Comeuppance: Stocks Will Not Be Able To Shake The Overhang Of Higher Borrowing
Pacific Park Financial Inc. | Apr 05, 2018 12:41AM ET
The average American household has roughly 6% less spending power than it did a decade ago. How can that be? Hasn’t the economy been expanding at an appropriate clip since the Great Recession? Haven’t median incomes been rising briskly in conjunction with “full employment?”
One of the problems may be attributable to demographic shifts. A rising percentage of young adults are living with their parents longer. Meanwhile, a significant wave of older folks are moving in with their adult children. When one adjusts household income for family size, where more money is required by the multi-generational group, the decrease in living standards may approximate 3%.
Equally worthy of note, non-mortgage household debt (e.g., student loans, credit cards, etc.) sits 40% above its 2008 peak. The interest payments on these debts for the typical household likely reduces living standards by another 3%.
Keep in mind, credit card debts are also becoming increasingly expensive. For one thing, virtually all cards in the US have variable rates that move higher when the US Federal Reserve raises its overnight lending rate. That 11.99% “bargain” APR? The average today is closer to 16.5%. It might not sound so onerous were it not for the reality that consumers continue using credit to make ends meet.
Investors ignore the evidence on heavy debt loads and rising borrowing costs at their own peril. Yet the debt-to-income picture for consumers is corrosive. Moreover, record highs for residential housing alongside higher mortgage rates imply limited affordability.
Consider the rapid repricing of the 30-year fixed rate mortgage over the previous six months. On a relative basis, the difference between 3.85% and 4.45% may not seem like a big deal. Yet mortgage rates had been so low for so long, the shift has decimated the market for “refis” and reduced the pool of qualified homebuyers.
The gravy train for residential real estate could continue a little while longer if “subprime” and “negative amortization” return to the front of the lending line. Absent that, however, too few people have the ability to make housing-related payments in a rising rate environment.
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Not surprisingly, consumers are not the only ones who have borrowed in excess. Nor will they be the only ones adversely affected by rising borrowing costs.
Corporations ratcheted up their debt levels by approximately 80% over the last 10 years. In contrast, after-tax profitability has grown only 30% in that time frame. And not a whole lot of profits can be attributed to the last six years either.
With all that corporate leveraging via the issuance of “IOU” obligations in bond-land, they must have put those dollars to good use, right? That depends upon whom you ask.
It is hardly a secret that the bulk of the borrowed dollars have gone directly into stock share buybacks. Reducing the share count in existence means that, while corporations themselves may not have been generating much in the way of after-tax profits, the profits-per-share picture has improved. In fact, roughly three-quarters of the earnings growth per share since 2012 has been a function of buybacks.
Believers in the buyback bonanza do not appreciate criticism of what they perceive as beneficial to portfolios. Still, most are not even aware that, for the better part of the 20th century, the SEC had deemed stock buybacks illegal. The practice had been viewed as a form of market manipulation until the SEC reversed course in 1982.
The unresolved issue with respect to buybacks? The longer the myth of corporate prosperity via seemingly reasonable price-to-earnings presentations, the more painful the comeuppance when higher borrowing costs get too high.
For instance, S&P estimates that as much as $4.4 trillion of corporate debt is expected to come due over the next 4 years. Nearly one-third of that debt is rated as junk. Imagine the shock to corporate funding if a sharp hike in borrowing costs for these companies occurs when it is time for those corporations to reissue new obligations.
Additionally, plenty of major corporations take on shorter-term floating-rate debt tied to the London Interbank Offered Rate (LIBOR). With LIBOR hitting its highest levels in 10 years, the cost to service interest expenses keeps climbing.
Will higher borrowing costs kill the golden geese for stocks, bonds and real estate? While predicting the precise course of the future is impossible, the probability of falling asset prices and recessionary pressures occurring within the next year or two is quite high.
Take a peek at the red line in the graphic below. Each of the last three recessions – 1990, 2000-2002, 2008-2009 – had been preceded by record highs in corporate debt as it related to the economy (GDP). Is this time going to be different?
Some say that the tax cuts will make all the difference in the world. Yet the fiscal stimulus is likely to be offset by the monetary policy drag.
There’s more. Even with the tax cut bump to profit projections, prices are still quite elevated. When bearish price depreciation does occur, it typically overshoots. Prices won’t merely revert to the long-term mean; rather, they’re likely to journey well below it.
Bottom line? Stocks face an unusually arduous task in breaking out to new record peaks. Nevertheless, I adhere to a discipline that does not dramatically reduce the equity stake without confirmation from time-tested technical indicators.
For example, if the S&P 500’s MONTHLY close remains above its long-term trendline (green dots in the chart below), we will participate with a sensible allocation for our near-retiree and retiree client base. In contrast, if the MONTHLY close for the stock market finishes below its long-term trendline (red dots in the chart below), we will reduce our allocation to stocks significantly. This is how I averted the bulk of bearish losses during the 2000-2002 dot-com disaster and the 2008-2009 financial crisis.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.
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