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Breaking Bad News From The Fed’s Z1: Expansions Tend To Explode Near Current Leverage Multiples
Submitted by F.F. Wiley of Cyniconomics
Breaking Bad News from the Fed’s Z1: Expansions Tend to Explode Near Current Leverage Multiples
In an earlier article, I argued that the S&P 500 (SPY) is more expensive than you might think if you only compared prices to trailing earnings. I recommended a different approach that suggests today’s valuation is similar to that of 1997 or 2006, a few years ahead of the respective bubble peaks of 2000 and 2007.
But what about credit markets?
While bubbling assets are a major part of the history of the Greenspan/Bernanke economy, so too is unsustainable borrowing. It seems wise to keep an eye out for another borrowing binge, especially as policymakers are encouraging all forms of financial risk-taking. And one place to check is the Fed’s quarterly “Flow of Funds” report, which recently took the fancy new title, “Financial Accounts of the United States,” but still goes by the nickname “Z1.”
Z1 data for the second quarter was released last Wednesday. It showed there’s little to worry about in the mortgage sector, which continues to shrink, whereas federal government debt stands out for having astoundingly doubled in the last five years. Soaring government debt may be our biggest threat today, but I’ll leave this topic alone for now. I’ll look instead at nonfinancial corporations, where I’ll check for froth by calculating two types of debt-to-profits ratios.
First, I’ll divide debt by nonfinancial corporate profits as found in the National Income and Product Accounts (NIPA), while making two adjustments:
- To eliminate the problem that debt ratios tend to skyrocket when profits temporarily shrink in a recession, my denominator is the maximum profit in any prior period of four consecutive quarters.
- To account for credit market instruments on the asset side of the nonfinancial corporate balance sheet, these are subtracted from the total “credit market instruments liability.”
Here’s the chart:
At first glance, you might say: “Okay, we’ve reached a 9-year high, but the last bubble was concentrated in the household and financial sectors. The second quarter reading is lower than it was the early 1990s and early 2000s, and that’s not so breaking bad.”
But just as the most recent earnings measure doesn’t tell the whole story when you’re assessing stock values, the same goes for the debt-to-profits ratio. Consider, for example, that interest rates on corporate debt reached extreme lows in the second quarter when the Z1 data was recorded. Back-of-the-envelope estimates (which I’ll post separately) suggest that profits are more than 20% higher than they would be if interest rates were closer to normal. And that’s just one of the reasons to question the permanence of an outcome that’s followed six consecutive years of ultra-strong stimulus.
A “smoother” debt multiple with a knack for flagging recessions
For a more revealing look at corporate debt, I’ll borrow a page from Professor Robert Shiller’s book. The earlier post I mentioned included stock market multiples based on Shiller’s recommended 10-year averages for corporate earnings. By smoothing the ups and downs of the earnings cycle, this approach offers a better picture on long-term valuation. And I’ll use nearly the same method for the corporate debt ratio. Instead of dividing by trailing four quarter profits, I’ll divide by 10-year averages.
(Note: I’ve modified Shiller’s method slightly by converting the profit figures in each 10-year window to constant dollars as of the last year in the window. This makes for more meaningful comparisons between periods with different inflation rates.)
Here are the results:
As you can see, the chart shows a persistent upwards trend. It also shows unusually high volatility in the Greenspan/Bernanke era, consistent with the Greenspan/Bernanke puts that encouraged overreaching in expansions. And with today’s policies setting new standards for “whatever it takes” central banking, Bernanke’s soon-to-be-named successor may yet ring in a new record for the debt-to-profits ratio.
But there’s a cautionary note in comparisons of today’s leverage ratio to the last three expansions. The last three times the ratio jumped above the current reading of 7.2 were Q1 1990, Q1 1999 and Q2 2007. And from these points in time, the economy fell into recession about a year later, or less, in each case. (The respective times to recession were two, four and two quarters.)
The last chart maps out three years of S&P 500 performance from just before to well after the historical breaches of 7.2:
The stock market picture isn’t all doom and gloom – at least the 1990 downturn was short-lived – but it isn’t exactly encouraging, either. What’s more, it adds to other signs of a new corporate credit bubble:
- Year-to-date covenant-lite loan issuance has already shattered the previous record, set on the eve of the global financial crisis in 2007.
- Leverage multiples based on EBITDA (similar to the ratios in the charts above but without depreciation, amortization and today’s unusually low interest expenses) are also well beyond 2007 levels, and even higher than the temporarily swollen multiples of the low-EBITDA years of 2008/09.
- PIK Toggles are bubbling up once again.
It seems to me that the Fed isn’t quite capable of detecting imbalances that accumulate in periods of über-cheap money and moral hazard. Or, maybe they just don’t think much about the potential consequences of those imbalances. And as Breaking Bad’s Walter White might say: “those consequences, they’re coming.”
In my opinion, the question isn’t so much whether the Fed’s approach leads to another financial bust, but where the bust originates and when it occurs. Evidence presented here suggests that the corporate credit markets are one a few possibilities for the where, and the when may be sooner than you think.
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Maybe Walter will rescue Jesse and they'll stroll off into the sunset (Having killed off Skyler, her sister, everybody else... all fucking dead as door-nails) to cook forever.
Remember folks, he's still got that msixty belt feed hidden somewhere from a long time ago......
Oh my.
Yeah yeah yeah... so the gubamint gets shut down
Oh yeah..
High valuations
Get it... High?
Tuco! Where's Tuco?
Wal Mart starts shutting down stors in 3...... 2....... 1........
The real tragedy here is that there's hardly anybody left alive who knows anything other than financialization as a means to grown an economy.
So welcome to the New Dark Ages serfs!
Snort
TIGHT, TIGHT, TIGHT!!!
Looks like a debt breakout...could be years to reverse and take stocks down
Dont sweat the small stuff
Yow! All of this bad news can even get to a legit prepper and gold fan like me...
Maybe it's time for a vacation...
http://tinyurl.com/9hlvzdx
Great travelog and that is some pretty country!!
Have you done Utah yet? Zion national park is AMAZING, literally have to pack for all possibilities (snow, wind, rain, tropical, hot, cold). Someone painted that canvas and left it for everyone to see. If you are going read up on it first though, it's rough land and the Park is HUGE, so it's a solid week long hike.
Yes, we have been (2009) to the amazing Zion National Park (oh, sorry, Jooo-haters, LOL!) My wife took a picture of me doing Tai Chi on that large grassy area with the big tree (in front of the lodge), but that picture is gone...
I liked Zion as much as any National Park, while she liked Bryce Canyon.
North America DOES have more than its share of natural beauty. Too bad we cannot say the same about our governments...
DoChen, Zion was named by Mormons back in the day as Brigham Young had another drunken delusion. PS: Mormons despise Joos.
I did not know either fact, thanks for passing along the info. I was taking a humorous poke at the J-haters here, that's all.
There's a reason people love it. It's not the cities or the government, it's the land that talks. Montana is another great space. Just cue up the entire Floyd collection and just drive. Big country. Big Sky. With or without some impressive guitar work. It's staggering and all you can do is surrender to it.
...and the word Zion is pretty flexible. Jews refer to it as Jerusalem. But there are also Sanskrit Indian words that are pretty close in the sound, Sion outside of Mumbai. Then there are the Rastafarian that say it's some place in Ethiopia and have been throwing darts at a map for years on the topic.
Arabs put the marker in Persia somewhere, but nobody owned a pen or a map so it got lost in time. Probably a big city where ever it was, they seem to be digging stuff up weekly now looking at the history blogs out there. However Muslim edicts with Mohamed put it in Jerusalem, maybe to get people to figure out how to live with many faiths I suppose. Early Christian point of sword conversion techniques were all the rage in Europe along with covering up their women and burning witches (women that dared show ankle). They also wanted Jerusalem because the THREE popes at the time (Schism, look it up, very weird and funny) were pulling ideas out of a hat to make money.
There are also variations in most modern living languages (even Inuit and their common relations around the north pole, http://en.wikipedia.org/wiki/Ilulissat). If you are ever stuck in a piece of history research, Etymologies are handy. History shows us we are lousy are writing things down, but people love gabbing about stuff so it stays in the meme pool of words.
Any case the word is a mess but means the same thing in multiple languages though. Home.
Collapsing all currencies in unison is like shooting fish in a barrel. <background noise> We’re running out time, there are empty seats to fill on the Global Monetary Reform committees Chair creature’s table..
Keep your eye on the pound sterling
pound fait. It hasn't been sterling for a long time.
Obama Administration: These motherfucker's need to stop looking over are shoulder. We have a Ways and Means committee to provide vital information to all American’s who should be watching TV, not surfing financial business sites.
/LOL
http://waysandmeans.house.gov/about/members.htm
Time for Congress to find rope and lightpoles and take their families with them. Might solve the problem in the long term.
Sander Levin, Charlie Rangel and John Lewis do make me feel so much better!
/LOL
/s
"Covenant-lite loan issuance" is the bellwether for me.
From "Investopedia":
"A type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower. The issuance of covenant-lite loans means that debt is being issued, both personally and commercially, to borrowers with less restrictions on collateral, payment terms, and level of income."
http://www.investopedia.com/terms/c/covenant-lite-loans.asp
In other words - leveraging up on risky debt to make a buck today without concern for tomorrow.
Sound familiar? Yeah.
US Fed printing and government borrowing until the dollar implodes.
The only way to take down the US is economically. The US Fed is the great enabler of this.
"We'll Kill the Dollar!"
The awakening cannot be stopped. They know the gig is up for tricking the serfs. This is where the NSA comes into play. Watch this unfold in the wrong direction for those who needed a layer of protection to guard against the interworking’s to push the Global agenda.
We shall see. Which are true canaries and which are fundamentals trampled by market manipulation
Apparently the DNC and Obama PAC do not read the comments at ZH.
Banner ad for Obama.
"Are You In?"
No, but you are, and it hurts.