Stealthy Bubbles

A major investment bank issued a research report yesterday encouraging its clients to immediately purchase stocks, because there won't be another opportunity to buy them as cheap as right now, as they said. Market timing opinions are a dime a dozen (my own are even cheaper), so no great news there. What is interesting, however, is that one of their reasons for recommending shares is that they have not observed any telltale signs of euphoria, mania or bubbles in such markets. Ergo, contrarian investing dictates buying.

I have a couple of comments...

Firstly, not all bull markets end with manic buying. Sometimes they just roll over quietly and head lower in a slow, grinding process. In fact, clearly observable and spectacular bubbles a la dotcom are the exception, but it could be that the writer of the report is not old enough to have experienced other market modes.

Secondly, the record-breaking emergence of hedge and private equity funds in conjunction with structured/derivative finance has meant that bubbles are perhaps much better hidden than in the past. Such professional speculators do not rush headlong into markets and can use more sophisticated techniques than direct purchases of shares. For example, they may sell CDSs (credit default swaps) to create equity risk exposure, instead of buying shares directly. This has the expected effect of boosting share prices, but in a less volatile fashion. There is very strong evidence of this occurring, as CDS notional amounts literally rocketed from $8.5 trillion at the end of 2004 to $34.4 trillion at the end of 2006 (Data from ISDA). I believe this is at least part of the reason why equities kept creeping higher and higher in a reverse drip-dry process, with no correction at all - until recently.

There is another crucial implication to the emergence of CDS. To arrive at a proper price for shares, we must now include CDS to the equation. Remember, the existence of CDS means that we have stripped credit risk out and we are trading it separately. For market exposure purposes, a share's price is not just what is shown on NYSE or NASDAQ. We must add back - somehow - that part of the "price" that is now trading separately as CDS. I do not know what the size of this upward adjustment should be, but the enormous amount and super-aggressive pricing (until recently) of CDSs tells us it has to be very considerable. (This will make a great PhD thesis, by the way).

This means that conventional measurements of equity market valuations are now obsolete, at least in markets that use heavily such "innovative finance" enhancements. I think of it this way: Stocks are now made up of two "parts" - part A trades on the regular stock exchange and part B trades OTC in the CDS market. To get a proper valuation we must add A and B together; just looking at part A is misleading.

I believe there are stealthy equity bubbles out there and they are already popping, as can be observed by widening CDX and iTraxx spreads.

The more I think of this subject, the more I like it. So I will attempt to come up with an "adjusted" S&P 500, or some such broad valuation index, taking into account CDS factors. This will take some research and time - if anyone has any suggestions please use the comments section. Proper credit will be given where due, of course.