A recent research note from Morgan Stanley (MS, Financial) has shone light on a dangerous problem in the financial system: the buildup of bad corporate debt. There was also a second issue identified: the unwinding of the shadow banking sector.
What are shadow banks?
Although they sound like nefarious secret organizations, they are simply unregulated parts of the financial sector (not to say that some of them don’t frequently act in nefarious ways). These bodies have significantly expanded since the 2008 financial crisis, despite the fact that it was irresponsible financial practices that led to that collapse in the first place. How did this happen?
Ironically, it was tighter regulations on traditional banks that drove capital into the shadows. This demonstrates that even the best-intended policies can have unforeseen secondary consequences that end up causing more problems. Regardless, these shadow banks were also heavily levered and are now being forced to de-lever, which is adding to the confusion in markets. I previously explained the role that leverage and margins play in selloffs, which you can read about here.
According to the author of the note, however, there is a good aspect to this rather grim story - the traditional banking sector is stronger today than it was in 2008, which means that the Federal Reserve has a conduit by which to inject more liquidity into the financial system, a needed strategy as cash flows run out for most businesses. According to Morgan Stanley:
"This is one of the reasons why the Fed’s aggressive actions to date, which includes intervening in the corporate credit markets directly, will ultimately have a positive effect on the duration of this recession, even if it can’t stop the severity of the slowdown in the very near term. Rarely do markets become so dislocated, but such are the conditions from which great investment opportunities are born. While we never know what will tip us over into a recession, the conditions for one have to be in place, and excesses in the credit world were exhibit A in that regard."
The note argues that bear markets end with recessions, rather than begin with them. While this sounds counterintuitive, given that the major indexes had been making new all-time highs as recently as February, this is because they are heavily weighted toward a handful of marquee outperformers. Most smaller stocks have actually been in a bear market for the last two weeks. Investors will no doubt be hoping that he is right.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Dangers of Excessive Corporate Leverage
- The Value Investor’s Handbook: How to Read a 10-K, Part 2​
- The Value Investor's Handbook: How to Read a 10-K, Part 1
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
