By Joel Litman
Market strategists, financial journalists, and investors are calling for a recession in 2020. Some would have you believe it’s already begun.
Moreover, many folks conclude that this recession will launch the next great bear market, popping the current market bubble in equities.
The headlines grab attention. They generate views and ad sales. The comments could even be called incendiary.
Don’t believe the hype.
These folks are looking at insufficient data. Or worse, they simply already believe something to be true and are looking for data to support it. If “market bubble” headlines are grabbing the attention of the readers, it’s easy for the financial press to pour more fuel on that fire.
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But that doesn’t make their opinions accurate. It just creates more headlines.
About 20 years ago, I was asked to speak at a high-yield debt conference in Las Vegas. One of the conference sponsors was a man named Mitch Julis, one of the two partners in the formidable Canyon Capital hedge fund.
I didn’t know it when speaking with him at the time, but Mitch was on his way to becoming, if he wasn’t already, one of the most successful hedge-fund managers ever.
I told Mitch that I was a bit uncomfortable speaking in front of a room full of credit experts as I considered myself to be “an equity guy.” Why would this audience want to hear from me?
Mitch explained that it was my accounting expertise that he and the audience were after. He stated how the importance of getting to the right corporate performance numbers was as important to credit holders as it was to stockholders.
Then, this icon of investing was kind enough to provide me with some of the most important advice I’ve ever received in my career.
“If you want to be a great equity investor, you’ve got to be a solid credit analyst.”
He added something to the effect of, “Got that, kiddo?”
That conversation changed my life.
Of Course a Recession and a Bear Market Are Coming… Eventually
Over the past 10 years, one of the most common conversations we have in meetings with our institutional clients is about the end of the bull market.
However, just because the stock market is at all-time highs doesn’t mean it has to go down. It all depends on where we are in the earnings and credit cycles.
In fact, over the last 150 years of recorded financial history, it is very difficult to find a bear market that isn’t preceded by a seizure in the credit markets.
That goes for the savings and loan crisis, the Asia financial crisis, and the Great Recession… and throw in the Panic of 1907, the stock market crash that led to the Great Depression in 1929, the Roosevelt recession in 1938-39, and the 1970s recession if you still needed more examples.
All the severe bear-market collapses that people fear most have been preceded by major breakdown in credit markets.
Stock markets don’t fall because of high valuations. History has shown that those very high valuations can get even higher still. They fall because of collapsing credit…
And right now, the most advanced credit and earnings signals all point to a stock market that is highly likely to continue climbing for another 12 months or more.
We’ve been telling our institutional clients this since 2013. Over these past many years, we probably sound like a broken record. But while it isn’t as exciting as telling folks the sky is falling, the difference is that we’ve been right…
To understand if we’re headed for a recession and a bear market, we pay attention to one key question… Are we headed toward a debt crisis?
The best, most comprehensive signals say that the answer is a resounding “no.”
Not yet anyway. For U.S. corporations, there are no near-term signs of an impending debt crisis. Companies have two options to service their debt as it comes due.
1. They can pay off the debt with their cash balance and cash flows.
2. Or, they can refinance their debt with more debt due at a later date.
Debt crises normally begin when companies are unable to refinance their debt. They are still on the hook to pay. But they don’t have the cash to do so. And banks aren’t willing to lend to them.
By looking at all U.S. corporations’ debt, cash flows, and cash on hand, we create a signal that accurately gauges the overall health and runway of the entire U.S. economy.
Using traditional accounting metrics, this wouldn’t be possible. The problems with how different companies treat metrics – like leases, interest expense, capex, and other line items – make as-reported accounting totally incomparable and trend analysis impossible.
Any big-picture macro analysis of U.S. corporates in aggregate would be “garbage in, garbage out.”
Forget the Spin Cycle, Look at the Credit Cycle
By using Uniform Accounting, a more reliable way of looking at companies than the U.S. generally accepted accounting principles (“GAAP”), we can see a better, macro picture of companies’ ability to service their debt obligations.
The following chart highlights the aggregated “Credit Cash Flow Prime” chart for the S&P 1000, which is the S&P 1500 minus the S&P 500. The S&P 1500 is basically the 1,500 largest U.S. companies. And we focus on the S&P 1000 because the 500 largest companies (the S&P 500) are so large and have such healthy-income statements and balance sheets that they wash out any insight around credit risk for companies that are the real potential catalyst for a credit crisis.
The chart has a few important features worth highlighting…
The vertical bars represent all financial obligations U.S. companies have after Uniform Accounting adjustments. The blue line represents the aggregation of corporate cash flows used for paying their obligations. And the blue dots are aggregate cash on hand (added to the cash flow each year). Companies begin getting in trouble when their cash and cash flows no longer exceed the stack.
As you can see, U.S. corporations can nearly service all of their obligations, including share buybacks, with cash flow alone. And that cash allows a fair amount of buffer should any factors impact their cash flows until 2022.
It’s not until 2023 that cash and cash flow combined fall squarely in the middle of maintenance capex and annual-debt maturities have tripled.
That’s a three-year runway before we expect to see the kind of debt issues that could send the market and the economy into a real tailspin.
Of course, we also see some concerns starting in 2021, because that’s when the buffer between cash flow and non-share-buyback obligations starts to shrink. If companies haven’t continued to steward their cash and don’t refinance their 2021 debt maturities before 2021, there may be issues then.
Importantly, this chart is changing over time. The debt maturity stacks we’re showing here for 2019 to 2021 are what those maturities looked like as of December 31, 2018. We only get that data systematically when companies file their annual 10-K reports.
Since we we’ve already seen some refinancing occur as we analyze individual bonds and corporate credit, it’s likely the actual picture looks even better now.
Debt That Is Due Is Less Costly
While the U.S. has a big debt headwall coming in 2021, that can change when U.S. corporations refinance their debt.
That wasn’t happening last year or earlier this year… but it’s exactly what we’ve been seeing recently. And it’s been speeding up in the past few weeks.
There’s a simple reason we’re seeing a renewed interest in refinancing… After rising massively in 2018, the costs for corporations to borrow have fallen this year.
The chart below highlights the cost to borrow for U.S. corporations currently, which we look at by combining aggregate credit default swap (“CDS”) prices plus the risk-free rate over the last decade. Credits are broken into three buckets: investment grade (“IG”), crossover (“XO”), and high yield (“HY”).
IG companies are the largest, safest, and most stable public companies, while HY companies are the smallest and riskiest. So it makes sense that HY corporate cost to borrow is always more expensive than IG cost to borrow, with XO always in the middle.
As you can see in the chart below, the cost to borrow for all types of credit is significantly lower than it was in 2010 as we were coming out of the Great Recession.
Companies have used those lower costs to consistently refinance their debt maturities. It made sense. When companies “roll out” their debt this way, they get to delay repaying it and also get to see interest expenses decline or, at worst, stay flat.
Then in 2018, something changed. The refinancing market dried up. Companies weren’t as active refinancing their debts. The cost for them to do so had risen significantly…
First, the Federal Reserve was actively hiking interest rates, with four rate increases in 2018.
And the underlying CDSs for corporate borrowers were rising too as perceptions grew that the bull market was running out of steam. The cost to borrow for IG companies rose from around 2% to 3.5% in 2018 through early 2019. The cost to borrow for HY businesses jumped from 3.5% to 5.5%.
Companies saw these increases and paused their debt refinancings. That’s how the debt-maturity headwall in 2021 got so big earlier this year.
But in recent months, we’ve seen a big inflection… which has caused the refinancing market to return. It’s why we think debt-maturity headwalls that had been looking material for 2021 are likely to be pushed out to 2022 and beyond.
Without the sorts of debt-maturity headwalls that we see beginning in 2021, there’s very little risk of a stock market collapse before then.
The rise in the cost to borrow in 2018 has completely reversed itself. Thanks to the Fed cutting rates and CDS levels moderating, cost to borrow is roughly in line with what it was in 2014 through 2017, when the refinancing market was strong.
We already know that the risk of a recession in 2020 is much lower than many on Wall Street are claiming, just by understanding how debt maturity headwalls look. But we also can get new confidence about how 2021 looks for the U.S. and global economy, by understanding how important the refinancing market is to economic growth.
The fact is that traditional, as-reported means of looking at credit and equity will not provide a suitable model for understanding where we are in the bull and bear cycle.
So while the stock market has run a lot, it still has strong legs to continue running.
Don’t believe the hype or scary headlines. The stock market won’t collapse simply because journalists are calling for a bear market, regardless of how many random, poorly calculated data points they try to use.
Instead, rely on signals that drive the forecast and have for centuries… regardless of how boring that might be or how few ads that might sell.
The U.S. stock market is experiencing new market highs because credit and earnings cycles support it. They will continue to do so for another year and more, and the market will continue to rise until the right signals say otherwise.
Professor Joel Litman is the chief investment strategist at Altimetry. There, he’s focused on helping individual investors make sense out of accounting standards that obscure a company’s true earnings. In other words, he helps investors get it right when Wall Street gets it wrong by using a team of 90 accountants and analysts who sift through more than 8,000 publicly traded companies around the world.
We published a cover story on Joel in our September magazine, and were so impressed with his work that we invited him to contribute an article this month. If you’re interested in reading more from Joel, he publishes a free daily letter called the Altimetry Daily Authority. You can learn more by clicking here.