In a recent blog post, we shared our concerns about historically high market valuations and why it increases your risk of paying too much for a stock or index fund. But, with a stock market that has gained 11,000 points in three years, it’s easy to see that coming. And, as we suggested, you can lower your risk through direct stock ownership in well-managed, undervalued companies. However, what you may not see coming is something that has the potential to wreak havoc on the markets and the economy, and that is historically high corporate debt.
Easy Money Leads to Corporate Binge Borrowing
In the last ten years, companies have been feasting on the combination of surging market valuations and historically low interest rates by taking on a record amount of corporate debt. However, with all eyes on the soaring stock market, record corporate debt, which is now near $10 trillion, has become the elephant in the room everyone is ignoring.
To put that in context, of all the money that investors have put into public companies in the United States (what is called total capitalization), 43% has been lent to those companies. Keep in mind that all of that money has to be paid back at some point. That should be concerning to investors but, as long as the economy and corporate earnings remain strong, no one is paying attention. It’s not a problem as long as equity market capitalizations continue to grow faster than the amount of debt outstanding, and companies continue to pay their bills. So, companies continue to borrow at a record pace.
When the Bough Breaks
The problem is at some point – we don’t know when – the economy will turn south. Total corporate debt, which has increased more than 50% since 2008, now represents nearly 75% of GDP, close to the levels seen just before the financial crisis. And, an increasing portion of corporate debt is in the form of short-term private loans with no transparency and no understanding of the terms of the loans. When interest rates rise – and they will – companies that rely on rolling over their short-term debt will face significant financial challenges. When a recession eventually hits, the problem could spiral out of control.
It wouldn’t necessarily be a big problem if these leveraged companies were using their debt for capital investments. Companies that invest their capital in improving their return on capital and gross margins can create a cash cushion in the event of a downturn. Instead, a large percentage of these companies have used it for enriching shareholders at the expense of growth. According to Standard & Poor’s, companies have spent more than $3 trillion over the past five years buying back their own stock.
As cash balances continue to deteriorate, the first sign of trouble will be when companies have to slow their spending to have the cash to pay down their debt loads. When that happens, the buyback binge will be over. Since buybacks have been a pillar of the market over the last five years, a sharp reduction could be devastating for the equity market. Alternatively, companies could face defaults or junk downgrades, which could devastate the bond market.
Is the S&P 500 Index a House of Cards?
If you think you can hide from the problem by investing in an index fund, consider this: nineteen of the companies inside the S&P 500 companies hold one-third of the $10 trillion of corporate debt and more than half of the S&P 500’s total cash is held by the top 5% (25 companies). The bottom 95% hold 73% of the index’s debt. The most cash-poor companies in the index have an aggregate cash-to-debt ratio of just 18% — that is for every dollar of debt these companies hold they have 18 cents of cash.
You Have to See the Threat to Avoid It
To be sure, investors are going into 2020 with their eyes wide open. But, are they looking in the right direction? Everyone is looking at China and Brexit and the elections – none of which will actually drive the stock market in 2020. No one is looking at the real threat because they are having too much fun enjoying the ride. At the very least, investors should be tapping the breaks a bit so they can see what might be coming from the other direction.
The obvious solution for investors is to reduce their exposure to leveraged companies. In an aging cycle with corporate debt levels at their highest in a decade, the focus should be on quality companies with little or no debt and solid management that knows how to generate lots of free cash flow and compound it over time. While it’s not possible to avoid the contagion of market turmoil, the stocks of these quality companies will hold up better than the market as a whole. And, that’s the key to building wealth – to preserve your capital while waiting for the next market surge.