article 2014 06 analytic insights mispriced risk

8/12/2019 Article 2014 06 Analytic Insights Mispriced Risk

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GordonTLong.com

MISPRICED RISK & CREDIT CRACKSTRIGGER$ - JUNE 2014

Gordon T Long

5/28/2014


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The point here is that this sort of

manipulation does not come free, as has

been most evidently witnessed by the serial

bubbles that we have experienced over at

least the last two decades.

When we look at factors such as Margin Debt

levels it is blatantly obvious we are once

again at levels that have proven in the past

not to be kind to the equity markets. Actually

we are levels we have never experienced

since the US came off the gold standard.

No doubt you are familiar with the Emotional

Euphoric Cycle which the equity markets gothrough. An example of which is shown here on the left. What you may not be as familiar with is that

the credit markets go through a similar cycle despite it being more analytic and traditionally more

conservative that equity markets.

When you map developments and milestones in the credit markets you immediately see we are at levels

that are traditionally considered elevated and excessive.


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US distressed debt spreads have now reached five year highs. We are quickly reaching levels which we

witnessed prior to the 2008 financial crisis and when you look at the details appear to be accelerating.

Though this is a US chart I would be a miss if I didnt tell you that Chinas is even more dramatic with

Non-Performing Loans going through the roof.

COVENANT LITE & PIK LOANS

There are various kinds of loans such as PIK Loans (which is short for Payment in Kind), Covenant LiteLoans and others that are good indicators of the risk being taken by lenders and borrowers assuming

higher levels of leveraged risk. As you can see they are also at extremes.


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I have mentioned previously in Trigger$ of a Bloomberg Proprietary Credit analysis which involves a

regression analysis of a number of key credit metrics. I refer you to PAY ATTENTION TO CREDIT

MARKETSfor more detail. I have been finding it extremely accurate if analyzed properly.

It is presently signaling a significant 70 point S&P 500 divergence. If credit weakens further, which I

expect, this divergence could worsen. Certainly it says caution is advised near term or volatility may

soon be the order of the day.

BOND ROTATION

I am also seeing signs of a potential bond

rotation and potentially major portfolio

rebalancing moves from equity positions to

Treasuries.

As big as the US deficit is it must be

remembered it is being brought down from

well over $1T to the $600-$700B level. This

means shrinking near term supply. When

you couple it with the actions of the Fed to

dominate the buying of USTs there is a

potential supply shortage coming that any
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sort of fear trade would ignite.

This is precisely what the engineers of Financial Repression would consider a home run and would map

perfectly to the long term treasury chart I showed earlier.

CONSUMER CREDIT MARKETS

In a recent article entitled Consumer Credit Cracks - The 'New Shadow Banking' Collateral Problem I

showed the emerging cracks in the US consumer lending details and practices. Whether we are talking:

1. HELOC Delinquencies

2. Non Performing Student Loan levels,

3. Car Loan subprime lending and leasing levels,

4. Home Mortgage credit scores

5. Housing Down payment requirements

6. Shipping Credit

.. . There is mounting evidence of serious decay in credit.

The problem is that most of this credit is funded through the shadow banking intermediation channel. A

process built on borrowing short and lending loan with significant duration risk exposures if credit was

to tighten abruptly due to fearfor whatever reason. During the financial crisis it was an Asset Backed

Commercial Paper problem. Today the acronyms have changed but the exposure is the same when we

delve into the world of Repos and Collateral Transformations.

Dodd Franks has done almost nothing to fix this systemic hot spot.

Another article I recently wrote entitledRisk is Leaving the Market - Stealth Movements Warn of

Potential Q2 Market TroublesI showed the cascading nature of risk-off leaving the market. By that I

mean how the higher risk stocks are weakening ahead of what is considered the less risky stocks. This is

a classic market topping signal. It may not be a long term top but is likely, minimally an intermediate

term top.

The large players are leaving as the public begins feeling confident enough to re-enter. As usual it is the

fear of missing out that attracts them when the risk is the highest.
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An indicator I like for situations like this is the Russell 2000 to Russell 1000 ratio. As risk leaves and risk-

off begins to take hold the ratio will fall, which it has. You then pay attention to the moving average

crosses for confirmation of a trend reversal. We see here this is also happening though the oscillators

suggest is may be overdone in the short term. As I said earlier, Credit is not a great market timing device

but it does do a great job of keeping you out of trouble at critical times.


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KEY LONG TERM INDICATORS

I would like to shift gears slightly and talk about credit from the big picture perspective. F.F. Wiley

published at the Cyniconomics blog three interesting charts.

The first chart shows the percentage of total borrowing thats funded by the three riskiest sources of

funds. Three periods stand out for an unusually high percentage of risky borrowing. The first two

coincide with the creeping inflation of the 1960s and Great Inflation of the 1970s. The third overlaps

the serial bubbles of the last two decades and leads into the 2008 financial crisis. Problems with either

inflation or financial instabilityare exactly what you should expect when debt funding is tilted

heavily towards risky sources.

The second chart divides risky

borrowing by GDP.This chart canhelp you gauge how hard the

economy might fall after the

inevitable cracks appear in credit

markets. Not surprisingly, it shows

that the three periods with the

greatest amounts of risky

borrowing were followed by thethree hardest falls severe

recessions in 1973-75, 1980-82

and 2008-09. Virtually every

recession follows a drop in risky

borrowing. Large amounts of risky

borrowing eventually lead to

vicious circles in which soured

loans and a slower borrowing pace


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drag economic activity lower then you should expect recessions to occur after risky borrowing

peaks. This is exactly what we see.

The third indicator measures the change in risky borrowing using a two year change. It helps to

narrow down recession probabilities. And while it doesnt offer ironclad proof that borrowing in excess

of non-money savings leads to recessions (theres no such thing), it fits into the very process

described by economists whove dared suggest that such borrowing is risky.

These charts ring hard when we consider this next chart.


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Companies are reporting revenue problems though they are still able maintain the bottom line through

labor costs cuts, financial engineering, low interest rates, and stock buybacks (as well as dividends to

keep stock prices up), but for how long?

A recession scare is not out of line from a historical perspective.

My work with Richard Duncan says that there is a liquidity problem coming in the 2ndhalf if the TAPER

program is maintained. I personally expect that by Q4 the Fed will be forced insert liquidity or face a

potential recession. The markets will react to all of this with fear from very elevated levels.

COPPOCK LONG WAVES

My Macro Analytics Co-Host Charles Hugh Smith recently posted this chart.

I have long prized the Coppock measure in the bond market so I found the analysis interesting. This

chart shows the Coppock Curve for the S&P 500, overlaid against previous deflationary secular Bear

Markets in the late 1800s, the U.S market in the 1920s and 30s and the Japanese Nikkei stock market

index from 1986 to the present. Charles added notes to the chart to mark the potential market

bottom in early 2015 and a possible peak in Fall 2016.He also added a note that suggests theshallow troughs in 2005 and 2011 were the result of unprecedented financial engineering by central

banks> He suggests that financial authorities have been dead-set on limiting market declines and

"buying time" so the broken parasitic financial system could feed off the real economy long enough to

restore its viability.

It fits with our expectations of a an Intermediate correction/consolidation into the fall elections and

then a rise to new highs in the first half of 2015. Charles Coppock Curve suggests this could last

longer and go higher than my forecast for the final hyperinflation wave


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BE PATIENTWAIT FOR THE DEATH CROSSES

As a lay out inBe Patient: Wait for the Death Crosses!The key here is to anticipate but wait on

confirmations.

I expect major liquidity injection announcements from the ECB by June and the BOJ in Q3. These will be

market movers as will Ukraine events and a potential US$ damaging Energy deal between Russia and

China.

The bottom line to me is that I see volatility increasing over the next 60 days, between now and June

quadruple witch with a major market correction beginning by July options expiration and lasting into the

fall.

Gordon T Long

Publisher & Editor

[email protected]

Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion onlyand should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodityor any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliabi lity of hisown credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriateregulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that you are encouraged toconfirm the facts on your own before making important investment commitments.
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article 2014 06 analytic insights mispriced risk

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