Junk Bonds, Hot IPO Market, and “Unexpected Events” Compared

By the Curmudgeon with Victor Sperandeo 




Last week's Curmudgeon post, Victor noted the tight credit spreads and low yields on junk bonds are signs of extreme “investor” complacency.  We expand on that theme in this article and also look at the resurgent IPO market in the light of GoPro's successful debut this past week.  Victor weighs in with his insightful comments and analysis, particularly related to the current IRS scandal becoming a lot bigger.  He then wraps up by challenging the reader to think of "what could possibly go wrong" amidst all the warning signs being ignored by the financial markets.


Note:  The Curmudgeon and Victor Sperandeo put quotes around "investor," because we believe that term has lost its meaning.  The current financial markets are dominated by asset managers who are "investing" other people's money and are subject to tremendous pressure to beat their benchmark.  The sense of fiduciary responsibility seems to be a thing of the past.  The public mistakenly believes that their asset managers can protect them from huge losses during a severe market decline.  We think that view is naive and preposterous.


Junk Bonds are No Longer High Yield:

Junk bonds are low rated, corporate debt instruments with the least attractive balance sheets and therefore the highest risk of default.  They're most vulnerable to declines in principal as fears of default rises in a weak or stagnant economy like we've had for the past several years.  Yet this past week, the Merrill Lynch 100 High Yield Index was 4.33% [Source: WSJ Data Center] while Barclays Capital High-Yield Index was 4.83% [Source: USA Today].  Those are the lowest yields for junk bonds in history!  Meanwhile, the number of rating downgrades for junk bonds is outpacing the number of upgrades.  Could that now be a bullish sign in the convoluted investment environment we're in?


The Curmudgeon finds it remarkable that “investor” memories are so short.  The fear of a huge decline in asset values has been completely forgotten.  In 2009, "investors" were deathly afraid of junk bonds as yields spiked to over 20% (see chart below).  In the 2007-2008 junk bond meltdowns, the average junk bond mutual fund fell over 30%, including reinvested interest payments. In contrast, the average intermediate-term government bond fund rose 2.33% [Source: USA TODAY].


Today, with yields of less than 4.5%, "investors" can't get enough junk.  Merrill Lynch's High Yield 100 Index is up over 5% this year while junk bond funds continue to attract new money.  High-yield fund inflows totaled $437 million in the week ended June 11th, according to Lipper and $2.8 billion over the past six weeks.


The chart below illustrates extraordinary complacency (or lack of fear) with junk bond prices at record highs (i.e. yields at record lows).  


                                Chart Courtesy of Elliott Wave International


Another problem emerges in serious junk bond sell offs.  When everyone heads for the exits, fund managers must sell bonds to pay redeeming shareholders. But in a panic, there are no buyers.  The lower quality junk bonds become totally illiquid. Managers must sell their highest-quality bonds, often at steep price reductions, to meet redemptions. As a result, the overall quality of the bonds in the fund's portfolio deteriorates, leaving shareholders with an even riskier investment--one more vulnerable to future price declines.


As Victor and I have repeatedly stated, an "illusion of safety" has been created by the Fed (and foreign central banks) which has caused “investors” to ignore numerous financial, economic and geo-political warning flags (i.e. bells ringing) that in normal times would cause them to nervously sell "at risk" assets and head for the sidelines in cash.


IPO Market Heats Up and Will Get Hotter this Summer:


GoPro's successful IPO this past week was the largest public market debut by a consumer hardware company in over two decades.   The San Mateo, CA based videocam gadget maker raised $427.2 million to become largest consumer electronics IPO since Duracell, which went public in 1991 and raised $433 million.  Out of 53 companies from Silicon Valley that went public since January 2013, GoPro raised more money than all but Twitter.


As of Thursday's market close, GoPro had a valuation of $3.86 billion, tying it with San Jose-based semiconductor company Atmel as the 58th largest market cap among all Silicon Valley tech firms, according to an analysis by the San Jose Mercury News. 


Many analysts say that Go Pro has warmed up the market for bigger IPOs, such as Alibaba, and emboldened tech firms to price their shares higher.  It's likely a prelude to what could be the busiest summer for IPOs in years. 


"The GoPro IPO is a great sign for the IPO market in general, and now market conditions are great for Alibaba to come (public) in early summer," said Matthew Turlip, senior analyst at Privco.  The successful GoPro debut may also begin to push up the price on public offerings, Turlip added.


"The deal activity has been just huge, and it's been broad-based—[real-estate investment trusts], energy, biotech, tech—so we've been participating quite a bit," said David Chalupnik, head of equities at Nuveen Asset Management, which oversees $120 billion.


"This is a great year to IPO," said Jacqueline Kelley, who oversees U.S. IPOs for research and consulting firm Ernst & Young. "It's not just companies that are mature businesses. This market is open for innovation and really welcoming entrepreneurs," she added.


In June 2014, 31 companies have floated shares for the first time in the U.S., raising $9.2 billion, according to Dealogic.  By both the number and dollar volume of offerings, that marks the most active month since October.  This month, 81% of IPOs have priced within or above the company's expected range.

91 companies went public in the 2nd quarter of 2014- up from 62 during the same quarter last year and 33 in 2012, according to a report out Thursday from Ernst & Young.  In this year through Monday, there have been 144 U.S. IPOs raising $30 billion. That puts the IPO market on pace for the busiest year since 2000, both by dollar volume and number of deals, according to investment research and data provider Dealogic.  For the week ended Wednesday, 21 companies had filed initial IPO paperwork, according to Renaissance Capital.


"We are experiencing one of the rare instances of an IPO market that can support a very full and varied collection of companies from different sectors and of different sizes and stages of development," said James Palmer, head of Americas equity capital markets at UBS.


The Curmudgeon must be having a senior moment, as he's sure he's seen this movie play before.  It was titled, "The DOT COM Boom & Bust."  Does anyone remember pets.com?

Victor's Comments:


The very low yields on junk bonds and the buoyant IPO market are strong indications that the tolerance for market risk is very high.... One indicator means nothing in market analysis. What counts is a number of historically correlated measures of high risk vs low risk markets.


When a company goes public, management and VCs either want to cash out of that investment or raise capital to expand operations.  Today, when companies can borrow at the cheapest rates in U.S. history, why go public?  If you are a private company, have a good business and need capital for future growth, you can borrow at ultra-cheap rates.....Unless you want to transfer equity risk to someone else (the "investors" who buy your IPO shares), because you believe that the economy will be weak in the future and the IPO window of opportunity will close.


According to this week's Barron's, the S&P 500 trailing P/E ratio is 19.57, while the S&P 500 Industrials P/E is 20.52.  I don't buy into "forward P/E's," because the projections of future earnings is soothsaying or pure guess work.  No one knows what the future earnings and/or P/E ratio will be?  Therefore, the comments of $116.00- $132.00 of future S&P 500 earnings are very naive, IMHO. 


Also, the "Quality" of earnings is critical ... Firing and/or laying off employees,  buying back stock (especially with borrowed money), accounting tricks/shenanigans,  reshuffling operations to lower tax rates in different countries  lead to higher after tax earnings per share, but the quality of earnings is very low.  That is not what "investors" should pay 16-20 times earnings for. 


Curmudgeon Note:


IBM has been called the poster child of such financial engineering that artificially boosts after tax earnings per share.  This weekend Barron's reported its list of top 100 respected companies.   IBM fell to number 52 this year, down from number 10 in 2013 and number 2 in 2012.  "Investors" no longer seem willing to cheer the company's negligible top-line growth or earnings-per-share gains that owe largely to stock buybacks and accounting tricks. 


This topic was comprehensively covered in the Curmudgeon post titled, "Managed Earnings, Tech Bubble Talk, and IPOs with No Earnings." 


We think this market is currently in "weak hands" ......There are probably many "investors" who are prepared to sell on a moment’s notice if an "unknown event" occurs.  This would be an event that the Fed couldn’t counteract with easy or free money.  Such "unknown events" come in many forms.


For example, 1973 was expected to be a very good year for the U.S. stock market, following a solid 15% advance in 1972.  In early January 1973, Time magazine reported that it was "shaping up as a gilt-edged year for the stock market."  Yet the market fell in roller coaster fashion that year (the S&P 500 was down 14.66%, with a P/E of 18.08 on January 1, 1973).  The decline was largely due to the OPEC oil embargo which caused huge lines at gas stations and led to sharply higher inflation.  The market had to contend with two other "unexpected events" -- the Watergate hearings and Vice President's Spiro Agnew's resignation.


The 1973 stock market declined off a January 11th all-time high, rallied off an August low, but then declined in earnest after Vice President Spiro Agnew was forced to resign on October 10, 1973.  That was after the U.S. Justice Department uncovered widespread evidence of his political corruption, including allegations that his practice of accepting bribes had continued into his tenure as Vice President.


In 1974, the market fell again (the S&P was down 26.47%, with a P/E of only 11.68 on January 1, 1974).  That decline was primarily due to "Watergate" and accelerating inflation which had its roots in the Arab Oil embargo of the previous year.  Measured by the CPI, inflation jumped from 3.4% in 1972 to 12.3% in 1974. 


Victor Personal Note: I successfully traded on the short side of the market during that 1973-74 time period.  My bearish bias was predicated on President Richard Nixon causing a crisis and the question of what would happen to the Constitution when the "crisis" actually occurred.


Curmudgeon Counter Note:  Like so many other non-professional traders, I was mostly a buy and hold investor that suffered both financially and psychologically during the great bear market of 1973-74.  For many years thereafter, I was skeptical that any stock market rally could be sustained.


Fiendbear Counter Note: The Fiendbear was just a cub in grade school but he did study this particular bear market a while ago. You can see a summary of the 1973-74 bear at this link.


Watergate and IRS Scandals Compared:


The "Watergate" hearings and cover-up talk dominated the news during the 1973-1974 bear market.   It was a simple burglary of strategy papers (on June 17, 1972) at the Democratic National Committee headquarters at the Watergate office complex in Washington, DC.  President Nixon resigned (rather than be impeached) on August 9, 1974 after he was caught as a liar and cover-up leader--2.25 years after the crime had been committed. 


Let's compare "Watergate" to the IRS scandal of today.  It looks highly likely that lies and an IRS cover-up may have also occurred.  This is far worse a crisis, in my view.  If proven true, the IRS will be seen as discriminating against Conservative groups like the Tea Party in order to "directly sway" the 2012 elections, while also infringing on the Constitutional rights of U.S. citizens.   Lois Lerner -- the IRS official who was involved and pleaded the Fifth Amendment - is in the category of many mafia bosses, IMHO.  


Libertarian Wayne Allyn Root thinks that Obama might be involved in the IRS-Tea Party affair.  He wrote in a blog post: 


"The real scandal is that this was a widespread criminal conspiracy by the Obama White House to use the IRS to target, persecute, intimidate and silence Obama’s critics and political opposition.......Congress needs to ask Lois Lerner and other IRS officials about the targeting of individual critics of Obama…good Americans with names and faces and families…who they tried to destroy and intimidate…people like me. That story will resonate with the American people."


In light of the above, we call your attention to a July 10th IRS hearing presided over by Judge Emmet Sullivan.  That judge reportedly hates corruption and has the power to force the IRS to answer questions they avoided during Congressional testimony. 


A few quotes on this issue are well worth reading at this time:


“Internal Revenue Service officials will have to explain to a federal judge on July 10th why the tax agency didn’t inform the court that Lois Lerner’s emails had been lost." ...The Washington Examiner.


“The IRS is clearly in full cover-up mode.  It is well past time for the Obama administration to answer to a federal court about its cover up and destruction of records.”…Judicial Watch President Tom Fitton.


“We the people are the rightful masters of both Congress and the courts, not to overthrow the Constitution but to overthrow the men who pervert the Constitution.”…Abraham Lincoln




Will the IRS scandal be the "unexpected event" that trips up the market?  Or will it be from geo-political tensions that become a full-fledged war (e.g. Sunni militants vs. Shia in Iraq and Syria)?   No one really knows.  Yet there are so many warning signs pointing to danger that are being ignored by the markets.   And so it goes...... until it isn't the same anymore.....


Till next time........................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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