Why I’m being fearful during this market euphoria

Warren Buffett famously said that, to be a successful investor, you should be fearful when others are greedy, and greedy when others are fearful.  I think his advice is especially relevant in today’s ‘risk on’ environment, in which the fear of missing out is usurping the fear of loss.

I am generally suspicious when I see evidence of euphoria in markets. Silly behavior usually means caution has been tossed to the wind and the fear of loss replaced by the fear of missing out. In the absence of caution, price discovery gives way to bubbles.

This week, it seems euphoria has returned. On Monday, the US S&P 500 erased all its earlier losses to show a gain for the calendar year. Monday’s 1.2 per cent jump in the S&P 500, the 1.7 per cent jump for the Dow and the Nasdaq’s 1.1 per cent gain were all fueled by enthusiasm surrounding the economic recovery after a surprise surge in U.S. employment. The Labor Department had noted last Friday that the economy provided 2.5 million new jobs in May.  The Nasdaq registered a new record high!

Interestingly it was sectors and stocks that had the most leverage to a recovery and those that had previously been hit hard that surged. Leisure, airlines and cruise line operators jumped. United Airlines was up almost 10 per cent and Carnival Corp., the operator of Carnival Cruises, was up over 12 per cent in one day.

In addition to equities, sub investment grade or ‘high yield’ bond spreads have rallied materially and earlier this week High Yield spreads rallied nearly another 100bps to leave US HY at 580 basis points over Treasuries.

With significant conjecture about the pace of economic recovery but less uncertainty about the fact that a recovery is underway it seems equities and credit are the most liquid avenues for investors to participate. Consequently, it appears money is literally pouring in and extreme price responses have become normal.

None of that really worries me. I have seen it all before. But the point to remember is that 10 and 20 per cent price moves, in a single day, are not normal and they represent a signal that investors should be on alert. What is worrying is the lack of discernment by some investors in some corners of the market.

With 70 per cent of its revenue dependent on airport car rentals, car rental company Hertz recently filed for bankruptcy and yet its stock (HTZ) is up 680 per cent in just the last few days and almost 1500 per cent from its bankruptcy-announcement lows. Explaining the move is pretty straightforward: the number of retail investors with online trading accounts that own Hertz shares has roughly tripled in just a few short days.

Perhaps someone should remind these investors Hertz has filed for Chapter 11 Bankruptcy.

As several analysts have reminded investors: equity holders sit behind a raft of variously-ranked creditors in a bankruptcy. Indeed, the financial business model of Hertz is for the holding company to stay asset light. The rental car assets are securitized and the securitization vehicle then leases the cars back to the parent company. That liability had grown to nearly $15 billion of the company’s $19 billion debt. According to one analyst, “It’s important to bear in mind that Hertz equity sits behind $14 [billion] of vehicle debt and nearly $6 [billion] of corporate debt—all of which would be needed to be paid in full (either in cash or an equity stake) before equity holders could recover.

As we have said in past bubbles, when the fear of missing out usurps the fear of loss, be careful.


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