From The Gowdie Letter (AUSTRALIA)-
‘There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.’
— Former US Secretary of Defense, Donald Rumsfeld
Unknown unknowns are the things that come out of left field. The Black Swans. Outliers so remote that hardly anyone sees them coming…like share markets falling up to 90% in value.
Known unknowns are contingencies you consider a possibility, but can never be sure whether they will actually come into existence.
Then we have the known knowns. These are the events that you know from history will deliver an outcome that’s fairly predictable.
Does 99% constitute a known known?
Goldman Sachs compiled the following table of six valuation metrics to determine where the median stock value currently sits in relation to history.
The six valuation metrics used are:
- Price to Earnings Growth: This determines the price of a company, the earnings generated per share (EPS), and the company’s expected growth.
- Enterprise Value (EV) / Sales: This is a financial ratio that compares the total value of the company to its sales. The ratio is measured in number of years. For example, a company valued at $100 million, doing $50 million in sales, has a ratio of two (years).
- Enterprise Value (EV) / EBITDA (earnings before interest, tax, depreciation and amortisation): This is a multiple based on earnings (before all the accounting takes place) to determine a company’s value.
- Forward P/E (price to earnings ratio): This is the P/E ratio based on forecast earnings.
- Price/Book: This is a financial ratio used to compare a company’s current market price to its book value. Currently, median companies (on average) are being priced at 2.9 times their book value. Value investors want to buy a company that is trading at a price substantially below book value…a ratio of less than one.
- Cyclically adjusted PE (CAPE), or Shiller PE 10: This is a valuation metric I have mentioned many times. It is the average of earnings over the past 10 years (to smooth out the highs and lows in the earnings cycle) divided into the current price.
Source: 720 Global
Using these six metrics, Goldman Sachs provides us with a pretty clear picture of where this market sits on the historical valuation scale.
All we need is for markets to nudge a little higher and we’ll have the most expensive market in history.
There’s an old saying that investing in very overvalued markets is ‘like trying to pick up pennies in front of a steamroller’. Looking at these numbers, it’s fair to say the steamroller is gathering pace, and that the pennies are few and far between.
The following chart shows you what happens in a world of suppressed interest rates…values become distorted.
The green and blue lines (S&P 500 index and S&P 500 P/E) have both been expanding (over 80%) since 2011, while earnings have gone nowhere.
Source: 720 Global
Investors searching for any return above 0.25% have been forced into paying more for companies with stagnant earnings.
This is illogical but, then again, everything since 2009 has been irrational.
Will this distortion in values come crashing back to reality? Or — as a result of QE, zero interest rates and central banks backstopping markets — have we reached a new normal in permanently high valuation metrics?
Those in the ‘shares for the long run camp’ obviously believe the latter — that there is a new, artificially-created normal. Market forces have been made redundant thanks to the interventionist strategies
employed by the world’s money men.
History says there’s a 1% chance this Fed-created ‘new normal’ is our future reality.
The way I see it, on a risk versus reward basis, there’s a 1% chance of making (say) 10%, balanced by a 99% chance of losing at least 50%.
While the odds are heavily in favour of a serious capital destructive market downturn, it doesn’t mean that it will happen tomorrow, next week, or next month.
This market is one for the ages. In due course it will be spoken about in the same awed tones reserved for The Great Depression.
Central bankers are caught in an asset appreciation trap of their own making. It is quite possible they will take this market higher…setting an all-time record in the annals of valuation metrics.
All I know is that I do not want to be in front of the steamroller being driven by these lunatics.
Another 99% signal…this time from Standard & Poor’s
The ratings agencies hardly covered themselves in glory during the subprime lending debacle.
The cash for ratings scandal certainly tarnished their brands.
It appears they may have learned their lessons from that rather ugly period of greed, excess and complete abandonment of their duty of care to investors.
On 20 May 2016, S&P Global Ratings released a research report titled: ‘U.S. Nonfinancial Corporates’ Record $1.84 Trillion Cash Holdings Mask A Massive $6.6 Trillion Debt Burden’.
The ratings agency is sounding the warning bell on the build-up of debt in corporate America (emphasis mine):
‘S&P Global Ratings’ universe of over 2,000 rated U.S. nonfinancial corporate issuers reported holding a record $1.84 trillion in cash and short- and long-term liquid investments as of year-end 2015, a 1% increase from 2014. But the imbalance between cash and debt outstanding that we reported on last year has deteriorated: Total debt rose by roughly $850 billion to $6.6 trillion in 2015, dwarfing the cash growth of just under 1% ($17 billion). This jump in debt reflects the scant resistance borrowers faced from yield-starved investors as companies pursued acquisitions and returned cash to shareholders.
‘Strip away the top 1% from the equation, and the numbers look even worse: Cash and marketable securities for the remaining 99% of issuers actually fell 6% in 2015, and these issuers held just $900 billion in cash versus $6 trillion in debt as of year-end 2015. This indicates a cash-to-debt ratio of 15%, which is a significant decline from the comparable peak of 23% in 2010 and below the trough of 16% in 2008.’
To help you envision the cash to debt imbalance between the top 1% of companies (Google, Microsoft, Apple, Johnson & Johnson, etc.) and the other 99%, I’ve prepared the following table:
|2,000 Companies||Cash Holdings||Debt Outstanding|
|Top 25 (1%)||US$940 billion||US$600 billion|
|Remaining 1,975 (99%)||US$900 billion||US$6,000 billion|
|Total||US$1,840 billion||US$6,600 billion|
The consequences of suppressed interest rates at play are evident in these numbers.
The top 25 companies — due to their strong financial positions — can borrow money at very, very cheap rates.
If you’re a yield-starved investor, you are in for very slim pickings if you lend money to the top 25.
So what do you do?
You go searching among the other 1,975 companies. Searching for those that will pay you a higher return…while ignoring the reason they’re paying a higher return to attract your capital in the first place. Scant regard is given to whether the company can service its debt obligations if economic conditions take a turn for the worst. What’s important is the here and now…I WANT INCOME, I NEED INCOME!
First quarter earnings in the US have experienced the biggest decline since 2009. Which begs the question: If earnings start to reflect the real economic conditions (as outlined in last week’s update), can companies repay their debt obligations?
According to Jefferies Global Research, there have been more than 70 corporate defaults so far this year worldwide…the largest number since 2009.
In spite of a background of falling earnings and rising defaults, the following chart shows investor appetite for US corporate bonds has not waned. Money is still chasing a rate of return…irrespective of how reliable that return may be.
Source: Value Walk
The following chart from the S&P report shows corporate debt levels (the yellow bar) have been steadily rising since 2009…increasing by US$3.1 trillion.
Whereas cash holdings (the blue bar) have increased by only US$800 billion (and most of this can be attributed to the top 25 companies).
Source: Standard & Poor’s
Click to enlarge
Companies have taken advantage of the ultra-low interest rate environment to access cheap funding for share buybacks, dividend enhancement schemes, M&A (mergers and acquisitions) and leveraged buyouts.
Precious little of this new debt has been used for capital expenditure (reinvesting back into the business for future growth that generates income to repay the debt)…as evidenced by the following chart.
Source: Seeking Alpha
The Fed’s cheap interest rate policy has been a great enabler — providing savvy executives (keen to put their stock options in the money) the perfect opportunity to marry up with investors desperate for any rate of return on their capital.
It took the best part of a century for US corporate debt to reach US$3.5 trillion in 2009. Thanks to the Fed, it only took six more years to add another US$3.1 trillion to the debt pile.
This US$3.1 trillion has largely been used to game the market, not to build better and stronger businesses.
Which is why Standard & Poor’s issued this warning in a recent report:
‘The situation is worse for the bottom 99% because they now hold $6 trillion in debt versus just $900 billion in cash, and their cash-to-debt ratio of 15% is the lowest we’ve seen in the past decade, including the years preceding the Great Recession.
‘We believe credit risks are rising as the corporate credit cycle ages, and if capital markets access becomes fragmented, liquidity risk and corporate default rates could rise.’
99% of Corporate America has taken full advantage of ultra-low interest rates to goose up share prices to a level that registers 99% on the historical valuation metrics.
This market is an overpriced fraud. A fraud the Fed has aided and abetted by forcing investors to chase yields.
The knee-bone is connected to the thigh-bone. When corporate defaults start to increase in number, watch share valuations drop like a stone.
What happens across the Pacific matters a great deal to the Aussie market.
When the US goes into a tailspin, we will be caught in the downdraft.
When that will happen is anyone’s guess, but the odds are 99 to one in favor of it happening.