Bear Case by Guest Blogger John Succo

John Succo graduated from Indiana University with a graduate degree in finance concentrating in option pricing theory in 1984. His work bio includes stints at Morgan Stanley, Paine Webber, Lehman Brothers, Alpha Investments, and Vicis Capital. In 2012 he became an adjunct professor for Indiana University and created IU Capital, a synthetic multi-asset fund where students manage risk around a variety of asset classes including equities, fixed income, currencies, commodities and derivatives.

 

SP500 companies’ adequate profits have been due to increasing margins on slow (if not now stagnant) revenue growth. Margins are at all-time highs and have been driven by lower interest expenses, stock buybacks (which retire outstanding shares and increase per share earnings at the expense of more leverage, making earnings "riskier"), and wage compression (wage participation of earnings are at recent history all-time lows). It will be extremely difficult for companies to improve these margins further.

There is negative margin pressure now building. Interest rates must normalize at some point and we are seeing pressure for that now. QE by the Fed has artificially kept interest rates low: they have been buying 70-90% of all treasury issuance causing their balance sheet to explode to $4 trillion and owning nearly 30% of the entire publicly traded treasury market. Interest rate risk is very high and just a 100 bps rise in rates would destroy the Fed's capital. The Fed's objective has been to drive investors into risky assets by creating no alternative; they have also targeted low volatility as a secondary measure to keep investor sentiment high, which is at all-time extremes right now. But tapering their asset purchases are now a function of risk and will continue. The Fed, BOJ, and to some extent the ECB have no way to "ease" except for asset purchases, so any new "weakness" in economic activity cannot be met by monetary policy and the markets will quickly lose confidence, which is the primary driver (psychology) of higher asset prices at this point.  Wage compression is now at the point where it will begin hurting consumption and work against margins. Higher rates will make it difficult to continue stock buybacks at the current pace and cause interest expense to rise. Corporate cash is a function of high corporate debt and rolling the debt will be more expensive.

Total debt in the economy is still 350% of GDP, levels that cannot be sustained. Some mortgage debt has been destroyed but an increase in public debt has offset this. Public debt is the least productive debt and as rates rise will become unserviceable: current interest expense is $450 billion a year and every 100 bps rise increases that expense by $200 billion. The treasury is now being forced to extend maturities and just normal rates will cause that annual expense to rise to nearly $1 trillion, creating systemic untenable deficits and crowding out of capital (even higher than normal rates). Additionally margin debt is at an all-time high, which is a precursor for too much risk and price inflation in financial assets.

As this process begins risky asset prices will suffer dramatically, normalizing rates and bottoming those prices but at much lower levels. Valuations by any measure are at least 30% overvalued and much more so if we truly are in a stagnant revenue paradigm. The Shiller P/E, the best measure of relative valuation, is over 26x, 56% higher than average. Pre-1987 crash gold went down and the 10 year yield rose 200 bps, very similar to today.