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
(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
) 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
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
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
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
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
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
(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
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
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
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
, 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
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.