Precarious Risk/Reward Setup In Debt Markets -- Not To Mention In Stocks As Well

Stocks (large cap) continue their ascent into all time high territory, smack in the face of somewhat sketchy fundamentals and what I fear is becoming a corporate debt bubble for the ages.

Clearly, record high stocks and this growing corporate debt phenomenon are supporting one another.

Arena Investors’ Daniel Zwirn, in yesterday’s RealVision interview with Ed Harrison perfectly articulated what I believe is a stage-setting for the next potentially severe economic and financial market downturn -- whenever it may occur. Although Zwirn sees two possible resolutions:

“What is inevitable is either a crisis or a long-term malaise.”

He also offered a word of caution for those who would attempt to all-out exploit (short) this prevailing risky setup:

“Markets can be stupid longer than you can be solvent.”

Here are a few highlights from the interview:  emphasis mine...

“When you dispassionately look at the amount of leverage in the system across corporate, property, structured finance, consumer and other personal obligations out there, what you see is an enormous amount of debt relative to the underlying asset value. And actually you have a tremendous appreciation in asset levels, and what is not necessarily understood is the degree to which people perceive there to be substantial equity value because debt is cheap.”

“Effectively it's like two drunken sailors keeping themselves up, at some point one of them might stumble over.”

“You’re seeing an enormous amount of debt relative to asset values, you’re seeing structures that are very very weak, where people are not getting appropriately protected as creditors at the top of the capital stack.”

It’s hard to imagine that indeed the rating agencies will prove to be complicit in yet another debt bubble, but the deeper we dig, the more likely that appears to be:

“...if you look at the stats across the ratings agencies you’re seeing a tremendous amount of triple-B relative to the rest of high yield. Why is that? Because there is a particular subset of investors that will only invest in investment grade and above, so there are tremendous incentives to do a whole lot of numerical gymnastics to be able to access an investment grade rating that otherwise, perhaps 10 years ago, wouldn’t have been given in order to access that group of investors...”

Lastly, Zwirn echoes what we've been preaching for too long about folks not understanding the risk they're assuming as they reach for yield in this dangerously-low interest rate/low-credit quality environment:

"...everything is set up such that people are not getting compensated for the risk they’re taking."

I'd add "and they don't even know it."

My including "stocks" in the title has to do with the inevitable economic impact the ultimate resolution of this huge mispricing of debt will have on the economy.