High Debt & Low Revenue Growth Didn’t Cause A Crash

The stock market was down Monday. The S&P 500 is down about 1% from its all-time high. Anytime the stock market has been down since the election, it’s bigger news than it normally would be because it’s been in almost a straight line higher. It is difficult to remember what a normal market is like because we’ve been in an abnormal market for quite some time. The earnings metric I will mention later which uses 5 and 10 year averages is now distorted because the market has gone awry due to central banks’ accommodative policies. The distortion can be described by the combination of expanding market multiples and expanding debt levels. Stocks have gotten more expensive while firms are borrowing more to push their earnings higher with buybacks and acquisitions funded by cheap debt.

The chart below shows the 12-month change in the S&P 500 p/e ratio going back to late 1979. As you can see, the p/e ratio increases and decreases because of fluctuations in earnings and stock prices. While this current cycle never saw a spike higher in the market multiple like in other cycles, this has been the longest streak of multiple expansion in the past 37 years. 57 months of multiple expansion has left us with a Shiller PE of 29.27; the median is 16.12.

Even though earnings paint a relatively bleak picture for stocks it’s not a full description of the situation because, as I said, earnings are being boosted by the issuance of cheap debt. The number of publicly trading firms is declining because of acquisitions by larger firms. It’s doubtful this helps the economy since it leads to less competition and fewer jobs, due to synergies. It’s also doubtful that buybacks help the economy when the stocks are purchased at elevated levels. These poorly timed purchases make the peaks higher and the troughs lower (because the equity is re-issued at troughs). The catalyst for these two trends is cheap debt which makes earnings look better than they are. As you can see from the chart on the left, the median net debt to EBITDA of investment grade firms is now near the cycle high seen in 2002. The debt ratio has started to fall which is very strange because it has previously fallen after stocks corrected in the past two cycles.

As you can see from the chart on the right, the median investment grade revenue growth rate has been non-existent. Weak revenue growth has been helped by peak cycle margins, which won’t be sustained when the stress cycle begins. The revenue growth rate will need a big acceleration in 2018 to make up for the declining debt rate and stagnant profit margins. One point worth mentioning on the bullish side is earnings growth didn’t go negative to the extent it did in the 2008 recession. There hasn’t yet been a sharp tick lower in most of the economic indicators and the revenue growth rate. Given the level of optimism in the market today, this is likely what needs to happen to tip it lower and have the house of cards come tumbling down.

When I was mentioning 5 and 10 year averages being duplicitous, I was referring to earnings estimates. The chart below which shows the stock market rising and earnings estimates falling has become normal. In fact, the 3.1% decline in bottom-up S&P 500 EPS estimates in the first two months of the first quarter is better than the 5 and 10 year averages. The first two months of quarters in the past 5 years have seen earnings estimates fall 3.3%; they have fallen 3.9% in the past ten years. This is why bears are against using the forward p/ e to value stocks because it’s usually using numbers which won’t be met. As you can see, the blue line has fallen to $29.59 from $29.72 last week.

The about 13% earnings growth rate for 2017 which was once expected in September 2016 was never going to happen and most investors knew this. As you can see in the chart below, like usual, bottom-up EPS estimates for 2017 have steadily fallen. Therefore, far-out earnings estimates shouldn’t be used in bullish arguments.

The chart below showing the forward p/e should be higher because the current estimates will be missed by a few percentage points. The reported earnings almost always beat the latest expectations, but almost always miss the estimates from a few months prior. On the bright side for the bulls, this p/e which assumes estimates are going to be missed by the average amount would look better using the latest numbers since the decline has been lower than average.

The lower than average decline in earnings estimates in the past two months for Q1 was partially driven by energy earnings estimates which only fell 2.4%. The FactSet 2017 energy earnings estimates changed due to revisions. Last week it showed earnings growth of 340.4% was expected on December 31^st and now it shows 368.1% was expected. With this 27.7% revision considered, energy earnings grew 2.3% from last week because last week 284.9% growth was expected and now 314.9% growth is expected. Full year earnings growth estimates fell from 10.0% to 9.8%. My target is 4% to 6% growth; this seems bearish, but it’s still very early as no earnings have been reported yet.

Conclusion

This cycle is unique compared to the last two cycles because the high debt level didn’t trigger a crash. The low revenue growth rate didn’t plummet too far into the negatives. That’s why stocks are so expensive. The cycle ended in some respects, but there was never an economic crash which is what is needed to make stocks fall. It’s possible that a stock market crash due to overvaluation could catalyze a recession in this cycle. This crash would be a 1987-style correction. This week was a normal one for earnings estimates. They fell moderately, but since they always fall at that rate, it wasn’t particularly noteworthy.