By Robert Lenzner, Forbes Staff I have been surprised by week after week of higher stock prices even after the 15% run-up during 2012. Investors seem to be discounting the adverse economic ramifications of reducing government spending by $1.2 trillion and the the President’s signal he means to increase taxes by closing loopholes. The most absurd sign of this new optimism is PIMCO‘s resident genius, Mohammed El-Erian’s prognostication that “The New Normal” — his very own personal warning about an age of low growth and high unemployment– is now apparently going to be replaced by far more abnormal growth, gains in employment, maybe a continued bull market as money moves from fixed income into equities. No, I reckon we should rather pay attention to the “aggressive transactions indicating the presence of risk tolerance in the markets,” according to Oaktree Capital Management’s Howard Marks in his January “cold-shower” letter. Here are Marks’ best examples for “errors of the herd”- “the brevity of financial memory,”- “the role of cycles and pendulums.” 1. During 2012 some $812 billion of new issue leveraged finance was done, eclipsing by 20%- or $160 billion– the former record amount of such risky stuff set in 2007– which was a not so early warning signal of the 2008 meltdown. 2.The scary amount of leverage is best measured by the deals arranged by private equity firms, KKR, Blackstone, Carlyle, TPG, Apollo et al. Over the past 6 months these wheelers and dealers have been employing almost record amounts of debt–debt equal to 5.5 times the EBITDA, income before interest, taxes, depreciation and amortization– of the companies they have acquired. Just to get the proper perspective on this activity– consider the revelation by Carlyle’s David Rubinstein in October, 2008 just how dangerous it was that the average debt to EBITDA in the private equity world of 2007 had risen to 6.2 times. Carlyle immediately began to cut back and try to liquidate some investments. 3. Companies are borrowing scads of money for the purpose of paying cash dividends to their shareholders– a kind of arbitrage with tax advantages– unrelated to the company’s earning power. 4. The phenomenon of CLO‘s– the ravaging monsters of 2008’s meltdown are making a comeback. I challenge the public and the rating agencies to assure me these are prudent investments for insurance companies, mutual funds, maybe even hedge funds. You want to issue a Triple C bond of very low credit safety; it’s doable because so many investors are reaching for yield. Remember reaching for yield? I can tell you all those European, Japanese and Middle Eastern banks still suing the rating agencies would like to have their money back from the foolish investments they made just over half a decade ago. As Marks so grittily puts it; “The scramble for return has brought elements of pre-crisis behavior very much back to life. Mull that description of the fixed income markets in early 2013 over– and decide what the fallout might be on equities. Just as took place most shockingly in 2008 and early 2009.
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