By John Del Vecchio

Chances are, if you watch the talking heads on TV, they are drooling all over themselves about the Federal Reserve and what actions members plan to take on interest rates. It’s the Fed this and the Fed that.

But, the interest rate that really matters is LIBOR. LIBOR stands for the London Interbank Offered Rate. It’s a really, really important rate.

Here’s why…

When investors borrow money and use their portfolio as collateral, the loan is often priced at LIBOR plus some base interest rate. For example, the loan might be priced at LIBOR plus 1%. Importantly, these loans are not priced on the federal funds rate.

Look at the chart below. The blue line is 3-month LIBOR. Over the past 30 years, LIBOR has trended down. However, recent history tells a much different story.

It’s been rising steadily from the ashes to multi-year highs. Nearly every day it is getting more and more expensive to maintain these lines of credit that wealthy investors have been using.

How much credit is out there borrowed against stock portfolios? Trillions of dollars.

You see, people with portfolios of liquid assets get access to these credit lines. That means people who own stocks. Often you must have more than $1 million in stocks and bonds to get access to LIBOR-plus loans. These are the one percenters.

They can buy a new house or finance a large purchase of an illiquid asset by using their portfolio as collateral. These assets might be boats, planes, fine wine, or investable art.

You name it.

The rub is that the banks don’t ask you what you’re going to use the money for. You just can’t use it to buy more stocks. Anything else is fair game. Want to have a great time in Montreal this weekend? No problem! Just tap into the line of credit. Need to charter private plane for a round of golf at Pebble Beach? The bank will be more than happy to let you tap the line of credit.

The problem is, as interest rates creep up and more portfolios have been used to finance asset purchases, it could create a huge storm if stocks and bonds take even a minor dip. Montreal is fun, but that money has been spent. Hopefully that round of golf wasn’t full of three putts. There’s an old saying that you can always buy a boat but you can’t sell one. And, that’s the problem. Shedding assets when everyone else is feeling pain leads to terrible deals for the seller.

If stock prices slide, the borrower could get margins calls. They have to sell stock. But, they also have to reduce their leverage because they can only borrow so much against the portfolio. Everything unravels at once. This accelerates the selling pressure. What should be down 10% in normal markets might be down 30% in a highly levered market.

Each day, we get closer to the tipping point…

By John Del Vecchio
Subprime auto loan delinquencies are now higher than during the financial crisis in 2008-09. As you can see from the chart below, the 60+ day delinquencies rate for subprime auto loans has surged in recent years and is approaching 6%.

Looser credit standards might be to blame for the rise in delinquencies. Haven’t we seen this movie before with mortgage lending standards? That’s right, it was a horror film that ended badly and resulted in trillions of dollars in bailouts.

Any Joe Schmoe could buy a house well beyond his means? You make $35,000 in a retail job? No problem, here’s a $700,000 house. All you have to do is sign on the dotted line and take out an equity loan on an asset you have no equity in.

Human nature is a funny thing. It never changes. We are right back to the loose lending standards that we experienced years ago. It’s like the lesson of tremendous pain was never learned.

This crisis might not be as bad as the housing crisis in that autos are not quite the big-ticket expense as a house. However, if your car is repossessed, you might have trouble showing up for work.

The trend in delinquencies does indicate that a portion of the consumer market is feeling some pain. They’re being left behind in the “recovery”. Of course, government statistics such as the unemployment rate use a lot of adjustments and, in the end, are just made up numbers.

The risk is that this starts to spread. Initial pain by the weakest credits could creep up the latter. Eventually companies will feel the pinch and we will start to see this pain show up in other parts of the economy.

By John Del Vecchio

The National Association of Active Investment Managers (NAAIM) conducts a survey of its members and reports the average U.S. equity exposure among the group.

This survey has been a great contrary indicator in the past. Collectively, professional managers are terrible allocators. Individual investors are too. As a group, they tend to be too heavily weighted into stocks near highs and not have nearly enough exposure on when stocks are bottoming.

Recently, the market took a dive, and investors for the first time in years were rudely reminded that stocks sometimes do go down! As a result, more than a few people got scared.

Below is a chart of the exposure courtesy of NAAIM.

As you can see, as the market was rocketing higher, so was the exposure. But, the dips in February and March brought down the exposure dramatically from 120% in December, 2017 to under 50% in March, 2018.

What a move!

This is a good contrary indicator. Under normal circumstances a short-term bottom may be in. However, we have been operating in anything but normal circumstances. In the 50% range, the average annual returns are about 7.5%. That’s good but not great. We want to see something under 25% when the returns more than double current expectations.

It’s also important to remember than valuations are stretched as well. And, we are entering earnings season so anything can happen with individual stocks as they report their quarterly results.
While sentiment has become more reasonable, we still have a bit to go before backing up the truck and buying stock. Let’s wait and see where the next dip takes us.

If you’re afraid of heights, then don’t look down. The current median price / sales ratio on large cap stocks will make your palms sweaty and your mouth dry.

At 2.5x revenue we are at incredibly high levels. Back when the crisis was ending in the first quarter of 2009 and many people had unloaded their stocks at the lows, the price / sales ratio was at the low, low price of 0.80. It was a generational buying opportunity.
What use price / sales?

Conventional wisdom suggests that it’s harder to manipulate revenue than earnings so using a measure of revenue to value the market provides a clearer picture of where we are at today.

That’s simply not true. In my book, What’s Behind the Numbers?, I spend a chapter talking about many ways management teams can pull the wool over investors’ eyes and make revenues look a lot healthier than they really are. This late in the stock market cycle, there’s much more incentive to goose the numbers because management’s wealth is increasingly tied to higher stock prices.

But, even if we assume that the revenues reported by large cap companies is true and sustainable, we are at nosebleed levels.
You don’t need to be a math major to know that when an asset class is trading nearly three standard deviations higher than the norm that risk has increased dramatically. It doesn’t really ever happen. We are in uncharted territory.

Not only are the valuations extreme, it’s the case across the market. When the Internet bubble popped, it was mostly technology stocks that took a beating. In the 2008 financial crisis, many stock rebounded faster and more sharply than the major indexes.
This time around though, there’s nowhere to hide. Everything is priced to perfection. That doesn’t mean the stock market is going to crash tomorrow. But, it does mean future returns are likely to be much lower. In fact, when the ratio is over 1.5x, the returns are just 2.5% annualized! It also means that in this game of hot potato you might be the one getting your fingers burned if you’re not starting to work some hedges into your portfolio.