Borrowing money to get something that a person wants today can be financially rewarding. For example, mortgage debt helps a borrower acquire a home that is likely to appreciate in value over time. Not only does one enjoy the use of the property, one often increases his/her net worth through the use of leverage.
A problem might develop, however, if an individual or family struggles to make the monthly payment. Job loss, sickness, ill-advised spending habits – a lendee might pay the bill later and later. The pattern of delinquency may worsen until, ultimately, a borrower may fail to repay altogether. Delinquency is often a precursor to default.
Now consider what is transpiring in today’s corporate environment. Companies across the globe could not resist the siren’s song of borrowing money at ultra-low rates. The bulk of the debt should have been used to finance business operations. In that manner, increasing debt without increasing equity might have been beneficial, as it likely would have contributed to longer-term growth.
Unfortunately, scores of company executives focused on shorter-term victories. How so? They “invested” the lion’s share of borrowed dollars in acquiring stock shares to inflate respective corporate stock prices, rather than invest significant capital in land, buildings, equipment, R&D and human resources.
The chart above, courtesy of the Wall Street Journal, shows how companies have piled on the debt (and the leverage) throughout the 8-year economic recovery. Even the least indebted corporations (a.k.a. “investment grade”) are operating with more leverage than they did back in the 2000-2002 stock bear or the 2008-2009 financial crisis.
Adding excessive debt during economic expansions may seem like a “no-brainer,” yet an adverse breeze could quickly push companies to the brink. Oil-n-gas companies that binged became delinquent when the industry toiled (2015-2016). Some have since defaulted. Similarly, brick-n-mortar retailers that borrowed as though a future day of reckoning would not occur are hitting the delinquency skids right now. This is not the case for brick-n-mortar retailers that kept debt modest from the get-go, even as sales might have been anemic.
Now get a glimpse of the chart of consumer and corporate loan delinquency. The blue line shows how corporate loan delinquencies have been rising dramatically since 2015. The trend leading into the 2000-2002 tech wreck as well as the 2008-2009 financial collapse is eerily similar.
Granted, delinquencies on consumer loans do not appear nearly as ominous. Yet they too are on the upswing, and that is unlikely to be a net positive for the economy at large.
There’s more. The overhang of debt has already gone beyond the delinquency stage for corporations. Wolf Richter of WolfStreet.com points out that commercial bankruptcy filings are steadily climbing. First we witnessed what happened to over-leveraged oil companies in 2015-2016. And today? Over-leveraged brick-n-mortar retailers are hurting.
Perhaps it would surprise some folks to learn that board members of the Federal Reserve expressed worry in late 2016 about corporations using rock bottom rates to borrow far more than they should. The minutes from the September policy meeting included “…the protracted period of very low interest rates might be encouraging excessive borrowing and increased leverage in the non-financial corporate sector.” Ya think?
Perhaps ironically, the people in charge of managing the Federal Reserve’s own pension fund have rarely been as cautious on stocks as they are right now. Overall stock allocation has been cut from 48.3% in 2014 to 45.6% in 2016. Reasons likely include Fed concerns about corporate debt and Fed worries about extreme stock valuations.
One highly respected method for valuing stocks (a.k.a “Warren Buffett Indicator”) is the relationship between the total value of the stock market (market cap) and the economy (GDP). Why? It has a rather impressive resume in forecasting 10-year forward returns. At the present moment, market cap-to-GDP implies that the S&P 500 will annualize at -2.5% over the next decade. (See the chart below courtesy of Jesse Felder.)
Obviously, there are credible voices with a higher degree of optimism. Warren Buffett’s hero, Jack Bogle of Vanguard fame, forecasts 4% annual over the next decade. Bogle may be taking a page from Ned Davis Research. The current median P/E for the S&P 500 is 24. Subsequent 10-year returns place us in the fifth quintile, or 4.3% annualized over the next decade.
Stock market forecasts over 10 years between -2.5% and 4% are a far cry from the typical expectation of 8% or 9% or 10%. The only way to get to a more desirable forward return for equities? A bearish price retreat.
According to Ned Davis Research, the S&P 500 would need to fall to 1665 just to revert to “fairly valued.” That would require a 29% haircut. And that would only constitute an average bear market in the 30% range, historically speaking.
Since the Federal Reserve stopped expanding its balance sheet on December 18, 2014 (S&P 500 2075), I have kept a lower-than-normal stock and lower-than-normal income allocation. For “moderates” who might otherwise have had 70% stock, they’ve had 50% stock. And rather than hold onto 30% widely diversified income producers, only 25% investment-grade remains. The purpose has been to raise 25% or so in cash/cash equivalents, reducing the possibility of volatile downside shocks as well as provide opportunity to acquire assets at more attractive prices.
Has it been a long wait? Sure. The risk-adjusted returns remain admirable, but the wait has been hard. That said, I do not think the wait will require another two years and four months. Gurus are once again beginning to dismiss bubbly asset prices.
For example, in 1999, many erroneously explained why profitless dot-com companies should not be valued the way that non-tech companies should be valued. The NASDAQ 100 Index (QQQ) logged -80% in the 3/2000-9/2002 mauling. Others foolishly expressed why real estate’s lack of affordability in 2007 had no bearing on the direction of property prices. Home values logged -40% over the next three to four years.
Fast forward to 2017. The current bullish run in stocks is the 2nd longest in history. P/E multiple expansion is the longest in history, rivaling the lead-in to the 1987 market crash and the dot-com fiasco at the turn of the century. Debt levels and leverage have rarely been this egregious, even at the onset of the Great Recession. Valuation extremes are as ugly as 1929. It leads me to wonder, did media darlings like Jim Cramer learn anything from 2000 and 2008?
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.