The Good Interest Rates, The Bad Valuation And The Ugly Debt

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by: Daniel Schönberger

Summary

The US stock market is definitely overvalued right now, but that alone is not what should cause worries.

It is the combination of the extremely high debt levels, the stock market valuation and rising interest rates.

The extremely high debt to GDP ratios are a severe threat to the economy and therefore also to the stock market.

With rising interest rates, we seem to approach the point where almost risk-free bonds have a higher return than the risky stock market.

Dangerous cocktail

If someone is predicting a recession or a stock market crash long enough, he will be right at some point in time. No bull market – at least until now – has gone on forever, and therefore, a time will come where the prognosticator of a crash can say: “I told you so!” But in the meantime, he could have been wrong for many years and it doesn’t seem like good investment advice if you are right just one out of ten times.

I don’t want to be the guy who is continually predicting the next crash (hoping to be right someday), because it is almost impossible to exactly predict a bear market or crash. But it certainly makes sense to be careful if the risk for a bear market or severe correction is very high. One of the most important aspects in investing is avoiding (unnecessary) risks and if the risk for a correction or a crash is rather high one should be careful – if and when that crash is coming is a total different question.

Especially the recent Trump euphoria as well as the so-called “Trump rally” over the last few months are rather concerning to me than making me euphoric. And anybody who is familiar with sentiment knows, that euphoria is never a good sign for the bulls.

Of all the factors that are cornering right now, I will pick out three, which result in a dangerous cocktail for the stock market (especially the US stock market):

  • Valuation: No matter what methods and indicators we use, the stock market seems overvalued right now.
  • Debt: Aside from the stock market are the worldwide debt levels very concerning (especially the government debt to GDP ratio in the big developed countries).
  • Interest rates are rising and could hit a point where the expected yield of the stock market is only slightly higher than the US 10-year treasury rate.

It’s overvalued

In a first step, we take again a look at the US stock market. There are many different indicators to describe the current state of the market, and like most investors, I have a few favorites. I closely watch the P/E as well as the CAPE ratio, the market cap to GDP and also pay attention to duration and percentage gain of the current bull market. When we look at the same indicators like in my last macro article, The showdown that never came, the picture looks even worse. Since then the Dow Jones Industrial Average (NYSEARCA: DIA) climbed another 2,000 points during the so-called “Trump-Rally” but I am more concerned than before.

No matter at what indicator we look, usually, there is only one bull market since 1929 where the valuation was higher than today – the one that led to the tech bubble in 2000. Hence we could argue right now that investors don’t need to worry, because in 1998, we were at a similar level and the market rose for another two years. In these two years, many investors learned the hard and painful lesson that an overvalued market doesn’t automatically mean a crash is around the corner. Nevertheless, I certainly won’t bet on a scenario that occurred rather seldom during the last 100 years.

At first, we take a quick look at the duration and percentage gain of each bull market. There are sometimes different definitions about what counts as a bull market and what as a bear market. In my opinion, it is a bull market as long as there has been no correction for 20% or more. The current bull market (since March 2009) is therefore going on for 96 months and rose about 258% during that time.

Since 1929, only the bull market from 1987 till 2000 (which led to the tech bubble) was longer. In 1990, there was a 19.9% correction (not counting as a bear market) and another 19.3% correction in 1998 (also not counting as a bear market). During that time, the market gained 582% (the highest percentage gain since 1929). Aside from a 266% gain during the bull market from 1949 till 1956, the current bull market is not just the second-longest but also second-biggest percentage gainer since 1929.

The ”Buffett Indicator” – Corporate Equities to GDP – has only been higher for a few quarters than right now – once in 2014 and also four quarters in – you guessed it – 1999 and 2000. The data only goes back until 1950, but it is far above the average of the last 65 years.

The next indicator is the TTM P/E which is 23.8 right now. There have been a few times where this number was higher during history, but the indicator is very sensitive to short-term changes in either the price or the earnings (and especially if earnings decline during a recession, the TTM P/E will be very high). To get a number that is more comparable over time, we will follow the approach of Graham and Shiller and use the CAPE ratio instead (the 10-year P/E). This indicator is 29.0 right now and has only been higher in 1929 (32.6) and again during the tech bubble (44.0 in the year 2000).

The last indicator is the NYSE Investor Credit Balance. The credit balance has always been negative in the last 35-40 years – except during bear markets. At least during the last two bear markets, the credit contraction started a few months before the market dropped and can therefore serve as an early warning signal. Right now, we can only state that the credit balance is as negative as it has never been before, but we don’t see a contraction right now. But the extreme negative credit balance alone is reason enough to be cautions and look out for signs of contraction.

Debt and the stock market

But not just the NYSE credit balance is important to look at, but also the government and public debt of different countries. We can differ between government debt and private debt (households and corporations). Since 2007, the picture in the G7 countries is very similar: There were different attempts to restructure debt from (mostly) corporations to government and therefore the government debt to GDP ratio rose in all seven countries in order to minimize the private debt (especially in the financial sector). But aside from the United States and Germany, the private debt to GDP ratio also continued to rise (undermining a great plan).

Germany is the only country of those seven that managed to hold the total debt to GDP ratio at least constant. The other six have grown the total debt to GDP ratio and – what is even worse – have ratios over 300% (with Japan close to 500% already).

Why are we concerned with government and private debt levels in an article about stock markets? Extremely high debt levels are a burden to every economy and raise the risk of a collapse (i.e. severe recession), which almost always goes along with a huge decline in the stock market. During the Great Depression in the United States, the total debt to GDP ratio reached 250% in 1933, in the United Kingdom it was 395% in 1947, in Japan it was 403% in 1990 (and hasn’t gone down since). A few years ago, Spain had a debt to GDP ratio of 389%, and in Germany (Weimar Republic) it was even 913% in 1919 (leading to a total collapse, a new currency and in some way also to Hitler and World War II).

It is also important to know that during all those phases of deleveraging mentioned above, there was at first an “ugly deflationary deleveraging” (Ray Dalio, p.25-59) where the total debt to GDP rose, but the nominal GDP growth was already negative and the stock market tanked during that phase. At the beginning of the “ugly deflationary deleveraging,” the debt to GDP ratio was 155% (US), 250% (UK), 403% (Japan) and 348% (Spain). With debt to GDP ratio in most developed countries being over 300%, we are at a level where the deleveraging has already begun in most cases.

We could argue that the 2008 crash – where total debt to GDP ratio was going up – was already the phase of “ugly deflationary deleveraging” with negative GDP growth and the stock market crash and that we are already in the phase of “beautiful deleveraging” with the worst behind us – like in the mid-1930s. But the actual deleveraging that took place in the 1930s in the United States is missing right now and therefore – in my humble opinion – the risk is not banned yet and we are rather heading towards another Japanese disaster with almost 30 years of extremely high debt levels and no deleveraging in sight.

Interest rates and the stock market

Janet Yellen has raised interest rates already one time this year and chances are not bad that another two rate hikes might follow before her term as chair of the United States Federal Reserve will most likely end in February 2018. The 10-year treasury rate is 2.60% right now and could climb higher during 2017 if the Fed will raise rates again.

At least theoretically, investors always seek the asset class with the highest expected return. Of course, there have been times in history where the annual return of almost risk-free bonds was higher than the expected return of rather risky stocks and people still kept buying stocks. The orange part in the chart below marks the time from June 1997 till January 2002 where the P/E10 was above 30.0 (and the annual expected return therefore 3.33% or lower) while the 10-year yield was between 5% and 7%, and therefore definitely higher than the risky stock market.

If we use the TTM P/E of the S&P 500 (NYSEARCA: SPY) (right now 23.8), the expected annual return of the US stock market is 4.2%; if we use the P/E10 (right now 29.0), the expected annual return would only be 3.45% and therefore about 1% higher than the 10-year treasury rate (being 2.50% right now). Even if the expected return of the US stock market is a little higher, we seriously have to ask how long investors are willing to take on that additional risk (keep in mind the debt levels and high valuation) for a slightly higher return.

We can’t be sure that the 10-year treasury rate will soon be higher than the expected annual return from stocks and we cannot state categorically that people will stop buying stocks if the return from bonds is higher, but it certainly is a rather seldom event. For the last few years, the low interest rates were often used as legitimation why the high valuations of stocks are no risk (and why it is different this time).

But if the return of bonds should in fact be higher than the return of stocks in a few months, this argument doesn’t really count anymore and we only could speak of an absurd abnormality. And although abnormalities are a big part of every stock market, I don’t want to invest in it.

Conclusion

Since the election, we have witnessed a 3,000 point rally of the Dow Jones Industrial Average without a real correction, and therefore, the chance for some sort of correction is very high. But over the next few months till the end of 2017, the market could climb again. Between all the different metrics and valuations, I also find some reasons why the stock market could climb further.

The GDP growth for example has been falling below the long-term 2% average annual growth since the financial crisis in 2008. At some point in time, the GDP will catch up again and the GDP as well as the company’s earnings could climb and therefore justify higher stock prices. But I see the risks of a rising bond yield, a highly-overvalued market and a highly-indebted country as far more concerning.

In the past few days, I have read many different articles especially on macro analysis on many different sites (including Seeking Alpha). Especially in the comments below these articles, I found some terrible advice like “Buy as long as there is no official recession!” or “Yes, stocks are overvalued, but right now there are no signs for trouble or no reason why a crash should come and therefore you should buy as long as stock prices are rising.”

You either have to be convinced of yourself big time or never experienced a stock market crash before to say things like that. Do these people really think they keep buying and exit just before disaster strikes because there will be a big new story “Sell now – stock market crash in two weeks!” or some warning sign? For those who think they can exit right on time, I have just one date for you: January 15th, 2015. Everybody else should be cautious right now.

(All charts except those on debt are taken from Advisor Perspectives)

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.

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