Contrarian Chronicles The nasty little spoiler in every market fantasy It's easy to go ratio-shopping for proof that stocks have turned a corner -- and easier still to simply invent numbers. But debt that's whopping by any measure is a recovery-killer. By Bill Fleckenstein
"Man Bites Dog." Now that's a headline guaranteed to sell a few newspapers. But "Debt Comprises Nearly 300% of GDP" would have fewer takers. Regrettably, there's nothing sensationalistic about this alarming statistic, yet the mainstream press has barely noticed. What we read are just questionable (and unchallenged) statistics -- or worse, the attempts by "experts" to contort them into validating spurious notions about the economy and the stock market. In any case, if the paperboy has already thrown the latest edition of the Contrarian Chronicles onto your doorstep, you'll note the banner headline: "Bear Bites Myth."
Let's proceed directly to the where-does-The-Wall-Street-Journal-get-these-people department, for a look at a recent op-ed piece titled "The Market's P/E Is Low, Not High." The writer, economist Marc Miles, works for Laffer Associates. It's not spelled l-a-u-g-h-t-e-r, though in this case, it ought to have been, given the farcical nature of his "analysis," which is nothing more than just making up numbers to get the results that you want.
Miles begins: "Bargain hunters remain glued to the sidelines by the mantra that the market's price-to-earnings ratio is too high. But bystanders beware – today's P/E is already very low. If you wait longer, you just might miss the bull market." Sound familiar? You hear this kind of refrain all the time.
Then he goes on to allow that "conventional" measures of P/Es look scary, meaning that the market appears overvalued when judged by them. He faults this perspective for just taking the past into consideration, while in his view, it's future earnings that the market cares about. His point is correct. The market does care about future earnings. But unfortunately, the future is not always so easy to discern. One can look at past earnings in order to get some sort of a guide as to what might be possible. Nobody with an ounce of brains uses P/Es as the be-all and end-all of analysis. It's just one of several tools.
Elegiac on the formulaic For instance, one can look at the price-to-book ratio, which of course also is dismissed because it's too high. (During the mania, the favorite argument was that one couldn't look at price-to-book because, after all, book value didn't matter. It was a service economy.) And one can also look at the total value of stocks to GDP (much more about that below). Lastly, one can look at the price-to-sales ratio. All these ratios and others have to be considered when trying to get one's arms around the subject of valuation.
I myself like to use price-to-sales, especially when earnings are depressed by weaker economic activity, as is the case now. According to data that I saw from ISI Group, the price-to-sales for the S&P industrials is currently about 1.5, i.e., you're paying $1.50 for every dollar’s worth of sales here. The P/S got to about 2 at the peak of March 2000. From 1963 to the late 1980s and early 1990s, it rarely surpassed about 1.2. So, we are still in uncharted waters.
Of course, when you pay a multiple of sales, you are also making a de facto statement about what you expect margins to be, as well as barriers to entry. That all has to be taken into consideration. It's not simply a matter of P/Es being inversely correlated with interest rates, as Miles suggests. They happen to be. But just because rates are low doesn't necessarily mean you can pay a high P/E, because if profitability is scarce and there's no growth, that analysis needs to go out the window. It's not a corollary that in all cases, lower rates mean you should pay higher P/Es. Again, it's just another tool.
Proprietary hubris In any case, Miles proceeds to make a statement that I find to be the height of arrogance -- "My properly adjusted numbers (the italics are mine) suggest that the current P/E is low by historical standards" -- which he then attempts to justify by saying that it's the lowest in 33 years. Now, let's be perfectly clear. No one person can have the correct numbers, because there is no one set of correct numbers. He also doesn't tell us what these properly adjusted numbers are, or what he thinks the true earnings power is, based on his proper adjustments, though he does allow that if interest rates were to go up, which is another possibility, stocks are still the cheapest since 1998, according to his "properly adjusted numbers."
What Miles does do, via his twisted tautology, is to argue that there's no reason why stocks shouldn't rally. To which I would respond that markets, being comprised of animal spirits, can rally when stocks are expensive, and markets can go down when stocks are cheap. Stocks are not cheap, however, based on price-to-sales and other measures that I look at.
Thin-air analysis This is not to say that all stocks are expensive. But I, for one, get tired of people trying to say that stocks are cheap, based on some sort of analysis of future earnings, for which no support is given. Earlier this year, people were tossing out $50-plus estimates for the S&P. I mean, if all we want to do is to make the data fit our conclusion, we can go ahead and make up numbers about what companies will earn and convince ourselves that stocks are cheap. But that is not necessarily going to make us any money.
Finally, in the fantasize-by-numbers department, Miles winds down his case with more outlandish statements, such as, "If economic conditions did not change, profits would be expected to rise by 30% to 40%." Oh really? I didn't know that. He thinks "unusually low reported earnings will be replaced by earnings at current or higher levels." Well, as long as everything gets better, that might be the case, but if things don't, they won't. Anyway, this exercise is not to single out this fellow, but to pick on the kind of "analysis" that amounts to nothing more than a whole lot of arm-waving and trying to support a conclusion in any way possible. When it comes to investing, that is a recipe for disaster.
Nickel-plated debt hypertrophies sold here Well, enough of the world of boilerplate financial analysis. I'd like to turn now to a discussion of debt, balance sheets and valuations -- topics that I believe receive too little coverage by the mainstream press. First of all, let's talk about debt. While leverage works well when things are going up, it obviously magnifies problems when things are going poorly. In some sense, assets are contingent, but debt is forever. Here in America, total debt compared to GDP now stands at around 280% to 300%. (By definition, these numbers are estimates, since it's impossible to arrive at a precise figure, but the latter is not needed in order to get the gist of what's going on.)
This is the highest debt-to-GDP ratio that the country has ever seen. By my calculations, as we exited 1929, debt-to-GDP was about 200%, though it did rise pretty dramatically while we were in the Depression, to about 300%, according to the latest research that I received from the Leuthold Group. But by 1950 or so, the debt-to-GDP ratio came in at about 150%. It rose to some 220% in 1990. So obviously, our current ratio of total debt outstanding to GDP is the highest it's ever been (the Depression excepted). And to repeat, despite the mounting risk associated with these increased debt levels, I rarely see the media taking the time to talk about the problem.
Further, it should be remembered that as we headed into the Depression, corporate America had behaved differently than it does now. During that bubble, it had been raising equity money and could boast of balance sheets being in pretty good shape. Whereas in the most recent mania, corporate America took on a lot of debt and bought back stock.
Chewing on debt-to-GDP radicchio One of the more disturbing reasons for this assumption of debt is that, over the course of the last 10 years -- and even worse, in the last five years -- it has taken ever-larger amounts of leverage to generate an additional dollar of GDP. The data I am about to offer come from the Richebacher Letter, which a friend shared with me. (While not a subscriber, I have read the newsletter often in the past, and for anyone who lacks access to this kind of information, I find it to be a pretty good source. Their phone number is 800-433-1528. You can see a sampling by following the link at left.)
According to the Richebacher Letter, it turns out that from World War II until the late 1970s, it took about $1.40 of debt to increase GDP by a buck. Said differently, for every dollar added to GDP, 1.4 dollars was added to nonfinancial debt in this country. The latter began to mount in the 1980s, and levels really escalated in the 1990s. From 1997 to 2001, it took 2.6 dollars in additional debt to generate an additional dollar of GDP. From there, as the newsletter reports, things have gotten worse: "In 2001, the aggregate indebtedness of nonfederal borrowers rose by $1.109 trillion, while GDP only grew by $258 billion. This boosted the debt-to-income ratio to the unprecedented level of 4.3 to 1." In other words, it took 4.3 dollars of debt to generate an additional dollar of GDP growth.
Now, these numbers aren't as precise as the decimal point implies. But I think the overall thrust of the information is powerful. We have piled up a tremendous amount of debt compared to total GDP, and it is taking ever larger amounts of debt to power the economy. I was aware of this during the late 1990s, and I wrote about my concerns on a handful of occasions. I always thought it was rather curious that people were giving productivity all the credit, when part of the credit may have been due to leverage. (Of course, the recent revisions have confirmed what a few of us skeptics believed all along -- that productivity was overstated at the time.)
As an aside, I might add that people always talk about how what we are seeing here can't turn into what's gone on in Japan. While we have noted a difference between our two brands of capitalism, among other things, it's worth pointing out that Japan is a nation of savers, and we are a nation of consumers. So, when they got into a protracted period of debt, they at least had domestic savings to lend money. We are not in that position, which is why, at some point, the role of the dollar could affect where our credit markets trade. But as I said, that's a bit of an aside.
Still-mammoth market cap Turning to the other side of the balance sheet, rather than look at P/E ratios when considering the big sweep of things, I have often preferred to talk about market cap compared to GDP. For those not familiar with that ratio, at the peak in 1929, it was 75% to 80%, and it never rose above 100% until 1996. In fact, this ratio had only surpassed the high 70%s for one quarter, briefly, in 1968. (This information also comes from the most recent monthly piece by the Leuthold Group.) Where we stand today is that market cap to GDP is about 100%, down from a peak of 160%, plus or minus, in March of 2000. Obviously, one could look at a chart and see in some cases that the market has corrected to 1996 levels. But one should remember that on this basis, there was nothing cheap about 1996.
People sometimes like to take the tack of asking, "What is the median for the market cap-to-GDP level?" Since 1926, that is about 51%. So if we were to trade back to the median, the market would get cut in half. Now if one looks at a chart of this, as I have over the years, one sees that the market only accidentally trades at the median. It tends to trade way above it, or way below it. My gut feeling is that considering our recent period of insane overvaluation, we could have a period of quite cheap stocks, but it doesn't have to work like that. In any case, there's the math. Based on this ratio, stocks could become far cheaper, which is obviously what I believe and have been saying.
Greater liquidity through dry data Lastly, I'd like to add a little flesh to the point I made earlier about the difference between the growth rates of the economy and the financial markets. Along those lines, the Leuthold Group provided some additional interesting data. From 1991 through 1999, the equity market quadrupled, growing at 19% per annum. GDP rose by 55%, which is 5.6% per annum. And corporate bonds outstanding expanded by 146%, which is 11.9% per annum. These numbers make clear the more rapid rate of both equity growth and debt growth vs. GDP. To the extent that the drop in the stock market is a proxy for declines in book values (admittedly, not a perfect analogy), corporate balance sheets continue to deteriorate.
In any case, I hope people find this information useful, even if it's a little bit dry. What they need to consider is the point that in the aggregate, the equity market is still quite rich, and that our high level of debt will accelerate any negative economic developments going forward. A company with substantial leverage (debt) can make a lot of money when things are going well, but in tough times, its debt burden dramatically increases the risk. And that is why everyone who buys stocks ought to be focusing on balance sheets as well as income statements.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At time of publication, William Fleckenstein owned none of the equities mentioned in this column. Positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money.
Don't forget West Coast Dock problems. This promises to be the fallback distraction in case the War with Iraq gets suppressed by inspectors. Armed Guards at the negotiations? I gather that goon squads are next, all to keep the headlines away actual constructive actions that could be taken on the economy.
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