The Dividend Cafe - The Next Bad Thing

Episode Date: June 10, 2022

I purposely wrote this week’s Dividend Cafe before the CPI number posted this morning at 8:30 am ET. Lots of traders were getting in front of this late Thursday, and a market that had rallied up +2,000 points in the last two weeks was down -1,000 points in the last five days and is now down a lot as markets open Friday. We are in a period of short-term traders trying to front-run the Fed, but more particularly, trying to front-run those who they think are trying to front-run the Fed. What I mean is not as complicated as it sounds: The basic belief is that if inflation data looks worse, for longer, the Fed becomes more Volcker-like in their hawkish tightening, and that hurts risk assets; therefore, if we see a whisker of “more inflationary than expected” some will start selling, and we should sell before they sell. Well, good luck with all that. Today I am going to look at what could make this market get worse, not in a “traders are going to do this” kind of way, but in a real systemic, significant, macro kind of way. It will turn into a two-parter, no doubt. But let’s look behind the headlines of the day, the CPI print of the moment, and the Fed actions of next week. Let’s dive into the Dividend Cafe … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to Dividend Cafe from the wonderful New York City studio. I am recording here on Friday morning and it's been another whirlwind week in markets. And so I am kind of excited for this topic because, you know, the markets had been up about 2,000 points in the last couple of weeks, and then they had given about 1,000 points of that back, kind of front running the CPI number that came out this morning. In other words, the belief that if that inflation reading came in higher, it would mean more Fed tightening, and then more people might respond to that. So people wanting to get in front of folks who may

get in front of this. And if it sounds like I'm sort of being critical of that thinking, it's not so much that I'm critical of it as just describing it for what it is. And in the mere description, you can probably tell it isn't really what I believe in or would ever think about doing. Here's the thing. I am interested in talking today not about what the Fed is going to do next, not about what the CPI number showed this morning, and not about what day traders and speculators and the last 1,000-point move down or the last 2,000-point move up or all that stuff. I'm interested in kind of where we are after this repricing that we've been talking about all year,

especially in the frothier parts of the market, where we are that could lead to another significant leg down. What would be a potential catalyst to, instead of a kind of routine and so far pretty shallow correction or bear market, the S&P did get down 20 at one point. The NASDAQ is down over 20 now. The Dow is still only down 10 or 11 as of yesterday, but has been down a little bit more. So it's a market adjustment. And depending on how people are allocated, it could be significant, but it also could be somewhat routine. But you have sort of more significant drops from time to time, 1973, 74, and the 1987 crash. You have the 19, well, the 2000 crash from the bubble in late 1990s. And of course, the great financial crisis and these various moments that are more sizable and more prolonged.

And because we're talking about the current market conditions as being afraid of the Fed breaking something, it behooves us to wonder what is the thing the Fed could break that could lead to a more sustained market drop. I am of the belief that always and forever, bear markets are periods where risk assets get returned to their rightful owners. That's a line that Warren Buffett has used over the years. I don't know if he stole it from someone else, but I do know that I'm stealing it from him, but I believe it very much. I think that there are so many people in financial markets that are kind of renting or temporarily holding onto an asset. What is an asset? What do I mean when I refer to capital? It's an investment in either the debt or equity of an enterprise, of a thing, of an underlying investment, whether it be a company or real estate,

there is debt and equity in the capital structure attached to these entities. And what those entities are attempting to do is create value. So an investor is invested in the value creation process of the underlying investment. Someone temporarily holding onto it is speculating, trying to gamble or play an anomaly or chase something. Sometimes it's gamesmanship. You look at the modern app use of just in and out type investing. So people can do what they want to do. I have fiduciary responsibility to clients to do something a bit different, a bit more thoughtful. But when it comes down to bear markets, you see people that were not serious about being involved in the value creation of investment selling, and they're selling them to people that presumably

are serious about being part of value creation. And again, this can apply to either the debt or equity side of capital structure. So that will happen for a long period of time and it can happen in quite a magnitude in a bear market. Generally, bear markets of size and stature come when there is an excessive indebtedness that has to substantially get corrected, kind of repricing out of a leverage blow up. That's basically the mother of all evils. And I've done several dividend cafes about this subject before. So there's over leverage, excessive indebtedness leads to some sort of a failure, then leads to a lot of people kind of shuffling the deck. And somewhere out of it, there are people who are real rightful owners of well-priced assets

that end up holding more of or reholding those assets and then things correct and resume some sort of normalcy. And those rightful owners generally receive quite handsome returns out of such a process. Well, I guess what I would say to you is that I spent a lot of time this week thinking about what could be that next catalyst for a more sizable drop. Because I am still very much of the opinion that I don't know if we're going to go into a recession or not. I don't know how steep one could be. I don't know when it would happen. I don't know what markets would have already priced in. And I think there's a lot of compelling arguments for all sides of this issue, including there not being a recession at all. And there's compelling arguments for all sides of this issue, including there not being a recession at

all, and there's compelling arguments for it coming sooner or being more meaningful. There's a lot of unknowns in all of this, and I've been quite humble and yet forthright in elaborately talking about this subject for several months. But in terms of breaking the market, where the Fed just breaks something and it really leads to another more systemic breakdown out of some sort of excessive indebtedness leading to a problem, the aftershocks shake through all financial markets. I went through a kind of list of things that kind of made sense. I think most people looked at housing and the credit market back in 2006, 2007 is the great risk. And yet the degree of leverage that was built into the system held by the American banking system in 2008 created that

ghastly financial crisis. Since then, we've talked about European bonds quite a bit, for good reason. You go all the way back to 2010 was the initial stage. We used to call it PIGS, was the acronym for Portugal, Italy, Greece, and Spain, that were countries kind of on the brink of default. And on again, off again, Greek risk, as well as peripheral southern European countries, stayed on the map for a couple of years. And then at some point, 2012 into 2013, for all the debate about what was going to happen with the euro currency and what was going to happen with the kind of European Union countries and their individual indebtedness, despite being part of a monetary union, but all having fiscally independent states. Mario Draghi of the European

Central Bank kind of answered that question for us, which was that they were going to do anything and everything, including use of a bazooka to hold the euro together. And in fact, a couple trillion euros later has bought so many bonds with money that doesn't exist on their balance sheet. It's unfathomable and run at negative interest rates for so long. So those European bonds tightened up real quickly and, in fact, went to negative yields, let alone not being a blowout yields anymore. And I can make all kinds of arguments for the other problems that they created. But in the course of these other problems, what they solve for or sort of put aside is this

notion of a systemic sovereign default in a major European fixed income security. It's just simply not in the cards right now. And the European banking system and the sovereign debt have all shown far, far, far more health than where we were 10, 11, 12 years ago. I think that the municipal bond world in America has been a prime candidate for vulnerability. And yet, again, we went through the bankruptcy of Detroit. We went through a lot of downgrades in Chicago, in the school system, in the state of Illinois even. You're talking about pretty major municipalities. We saw California's bonds trade from a big discount to par to a massive premium to par.

And then, of course, during COVID, there was all the questions. Would sales tax revenue, state income tax revenue, property tax revenue dry up so much if the country was shut down that you'd have a mass default in municipal bonds? And what would that look like downstream. And then states right now ended up with the most cash they've ever had, the highest tax receipts they've ever had, as basically the risk of all these cities, counties, and states was transferred to the federal taxpayer as the feds just poured money into states, cities, and counties, many of which you could debate whether or not these people deserve a checkbook or not. But nevertheless, they're checking accounts, have an awful lot of money, and municipal bond defaults in a wave of systemic risk. How that sort of went away.

There is, from time to time, discussion of some big hedge fund that's holding a lot of systemic risk. And there's counterparties and leverage we don't know about. And people bring up the 1998 incident with long-term capital management, where again, the counterparties that had helped that hedge fund lever up 70 to one, 90 to one, all these ridiculous things. The risk was not about the investors and long-term capital losing their capital. They did deserve it and they deserved to lose it. And for them and their families, I'm sorry, but for the rest of the world, I just don't care and nobody needed to care. But the risk there was that is there so much loss absorption coming

to the big banks that had backed them that it could become systemic. So then people use this analogous to like last year, this family office, Archegos, that blew up. And it's just so dishonest and so stupid that I can't believe people say it. It was an individual family office, someone who personally had blown their net worth up to $10 to $15 billion, and then it all went away. And so they got to be very, very rich, and then they got to be not very rich. And some banks lost some money. Most banks covered their positions, but the losses were held by the person who held the positions and took this big speculative risk with leverage. And there was nothing even remotely systemic. So I mean, I think it's a fascinating story. But I think the media's coverage of it is weird. And then the politicians coverage is either

ignorant or agendized. But there was no risk there to anybody else besides the people directly involved. And again, I think it's a really sad story in a lot of ways, but I don't care. It doesn't matter a whit to financial markets when someone takes risk and loses. What we're talking about here is when some particular event has a spillover effect that we call contagion that becomes systemic across all financial markets. And so some hedge fund blowing up is not that either. Crypto now this year, you're talking about over a trillion and a half dollars of wealth, of value that has been destructed in recent months. I suspect that number gets worse.

Nobody knows. It's an entirely speculative play. But again, it isn't highly levered. It isn't sitting on the balance sheet of banks. I think it's mostly very small investors. I think they'll all learn some painful lessons, probably already have. There is a part of me, and I don't mean it cynically or sarcastically. I do kind of mean what I'm saying, but it may come off a little more smug than I mean it. I think some people that maybe were seeing such big gains in crypto trading and then therefore had left the workforce that I think it might put some people back in the workforce, which I would argue could be a good thing ultimately. But again,

there'll be tough lessons learned here through the crypto situation. But is it really a systemic issue that will lead to a broader recessionary downward push? I don't think so. I think, again, it's isolated to the risk taker. So the example that I'm going to focus on here today is whether or not private equity is the situation that right now could be our next cause du jour of a leg down. That is there such a bubble in private market transactions, which are generally private companies being bought by a professional pool in the private market outside of public equities. And then a lot of times funded and what we call an LBO, a leverage buyout, where there's debt put on to acquire the company. And then there's more debt service that goes into that company going forward.

the company, and then there's more debt service that goes into that company going forward. And so I read a report this last week that caught my eye, ear, attention, and frankly, kind of caught my eye-er, that stated that the average private equity leverage buyout in the year 2000 was done at about half of the valuation of the S&P. And that the average valuation in 2021 was 10% higher than the S&P. And so immediately, my first thought was, knowing that most people reading would be like, oh my gosh, that sounds very scary. And the author was quick to point out that there's a heck of a lot more transactions now than then, and with higher leverage and with lower quality credit. So ergo, this whole thing is about to blow up. And I just thought to myself,

well, that's interesting. How in the world could they know what the average valuation of an LBO was in the year 2000? It's not indexed. There was a fraction of the transactions then that there are now. There was very little press. There's not the organizational archiving where you can get data. Today, about 85% of transactions get reported as terms not disclosed. It is not easy to know what one is paying or what multiples are used or what projections are used. And that's with now in a full industry around data analytics in this space. Back then,

it didn't exist at all. There was no ability to kind of unpack those specific numbers, unless you were talking about in public equities, like a private takeout of a public equity, but that's not what we're talking about. And by the way, if somehow someone had all this optics, which they don't, the S&P was trading at 29 times backward earnings and 25 times, excuse me, 29 times backward earnings and over 30 times forward earnings. And which, of course, those earning projections came down real quick. But am I supposed to believe that, you know, like in 2021, we were trading at 22 times forward earnings and 25 times backward earnings? trading at 22 times forward earnings and 25 times backward earnings. Am I supposed to believe that when they say 10% higher that the average private equity transaction last year was done between 25 and 30 times earnings? It's just utterly absurd. So this data point is not true, not verifiable.

Some parts are verifiably untrue. And also you look to the leverage ratio, where you have two variables, one of which is a negative and one of which is correlated to the other. The average, you know, cost of capital when LBOs began were between 12 and 20% to borrow money. And let's say it's been somewhere between four and 8% over the last year or two. Now, on one hand, I'm not saying, see, it's all good. It's a much lower cost of capital. I am pointing out that that changes the pro forma in a spreadsheet. It changes cashflow expectations, but I also believe that that changes it distortively, that people pay more for a company because of the lower cost of capital. They put more debt on because the debt service is cheaper at a lower cost of capital. And that by kind of distorting the cost of a

transaction, you end up doing some bad deals. And I freely admit that. The remedy to that, though, is in quality underwriting, quality operators, due diligence, strategic financial planning. There's fundamental elements that can be used to remedy that. But that general rule of thumb, I would at least like it to be acknowledged that there's a massively lower cost of capital now, and then have the problem properly identified, which is not trying to compare apples to oranges, which is 1989 transactions to 2021 transactions, but to recognize that there's a greater risk of distortion than just the actual nominal amount of leverage.

So these are two totally different things. And I just don't think people are understanding it or getting it. And the only question is whether or not that is because of ignorance or because of dishonesty. And my guess is sometimes it's a little bit of both. So in the overall private equity world, I believe that you have transactions that have taken place that will go astray. You know, last I checked, the most famous private equity transaction of my youth, Barbarians at the Gate, remains my favorite business book drama I've ever read, probably ever will read, about the famous RJR Nabisco LBO that took place in 1988. I don't know that there's been a lot of transactions since then that blew up that much capital, especially adjusted for inflation, like in yesterday's dollars.

And so we're talking as if there's all this embedded risk now, and it supposedly was some free ride 30 years ago. It's just not true. and it supposedly was some free ride 30 years ago. It's just not true. There are some high profile bad deals that have been done in the last 10 years. There's been some really big success stories in the last 10 years.

Some of the deals done in the last two or three years are gonna prove to have been good and some are gonna prove to be bad. And some of the deals that get done in the next two to three years are gonna be good and some are gonna prove to be bad. That is not a systemic statement that trickles its way down to financial markets. That is simply a byproduct of a capital markets evolution and the distortion that may be existing from low cost to capital and then overall business conditions.

maybe existing from low cost to capital and then overall business conditions. But if we say like, hey, I'm worried there could be a recession because if there's a recession, you'll get a lot of operating businesses that fail and these were just bought. And so that could hurt private equity. That would be an effect into private equity, not the cause of private equity dropping. It's a tautology that those companies will suffer if there's a recession. The question is, will those companies suffering cause the recession? And I think that's questionable logic. Ultimately, I would really encourage people to focus on quality private market investing, a high priority on underwriting, on quality control, still recognizing the risk embedded in the system. You want operators right now and buyers to be

disciplined. But no, I do not believe that we're facing this systemic risk that brings down the whole economy out of the private markets and the leverage that is embedded therein. Now, what I want to take up next week is, is there another angle to leverage finance? The non-bank lenders, which are largely who has financed private equities, leverage buyouts. A lot of the private credit in the system, There's new middle markets lending, direct lending. There's cash flow based businesses. There is securitized credit. There is all kinds of floating rate debt that is existing out there outside of the bond market. We know about the structured credit I've talked about in the past, securitized finance that exists in commercial real estate, in residential real estate, in other aspects of sort of asset-backed securities, credit card receivables, student loan receivables, auto receivables. There's a lot of innovation

that's happened in credit markets and debt markets in our country. And a lot of it could end badly. A lot of it has thus far gone quite well. The Fed has a vested interest in not breaking that for various reasons. But let's unpack that and see what systemic risks exist inside non-bank financing and other elements of credit markets that go beyond what we think of as conventional debt. We know about municipal debt. We know about sovereign debt like our conventional debt. We know about municipal debt. We know about sovereign debt, like our federal government. We know about global debt, like Japan and Europe. I'm referring to debt that is not in the mainstream traditional financial system of your big commercial bank down the street. Those capital holes are what caused the financial crisis in 08. And they got filled with greater indebtedness from the government. Now, the large reflation

that's existed in the corporate economy is off the balance sheet of banks. And there's various non-bank lenders. And a part of it I talked about today that has gone into financing American businesses. But I think the question I want to ask is whether or not there's something else in credit markets that creates a systemic risk. We'll make that kind of a part two for next week. So hopefully, I know I covered a lot rather quickly here today, but I hope you got something out of this discussion. Understand why I think many of the potential culprits for a whole blow up in American economy are vastly misunderstood or simply off the table. Why I think private equity right now both calls for a sober judgment in the way one looks at it, not making up false statements and doomsdayism.

And then on the other hand, not assuming that everything in the private markets is totally great because there will indeed be bad deals done. So we're going to try to do this with sober judgment, prudence, honesty. And next week, we'll unpack some more hard truths and see if we can't make good decisions and formulate a good, coherent understanding of risk and reward in this current economy. I hope this is helpful. Thank you, as always, for listening to and watching the Dividend Cafe. Reach out with any questions. Some of the concepts here today, you know, maybe presented a new vocabulary. We'll unpack any of it you want us to. That's what we're here for. Thanks so much for listening to the Dividend Cafe. The Bonson Group is a group of investment professionals

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