What This Scary Chart Tells Me About The Market

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As a rule, I try not to be a merchant of doom and gloom. It is always possible to find things to worry about, even things that scare you to death, but history shows that the best long-term investing strategy is to stay bullish, as the modern capitalist system is based on and has always resulted in long-term growth.

There may be wobbles along the way, but overall you are better off not looking for trouble. Sometimes, however, in the course of my research I come across data and charts that are really scary, and that is what happened this week when I saw this.

It shows the corporate debt of non-financial U.S. companies as a percentage of GDP, and indicates a clear pattern of corporate debt spiking before each of the last three recessions. Corporate debt is spiking now as well, so the obvious question is should you be worried?

When you look at the underlying causes of this pattern and analyze the chart a little further, the answer seems to be “probably.”

First, look at the chart again. If you ignore what it represents and look at it merely from a technical perspective the peaks and troughs are not contained within a horizontal range, but for an upward sloping channel of higher lows and higher highs.  We have seen further expansion in corporate debt since the end of last year, when the chart ends, and the rate of increase is itself increasing.

We are now at record levels above the last peak, which suggests that bad times are a coming. That doesn’t mean that they are coming tomorrow, of course, but a look at the reason for the pattern does give us some clue as to when that may occur.

One of the main drivers of the expansion of corporate debt this time around has been that money is cheap. The Fed’s response to the recession involved ultra-low interest rates to encourage borrowing. As you can see, that worked, and while it was extreme this time, lower rates are normal following a recession, and do encourage borrowing.

The problem is not how much corporations borrowed, however, but what they used the money for. In the past it was usually to invest in preparation for the rapid growth that followed the recession, but this time, as we are frequently told, corporate investment has been low on a relative basis. Depending on your politics you may see that as a condemnation of greedy CEOs, of President Obama, or of whatever, but with debt accelerating so fast it raises the question of where the money is going.

In the current environment, where the market rewards short-term performance above all else and activist investors have made “return profits to shareholders” into a mantra, it is little surprise that it has often gone into dividends and share buybacks, as shown by another scary chart indicating another echo of 2007/8.

As a result of these buybacks, unlike in the past when the invested money resulted in increased profits to cushion the blow when rates started to rise, this time increasing interest rates could become a problem quickly. The Fed is expected to hike at its meeting next month and indications that we have finally reached near full employment and are even getting some inflationary pressure suggest that more hikes are to come. That makes debt more expensive and buying it back is harder when it has not been invested in more long-term profit.

There is an increasing fear that while the broader economy may justify rate hikes, they could be devastating to the stock market as stocks lose their relative value advantage against bonds and the above dynamic starts to bite. If the Fed hikes as expected next month and indicates an intention of accelerating the tightening process, the market will not take it in its stride as it has hikes in the past.

It should be pointed out that both of the charts above can be, to some extent at least, explained by the normal business cycle. As recession bites, companies cut back on buybacks and debt issuance, and the “spikes” are really more like recoveries. It is also quite possible, based on the old saying that the market can stay illogical a lot longer than you can stay solvent, that even if there is trouble ahead at some point, we could keep surging for a long time before that comes about.

That is all true, but the warning signs and similarities to the top of past boom and bust patterns are piling up, and taking out some portfolio insurance by a leveraged bear holding of some kind is looking more and more prudent.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks , Central Bank , Economy , Investing Ideas , US Markets

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Martin Tillier

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