This week Bloomberg reported a sad story that epitomizes today's quantitative easing-induced investment climate. The following is from a story titled "Blackstone Unit Wins in No-Lose Codere Trade"
by Stephanie Ruhle, Mary Childs, and Julie Miecamp:
GSO Capital Partners LP provided a loan to Spanish gaming operator Codere SA (OTCMKTS:CODEF) in June with terms that gave it a guaranteed return on credit-default swaps, outmaneuvering sellers of the protection.
The unit of Blackstone Group LP (NYSE:BX) structured the loan in a way that would lead to a payout on swaps it held, according to three people with knowledge of the situation who asked not to be identified because the discussions were private. The contracts were triggered on Sept. 18 after Codere delayed an interest payment by two days to comply with the loan terms.
The company’s willingness to pay the coupon late helped ease restructuring negotiations as many bondholders also held credit-default swaps and would benefit from a missed payment, the person said. Codere made the August payment two days after a 30-day grace period, and the International Swaps & Derivatives Association ruled that there was a failure-to-pay credit event, resulting in a $197 million payment to holders of the swaps.
Unreal. This is how investors make money in today's market. It's not about creating value; it's about profiting at somebody else's expense. This is what happens when real rates are negative. This is a product of the Fed's monetary policy where there is no long-term capital allocation; there is only short-term capital exploitation.
This risk-free exploitation reminded me of a condition present at the top of the credit bubble. I remember reading an article in the Financial Times
about corporate bond investors taking advantage of the insatiable demand for structured products that sold credit protection to juice returns. The following is from "'Negative Basis' Is Easy Money"
by Michael Mackenzie:
When it comes to easy money, it is hard to overlook a dramatic distortion in the credit market that has generated virtually risk-free returns for some investors in recent months.
For some companies, the annual cost of buying credit protection has fallen below the risk premium, or spread, a bond investor receives on the same company's bonds over and above the benchmark risk-free interest rates.
This situation is known as "negative basis."
Investors can buy both bonds and CDS protection, leaving them with net credit risk of almost zero but still able to pocket a spread above risk-free rates.
Strong investor demand for credit exposure in derivative form is still supporting the negative basis trade -- in which the bond investor takes the other side of the trade in the derivatives market. A particular source of demand for credit risk has been structured investment vehicles such as collateralized debt obligations.
That was the top. There was not enough yield in vanilla CDOs so investors looked to structures that sold credit protection as a way to get levered long credit, thereby enhancing returns. The demand was so great that it fostered a relationship that should never happen. Credit protection was cheaper than credit risk. This wasn’t a product of long term investment; this was short term capital exploitation. This is what happens when short term capital rules the market. This is what happens when the cycle is mature and there is no intrinsic value left in price. The Blackstone trade is indicative of today's investment climate that is focused on gaming the system. Investors aren’t allocating capital to investments in companies; they are trying to exploit prices at somebody else’s expense. Every trade is a flip.
When working on the sell-side during the last bull market cycle, I once heard an equity salesman proclaim that his clients don't buy companies, they buy stocks. He was dead serious. Under Alan Greenspan’s uber-easy cycle, the market was dominated by momentum-induced speculators. The goal wasn’t capital allocation, it was capital exploitation. This is what happens when the central bank produces negative interest rates. Assets are turned into commodities subject only to the supply and demand of the securities.
Sadly, this is the goal for the current central bank monetary policy. The goal of QE is to foster a negative interest rate environment. The goal is to trick investors into pricing in future inflation expectations to lower real rates. This was the catalyst behind the re-pricing of equity valuation during the credit bubble, and it’s the catalyst today. US stocks are not rallying because fundamentals are improving; the market is rallying because multiples are rising.
Since the 2012 lows, earnings have grown by a 3.9% annualized rate while the price-to-earnings ratio has expanded by a 21.4% annualized rate. There is more to the story. Because the bottom line is highly manipulated by one-time accounting gimmicks and share buybacks, top-line growth is a better barometer. The operating earnings, or earnings before interest, taxes, and depreciation of assets (EBITDA) are a true indication of a company’s growth trajectory. The growth rate of the S&P 500
(INDEXSP:.INX) EBITDA since the 2012 low is 2.6% annualized, however the price-to-EBITDA has grown by 22.5% annualized rate.
Investors often make a bullish case for US stocks by pointing out that the P/E multiple is still low by historical standards. This is a ridiculous assertion. Because valuation is about capital structure (aka the risk curve), equity multiples are a function of credit multiples. You can’t compare valuation without the context of interest rates and the cost of credit. Equity multiples are rising because credit multiples are rising because real interest rates are negative.
Credit Risk Premium Vs. Equity Risk Premium
Not only is this methodology flawed, but it’s not even correct. Sure, if you look at the P/E ratio at 16.7x trailing 12 months earnings in historical context, it’s not overly expensive. However, if you look at the P/EBITDA, stocks are the most expensive they have been in the last 10 years. In fact today’s 8.6x P/EBITDA is 17.8% rich to the 20-year average multiple of 7.3x. EBITDA growth is decelerating and the multiple for this growth is the highest in a decade. From the EBITDA line, which is what matters, the market is not
cheap relative to history.
Price-to-EBITDA Vs. EBITDA Growth
This is not what you are hearing from the sell side. You are hearing all sorts of ridiculous reasons why this rally has room to run.
Understand the sell side is not your friend. The sell side is not in the business of valuing companies for investment; they are trying to generate a commission for a trade. Their clients don’t buy companies, they buy stocks. Sell side theses are not based on what individual companies are worth, but instead by a need to identify the catalyst for the next x% pop in price. In other words, the theses are about buying the flip. This price action provides the illusion of a growth discount, and unsophisticated investors are seeing rising prices and are getting sucked into what they believe is improving fundamentals. When interest rates shot higher in May and June with the backdrop of equities going parabolic, we were told stories of a great rotation out of fixed income and into stocks because growth was accelerating. Markets were simply discounting an improving economy. I was skeptical, and on May 13 in Welcome to the Dark Side of QE: The Yield Curve Adjustment Process
I concluded the following:
Don’t kid yourself: This rally in stocks has been a function of multiple expansion based on a collapse in credit risk due to a depressed 10-year yield. If the Fed is truly mapping the exit that game is coming to an end. In a rising rate environment, earnings growth should shoulder more of the returns going forward, and in a sub 4.0% nominal GDP world, earnings growth is going to be hard to come by. According to FactSet
, Q1 earnings growth has been 3.2% which is in line with Q1 nominal GDP growth of 3.4%. The Bernanke disciples are claiming QE victory with stocks refusing to go down, however his metrics of growth and inflation are decelerating to near the lows of the recovery.
It’s now obvious that US stocks were not responding to better earnings or economic growth. Friday’s FactSet Earnings Insight
reports that with nearly half of the companies in the S&P 500 reporting Q3 earnings, the blended growth rate is 2.3% on revenue growth of 2.0%. Not coincidentally the growth rate of nominal GDP is trending near 3.0%. At the end of the day, companies are going to grow at the rate of nominal GDP, and any excess return you are receiving in multiple expansion today is return you are foregoing tomorrow. The higher it goes, the longer it will take.
There is nothing inherently wrong with multiple expansion, but investors need to know that there's a limit to this market dynamic, and there is no way to quantify what that is. The stock market is dominated by short term traders, not investors. The price action is trying to generate performance for the quarter, the month, the day, and the hour. Momentum trading is about the greater-fool theory. You are buying a business; you are buying a commodity. The pressure to participate in this rally is intense and investors left behind -- professional and retail alike -- are desperate to get exposed.
The buy-the-dip mentality has been rewarded, and investors are comfortable it will continue. But investors today aren’t buying the dip -- they are buying the flip. Each buyer is the greater fool hoping there's another fool waiting in line. This can continue for a while, but it can also end tomorrow -- and no one is going to tell you when the music stops.