Let me begin this installment with the disclosure that as far as the markets are concerned, I’ve been more wrong over this past three years than at any time in my career. There is something to be said that the stock market has entered a new bull market. I continue to disagree, to my detriment. But this too shall pass.
Let me also say that I sailed through the bear market in 2002 and was one of the very few cheering as stocks dropped hard in 2008. The day of the ‘’flash crash’’ was a highlight of my career as I was properly positioned for what seemed a likely outcome. The performance of my model account was far in excess of that seen in shares of Warren Buffett’s Berkshire Hathaway shares during the first decade of this new century.
That decade was one of the worst in living memory for equity investors, featuring two slow-motion crashes, the housing bust and the worst financial crisis since the Great Depression. For me, those were the good old days!
The rally in stocks off the bottom in 2009 has been one for the record books, and one I didn’t see as lasting more than a few months. With the government running massive deficits, the national debt screaming higher, record numbers of people signing up for food stamps and Medicaid each month, there seemed little reason to think the economy would grow strongly enough to justify rising stock prices.
As it turned out, I was dead right on that one. Where I was dead wrong is in the degree of financial engineering to come from the Federal Reserve and corporate America. I freely admit missing that the Fed would keep interest rates at zero for a full six years while still today assuring us that those rates will stay at that crisis-level low ‘’for a considerable period of time’’.
Why so low, and for so long? Rates at zero percent are what would only be expected during a severe economic recession, or depression. Isn’t the Fed confirming my bearish outlook for the economy?
Speaking of interest rates, bond yields are also scraping the floor. Government bond yields in the U.S., most of Europe and japan are sitting at all-time lows. By all-time lows, I mean those rates have never been lower in the history of those countries. Now, bonds are seen as ‘’safe havens’’. If rates are at record lows, bond prices are at record highs, signaling record demand.
If the economy is recovering and stocks are cheap, why is there so much demand worldwide for safer options? Are you starting to see where my confusion took root?
Now, bond yields sit at record lows in large part due to the Fed’s vocal support of them, and the stunning amount of money printing seen to support that sector. Over the past four years the Fed has printed four trillion dollars which they used to buy government debt and mortgage bonds.
That could be the main reason for my miss on the stock rally. I never imagined that the Fed would, or legally could, keep the discount rate at zero percent, or that they would swell their own balance sheet from $800 billion to the current $4.5 trillion. I’ve seen it, but still don’t believe it.
Some point to the Fed’s risk with that balance sheet levered by a ratio of 77 to 1. Simply put, a loss in the value of those bond holdings of less than 1.5% would wipe out the Fed’s capital and render it insolvent.
Of course, the Fed is no typical business enterprise and financial ratios like this mean little to an entity that paid nothing of real value for those assets to begin with, and can simply print whatever they need to offset any losses their portfolio incurs.
The Fed did what was necessary as in response to the economic crisis, the Federal government ran record budget deficits topping $1 trillion a year. I didn’t see that coming either. Since the government must also re-borrow about $3 trillion annually to pay off maturing bonds already on the books, there simply wasn’t enough money available to fund all that borrowing.
The Fed had to print like madmen. But is that what you would expect to see happening during a bull market in stocks and what we’ve been told is an economic recovery? It looks much more like what we’d see during the second Great Depression.
Something else I missed was the degree of financial engineering seen by some of our largest corporations. In a period of economic growth, companies are expected to invest in people, innovation, plant and equipment upgrades. During this cycle, companies instead used available cash to buy back shares of their own stock.
In many cases, those companies borrowed money to buy shares, urged on by activist investors citing the low cost of funds supplied by the Fed and Wall Street banks. The issue here is one of the total debt loads seen in our economic system.
The Federal government now owes almost $18 trillion to creditors, many of them foreign investors. Add in state and local government debt of $3 trillion and you see how far awry things have become. An academic study shows that when a nation’s debt rises to above 90% of its GDP, growth slows predictably. With GDP running at about $17 trillion, you can see that we’re not only well over the 90% threshold, but with continuing deficits, we’re sailing higher on a durable basis.
You can expand these debt concerns to the health of corporate America, whose shares have run far higher since the 2009 lows on the belief that we were entering a period of growth.
One of the first things I look at when considering investing in shares of a company is its balance sheet. This tells me a lot about management, the health of the company, and its ability to weather a down cycle.
Let’s consider some of the biggest blue chip companies in the S&P 500. I’ll start with drug giant Pfizer, one of the last AAA rated corporate credits in the nation. A quick look at their balance sheet using Yahoo Finance’s site shows the company has a negative tangible equity of over $5 billion.
This says that if you bought the whole company and took it private, sold all the assets at what they’re valued at by the company and paid off all the debt and other liabilities, you would come up that far short.
A major problem here is that much of the assets on the balance sheet have no tangible value. On the balance sheet, two large entries are for ‘’Goodwill’’ and ‘’Intangible assets’’. The former typically gets written down to zero over time. The latter can have real value, it’s just that assigning a reliable value to them is too subjective. There is also over $34 billion in long term debt on the liability side. Why so much for a cash machine like this one? The company’s reported trailing P/E is 19. Does that look cheap?
It’s not just Pfizer that sits in such precarious financial condition. Fellow drug giant Amgen sports a tangible value of over negative $6 billion and a trailing P/E of 25. Blue chip Proctor and Gamble sports a negative tangible value of over $15 billion and a reported P/E of about 25. Airline UAL, whose shares have done very well, sport a tangible book value of minus $6 billion and a P/E of about 18.
We can end with shares of high-flyer Amazon.com. While the company does have a positive tangible net worth of about $7 billion, its market cap is closer to $150 billion. This wouldn’t be an issue if the company was growing strongly and was very profitable like tech cousin Apple.
But the company still loses money, thus has no valid price to earnings ratio! The last time we saw this level of hype and hope was the market top in early 2000, and we know how that ended. These examples can be dismissed as data mining, which to a degree, it is. They can also be waved away as isolated examples.
Actually, that’s not true. Using investor Warren Buffett’s favorite measure of valuation, the stock market’s total capitalization compared to the economy’s GDP now sits at the second highest level ever, topped only by the peak in early 2000.
The aggregate price to earnings ratio of the S&P 500 is about 19. Typical market peaks have always featured aggregate valuations in that area, and low interest rates that begin rising. What we see today is a high level of price to earnings, and record low rates. What are the odds of rates rising off all-time lows?
What I missed most as to the rally of the past five years is that the Fed would be so willing to blow another bubble so close to the bursting of two stock bubbles and one historic housing bubble so far in this new century? What could they have been thinking?!
I never imagined it, still can’t fathom it, but see it for what it could be. This could be another wonderful setup for bears like me that did so well when those other bubbles blew sky high. And that’s a rally I will surely not miss out on.
The big question is the timing of the next down cycle. On that, I have no idea. With the Fed so overtly involved in propping up asset prices, normal cycle analysis is rendered useless. But over time, the fundamentals matter. This time will be no different.
Editor’s Note: Bob Wood is an established investment advisor, and long-time TMO contributor. His opinions are his own.