Over the past year, I have spent a lot of time discussing the problems created by falling house prices and the effect this has on debt levels and personal solvency. Falling house prices have placed many owners in the uncomfortable position of having no equity or negative equity in their homes.
Recently, I wrote a post considering the economic value of small businesses and the impact this is having on the sales of these organizations. The falling valuations of small businesses have put many owners in a similar position where the equity they have in their businesses has become rather small or has even become negative. (link)
Today in the Financial Times, financial manager and author Andrew Smithers provides us with a look at the valuations attached to larger businesses as represented by their values on stock exchanges. (See “The Conditions For The Next Crisis Are Firmly In Place”)
His fundamental conclusion, the US stock market is “overvalued” and this connected with high levels of private sector debt point to a very precarious situation for the economy. In the US, “private sector debt is 2.6 times gross domestic product, and nearly twice the level reached after the 1929 crash.”
His estimates of the US stock market: it is “about 60 percent overpriced.”
Smithers comes to this conclusion using two well known measures of stock market valuation: the “q” ratio, “the ratio of market value of non-financial companies to their net worth, adjusted for inflation”; and CAPE, “which is the cyclically adjusted price to earnings ratio.” (The “q” ratio was developed by Nobel-prize winning Yale economist James Tobin and CAPE was developed by current Yale economist Robert Shiller.)
He cautions about the use of the ratio in trying to determine market moves: “Value provides little guide to short-term market movements.”
“If we are lucky, stock markets will not fall sharply for some time.”
The reason is that when corporations are strong buyers of their own stock, the stock markets stay buoyant. In fact, “the US stock market has risen and fallen exactly in line with corporate buying.”
Thus, Smithers continues, it is important to “predict whether companies will continue to be strong net buyers of shares in the months ahead.”
A key predictive variable…whether or not companies have “relatively high levels of cash compared with their total debt levels”…which US companies currently possess.
“Over the past decade, at least, cash ratios have been a leading indicator of equity purchases by firms.”
But, Smithers warns about the near-record level of debt that corporations hold “whether measured gross or net of cash, and whether compared with net worth or output.”
He says that this fact is “startlingly at variance with the claims frequently made that US company balance sheets are in great shape.” Smithers argues that the aggregate data are most important here and not the individual balance sheets.
It is here I differ with Smithers. I have argued over the past year that the economy has split into two components…those companies that are in “good” to “great” shape and have a lot of cash on hand and have even borrowed at the excessively low interest rates to improve their cash positions…and those that are in “bad” to “terrible” shape. The division is, in essence, between the “haves” and the “have not’s.”
Some big companies are in really good shape financially while many other large- to medium-sized companies are not in very good shape at all. These well off big companies are “keeping their powder dry”, buying companies here and there, and also purchasing some of their stock. The others…well…they are really struggling.
This is one reason merger and acquisition activity has been so strong this year.
But, this situation is also one underwritten by the Fed with very, very low interest rates and quantitative easing. The “haves” have it all! The “have not’s” have next to nothing.
So far the Fed’s quantitative easing has kept the stock market going and part of this, as described by Smithers, has been the underwriting of the cash accounts of many of the biggest corporations which has led to a portion of the stock buybacks that have taken place. (Further gains have been achieved by using the Fed’s money to go “off shore” and get into world commodity and equity markets. (Link)
Of course, the businesses that are not in “good” financial health cannot engage in these activities.
Thus, the big and better off are fed…and the others must scratch for their survival.
Other than this slight disagreement with Smithers, we can get back to the crux of the story.
The US stock market, according to the two measures discussed here, is overvalued by about 60 percent.
We cannot predict the exact timing of market movements, but, historically, whenever these measures get so “out-of-line” there has eventually been a correction.
Smithers places this correction out somewhere in 2013. Why? “It’s the first year of the new Chinese government, of the new European stability mechanism, and—most important of all—the first year of the new US government.”
Wherever the “blow” comes from, corporate cash flows “will almost certainly fall sharply”
Consequently,Smithers asks, “If corporate cash flow drops, who will buy the stock market?”
My question is, “When will the large- and medium-sized firms that are not in good financial shape and that are overvalued have to sell?” We have seen this phenomenon take place in real estate. We have seen it take place with the smaller businesses. Given the analysis presented above, this phenomenon is going to spread over the next year or two to even the larger businesses. And, with market values too high, acquisition prices will be below stock market values, hence the markets will fall.
This is something that fiscal stimulus and quantitative easing cannot offset. It is a part of the debt deflation process that follows years of credit inflation.