A list of possible Black Swans - Part 3

In part 1, I listed 2 black swan scenarios where the ultimate consequence will take a long time to materialize. In part 2, I explored several other potential events that may happen sooner than expected and lead to immediate impact on the financial market.

In this article, I am about to present a multitude of bubbles contributing this one big black swan scenario, which I call as the "Big Credit Bubble" or some coined as the "Everything Bubble". The effects are sipping throughout the economy and the ultimate consequence may just happen any time.

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For the benefit of everyone, here is a quick recap on what a black swan event. Based on Wikipedia,

Black swan is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The term is based on an ancient saying that presumed black swans did not exist – a saying that became reinterpreted to teach a different lesson after black swans were discovered in the wild.

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The Big Credit Bubble

Ever since the USD became the global reserve currency, USA has been the world's credit factory. The US market is an open and free market. Therefore, as the US Federal Reserve print more money year by year, a lot of them actually flows out to the rest of the world. The world loves these credit and that is why when the Federal Reserve talks, the world listen.

Post the 2008 Great Financial Crisis, the Federal Reserve has kept the interest rate at near-zero level for years. In addition, new money was printed through quantitative easing (QE). As a result, massive credit entered the market during the period. When credit is cheap, it is bound to create bubbles.

BBB Corporate Bonds

Every bond that is issued has a credit rating and anything that is rated BBB and above is considered investment grade (IG). Anything that is not investment grade, are considered junk bonds. Typically, large financial institutions will rather hold more stakes in IG bonds than junk bonds.

In this article from PIMCO, they warned about a steady decrease in overall credit quality of corporate bonds and a trend toward higher leverage. PIMCO also mentioned that close to $80 billion in U.S. corporate bonds currently rated BBB potentially could be downgraded below investment grade.

According to the chart below, US corporate BBB grade bonds market has exceeded US$ 3 trillion, which is the majority of IG bonds. It is also important to note that globally, BBB corporate debt exceeds $7 trillion.

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This next chart shows there are a massive amount of these BBB rated debt maturing from now to 2023. This is quite concerning because, as PIMCO has reported, companies have been increasing their leverage which means they will be at a higher risk of being unable to repay the debt.

Potentially, this might trigger a domino effect in failure of BBB corporate debts and a lot of them might be downgraded to junk status. When that happen, financial institutions may be forced to reallocate their funds and the corporate bond market will sure take a massive hit.

Tech Stocks Bubble

The world used to be dominated by non-tech companies but in the past decade, tech companies were on the rise. As seen from the picture below, the top companies by market capitalization is now all tech companies.

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The growth of tech companies has been stellar as you can see from the chart below. The 4 companies depicted have all risen at least 4x over the past 10 years.

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The remarkable returns from these companies spurred the rise of many newer startups with extraordinary valuations during their IPOs. Furthermore, the success story of Amazon led many to take on more risk by investing in companies that have yet to make any profits. Companies like Tesla, Uber, Lyft and Spotify are all having extremely high valuations despite them not being profitable yet.

I personally have a theory for this. The earlier tech companies benefited from the fact that personal data came really cheap and they were able to monetize those data very effectively. However, many governments have now implemented privacy laws making it tougher to collect such data in the future. On top of that, there are now also talks on how the US government is out to curb the rising power of big tech through anti-trust laws.

While technologies have brought about more productivity, the current valuation seems absurd to me. I believe the current price is not sustainable in the long run and will eventually come crashing down. This will be especially soif the anti-trust probes do start and profitability of these companies get affected.

Index Funds Bubble

If you have watch Netflix's "The Big Short" you probably have heard of Michael Burry. He was one of those who foresaw the subprime crisis and was able to make a profit out of it. Recently, he pointed out how passive investments on index funds are much like CDOs during the subprime crisis. He said this,

"Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies -- these do not require the security-level analysis that is required for true price discovery. This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue."

He also pointed out liquidity risks saying that the vast majority of stocks are lower volume, lower value-traded stocks. Using the Russell 2000 as example, slightly more than1000 stocks traded less than $5 million in value during the day and among them over 400 of them traded less than $1 million during the day. Yet hundreds of billions are linked to stocks like this. The S&P 500 index is the same. He also gave the following analogy,

"That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally."

Index funds are instruments used by many for passive investments. The truth is that most passive investors are just allocating money into stocks blindly. The easiest way to get skin in the game is through these index funds and they are buying without really understanding them. It is therefore much like how investors were tricked into buying mini-bonds during the subprime crisis.

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Conclusion

A decade of easy credit has led to a multitude of bubbles. Just today, Nobel Laureate and "Irrational Exuberance" author Robert Shiller said that he sees bubbles everywhere.

We are already in a state of bubble and the more these bubbles grow, the worse the crash will be. The burst of any of these bubbles may be the black swan event that might trigger the burst of The Big Credit bubble.

At the end of this article, I will like to share this infographics that I found online depicting the state of the Everything Bubble. With this, I also conclude the 3-parts series. Thanks for reading!

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