November 5, 2018
Recently Published Articles:
- How to Survive a Stock Market Crash or Bear Market
- 7 Top Stocks to Buy and Hold for the Next Decade
- An Overview of Italy’s Debt Concerns (FEDweek)
- Record Buybacks: A Tailwind for Nov and Dec (FEDweek)
- Comparison of Netflix vs Disney (Equities.com)
Recent Market News
Global markets had quite a sell-off in October.
For the United States in particular, rising interest rates on things like mortgages and Treasuries and news reports of increased trade tensions between China and the United States were largely blamed for the correction.
It’s also true that U.S. stocks were and still are highly-valued by historical standards during this month. When stocks are expensive, it doesn’t take much of a reason to have a 10% correction.
The S&P 500 currently has historically high price-to-sales, price-to-book, market-cap-to-GDP, and cyclically-adjusted price-to-earnings ratios, and historically low dividend yields compared to the past. These high valuations are likely partly due to where we are in the business cycle, and partly because interest rates are historically low.
I actually enjoy corrections like this, because it lets out some of the pressure from the markets, rationalizes investor expectations, creates new opportunities in pockets of the market, and results in healthier valuations going forward.
The Buyback Catalyst for November and December
The full year 2018 is widely expected to have the highest-ever corporate spending on share buybacks.
Here’s the chart so far which includes the first two quarters of 2018:
Chart Source: Yardeni Research
One reason for the high buybacks right now is simply that this tends to happen late in the business cycle when companies are making a lot of money (and unfortunately, when stock valuations are high). Companies bought back a ton of high-priced shares in 2006/2007 as well, right before the 2008 crash.
The other reason is more specific- the corporate tax cuts that became effective starting in 2018 gave corporations an incentive to bring hundreds of billions of dollars in cash back to the United States. This cash-repatriation is basically a one-time event because corporations have been building up cash hoards overseas for years to avoid taxes, and now that money is coming home.
I wrote in the November 2017 newsletter issue that most of this repatriated cash would be used for buybacks, and that’s indeed what’s happening this year.
However, last month in October, most companies were in a self-imposed stock buyback blackout period where they have more restrictions on their buybacks. During months where corporations report their quarterly results, they can continue with pre-planned stock buybacks but can’t do any opportunistic buybacks, and overall buyback amounts dip significantly.
For this reason, there were fewer buyers in the market in October, because corporations themselves weren’t buying as much, and this was one variable (among many) that made it easier for a correction to occur.
Now that we’re in November, most companies are out of their buyback blackout periods:
Chart Source: Deutsche Bank
With up to a quarter-trillion dollars in buybacks set to happen in Q4, there’s a decent chance we’ll see a rally in November and December, which are historically good months for the S&P 500 anyway. Especially among the companies with major buyback authorizations, like Apple, Microsoft, Cisco, etc.
That doesn’t make it guaranteed. Lots of bad news can come out and drive the stock market lower. But the market does have some positive tailwinds for the last couple months of 2018.
Personally, I’m neither buying the recent dip nor selling. I’m simply rebalancing into it, continuing to add money, and holding my asset allocation relatively steady.
The Challenge of Global Debt Levels
One of the biggest financial challenges around the world is debt. As the world has become increasingly developed, it has also become increasingly indebted.
The 2008 U.S. subprime mortgage crisis and the 2011 European sovereign debt crisis were all about the consequences of excessive leverage in various parts of the global economy.
This newsletter issue takes a look at where debt exists around the world in governments, corporations, and households, and examines what it could mean for investors and their opportunities.
Case 1) United States Debt
As a percentage of GDP compared to other developed countries, the United States has moderately high household debt, corporate debt, and government debt. No individual area is bubble-high, but all areas are substantially leveraged.
U.S. Corporate Debt
Corporate debt is in the high part of the historical business debt cycle (recessions shaded):
Chart Source: Gluskin Sheff
It’s a bit higher than it was during the later bull stages of previous cycles.
The U.S. Federal Reserve allowed for unusually low interest rates for an unusually long period of time to stimulate the economy after the 2008 financial crisis, and corporations have taken advantage of that by leveraging up with a lot of low-interest debt.
While these numbers are not a great indication for the debt cycle going forward, it’s not a bubble by most metrics. The interest coverage ratio of the S&P 500 (aka operating income divided by interest expense) is about where it was prior to the 2008 recession, and higher than it was before the 2002 recession. Higher is better; it means less operating income is used for paying debt interest:
Chart Source: J.P. Morgan Guide to the Markets, 3Q2018
The interest coverage ratio hit a peak in 2014/2015 due to low interest rates and moderate leverage. But as the business cycle has continued, leverage has gone up, and interest rates are starting to go up as well, which has brought the coverage ratio back down.
The summary here is that corporations have a bit more debt than ever before relative to U.S. GDP, but historically low interest rates on that debt. With interest rates gradually rising, this will limit how much leverage corporations can take on going forward, and may constrain growth. It’s easier to grow when you are leveraging up, but harder to grow when you have to keep your debt levels static.
This is a case where individual stock selection means a lot. Some corporations or sectors are very debt-heavy, while others have excellent balance sheets.
U.S. Government Debt
Federal government debt is a significant problem, and I think people in aggregate are underestimating the impact of the deficit on the current economy.
The United States now has a higher percentage of debt relative to GDP than it has had since the end of WWII, and with current entitlements and taxation levels this figure is expected to keep increasing:
Source: Congressional Budget Office
The projections on the above chart for federal debt as a percentage of GDP assume no recessions. A recession whenever we get one would likely accelerate the debt ratio even more as tax revenues fall and spending goes up for things like food stamps and potential fiscal stimuli.
The federal deficit was $779 billion for the fiscal year 2018, which was 17% higher than the prior year. This is a deficit of 4% of GDP during a peacetime period of good economic growth, which is unsustainable.
The CBO expects the federal deficit to climb to just under $1 trillion in 2019 and over $1 trillion in 2020. By that point, the deficit would be a whopping 5% of GDP every year. Again, that assumes no recession, which would make things far worse. It also assumes no tax increases or entitlement cuts.
In financial media today, the economy is often described as strong. Whenever the stock market has a correction like we’ve seen in October, dozens of pundits go on CNBC and Bloomberg and claim that the economy is strong.
And that’s true in a way; GDP growth is solid for a developed country, official unemployment rates are historically low, and the economy is finally seeing some wage growth.
However, the raw labor participation rate (the percentage of U.S. adults employed, period) is lower than it was 5 years ago. One might assume this is due to an aging population, but actually older adults are working later and younger people are less likely to be employed, so it’s the opposite of what seems intuitive.
In addition, the core age 25-54 labor participation rate is also below its historical peak, but since late 2015 at least it is moving upward.
More importantly, this growth is being held up by stimulus. The current federal deficit acts as a stimulus every year, in exchange for increasing debt. If the government raises taxes or cuts spending to fix the deficit, it would likely slow economic growth. This period of decent economic growth is largely supported by deficit spending.
And, we’re in a period of unusually low interest rates, which are gradually rising. So we’re getting by with moderately good growth levels and moderately good labor participation during a period of unprecedented large fiscal deficits compared to other peacetime non-recession periods, and historically low interest rates.
An economy this reliant on federal deficit spending and low interest rates is not one I would characterize as strong.
If the economy were strong on its own in a sustainable way, we should have tiny deficits or even a surplus during a booming economy with low unemployment rates. Instead, this economy is being propped up by annual stimulus; deficit spending.
To put this into perspective though, Japan has sovereign debt equal to over 200% of GDP. Their aging population is very deflationary, which keeps interest rates extremely low, and which makes the Japanese government able to service that high debt for now.
Whenever we look at a trend, it’s useful to know where the limits are, to see where we stand compared to them. The United States has quite a bit of federal debt relative to GDP, but not as much as some countries like Japan (200%+) or Italy (130%+).
U.S. Household Debt
Household debt is a bit of a bright spot compared to the corporate sector and the government. We’re not at a peak here.
Household debt peaked at nearly 100% of GDP just prior to the 2008 subprime crisis, and has since declined to under 80% of GDP:
Chart Source: Trading Economics
It’s still high by historical standards, but not as high as the run-up to the subprime crisis.
In addition, at first glance this is one of the most beautiful and optimistic charts we could see. It’s the balance sheet of U.S. consumers:
Chart Source: J.P. Morgan Guide to the Markets, 4Q2018
The U.S. is truly wealthy. We collectively have $122.7 trillion in assets and $15.7 trillion in liabilities, resulting in a net worth of about $107 trillion.
With about 127 million households in the U.S., that’s over $840,000 per household. Not bad!
The caveat here is that the median is far lower than the average, due to historically high levels of wealth concentration. The average household has a lot of wealth, but the typical median household does not. When judging how the typical U.S. consumer is doing, the median figure is a lot more relevant than the average figure.
I find the research done by billionaire investor Ray Dalio and his Bridgewater associates to be some of the highest quality macroeconomic research I’ve read anywhere and he is talking a lot about this subject lately.
And I liked his recent book, Principles for Understanding Big Debt Crises. The first 60 pages or so serve as a great overview of how debt cycles tend to play out, and the remaining part of the book goes into more detail about historical debt crises in history.
Bridgewater posts a series of articles called Daily Observations, and the one they have had featured on their site for about a year now above all of their newer ones is this one:
Source: Bridgewater Daily Observations, October 2017
Dalio has also talked about this in a lot of interviews.
He’s a billionaire investor with high diversification, so not a lot bothers him financially. But what clearly keeps him up at night figuratively-speaking from what he talks about is the unusual degree of wealth concentration and political polarization in the United States compared to historical levels.
He expects that the next U.S. recession won’t likely be as quantitatively severe as the one in 2008, but because political polarization is at measurable record highs for the century, and the typical (median) American is not benefiting much economically as it is now, he expects the political and social consequences of the next recession to likely be severe.
The median American has a low net worth, stagnant wages, not a lot of savings, a big chunk of student debt (which their parents didn’t have to any similar scale), far less home ownership than previous generations, and the highest healthcare costs in the world.
For example, based on the 2018 Credit Suisse Global Wealth Report, the median per-capita net worth in the United States is less than $62k, which is lower than comparable countries like South Korea, Canada, Australia, the UK, and Japan. The median U.S. consumer is a lot more fragile than many of us think.
My article on economic bubbles quantifies some of the challenges that are building against the U.S. middle class. But at least, overall, leverage isn’t as bad on consumer balance sheets as it was before the 2008 recession.
Case 2) International Debt
Here’s a chart I put together using data from the Bank for International Settlements showing how much corporate debt, household debt, and government debt major economic blocs have as a percentage of GDP:
Data Source: BIS
- China has a large corporate debt bubble. Their policymakers are aware of it and are trying to gradually deleverage it. Their government has low debt and massive foreign currency reserves, and households are strong savers.
- Japan has a huge government debt load and high deficits, but relatively low household debt. Due to Japan’s large market capitalization, it’s the largest area of allocation in most broad international index funds and ETFs, but it’s not an area I want a lot of exposure to.
- Some countries, like Australia, have a ton of household debt (120%), but very low government debt (40%)
- Some countries, like Italy, have very low household debt (40%) but a ton of government debt (130%).
- Emerging markets on average have a lot less government and household debt than advanced/developed countries, but have slightly higher corporate debt.
Opportunities and Asset Allocation
For the previous newsletter issue, I wrote about the solid value of emerging markets currently (for brave investors).
One of the reasons I am bullish over the very long-term on emerging markets is that for the most part they have higher growth, lower debt, and lower stock valuations than developed markets.
- Japan has extremely low growth, high debt, and moderate stock valuations.
- Europe has quite low growth, high debt, and low/moderate stock valuations.
- The United States has moderate growth, high debt, and high stock valuations.
- Emerging markets vary considerably, but as a group they have high growth, low/moderate debt, and low/moderate stock valuations compared to Japan, Europe, and the United States.
The catch is that emerging markets are more volatile, so how big of an allocation to them an investor should have depends on their age and risk tolerance.
Russia and India have among the lowest debt levels globally.
- Related article: How to Invest in Emerging Markets
Besides emerging markets and certain developed foreign markets, I’m finding a lot of value in U.S. natural gas pipelines, regional banks, cash-rich tech-giants, and certain REITs. I’ve been busy lately but I’ve been meaning to publish more individual stock analysis articles.
Gold is historically reasonably-priced, and silver is quite cheap by historical standards. I like having about 5% of my portfolio in precious metals at this point in the market cycle as a hedge.
I currently have four investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue.
These include a primary indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and a new account specifically for this newsletter at M1 Finance.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account a month and a half ago with $10k of new capital, with a plan to put an additional $1k into it before each newsletter issue.
It’s by far my smallest account, but the goal is for the portfolio to show newsletter readers my best representation of where value is in the market.
I chose M1 Finance because their platform is free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great showcase portfolio with high flexibility, and it’s the investment platform I recommend to most people.
After adding $1,000 in fresh capital in October, here’s the portfolio today:
As you can see, it has taken a bit a haircut from this October sell-off across asset classes, but due to its somewhat defensive nature it held up a bit better than the U.S. stock market as whole.
With my $1k contribution in October, I diversified the portfolio a bit more by adding a small (5%) section for precious metals, including gold, silver, and precious metal streaming/royalty companies. This was done with new capital additions; not by selling anything.
Here’s the more detailed breakdown of the holdings:
Primary Retirement Portfolio
This portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017 in order to preserve capital I dialed my equity allocation down to 60% (40% domestic, 20% foreign). This was due to high stock valuations, rising interest rates, and being later in the market cycle more generally.
If and when the U.S. economy encounters a recession and significant bear market, I would likely increase equity allocations to upwards of 90% once again.
This is an example of a fund that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions.
My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options.
These are rather concentrated portfolios with quite large individual positions (except SunPower, which is a small position):
I haven’t had any changes for these accounts since the previous issue.
This chart by Meb Faber continues to be one of my favorite charts of the past several years:
You can read more about this chart here and here.
What it shows is that investing in the bottom 25% of countries based on their cyclically-adjusted price-to-earnings (CAPE) ratio, investors would have enjoyed 2,500% returns from 1993-2015 (red line), compared to 780% returns for the S&P 500 over the same period of time (blue line).
The chart is logarithmic, so the difference is a lot bigger than it appears on the chart. The data here should be interesting to anyone who cares about which geographic assets have a good chance of tripling the performance of the S&P 500 during their investing career.
(For reference, the cheapest major countries right now by CAPE are Russia, Poland, South Korea, China, Singapore, Turkey, UK, and Brazil, based on a mix of data from Star Capital and Siblis Research.)
First of all, the chart shows the continued relevance of the CAPE ratio. Many pundits have argued that the high CAPE ratio of the U.S. market (over 30x, its second highest period in history) is not meaningful anymore. (Aka “this time it’s different”). Since the 1990’s, the U.S. CAPE ratio has mostly been above average despite giving solid returns overall, leading to the argument that the CAPE ratio is no longer valid as a valuation tool. However, the pro-CAPE counter-argument is simply that if you had invested in foreign markets with lower CAPEs, you would have tripled your money relative to the high-CAPE S&P 500 over that same period.
Secondly, it shows the importance of patience. In this chart, from 1993 to 1999, low-CAPE countries had similar performance to the S&P 500. And again from 2009-2015, low-CAPE countries underperformed the S&P 500. There are multi-year periods where buying low doesn’t work. But over a full generation of investing, almost a quarter-century of time in this study, the fundamentals and valuations mattered and cheap countries outperformed as a group.
Third, it shows the importance of contrarian investing and international allocation. It’s generally a good idea to have global portfolio allocation. Sometimes, your home market simply becomes too expensive, and there are better opportunities elsewhere.
U.S. investors as a statistical group are under-allocated to global equities, and don’t put much thought about global asset allocation. For what it’s worth, we happen to be now in a period where the U.S. stock market has a unusually high CAPE ratio (and high price-to-sales, high price-to-book, high market-cap-to-GDP, low dividend yield, etc), while foreign stocks are relatively cheap.
Overall, I think the data shows:
- The United States is likely late in the business cycle with rising interest rates, weak housing markets, a lot of leverage, and high stock valuations. Not my favorite place to invest, but an area where I am holding value stocks. I also like some of the tech-giant cash-machines like Microsoft, Google, Apple, Intel, Cisco, and Texas Instruments.
- There are some global locations mentioned above with low valuations, low debt, and decent growth prospects that offer potentially better returns. For brave investors, I’m a fan of emerging markets over the long-term at today’s valuations as part of a diversified portfolio.
- It’s useful to to be globally diversified, and arguably conservatively-positioned in the current market environment. An allocation to cash-equivalents, investment grade bonds, and perhaps precious metals as a part of a portfolio is warranted in my opinion.
Have a great autumn,