In my last commentary on August 1st, I discussed how the current market fundamentals show more risk to the downside then a risk of “missing out” to the upside, and there were signs of buying exhaustion for the S&P 500 at the 2200 level. At the time of the last update the S&P 500 index was at 2173, climbed to 2190, then shot down immediately, and currently sits at 2150. I continue to evolve my outlook, but at this time the metrics have not changed. I continue to believe the risk is to the downside, and we should not be worried about missing out on stock market appreciation. More developments have surfaced which I would like to share with you.
Piling Into High Yield Assets
Income producing assets continue to be overbought; driving up prices, and suppressing yields for new investors. Due the Federal Reserve’s low interest rate policy investors are scrambling for yield (income), and investors are taking on more risk by 1.) reaching out on the risk curve to capture income and 2.) buying income producing assets at historically high multiples. Below you can see the flood of capital into assets that produce income; dividend paying stocks, high yielding bonds (HY, or Junk Bonds), Master Limited Partnerships (MLP’s), and Real Estate Investment Trusts (REITS).
There was a time in the past when risk adverse investors could go down to their local bank and get 4% yield in a certificate of deposit. Those days are over as the Fed has forced conservative savers into riskier assets. As prices of these assets inflate beyond normal price multiples those reaching for yield today will one day realize the pain of reaching; as the yield will not justify the ensuing capital losses.
Corporate Debt to Earnings
Corporations have taken out extensive amounts of debt. Debt to earnings has reached 2.4 times, an all-time record, and a level we have not been close to since the 2000 dot com bubble.
The chart illustrates that as debt levels are rising, the increased debt is not translating into higher earnings. Debt is favorable when it is invested to increase productivity, and that productivity translates to higher profits, but we are seeing that debt is being deployed in unproductive ways. It has been documented that much of the borrowing has gone to stock buybacks and sustaining dividend payments. Neither action will increase revenue. Low interest rates, again, is the culprit of this problem. When interest rates are at a normal level, say 8%, corporations are less inclined to borrow, but they will borrow if they believe the project will give them a return higher than 8%. In other words, there better be a damn good reason to borrow. While higher interest rates may slow the economy in the short term because companies are less inclined to borrow, the higher interest rate ensures capital is properly allocated into productive projects over the longterm. The allocation of capital becomes efficient because the credit market demands it. This helps the entire economy because resources are being used for the highest good.
When interest rates are basically zero for a prolonged amount of time corporations have no hurdle rate to justify not borrowing. Companies start to borrow for inefficient projects that make them only minimally more productive, borrow to buyback shares, or in the worst cases borrow just to delay their eventual bankruptcy as they live their last days as a zombie company hoping better times will resurrect them. Low interests rates in the short term will stimulate the economy as companies borrow and invest, but as time goes by the capital begins to be used in ways that do not command the same productivity and the capital is squandered.
Asset Prices to GDP
The spread between asset prices and GDP is also stretched to a level we have never seen before.
To explain why this is bad, imagine you were a real estate investor. The blue line would represent home prices and the orange line would represent income levels of the population plus rental income. The price of the home is rising at a faster rate than income levels and rent income. As the blue line widens further from the orange line your home becomes less available to new buyers because their income cannot afford it and less attractive to new investors simply because the rate of return on the rental income will be less.
The Fed has created a “wealth effect”; believing that if you make people feel wealthy because their house, stocks, and other investments on paper say they are; they will then go out and spend money to stimulate the economy. The wealth effect will work in the short term, but when assets begin to outstretch income levels and do not produce enough investment income the price of the asset can only run so far.
The same is true on a the macro scale of the US economy. When assets prices rise substantially faster than GDP you are eventually pricing the people of the country out of the market for the assets. The GDP is the income of the country and when the income does not keep up with the asset prices new investors are priced out of the market.
These dynamics are going to push asset prices down. This is not opinion. Fundamentals will take hold eventually. There are no “new normals”. As we come into the next credit crisis the Fed is in a conundrum. The Fed is desperately trying to increase interest rates because they realize they are blowing bubbles in all asset classes, but on the other hand if they do raise interest rates corporations are so levered with debt the system will snap. Increased borrowing costs will squeeze profit margins, defaults and bankruptcies will raise, which will lead to employment layoffs, and when the jobs go so does the entire economy. Until we see any reversal in these tends we must continue to be patient in buying new assets. The toughest action in investing is no action. Until next time.
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