Leverage, Leverage, and more Leverage
(May 24, 2007)
Dear Subscribers and Readers,
Despite what the mainstream media says, there are now signs that liquidity conditions are now deteriorating. These signs include:
- The hugely oversold condition of the Yen against the Euro, Pound, and other currencies, such as the Australian dollar, the New Zealand dollar, and so forth. During the first quarter alone, margin currency trading by retail investors in Japan alone increased 41% to a whooping US$896 billion – the highest ever. Quoting a Reuters article: “``Japanese individuals' trading volume accounts for 20 percent to 30 percent of the interbank foreign-exchange market in the Tokyo time zone,'' Fukaya said. ``They are also active in London time after going home. They are becoming a rival to be reckoned with for institutional investors.''” The fact that the rally in global equity prices had been so dependent on the Yen carry trade and the fact that the Yen carry trade is now hugely stretched suggests that world liquidity conditions are now deteriorating.
- According to S&P, the peak of borrowing conditions in the LBO market occurred in February. Quoting a Bloomberg article: “The high-yield loans that provided the most favorable terms to firms like Kohlberg Kravis Roberts and Thomas H. Lee Partners as they completed their biggest leveraged buyouts are drying up. Investors have scaled back such credit to leveraged buyouts by about 33 percent since February, according to Standard & Poor's. Yields on loans to buyout firms and companies considered below investment grade rose to 7.76 percent from 7.47 percent three months ago, S&P estimated.” This really should not come as a surprise to subscribers – given the outsized deals we have witnessed in recent months and the leverage and the “covenant lite” conditions that were attached with these loans.
- The effects of the subprime debacle that began in 2006 and that culminated in the bankruptcies of many subprime lenders (not to mention subprime borrowers) during the February to March period of this year. Make no mistake: This “pillar” of liquidity of the U.S. housing market has fallen and will have a depressing effect on the U.S. housing market and on U.S. households' liquidity for many years to come.
- The deterioration of liquidity can also be witnessed in the recent rise of ten-year yields. From the most recent bottom in equity prices on March 13th, ten-year yields have risen 37 basis points – from a low of 4.49% to 4.86% at the close yesterday. As I have mentioned in our commentaries and discussion forum before, this will not be bullish for equity prices both in the short and intermediate term.
In a capitalistic world that is dependent on ever-rising asset prices, having an ample amount of liquidity is essential – this is even more relevant today as the leverage in the U.S. financial system and in other countries have also dramatically risen in recent years as well. This is evident in the following chart showing the asset-to-liability ratio of U.S. households from 1Q 1952 to 4Q 2006:
As one can see, the asset-to-liability ratio of U.S. households has been on a secular decline ever since records have been kept in the early 1950s. While an asset-to-liability ratio of 5.18 can still be considered “high” by corporate standards, readers should keep in mind that even though U.S. households today have access to financial management tools that were unimaginable only 15 to 20 years ago, this does not change the fact that U.S. household leverage has been increasing for the last 50 years. Moreover – as evident in the most recent subprime debacle, many Americans today still do not have a concept on how to manage their finances responsibly. Coupled with a cut-off to cheap funds (given an elevated Fed funds rate and the huge drop in home mortgage equity withdrawals) – the only conclusion we can come up with is that consumer spending will be a drag on both consumer stocks and the U.S. economy for the next couple of quarters. While I believe household income will continue to increase going forward (and it may increase at a historically higher rate given that household income – which includes pension and healthcare benefits – is now near a historically low level due to outsourcing, offshoring, etc.), I would not bet on that too much in the short-run. As a matter of fact, a higher-than-normal rise in household income will also put pressure on corporate profits in the short-run.
On the other hand – while U.S. households have been piling on the debt, U.S. corporations have remained relatively constrained, as cash levels in the companies that make up the S&P 500 have remained relatively high in recent years. The following chart (courtesy of Goldman Sachs) shows the growth in absolute cash levels (left scale) vs. cash as a percentage of market cap for the S&P 500 (excluding the financial sector) from 1993 to the fourth quarter of 2006:
Of course, while cash levels as a percentage of market cap remains high on a historically basis, keep in mind that it has decreased somewhat since the end of 2001, mostly due to the rally in equity prices we have seen since the end of 2001. In other words, while cash levels have put on a tremendous rate of growth, the rally in equity prices over the last five years have outpaced that.
As far as the financial sector goes, many of these companies have been on a borrowing binge, especially in the LBO market, as evident from the following chart courtesy of the Bank of England:
Please keep in mind that the shaded column (the last column) represents the amount of LBO loan issuance so far in 2007 and only extends to early April! Assuming this pace keeps up for the rest of 2007 (I seriously doubt this will occur, although I definitely have been wrong before!), LBO issuance will top out at approximately $800 billion in 2007, more than 200% greater than what we saw in 2005 and 2006 and nearly ten times what we witnessed in 1989 – the peak year of the last LBO boom – culminating in the infamous leveraged buyout of RJR Nabisco.
Following is a chart (again from the Bank of England) showing the increase in leverage of LBO deals in Europe. Unfortunately, there is no similar chart for the U.S. LBO market:
Make no mistake – just like what occurred in the subprime market – the only reason why these private equity companies have been able to borrow so much funds (with practically no strings attached) is the growth of the securitization market in recent years and the “global search for alpha” by hedge funds, pension funds, endowments, foundations, and high net worth individuals alike – including newly-minted millionaires and billionaires from Asia and the Middle East. Just like the boom in subprime borrowing of recent years, lenders would never been this lax if it was their own money or if they were not able to repackage these loans and sell them on the open markets. Just like the subprime debacle of late 2006 (a story which is still continuing as we speak), the negative consequences of the global search for alpha or yield will end in tears at some point, especially since many central banks of the world is still in a tightening mood, and especially given the leverage of U.S. households.
As for leverage of a different kind, following is a monthly chart showing the Wilshire 5000 vs. the absolute change in margin debt levels from January 1998 to April 2007:
As mentioned on the above chart, the six-month increase in margin debt is now at its highest level since March 2000, while the 12-month increase in margin debt is now at its highest level since September 2000. Barring a major liquidation of margin debt over the next few trading days, it now looks like the 12-month increase in margin debt for the period ending May 2007 will also be at the highest level since March 2000 once data is released in the middle of next month.
More ominously, cash levels in both cash and margin accounts as a percentage of margin debt is now at its lowest level since August 2005 – even though it is still high relative to the levels that we saw during the late 1990s bull market:
Conclusion: There is no doubt that we are now much closer to the end of the boom compared to where we were, say, at the most recent bottom in equity prices in mid March, when the Dow Industrials was more than 10% lower compared to where we are now. Of course, there are still no obvious signs that a cyclical bear market is about to begin, but given the current sentiment in the market, the leverage, somewhat elevated relative valuations, etc., there is every reason to believe we will experience a sizable correction sometime this summer. Should the stock market continue to rally in the days ahead, then this author may initiate a 50% short position in our DJIA Timing System. Readers please stay tuned.
Henry To, CFA