2023-06-18 09:23:40 ET
Summary
- On January 9th of this year, I returned to the melt-up argument given it's a pre-election year, but also warned that a credit event looms large.
- In the coming two years, corporations are set to roll over trillions of dollars of debt.
- ChatGPT can't stop this.
The world is full of obvious things which nobody by any chance ever observes. - Arthur Conan Doyle
In October of last year, I made the argument on Twitter that "the end of the world is at hand, that's why stocks are about to have a melt-up."
In December of last year, I made the argument on Twitter that there was the risk of an imminent stock market crash. The S&P 500 ( SPY ) didn't crash in December, but it was the 5th worst December in history going back to the Great Depression.
On January 9th of this year, I returned to the melt-up argument given it's a pre-election year, but also warned that a credit event looms large.
I want to expand on this now given screams about a "new bull market" which I believe is in reality the greatest bear market rally in history.
The Corporate Debt Overhang
In the coming two years, corporations are set to roll over trillions of dollars of debt. This colossal debt burden creates a precarious situation since the ability of these corporations to refinance their obligations hinges on the health of the credit markets. If the credit market tightens or investor sentiment sours, refinancing could become challenging, leading to an increased risk of default. This is consistent with the idea that a longer-term allocation to small-caps ( IWM ) will be challenging. It's hard to see breadth meaningfully widen beyond short-term trades when there's a very real risk zombie companies won't survive.
Complacency in Debt Markets
The current complacency in the debt markets exacerbates the potential for a credit event. Investors are not sufficiently pricing in the risk associated with the massive corporate debt overhang post-Covid. This complacency could result in a sudden and severe market correction if default risks materialize. Yes - there is a lot of cash and locked in capital at low rates. But at some point the market begins to discount the realization that low credit spreads ( HYG ) and default risk is the anomaly, not the norm against the fastest rate hike cycle in history ( TLT ).
Mean Reversion in Credit Spreads
Credit spreads, the difference in yield between government bonds and corporate bonds of the same maturity, are another crucial factor to consider. Currently, credit spreads are relatively tight, indicating a low perceived risk of corporate default. However, credit spreads are known to be cyclical and can revert to the mean or even overshoot it. If there's a mean reversion in credit spreads, this would imply wider spreads, signaling a higher risk of default, increased volatility, and potentially significantly lower equity prices.
The combination of these factors could potentially trigger a recession. A highly leveraged system is inherently vulnerable to shocks. If corporations start to default on their debt due to difficulties in refinancing, this could lead to a contraction in credit availability, a common precursor to a recession. In such a scenario, we would likely witness higher unemployment rates as businesses cut costs in response to the economic downturn, and an increase in housing inventory as construction slows and foreclosure rates rise.
Stock Market Implications
The stock market would not be immune to these developments. As the VIX ( VIXY ), often referred to as the "fear gauge," spikes, stocks typically fall significantly. This relationship is due to the increased uncertainty and risk aversion among investors, which leads to higher volatility and selling pressure in the stock markets. Volatility rises in equities when credit spreads widen because of increased default risk perception in the bond market. This is still coming.
Conclusion - There's More Pain Coming
ChatGPT can't stop this.
Nvidia ( NVDA ) and their GPUs can't stop this.
And your gamma trading FinTwit bros can't stop this.
I have no idea when an event will happen. No one does. That's like knowing the exact mile marker you might crash your car. But I do know that when conditions suggest it's about to rain heavily, you start slowing down your car. The conditions will at some point favor a tail event in equities, which means consider your gains far more transitory than you may want to accept.
For further details see:
A Credit Event Is Coming That Will Shock The Nouveaux Bulls