lower nosebleed valuation give you great comfort?

Looked at from a holistic perspective, the VIX, or so-called fear index, which reflects investors’ comfort level with stocks, flirted with single-digit territory last week. Though it did not break through 10 on the downside, which would have matched its 2007 low, the 10-handle is associated with plenty of daunting history.

“When the VIX is low and yields are falling, stocks do very well,” wrote Citigroup’s Brent Donnelly in a recent report. “When the VIX is low and yields are rising, stocks do poorly.”

That’s intuitive enough. Donnelly then goes on to compare the move in the benchmark 10-year Treasury to moves in stocks over the next 120 days. The sample set he used incorporates instances in which the VIX was less than 11 since 1990. A second step entailed comparing these occurrences to their corresponding three-month moves in the 10-year. Donnelly found that the largest three-month rise had been one standard deviation (you recall the term from Statistics 101, as in the distance from the center point on the bell curve). That is, until today.

“The craziest thing is this: Currently, the three-month rise in 10-year yields is more than 2.5 standard deviations. So based purely on this analysis, the 120-day outlook for U.S. equities is very poor.” The strength of the relationship between yields and future returns suggests stocks will fall by about seven percent over the next three months.

Like it or not, risky assets certainly appear to be sticking to the post-election, honeymoon-is-over script.

The burning question will quickly become one of, how will the Fed react? In its past life, stocks wouldn’t have to give back even 10 percent to trigger the next iteration of quantitative easing riding to the rescue. Listen to the doves’ tough talk today, though, and they sound as if they’re finally comfortable leaving risky assets to their own devices. Politics anyone?

The problem is that perhaps too much like the breakable menagerie of glass animals on display in Tennessee Williams’ play, borrowers of all stripes have amassed a veritable collection of debts throughout the market acts playing out since the Fed first lowered interest rates to the zero bound.

In an economy contingent upon conspicuous consumption, it won’t take much for the Fed to bring on a recession. The recent downtick in the personal saving rate is no cause for alarm on its own. Combine it with the steady increase in credit card spending – inflation-adjusted credit card spending has outpaced that of income growth for over a year now — and you quickly understand just how dependent continued gains in consumption are on interest rates not rising.

It’s been a mighty long time, eight years to be exact, since paper gains eviscerated the net worth of U.S. retirement savings in its various 401k, IRA and pension forms. Factor in the demographic backdrop, however, and know it won’t take long for investors to tune in to just how precious their non-yielding cash has become.

Perhaps the best news is that all heretical arguments in favor of the abolishment of cash necessarily go by the wayside during times of tightening financial conditions. After all, economic theory advocates the destruction of cash for the purpose of forcing hoarded money back into the economy. Even the illusionists at the Fed, hellbent as they are in their insistence that the economy is overheating, cannot square that circle.


Click on one of the links below to purchase Fed Up:  An Insider’s Take on Why the Federal Reserve is Bad for America.

Amazon.com | Barnes & Noble.com | Indie Bound.com   |   Books•A•Million

 

The Corporate Bond Market: Binge-Borrowing

The Corporate Bond Market: Binge-Borrowing, Danielle DiMartino Booth, Money Strong, Fed UP: An Insider's Take on the Why the Federal Reserve is Bad for America

Celery and raspberry? Marathon miles of Sudoku and crossword puzzles? Extra reps at the gym? Binge away.

‘Tis the season after the season, that other most wonderful time of the year when it’s a challenge to get a machine at the gym and resolutions are resolute, at least until February or a more intriguing deal comes along. What better way to make amends for that huge holiday hangover that crescendos with so many a New Year’s Eve bash?

Some of us chose to ring in 2017 in a substantially more subdued manner that nevertheless entailed binging of a decidedly different derivation. Enter Netflix. Yours truly must confess that closet claustrophobia was the culprit in keeping this one indoors coveting the control, confining the choices to richly royal romps. It all started innocently enough, with a recommendation to catch The Crown, which has just won a Golden Globe. The devolution that followed began in Italy, with Medici, stopped over in France, with Versailles, and round tripped back to England, with the epic saga that kicked off the modern day, small screen genre, The Tudors. At some point hallucinations began to give the impression that all the series’ stars had British accents. Wait, they actually did.

Thankfully, at some point, bowl games snapped the spell and reality rudely reared its redemptive head before anyone’s else’s head rolled (those royals were a bloodthirsty lot!). Sleep and sanity followed.

Sadly, the same cannot be said of borrowers of almost every stripe these days. For those tapping the fixed income markets, the borrowing bingefest is conspicuous in its constancy. Not only did global bond issuance top $6.6 trillion last year, a fresh record, sales are off to a galloping start thus far in January.

In the lead are corporate bond sales, which accounted for $3.6 trillion of last year’s super sales. To not be outdone, investors ran a full out sprint in the new year’s first trading week, “shattering,” not breaking records, in the words of New Albion Partners’ Brian Reynolds. In the first three trading days of the year alone, investors bought $56 billion of new corporate bonds. Some context in the context of what’s been one record-breaking year after another in issuance:

“An average month in recent years would see investors buy about $130 billion of corporate bonds,” noted Reynolds. “Investors just bought more than 40 percent of that monthly average in just three trading days!”

For those of you who have ever had the pleasure of a good, long visit with Reynolds, he is anything but prone to using exclamation points. (!)

In any event, waves of heavy issuance often coincide with big deals carrying ‘concessions,’ or enticements in the form of higher yields than what the issuer’s existing bonds offer. Despite 2017’s already extraordinary deal flow, a good number of issues stood precedence on its head, coming out of the gate with negative concessions. “It’s as if corporate bond buyers are rabid, as if there are not enough corporate bonds to go around, even though there is a record amount of corporate bonds!” added Reynolds.

The kicker – there always is one when fever sets in – is that issuers are earmarking proceeds as generically as they can, for “general corporate purposes.” In other words, they can use the sales proceeds for whatever they desire, including share buybacks.

But wait! (Can exclamation points be contagious?) Haven’t we just learned that buybacks took a nosedive in the latest Standard & Poor’s data release? That quarter-over-quarter share repurchases had fallen by 12 percent and tanked by a stunning 25.5 percent over 2015’s third quarter? What superb sleuthing you’ve done, Watkins!

And right you are, except this one little thing. The pre-election world is so passé.

What are the odds share repurchases reaccelerate under the new administration? In one word ‘growing,’ fed by two springs. The first is mathematically driven. Calpers, the country’s largest pension, recently announced it would be “gradually” lowering its rate of return target to 7.0 percent from 7.5 percent. In the nothing-is-free department, estimates suggest taxpayers will have to cough up an additional $2 billion per year to make up for what the pension no longer anticipates in the form of pension returns.

(Suspend reality as the pension returned 0.61 percent in its most recent fiscal year ended June 30. We could ride off on a tangent but link to this if you’d like to hear more on pensions’ prospects http://dimartinobooth.com/will-public-pensions-trumps-biggest-challenge-2/)

The funny thing is California governor Jerry Brown just announced he anticipates the state will run a $1.6 billion deficit by next summer as the tax base continues to atrophy driven by – wait for it – rising taxes. And where are a lot of those tax dollars going? You guessed right again – backfilling that yawning pension gap. Will the exodus out of the Golden State continue, leaving only the uber-wealthy and economically immobile behind? You tell me.

Promise there’s a point here. Calpers will lead the way to other pensions also lowering their rate of return targets, which will in short order trigger more in the way of rising taxes and, it follows, more actual monies pensions allocate to fresh investments to thereby generate those fairy tale returns. To stay deeply deluded and convince oneself (still) high returns are achievable, the de rigueur investment is private equity credit funds in their many high voltage varieties. At Reynolds’ last count, pensions have voted a record dollar amount into credit every single month since the stock market panic of 2015.

And the momentum just keeps building. December 2015’s record pension credit fund inflows of $7.3 billion were blown to bits by this past December’s $10.6 billion – and that’s before any leverage is put to work. As we have hopefully learned, the credit machine feeds the buyback machine, and away we go. Tack on the prospects of a Republican Congress facilitating the repatriation of all that offshore cash and you’ve got the makings of a true buyback renaissance. Oh, and by the way, a seriously overvalued bond market.

Jesse Felder, president of Felder Investment Research, recently put pen to paper to quantify the value investors get today. What sets Felder apart from the crowd, in a good way, is that he factors in the backdrop of record bond issuance feeding what had, until very recently, been a record pace of share buybacks.

“When you look at corporate valuations more comprehensively, including both debt and equity, we have now matched that prior period,” Felder wrote in a recent report, referring back to peak dotcom bubble valuations. To arrive at this conclusion, he compares the value of nonfinancial corporate debt and equity relative to gross value added, an effective gauge of enterprise value-to-sales.

How does Felder calculate such a clever metric? With the help of some Federal Reserve data, no less, he incorporates the buyback bout to create a holistic valuation methodology to capture comprehensive corporate valuations. Because one frenzy, bond sales, has fed the other, the stock market’s historic run by way of share count reduction, it’s simply disingenuous to not marry the two. You can want to try, but it’s futile to examine bond or stock valuations in a vacuum.

“This has essentially been a massive debt for equity swap that serves to reduce the value of equity outstanding while greatly expanding the amount of debt outstanding,” added Felder. “Equity-only valuation measures fail to account for this phenomenon. This measure incorporates it.”

The point, though, is not that the current rally will necessarily buckle under the weight of bloated valuations. To the contrary, pensions’ sheer buying power, their trillions upon trillions of dollars of monies to be allocated, can indeed make it appear that we are now in 1999, or better yet, 1996. But don’t be fooled – you’re still paying a dear price to play with fire.

So stop yourself the next time you hear some talking head reassuring you that the price-to-earnings ratio on a trailing 12-month basis is dirt cheap. Fight the temptation to validate your sense of security by proclaiming, “Wow, that erudite expert has some set of lobes!” Don’t just move on to the next episode, hitting BUY on that equity ETF. Stop and ask yourself just how profoundly this deep thinker has probed into the true drivers of valuations in recent years. More to the point, ask yourself whether the source is clean or compromised.

If you need inspiration, look to some of the greatest lines ever penned in Politics and the English Language by George Orwell: “The great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink.” And yes, Orwell was English. You can safely read his words aloud, with a British accent.

Global Debt Investors: The Silence of the Lambs

Global Debt Investors: The Silence of the Lambs

More haunting even than the terrified screams of lambs being led was the silence that followed their slaughter.

Such was the searing pain of relentless recollection for FBI agent Clarice Starling, the tortured lead played to Oscar perfection by Jodie Foster. In an agonizingly whispered scene that has forever left its imprint on the minds of horrified audiences, we hear the bleating of Starling’s long-dead tormentors.

Clarice’s hushed revelations to Hannibal reveal a desperate act by her young orphaned self. Unable to bear the horror, she’s running away from the bloodbath of spring lambs being slaughtered and her cousin’s sheep ranch. Desperate to do something, anything, she struggles to drive them from their pens to freedom: “I tried to free them…I opened the gate of their pen – but they wouldn’t run. They just stood there confused. They wouldn’t run…”

A recent, reluctant re-viewing of the film, only the third in history to win the “Big Five” Oscars, Best Picture, Actor, Actress, Director and Screenplay, fed fresh food for thought. The image of captives rejecting their freedom brought to mind another flock of corralled and stunned lambs — bond market investors. They too have been given the opportunity to escape their fate. But so many choose instead to stay. Such is the reality of a world devoid of options, with time ticking ruthlessly by.

Against the cynical backdrop of bulls and bears manipulating data to plead their case, Salient Partners’ Ben Hunt’s insights stand out for their indisputability. In his latest missive he points to one chart that’s incapable of being “fudged,” to borrow his term – that of U.S. household net worth over time vis-à-vis U.S. nominal gross domestic product. Suffice it to say we’re farther off trend than we were even during the dotcom and housing manias.

Hunt asks in what should be rhetoric but is lost on so many: “Is it possible for the growth of household wealth to outstrip the growth of our entire economy? In short bursts or to a limited extent, sure. But it can’t diverge by a lot and for a long time. We can’t be a lot richer than our economy can grow.”

And yet we are. The culprit, which too few identify as such, is runaway asset price inflation led by debt markets that have grown to be unfathomably immense in size and scope. At $100 trillion, the size of the global bond market eclipses that of the $64 trillion stock market. A bigger discussion for another day comes from McKinsey data that tell us the worldwide credit market is over $200 trillion in size.

Zero in on Corporate America and you really start to get a picture of pernicious growth. According to New Albion Partners’ Brian Reynolds, U.S. commercial paper and corporate bonds have swelled by $3.1 trillion, or 63 percent, since the 2008 financial crisis. “This compares to nominal GDP growth of only 27 percent, so we are leveraging the heck out of the economy.”

For a bit more historic context, consider that U.S firms are more levered today than they were at the precipice of the financial crisis. According to Moody’s data, the median debt/earnings before interest, taxes, depreciation and amortization (EBITDA) is five times today vs. 4.2-times in 2008 for high yield companies. For comparison purposes, investment grade companies’ median debt/EBITDA is 2.6-times today compared to 2.2-times in 2008.

Michael Lewitt, the leading authority on all things credit and creator of The Credit Strategist, worries that companies are sitting on this pile of debt with not much more to show for it than, well, being in hock up to their eyeballs. “Much of this debt was incurred for unproductive purposes – buybacks, dividends to private equity owners, etc. – rather than for things that grow these businesses. Many high yield companies are not generating much, if any, free cash flow and are dependent on the ability to roll over their debt.”

On that count, there’s trouble brewing. Moody’s publishes a Refunding Index which gauges the bond market’s ability to absorb high yield bonds maturing over the next 12 and 36-month periods at the current pace of issuance. In the quarter ending in September, the one-year index was down 50 percent over the prior year while that of the three-year index was off by 40 percent continuing a protracted two-year slide. In dollar figures, three-year high yield maturities are up 45 percent year-over-year; they now total $156 billion vs. $108 billion a year ago. The flip side of these coins is that issuance is down by $13 billion.

“Debt maturities continue to increase at a rapid rate and are expected to rise to historic peaks within the next couple of years,” said Moody’s Senior Analyst Tiina Siilaberg. “And defaults are getting up there. Along with weak refinancing conditions, default rates for US speculative-grade issuers have been above five percent since May and ended at 5.4 percent in September. This compares to just 1.9% in May 2015.” Siilaberg expects defaults to peak at six percent in the coming months.

We can only hope Siilaberg is not being overly optimistic. A separate data set released by Standard & Poor’s (S&P) tallies the “weakest links,” or companies that are 10-times more likely than the broad high yield universe to default. In September, this count hit a seven-year high. For the moment, with an eye on recovering oil prices, investors seem to be operating under the assumption that stress in the pipeline is dissipating. Fair enough. But only one-quarter of the weakest links are energy firms. Chances are defaults, already at the highest level since 2009, will continue to climb.

As for the much bigger investment grade (IG) market, it’s not an energy story but rather one entangling the financial sector that promises to capture headlines in the coming months. S&P Managing Director Dianne Vazza recently warned that financials dominate the fallen angel universe, as in IG firms likely to be downgraded to high yield. The culprits include their exposure to energy firms, the fallout from municipal mayhem in Puerto Rico and weakness in global growth.

The immediate fallout for these fallen firms is a spike in borrowing costs. But even for those that manage to remain in the celestial, expenses could be poised to rise.

“The market is not waiting for Janet Yellen to raise rates on corporate debt,” warned Lewitt. “The risk is not default, but lower earnings as these investment grade companies borrowed enormous amounts to fund buybacks and dividends and have enjoyed an interest rate holiday that will sooner or later come to an end.”

That’s saying something considering that even with interest rates near their lowest on record, the interest expense among companies in the benchmark S&P 500 Industrials has been on the rise since bottoming at four percent of nonfinancial earnings in the third quarter of 2010. According to data compiled by S&P’s Howard Silverblatt, interest expense first topped six percent in the quarter ended March of this year. It remains above that level, the highest since recordkeeping began in 1993. Since then, we know borrowing costs have started to tick back up. With record debt loads, it’s safe to say many companies can simply not afford interest rates to rise off the floor.

As tenuous as the situation appears, this credit cycle may have one last rally in its gas tank. “I don’t think this is the big one,” said George Goncalves, Nomura’s Head of U.S. Rates Strategy. “However, I do view any sort of unwind of the ‘portfolio rebalancing effect’ hurting both stocks and corporate and sovereign bonds initially.” Once that panic sets in, though, expect sovereigns to regain the flight-to-quality status and stage a rally.

Goncalves does foresee one potential fly in the ointment of the relatively happy ending: “Ironically, a second Fed rate hike could trigger more currency devaluations from overseas, notably China. If the secondary markets cannot handle the volumes, it could lead to broad-based selling.”

New Albion Partners’ Reynolds doesn’t figure even an exogenous event could put the brakes on the current credit cycle. Pensions and insurers simply have too much in the way of fresh funds to deploy to allow that to happen; they’ve absorbed half of the $3.1 trillion in new issuance. Given more funds are expected to flow into pension coffers in the coming years as Baby Boomers retire in droves, there should only be more to come. So we go from the mammoth to the monumental when it’s game over.

“The cherry on top of the sundae of this credit boom is the shift away from money market funds to cash funds that take ten times the risk to get ten times the yield,” cautioned Reynolds. If you’re still game for a bit more irony, “This shift has nothing to do with the fundamentals. It is occurring solely because of the money market rule changes.”

It would appear to be only a matter of timing, and in turn, magnitude. The outcome though is undeniable. With defaults on the rise, refinancing capability in increasing danger and more distress building in the pipeline, you would think we would be hearing investors screaming. But we don’t. Just the deafening sound of silence as most in the herd refuse to be early, even if waiting with the gate to the pen open offers them ultimate salvation.