What Makes A Market Top?

A New Report by Variant Perception -  What Few Are Focused On

Our friends at Variant Perception have published an interesting report entitled “Understanding Market Tops” (please note: the article can be obtained for free here, but requires registration).

Readers will probably recall that we have frequently mentioned that the current ‘echo boom’ is more diffuse than previous booms in terms of bubble activities that can be easily identified. There is no focus on a specific sector of the economy (such as the tech boom of the late 90s, or the real estate bubble thereafter). Instead, the bubble is more broad-based, but there is one broad category of activity which we have indeed frequently singled out, and that is the dangerous growth in debt of all stripes, but especially in low quality debt.

It has been ten months since we wrote about the frenzy of debt buyers reaching even Rwanda, a nation that had never before been active as an issuer in international bond markets. Since then, there has been some regret in emerging markets on the currency side of things, but emerging market debt has largely weathered the storm (we have not kept tabs on Rwanda specifically).

However, the credit bubble as such has continued to expand at a dizzying pace, with junk bond issuance reaching record highs, while both the yields and the quality of the debt issued have never been lower. Leveraged loans have recently also exploded into the blue yonder, and their yields have collapsed as well.  Mind that we are talking about quality in a very specific sense here: default rates have also never been lower, but that is mainly because plenty of money for refinancing purposes is available, so that even companies that would normally have long passed on into the eternal corporate hunting grounds can easily continue to Ponzi on.

What we mean by ‘low quality’ is especially the lack of investor protection in terms of debt covenants. The hunt for yield has blinded people completely to risk; there has never been a smaller margin of error in corporate debt than there is today (issuance of ‘payment in kind’ bonds has also soared to a record – this is debt that obviously offers very little protection to investors).

Currently, ‘suspicion is asleep’, but one of these days, it will wake up, and the lowest junk default rates in history will likely become the by far largest. In fact, we hereby predict that this will be one of the characteristics of the next bust: there will be at least one year when an all time record high in junk bond defaults is going to be set.