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Stock market foundation built on sand

Earnings go up but so does debt
Earnings go up but so does debt
Federal Reserve Bank of St. Louis

If you were going to erect a building, the foundation of the structure is best served if it is anchored in bedrock. A foundation anchored in sandy soil would be deleterious to the occupants of that building regardless of how solid the exterior appeared. This is an apt metaphor for the U.S. stock market. The exterior looks terrific but the foundation is anchored in sand. Let me explain why.

I will relegate this article to "fundamental" approaches of valuation and deviate from other discussions in this space where I discuss chart patterns and proprietary analyses. If you examine what is happening on Main St. with respect to per capita income, we find an increase of 8.1% since the previous stock market high in 2007. That small increase leads to a further conclusion of how tepid the recovery has actually been. Examining this figure a bit further reveals that most of that income gain funneled to the upper echelon of earners. The large swath between the 50th and 90th percentile of earners has not experienced the same amount of income growth, thus tempering the economic expansion that stock prices seem to declare.

Investors of all stripes continue to hope the Wizards in the central banks keep pushing buttons and pulling levers in order to keep new money flowing through the system. Some will argue that fundamentals are in great shape since corporate profits are way up. Corporate profits are way up. After making a coincident high with the stock market top in 2007, profits fell nearly 50% into the stock market low of 2009. Since that time it has been a parabolic rise to record levels.

Again on a fundamental level the increase seems puzzling given the weak economic recovery. What we have, however, are very low interest costs that help earnings, federal government deficits and continued low household savings. Since the start of what I have referenced as the greatest credit boom in history (1982), these remarkable changes in corporate profits occurred after the 2002 recession, after the stock market top of 2007, and after the stock market bottom of 2009. In 2002 we had the Fed lowering rates, 2007 marked the onset of the Great Recession and credit crisis that followed, while 2009 coincided with another round of Fed easing. The last decade has seen tremendous variability in corporate profits the latest of which is historic in its increase and certainly unsustainable.

The elephant in the corner of the room for companies is the amount of debt acquired since 2010. The included chart, courtesy of the Federal Reserve Bank of St. Louis, illustrates how non-financial companies acquired nearly $2 trillion in debt in a very short period of time. After an understandable reduction in debt acquisition during the recessionary period, companies went on a debt binge. The proceeds of this binge have been targeted towards share repurchase schemes. Historically, companies have tended to buy back their shares near stock market tops. The current low rate environment merely exacerbated the extent of their purchasing. Of course, once debt is issued, it must be repaid. That repayment will place stress on future cash flows. Since the proceeds of the debt are not being reinvested in companies, the debt becomes a source of non-self liquidating debt. Companies are ultimately betting that their future earnings will continue on a great trajectory in order to have the cash to pay back debt plus interest. Are you willing to make that bet?

As with many things in the great credit cycle starting in 1982, the exterior conceals the foundation. This debt foundation will ultimately be as perilous as the others.

Jim Mosquera is the author of E$caping Oz: Protecting your wealth during the financial crisis and is a Principal at Sentinel Consulting, a business restructuring, debt mediation, and capital acquisition firm.