Ever since peaking at over 20% in 1981, the federal funds rate has been on a steady decline, occasionally being hiked to curb inflation before being lowered again as the U.S. economy hit bear market territory. As of June 2020, the Federal Reserve seems set to maintain the base rate of 0% to 0.25% at least through 2021, keeping the cost of debt low.
What does this have to do with overvaluation in the stock market? The answer lies with debt, and how the cheaper it gets to borrow, the more investors are considering debt to be a liquid asset equivalent to cash (so long as it’s not debt that needs to be paid off next quarter).
As corporate debt has risen to a higher and higher percentage of U.S. gross domestic product, the average valuation of the stock market has increased. Moreover, low-interest lending to companies has helped to sap the yields on treasury bonds, high-quality debt, cash and other assets traditionally considered “safer” than equities, driving yield-starved investors and institutions to allocate higher portions of their capital to stocks. Given all of these factors, could a certain level of overvaluation become the new baseline for the stock market?
Debt vs. GDP
By the time 2008 rolled around, corporate debt stood at $6.6 trillion (excluding financials), or 44% of U.S. GDP, and with interest rates going lower and lower, investors were increasingly considering debt to be part of a company’s assets.
The Buffet Indicator (pictured below), called thus because it is Warren Buffett (Trades, Portfolio)’s go-to indicator of market valuation, considers a market overvalued if the total market cap of a country’s companies exceeds its GDP. It’s no coincidence that after the dot-com bubble burst, the value of the total market cap of U.S. companies rose back above the country’s GDP again within a decade, given that higher amounts of leverage were being factored into current and future earnings.
At the end of 2019, corporate debt stood at an all-time high of $13.5 trillion (excluding financials) and, as of May, new corporate debt issuance in 2020 has already surpassed $1 trillion. That’s approximately $14.5 tillion in corporate debt compared to GDP of $21.53 trillion, meaning corporate debt has now reached approximately 67% of the country’s GDP. As we can see in the chart above, this increase has coincided with equity markets ballooning since the financial crisis as easy access to liquidity has boosted company earnings quarter after quarter.
While correlation is not the same as causation, in this case, it seems like cheap and ever-increasing debt issuance is at least one of the factors contributing to the overvaluation of equity markets, even though this is not the full story.
Corporate debt bubble
While the sheer amount of debt that companies owe to their creditors seems alarming at first glance, it does not exist in isolation. Where there are debtors, there are also creditors who believe they will earn money from their deals in the long term.
It’s difficult to say who owns how much of the corporate debt pie at this point. After the offerings are underwritten by banks, they are bought by a variety of institutions (largely pension systems) and investors either directly or via exchange-traded funds, with the Fed beginning to buy via certain ETFs in 2020. Many of the top bond holdings in ETFs are the “Big Six” U.S. banks, thus cycling bank debt to the hands of ETF investors. In the end, most of the money that is owed can be traced back to the assets that individuals, corporations and the government have stored in banks.
As the Fed’s buying of bond ETFs clearly shows, the economy’s dependence on debt has become so deep-rooted that debtors are gaining more traction against creditors, contributing to lower yields. In order to increase yields again, debt would have to become harder to obtain, which does not seem likely to happen without some sort of major stimulus.
One of the first terms that comes up regarding the question of corporate debt is the so-called “corporate debt bubble.” What is the corporate debt bubble, and what could cause it to pop?
The corporate debt bubble refers to the massive increase in the issuance of corporate bonds over the past couple of decades, excluding the debt of financial institutions. Lower interest rates have encouraged the practices of paying off debt with more debt, then paying off that debt with more debt, and so on. Additionally, borrowing money to buy back shares increases the share price of a company, making executive stock option compensation plans more lucrative and making investor sentiment more bullish overall. Ironically, the higher the price at which a company buys back its shares, the sharper its price increase will be, making it more attractive to high-risk investors at the same time it eats away at the company’s fundamentals. The result is that many companies exist in a state of perpetual borrowing and repayment, thus increasing their likelihood of going bankrupt if the flow of liquidity were to be cut off.
Analysts and investors have been speculating for years about when the bubble will burst. After all, share prices are being largely supported by increasing amounts of debt, but can the increasing issuance of debt last forever? If not, how long will it last?
Liquidity won’t increase forever
In the end, the answer lies with liquidity. The increasing issuance of debt cannot and will not last forever, as there will not always be a steadily increasing stream of capital from those wanting to buy corporate debt.
As world-renowned macroeconomist Raoul Pal pointed out in a March interview with Anthony Pompliano, the biggest buyers of corporate debt in the U.S. are pension funds. Looking for safer assets than stocks but unable to achieve high enough returns with government bonds, the pension funds turned to corporate debt for its higher yields. While these investments increased yield, it wasn’t enough of an increase for the majority of beneficiaries to retire comfortably on, so several states began mandating that a portion of taxes be allocated to the pension funds, essentially funneling tax money to the corporate debt market.
This automatic funneling of money has gone a long way toward propping up share prices by allowing companies to borrow more money for leverage and share buybacks. Thus, when portions of this liquidity stream inevitably dry up as the baby boomer generation retires, it stands to reason that share prices will fall accordingly.
A significant enough impact on the economy could also contribute, and not just by causing a wave of bankruptcies in publicly traded companies. In fact, in a recession, bankruptcies may be of even less concern than two things: the pausing of pension fund buying and company share buyback programs.
When the economy goes negative, pension funds stop buying until things recover. Pension funds put the safety of their capital first. They are not interested in sticking around for credit defaults as there are far too many people dependent on their income. That’s the biggest buyer of credit down for the count.
On the equity side, companies are the largest net buyers of equities in the world, according to aggregated security filings data. If you’ve been paying attention to company earnings, you might have noticed that words such as “temporarily paused our share buyback program” have been present in the vast majority of them, even among companies with low or moderate debt. Recessionary conditions and interruptions of cash flows necessitate caution. When things go south, few companies want to throw cash towards increasing the value of their shares, especially when they are already highly leveraged and have no cash to throw without borrowing.
There have been a variety of factors contributing to the corporate debt bubble in recent decades. As pension funds (and taxes) have snapped up corporate debt and the federal funds rate has increasingly been lowered, liquidity has come increasingly cheaply and easily to companies. Corporate debt now stands at approximately two-thirds of the country’s GDP.
Adding this liquidity to balance sheets, using it to buy back shares and pumping it into business activities to increase earnings has allowed businesses to achieve overall higher valuations, leading to overvaluation becoming the new norm.
Thus, one important question to consider when evaluating a company is how much it will be affected when the market’s biggest credit buyers take a step back. Even if someone steps forward to fill the void, will the terms be as favorable? Additionally, just how many shares will it no longer be buying back? Overvaluation isn’t likely to be the norm when liquidity dries up.
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