Bubble Trouble?

Bubble trouble?  Traders decided to put Turkish contagion behind them yesterday driving equities up throughout the session.  The S&P500 closed just below its session high essentially erasing the losses from Manic Monday (see chart 4).  The Dow Jones Industrial Index similarly ended trading just below its session high shoring up the index after 4 days of soft trading.  The index is in a tender position and needs to work its way back up to its strong Fibonacci resistance at 25562 (see chart 6).  The Russel 2000 was the star of the group posting a 1% gain in response to the NFIB small business optimism number which came in at 107.9 versus the expected 106.8.  What the number told us is that small businesses are optimistic… nothing shocking here.  But the report also made some interesting observations that seemed to escape traders.  The report talked about the increasing difficulty in hiring skilled labor.  Re-read the last sentence please!  Do you know what that means?  That means that the labor market is tightening.  Do you know what THAT means?  Inflation is on the horizon.  Remember that employment represents that largest factor in the cost of goods and large increases there will ultimately end up costing the consumers more. What does it all mean to investors?  Perhaps we should turn to Hyman Minsky for answers.  It is, after all, geek-out Wednesday.

Hyman Minsky was an American economist who existed in the shadows of the 20th century greats.  Unfortunately he was only really recognized by the mainstream following the sub-prime mortgage crisis of 2008, nearly 12 years after his death.  Minsky is credited with the Financial Instability Hypothesis which postulates how financial complacency leads to bubbles which ultimately lead to financial failure.  He is quoted as saying (1977) that “…the tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy.”  Lets go though it, shall we? The bubble begins its growth with relaxed, or accommodative funding conditions not unlike those that existed since the Fed lowered interest rates to near zero for an unprecedented amount of time.  This leads to increased borrowing by corporations and individuals. Initially the borrowing is described by Minsky as being “hedged” lending implying that the fundings are relatively low risk.  As the process continues it becomes easier for borrowers or fund-raisers to get access to capital.  You may recall that corporate debt issuance enjoyed a rapid expansion in the years following the financial crisis (see attached chart of Total Debt Securities).  So far so good?  As long as the economy is doing well this should be no problem right?  This is where things start to get tough.  As markets go up, debt and equity supply grow, wooing corporate and retail investors with high potential profits.  Investors enter a stage of high speculation as they relax their risk tolerance in search of great potential return.  Minsky refers to this as “speculative borrowing” for obvious reasons.  There are many examples of the presence of this stage and the best examples of this include the rapid rise, peak, and fall of Bitcoin as well as the “in FANGS we trust” mentality in which speculative investments lead broader market growth.  To be clear, that is not to say that good corporate profits and a burgeoning economy is not a good reason for markets to go up, but it is clear that there is much speculation fueling growth.  The final stage of the cycle is referred to by Minsky as being the “Ponzi borrowing” stage in which borrowers, increasingly finding difficulty servicing debt, borrow more in order to make payments.  Lenders in this stage blindly seek profits investing in a complacent manner.  This period can be characterized by investors ignoring obvious potential risks in their voracious pursuit of profit.  Eventually the borrowers can no longer afford to service debt, which leads to bankruptcy and a world of hurt for investors.  This has been coined a “Minsky Moment”.  You will notice that I jumped between debt and equity in my description because the theory can be applied to both instruments.  Additionally investors can include both institutional and retail.  Why do I bring up Minsky now?  Because now is the time for investors to re-examine the risk in their portfolios.  Whether you use Minsky’s description of the economic cycle or one of the dozens of others out there, it is clear that we are late in the cycle. Investors who are within 3 years of retirement should have a portfolio that protects assets with minimal speculation.  Younger investors who have longer time horizons should be focused on diversification of investments in order to minimize any potential drawdowns during tough market cycles.  The name is different but the message is the same:  De-risk and diversify to minimize the impact of that Minsky moment.

Markets start today’s session under pressure after overnight selling in Asia and Europe as the Turkish Lira weakened once again.  Turkish President Recep Erdogan announced counter-measure economic sanctions on the US in response to Trump’s last round of tariff increases.  His defiance, well received by his hard line followers, was not applauded by financial markets.  Selling in Asia also dominated overnight trade as large tech firms sold off in response to the Chinese government refusing permits to online game manufacturers.  This morning’s retail numbers came in stronger than expected with sales advancing +0.5% versus the expected +0.1% month over month.  These strong numbers were not enough to clear out the the risk-off mood, so we can expect a day of high volatility ahead.  This one may be best viewed from the sidelines.  Bubbles are, after all fun to watch from a distance rather than from within.

daily chartbook 2018-08-15

rising corporate debt post 2008