Vertigo is nothing if not a gut reaction and, looking at stock index levels and bond prices, today’s giddy heights are all too apparent. From trough to peak the rise has far surpassed that which preceded the 2008 crash. The pattern of credit cycles over the past 30 years has been the increasing reach of both the up and down swings, over a shortening timeframe.
Against this observation, market participants can argue that we have yet to see the real engines of a toppy market kick in this time. We should expect an increase of M&A, leveraged buyouts, as well as structured and synthetic products. Nor have we even seen any rise in interest rates yet, with the result that most asset classes are better primed for the next leg up than a scramble for the exit.
But the reason it has been the most hated rally in memory is because participants feel they are locked in. Anyone who was bearish over the last four to five years would no longer be managing money. The bears have been driven out of most territories, or recast as reluctant bulls.
As a result there is little capacity for two way trading. The illiquid nature of the global financial markets was thrown into sharp relief by October’s market volatility, when stocks and credit indices both saw sharp swings. Those movements were hailed by many at the time as unprecedented, but for some they recalled the bout of sudden volatility experienced in mid-2007, a rumble that preceded the imminent larger earthquake.
No-one is expecting another financial crisis of that magnitude – or not just yet anyway. But there have certainly been crowded trades that market participants should be worried about.
Emerging markets was a clear area of growing worry in 2014 and present an even clearer area of weakness going into 2015. Oil prices have fallen close to $50 a barrel – well below most producers' breakeven points – while the strength of the dollar means those that have borrowed in dollars at record sizes face an increasing burden to make the repayments.
Bulls can argue that investment grade borrowers in the west – and their lenders – are better insulated against market contagion than the previous cycle. Banks, for example, are much better capitalised and meet much higher regulatory standards. They also now live in the advent of central counterparty clearing, meaning the financial system should be more robust.
But there is another area of potential weakness: high yield bonds. Like EM, this has been a crowded and increasingly indiscriminate trade over recent years, as more and more people have searched for yield. Companies have obligingly levered up and some would only need to see a small fall in Ebitda before they find themselves in trouble, or an idiosyncratic disaster such as Phones4U.
Add in the threat of Greece exiting the European monetary union and some high yield names could be facing a confluence of calamities. Oil company Hellenic Petroleum, for example, was able to borrow €325m in June at 5.25%, and its bond has now fallen this week to just 87. US shale gas names have also been widening out.
The pain hitting EM could soon be felt in high yield, in other words. Looking for signs of contagion (such as the same participants being heavily long both, or geographic / sector concentrations) would be a good idea.
But a general downturn early in 2015 might also be good for the longer term well-being of the market. It would create healthy new levels for entry and the next engines of the cycle, such as M&A and other new investments. Investors might be able to buy at valuations they like, rather than valuations they must swallow.
It might also re-introduce a stable of bears to provide some trading volatility – rather than the strapped-in volatility seen in October. Better to have bears return than wait for the day when the bulls panic.
If the market continues its longer term tightening trend for much longer, then we will see overheating start to creep in. We will see acquisitions made at unfavourable price levels and on the back of increasing leverage. We will see silly synthetic and highly engineered products reintroduced, as people try to eke out every last drop of value where they can.
That’s the point where valuations start to depart from reality, like a rubber band under tension. And the more assets become overvalued the more they become correlated with other assets that are overvalued, as systemic risk and potential energy combine.
The greatest concern should be not that we might see a significant fall in 2015, but that we don’t.