Well, that certainly escalated quickly. The third quarter ended with the US market at pretty much all time highs (again) and the early February gyrations long forgotten by most. But then the calendar rolled over to October, the witching month, and much hell has broken loose. Not all hell, but much. As of last Friday, markets were down about 10% overall - and we mean all markets. Large Cap, Small Cap, International, Emerging...even bonds fell this month. In point of fact, in the last sixty years, this is just the 13th time US markets have sold off by 10% or more within a month after reaching all-time highs. (And yes, that stat is completely cherry-picked because it let us use “Friday” and “13th” in making the same point, and how else would we work a Jason Voorhees reference into this note?) Pretty much the only things that haven’t gone down this month are gold and cash. There has been a little bit of a recovery these last two days, but we are still well on track for all major asset classes to close the month below their average price level for the last year.
So. What was it that solved the puzzle box and unleashed the Cenobites on the market? According to anyone who gets paid to make up explanations for the daily movements of the stock market (and don’t kid yourself, they are made up), the proximate cause was rates going up.
From CNN: “simply put, stocks are sinking as Treasury rates rise...the 10-year hit 3.24% on Wednesday for the first time in seven years. That’s an about-face from 2.85% at the end of August.”
From USA Today: “the catalyst was the recent spike in the yield on a closely watched government bond to a seven-year high.”
There are some tangential things thrown into the mix as modifiers, usually about trade tariffs or geopolitical uncertainty or tech stocks falling, but the main culprit is this nasty “about-face” “spike” that happened in Treasuries. Let’s look at that for a second, shall we?
Check out a graph of the yield on that “closely-watched” 10-year government bond for the last 50 years. Hoo-boy! Take a look at that spike. No, not that first one, that’s the 70s. No, not the big one either, that’s the 80s. Yeah, it does kind of look a bit like a seismograph for the duration of the 80s. That spike? Nope, that’s 1995. Can’t you see it? On the far right-hand side of the graph? Okay, zoom in on just the last two years, since the most recent bottom.
Huh. Well, we’re not sure what that looks like to you, but to us there is neither a spike nor an about-face in that. An actual “about, face” is a two-step, 180-degree change of direction. This is more like “gradual sweeping arc around the entire parade ground, face”. The Fed has raised rates 7 times, or 1.75%, over the last two years. So yeah, yields are higher than they have been since 2011 because rates are higher than they have been since the Bear Stearns bailout in 2008! And what was the yield on the 10-year the last time the Fed Funds rate was at this level you ask? Between 3.5% and 4%. Versus the 3.25% that supposedly precipitated this market correction. If Freddy ever came after us, that would be our nightmare - stuck listening to market commentators whose entire world resets every weekend until our head explodes.
Okay, gratuitous sarcastic rant over. Let’s get to the rotting meat of this Halloween note - Zombies!
Zombies are real. Zombies are all around us. We are in the middle of a zombie apocalypse; you see them every day and probably have no idea until they collapse and die right in front of you. And the most recent one to be decapitated and burned (take your pick of favored zombie disposal methods) is...Sears.
That’s right, we’re talking about zombie companies! Zombie companies are those that should have gone out of business a long time ago, but have been reanimated through the Fed’s zero interest rate policies of the last decade. Here’s a fun fact: Sears filed for bankruptcy protection with about $5 billion in debt on its books. It spent about $6B over the last 12 years buying back its own stock.
Without going on another rant about how the Fed has destroyed the notion of productive capital allocation for the last decade, here’s an example of how zombie companies form:
Let’s say there’s a company called ZomB. ZomB used to be a decent company, but then for whatever reason (maybe they manufactured compact discs, maybe they’re being out-competed by Amazon), they’re not making enough money. They’re still posting revenue in the millions of dollars, but it’s not enough to cover all the overhead, the interest on their debt, their dividends, etc. They’re losing money and need to get their hands on more. So what happens? They issue more debt. Is this debt at 10% or 12% interest, where it probably should be? No! It’s at 5% or 6% for 3 or 4 years. The reason it is so absurdly low is because 6% is a fantastical return when the S&P dividend and US Treasuries are all under 2%.
Zero-rate policy has incentivized a grotesque yield-seeking behavior among investors, but hey, we all go a little mad sometimes. So they give this ZomB money in exchange for 6% for a few years. When the bonds mature, ZomB doesn’t have the money to pay them, so it just issues new bonds, at 6% for another three years, say, and uses the money to pay off the old bonds.
This has been working brilliantly for the last decade. But, every zombie apocalypse comes to an end eventually (except, perhaps for Bruce Campbell), usually thanks to the army. Or plants, if you’re in a video game. In this case, that army is rising interest rates. If interest rates rise by 2%, then the next time ZomB needs to refinance its debt, it will have to offer closer to 9% or 10% instead of 6%. The amount of interest they are paying starts piling up, requiring ever more debt to satisfy. Eventually, they can’t refinance their debt because they are so obviously bankrupt that no investor will give them any money. And then they finally get to die in bankruptcy and society rebuilds from the fiery ashes. Roll credits.
We now have over $2 trillion (with a “t”) in below-investment-grade debt outstanding. A lot of that belongs to companies that should have been taken out behind the woodshed and shot years ago. But just like when your best friend/lover/whoever first gets infected/bitten/whatever and you know you should kill them before they turn into a zombie/vampire/whatever but can’t and then are forced into a life or death struggle for survival, it didn’t happen. And over the next few years, now that rates are moving higher and these companies won’t be able to refinance their debts, we’ll be seeing more and more of these zombies finally put down. Be afraid. Be very afraid.
Here’s a partial list of companies that have filed bankruptcy in the last two years, as rates have finally started normalizing:
Apocalypse indeed. Grab your crossbow, Daryl, the party’s over.
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