Chart Of The Day: The DV01 Time Bomb Beneath The World's Equity Tranche
While everyone is very familiar, and at times hypnotized, with the plain vanilla equity chart of stock prices which at least in the US are near all time highs, and where the small-cup Russell 2000 - long the object of Bernanke's affection - is already at never before seen levels, one chart virtually nobody has seen, perhaps the most important chart for the global capital markets right now, is the following from Goldman, which shows that while outright market cap for the G7 countries (ex basket case Japan) is near all time highs courtesy of the $15 trillion in liquidity pumped by central banks, the ratio of equity market cap to the outstanding value of debt securities underlying this equity is near all time lows!
Or, as shown another way by Deutsche Bank, the ratio of the equity tranche to all the other debt in the system is problematic to say the least:
Why are these two charts so important? Because while the bulk of equity speculators and algos out there are at best familiar with the concept of Price to Earnings, the reality is that P/E is a trivial indicator designed to fool the gullible into some anchored perspective of relative pricing, be it cheap or expensive. The reality is that for a full grasp of valuation, one must always look at the consolidated valuation metric given by Enterprise Value, which is the sum of market cap and net debt, to some metric of cash flow, either EBITDA or Free Cash Flow (EBITDA - CapEx), especially since unlike Non-GAAP adjusted "earnings", which are whatever the accounting firms makes them be to beat estimates, free cash flow is always what it is: cash the company makes, or as has been the norm lately, loses.
In other words, most forget that equity is just one half of the valuation equation. Or, as shown above, far less.
And what is even more important, is that preserving the equity tranche, which despite Bernanke's endless manipulation of every risk asset, needs ever more and more cash flows to keep the value of the debt below the equity tranche whole. Because we are confident that even the most naive investors understand perfectly well that when debt is impaired, the equity value above it is zero.
And here lies the rub: to preserve the value of the debt, and thus preserve the illusion of the overvalued market, the global financial markets need to constantly generate more and more cash flows just to keep up with this burgeoning debt
So what happens in a rising rate environment? Well, the debt, which like total sovereign debt will hardly ever be repaid and at best be rolled over (in an ever-higher interest rate environment), will demand more and more of the cash to go toward satisfying interest obligations beneath the equity tranche, leaving increasingly less for equity. The hope by the central planners is that as rates rise, and as inflation quickens, there will be more cash going out to consumers, who in turn will generate greater cash inflows. But the problem with this is that should the animal spirits indeed return, and the Fed's balance sheet can be unwound, then equities will collapse due to the simple obliteration of the abovementioned $15 trillion in government created money, before the real virtuous cycle can resume.
But before any of that happens, the DV01 time bomb contained in the world's balance sheet will first go off, as suddenly what little market participants finally remain do look at the chart above and realize that no incremental value creation will go to the equity tranche, with debt satisfaction taking up all of it. This simplified analysis also completely ignores that cash flows will implode once companies, who have delayed replenishing the asset bases with capex spend, can no longer afford to spend on organic growth and invest in themselves, resulting in even less cash going to debt, and certainly equity.
Finally, the reason everyone has ignored this chart is because in a ZIRP environment, the amount of marginal debt payments is negligible. However, once the much sought after "rotation" does indeed begin, and rates start creeping higher, suddenly the question of debt interest payments will once again become oh so very critical.
Until then: enjoy central planning.
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