Bond Liquidity Evaporating

Last week, the S&P500 moved up 1.7% on light volume. In fact, the week’s volume was among the lowest of the year, meaning once again that there was little investor conviction behind the price rise. At the same time, volatility dipped, falling to the lows of the year but not nearly as low as it was during the summer of 2014.

The economic picture is still fairly weak. Last week, the labor market conditions index disappointed. ISM services also missed estimates. The JOLTS jobs survey was somewhat weak, and in consumer credit, credit card debt is struggling to grow. On the positive side, initial jobless claims were still fairly low and wholesale trade beat consensus estimates.

The technical picture is still one that shows an extremely overbought condition for the S&P. On the weekly charts, this overbought condition has been in effect, for most of 2014 and for all of 2015. The only time prices backed off meaningfully in 2014 was in October, but they quickly became overvalued again afterwards. On the daily charts, prices have been vacillating above and below the 50 day moving average for most of 2015, and as mentioned in prior posts, this is reflected in an S&P500 that, year-to-date, is almost unchanged.

In terms of investor bullishness, the recent trend has continued to be in effect—investors are more bullish today than they have been in decades. At the same time, the percent of investors who are bearish is also at multi-decade lows.

Margin debt remains sky-high, for example, when measured as a percentage of market capitalization.

The primary fuel for equity increases lately—corporate buybacks—continues to flow.  And the primary source of this buyback fuel has been corporate debt issuance over the last three years. Because for US corporations to buy back more and more stock at higher and higher prices, the only source of cash needed to execute these buybacks—especially when operating cash flow after capital expenditures is insufficient—is the bond market. So US corporations, over the last three years, have gone on a massive borrowing spree, levering up more and more to buy back more and more of their stock.

What could go wrong?

For one thing, as yields on this riskier (due to the higher leverage ratios) corporate debt keep falling (due to the Fed’s suppression of rates), it leaves investors with very little cushion to withstand big fluctuations in price—especially price drops.

Prices can drop if investors reach a tipping point and decide that since yields are too low, they must sell. And if they were to sell as a group, the price of US corporate debt could collapse.  Why? It’s extremely overpriced—relative to history—right now. And it also collapse because there is very little liquidity in the corporate bond markets today, which means that relatively small sales can have devastating impacts on prices. The main reason that banks and brokers hold less bond inventory today is because new regulations make it very costly for them to hold the levels of inventory they held in the past.

The bottom line is that not only are US stock prices vulnerable to a price correction but that US corporate debt markets are vulnerable to a price shock as well. All the more reason to keep dry powder on hand to be able to take advantage of the corrections when they eventually happen.


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