How The Next Market Crash Does Not Happen: A Response To Damon Verial

by: Martin Lowy

Summary

Damon Verial has forecasted the next market crash as being fairly soon and as caused by corporate debt leading corporations to sell assets into a declining market.

Mr. Verial is right about the background facts, but not about the mechanism that he sees likely to operate.

Most debt of non-financial U.S. corporations is reasonable, given the debt to equity and EBITDA coverages. Therefore, it is not likely to initiate a downward spiral.

Damon Verial has written an interesting article forecasting that the next market crash will be caused fairly soon by a debt-driven recession in which American corporations seek to shed assets in order to pay down debts that they have incurred to buy back their stock at high prices. I beg to differ. When the next market crash will come, I do not know. But I do not see the mechanism that Mr. Verial suggests as being the catalyst.

There is no question that American corporations have bought back a great deal of their stock, that they have done so at historically high prices, and that they have used borrowed money to do so. Mr. Verial is correct about all of that. And I would add that many American corporations have made large acquisitions that were funded largely by debt; such acquisitions are, from an overall market perspective, the same as stock buybacks.

The growth of corporate debt is illustrated by the following graph from FRED that shows growth of non-financial corporate debt from 1989 to mid-2015.

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Thus the debt growth is there, and it could cause problems. But debt by itself does not necessarily cause problems for corporations that have incurred it. Coupon, coverage and maturity all are important variables in determining whether debt will lead to stress when earnings retreat from historically high levels.

We first should note that most of the debt that has been put on to buy back stock or to make acquisitions has been incurred by investment grade companies at historically low coupon rates and fairly long maturities. I regret that I have been unable to ascertain the average maturity of the debt that has been put on over the last five years, but anecdotally it appears to be in the five-year range, with some being far longer-dated. Low-coupon debt that matures in more than a year is unlikely, it seems to me, to cause a company to panic if its earnings decline.

In addition, coverage for most of the debt appears to be quite strong. Here is a list of the twelve largest borrowers of long-term debt:

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GE has been paying down its debt significantly as it has largely exited from the financing business, but it still has a way to go and remains an outlier.

These 12 companies (that, admittedly, account for only about 14% of the total non-financial corporate debt outstanding) show strong debt to equity ratios and strong debt to EBITDA ratios. I infer that the need to repay debt is unlikely to panic them into selling assets into a weakening market.

It is hard to know whether less indebted (by volume) companies will be in worse positions. Doubtless some of them will be. To get a handle on how prevalent that is likely to be, I used the csimarket.com website to summarize the debt coverage of their 1440 company database and the debt-to-equity ratio of their 2984 company database. The results are not conclusive, as you will see, but I find them persuasive.

Looking first at debt coverage, the results are encouraging. (By debt coverage, csi means EBITDA divided by total debt. That is the reverse way of looking at the coverage from the USA Today table of twelve companies that I inserted above, but it has the same result.) Of the 1440 company database, 813 have EBITDA to total debt of better than four times. That is very strong coverage. Another 76 have coverage better than three, another 126 have coverage better than two, and another 158 have coverage better than one.

That leaves 266 companies with weaker coverage than one time EBITDA. Of those more highly leveraged companies, my eyeball-review estimate is that 159 are banks or other kinds of financial companies that typically carry high levels of debt/leverage. Of the remaining 107 companies, the largest category appears to be energy companies, plus a surprising (to me) number of smaller pharmaceutical companies.

The database for debt-to-equity ratios is larger - 2,984 companies. I have made a table of the results:

Debt-to-Equity Ratio

Number of companies

Under .25

806

.25 to .39

301

.4 to .49

167

.5 to .59

182

.6 to .69

133

.7 to .79

142

.8 to .89

141

.9 to .99

111

1 to 1.09

81

Over 1.09

923

Click to enlarge

With over a one to one ratio, a corporation usually is considered highly leveraged, although leveraged buyouts typically involve even more leverage, and financial companies, oil and gas companies, and utilities typically carry much higher leverage as well. Again, eyeballing the 923 corporate names in the highly leveraged category, it appears that a large percentage of those fall into the typical high leverage businesses, led by the financials. I would welcome anyone making a more scientific categorization of the 923 names.

My conclusion is not that corporate debt of American companies is no problem at all, but it is that the coverages among the major companies and among the largest number of companies are adequate except in a severe recession. For that reason, I do not see the debt as triggering the recession or an accompanying stock market crash.

Recessions usually are caused either by the Fed overdoing an interest rate increase or by the real estate sector, which is more highly leveraged than the corporate/industrial sector. The increasing market share being generated by online sales as opposed to sales at brick and mortar establishments leads me to think that the commercial real estate sector probably is overbuilt. Being highly leveraged, when commercial real estate utilization declines, it causes pain to owners and to lenders. That pain translates into empty stores, a decline in construction activity, department store bankruptcies, and can lead to a recession.

As to a market crash, the market probably is overpriced. It is held up by the various factors that are enabled by low interest rates. A steep rise in rates could trigger a significant selloff. But other than that, the triggering events probably will come from abroad, where economic and political conditions, despite our awful-looking presidential race, are far less stable than in the U.S.

Damon Verial is an important member of the Seeking Alpha community. I am disagreeing with him in this article rather than merely in a comment following his article because a quick comment would not do justice to his professionalism. And maybe a useful dialogue will ensue.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.