Net worth used to be a simple concept. Add up assets. Subtract liabilities. And celebrate (or mourn) the tangible book value of the company.
It is not so simple anymore.
In a service-oriented economy, the value of a corporation partially depends on several intangibles. How influential is the company’s brand? What about the impact of the personality of one or two key individuals?
Nevertheless, the increasing importance of intangibles should not diminish the relevance of tangible net worth. Tangible book value for S&P 500 companies has been declining in 2018. In fact, since peaking in 2014, it has reverted back to levels not seen since 2010.
Drops in tangible “book” tend to occur in economic downturns. It happened in the global manufacturing recession (2015-2016). It occurred in the heart of the 2008 Great Recession. Similarly, it transpired alongside 2000’s tech wreck and subsequent 2001 recession.
The trend for book value does not appear particularly friendly. Keep in mind, here in 2018, the S&P 500 trades at an astronomical 10.6x tangible net worth. The 20-year average? 6.4x.
It gets more precarious. According to Bloomberg, 191 S&P 500 corporations have a negative net worth. Think about that. Nearly two-fifth of the largest U.S. companies in existence carry sub-zero tangible book values.
Why is net worth (at least the tangible kind) eroding? For one thing, Companies have spent a lot of balance sheet cash to acquire and retire stock shares. Consequently, the cash component on the asset side of the ledger has decreased.
Perhaps even more telling has been the dramatic increase in corporate liabilities. Corporations have nearly doubled their debt obligations since the financial crisis in 2008, from $2.8 trillion to $5.3 trillion. The more debt a company has on its books, the more those liabilities weigh on assets.
It follows that corporate-debt-to-GDP has never been higher. Yet unlike previous peaks in the debt ratio — occasions that corresponded to the inception of equity bear markets — high yield (“junk”) bond default rates have yet to spike upward.
Many investors seem to believe that the debt profiles of public corporations, as well as the adverse impact on tangible net worth, are not particularly relevant anymore. They’re mistaken.
According to Wells Fargo, two-thirds of all the outstanding debt of U.S. corporations will need to be refinanced over the next 5 years. The $4 trillion debt rollover is going to be at higher average interest rates due to quantitative tightening (QT), making it even harder for below-investment grade (“junk-rated”) companies to service their obligations.
The problem is not confined to the high-yield space either. Right now, 40% of U.S. bonds carry BBB ratings, which is only one step removed from junk status. When these investment grade corporations refinance their debts at higher rates, a large percentage of them will see their ratings slip a notch down into junk territory. (Note: CreditSights Inc. maintains that the current investment-grade bond profile is the worst that it has been since the 1980s.)
Don’t believe that higher interest rates in the current environment could cause a rash of credit-related defaults? Or that the spike in defaults that occurred during the previous stock bears (i.e., 1990, 2000-2002, 2008-2009) tell us anything about what is likely to take place in the not-so-distant future?
Fair enough. Just keep in mind that central bank tightening has always damaged the credit cycle. It is already happening in real estate in 2018. In fact, homebuyers have not been this dreary on the notion of purchasing since 2008.
The pattern is eerily reminiscent of the previous credit cycle. Alongside higher mortgage rates in 2006, home sales began dropping, even as prices logged new highs into 2007. In 2018, existing home sales have weakened every single month other than February. Indeed, affordability is being stretched by the combination of higher mortgage rates and record high home prices.
It should be noted that the signs are pointing to real estate weakness clear across the rooftops. Home sales, starts and permits are all declining in earnest. And mortgage rates? Refinancing activity is already at an 18-year low.
Granted, there’s less consumer subprime exposure in the traditional banking system today. That said, homebuilder stocks may be telling the investment community something that it does not want to hear.
After all, the Federal Reserve believes it can raise its overnight lending rate slowly enough so as to avoid a shock to the economy at large. What central bankers at the Fed may not be accounting for is the reality that, no matter how gradual the process, lenders and homeowners are not the only ones who will feel the sting of higher borrowing costs.
In my estimation, Fed policy error has been a major factor in the overwhelming majority of bear market busts. And I am by no means the only commentator who shares the opinion. Researchers at Bank of America/Merrill Lynch have suggested that the current Fed tightening will end in a similarly unsavory fashion as virtually all previous tightening cycles.
Researchers at Goldman Sachs, however, prefer to cast a wider net when addressing the potential for bearish stock price depreciation. They may not employ tangible book/net worth in valuation, but they do look at the cyclically-adjusted PE10 (Shiller PE). And while they do not specifically evaluate Fed policy, they place a heavy emphasis on the flattening of the Treasury bond yield curve.
The result of combining five key metrics? The Goldman Sachs Bull/Bear Market Risk Indicator. And right now, the indicator suggests there is more U.S. stock risk today than at any point since 1969. Worse than 1999 leading into 2000. Worse than 2007 leading into 2008.
It is certainly true that anything can happen in the near-term. U.S. stocks can go up, down, or sideways.
On the flip side, dismissing the risks associated with central bank rate hikes, overvaluation (e.g., price-to-tangible book, CAPE PE10, price-to-sales, market-cap-to-GDP, Q ratio, etc.) and troubling debt profiles is ill-advised.
Yes, most of my retiree and near-retiree clients possess equity allocations near the top of the range. For some that may be 50%-55%. For others, that may be 60%-65%.
Still, the recognition of risk requires a plan for managing it. We pay attention to stock “quality” via balance sheets and tangible book. Exchange-traded fund investors might prefer iShares MSCI USA Quality Factor (QUAL) for its focus on companies with lower debts/limited financial leverage.
In the same vein, we will cut our stock allocation percentages in half when the monthly close on the 10-month simple moving average (SMA) falls below its trendline. This risk management tool is the one that helped me sidestep a huge chunk of bearish price decimation in the 2000 dot-com disaster as well as 2008’s financial collapse.
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.