Good News! The Fed’s Debt Update Says to Stick With Stocks.
I show in my book Debt Cycle Investing (some copies still available!) that debt growth has a lot to do with economic cycles, and therefore with business profit cycles, and therefore with investment cycles. Boiling it down, when debt growth is likely to accelerate, it is best to allocate more of your investment assets into stocks and less into bonds, and of course vice versa. The enterprising investor therefore should constantly assess the odds that the trajectory of debt growth changes up or down.
The latest poop on debt
The primary source of debt data is the Federal Reserve in its quarterly Flow of Funds report. I therefore breathlessly await each release, the most recent of which was last week, September 20. In my opinion, the latest update provided comforting news for stock investors. Here’s my key evidence, namely the ratio between total debt outstanding (household + business + government debt) and GDP:
Sources: Federal Reserve and the Bureau of Economic Analysis (BEA)
The major debt risk investors have is whether a debt bubble is well in process and near the bursting point. This chart shows that is far from the case, despite the US achieving a proud goal of surpassing $50 trillion in total debt. Yay us.
The stable debt/GDP ratio may not make common sense to some of you. After all, the government deficit is now soaring due to last year’s tax/spending deal, and currently very low bank default rates usually signal strong private sector loan growth. So let’s drill down a bit more into the recent components of the debt/GDP ratio:
Sources: Federal Reserve, BEA
The chart makes a number of important points, at least to an economic geek like myself:
- Private sector debt growth does indeed remain anemic, despite those low default rates. In particular, home mortgage debt growth is historically extremely low. There are areas of concern in private sector lending, namely increasingly junk LBO and auto debt, but overall banks and other private sector lenders remain pretty responsible. The odds are greater that lenders will turn more irresponsible than more conservative, which is for at least the next few years good for stocks.
- Government debt growth indeed has turned upwards. Some of it is irrelevant to the economy – much of the corporate tax savings are just going into share repurchases – but much is going into consumer spending, which is showing up in…
- …Real GDP growth. Year-over-year (YoY) growth (which excludes inflation) came in at 2.9% for Q2, up a full percentage point from a year ago. So the increase in the pace of government debt growth has created its logical outcome of a near-term increase in GDP.
- Inflation has also increased. The BEA’s GDP deflator (the CPI for dweebs) was 2.5% YoY for Q2, up from 2% a year ago and 1% two years ago. So the debt growth is helping to raise prices. Rising inflation is bad for bonds, less so for stocks.
Are we paying too much for this good news? Not yet.
OK, the current debt cycle story tells us that the momentum of GDP growth remains positive and could accelerate if lenders get more frisky. But how much are we paying for that GDP growth? You can overpay for a good thing. This chart addresses that question:
Source: Federal Reserve
The idea behind the chart is the classic P/E ratio, or the price of an asset as a multiple of the earnings generated by that asset. The asset in the top line of the chart is total household net worth, or the total value of all of our assets, from stocks to bank deposits to housing to appliances, less the debt we owe. The bottom line measures just our stock investments, including those in our pension and life insurance assets. Both lines show that the value of our assets relative to GDP continues to set new all-time highs. That sounds awfully frothy, and a reason to panic.
But not so fast, Green Lantern. We don’t pay for GDP when we buy a stock, we pay for a component of GDP, namely earnings. So let’s compare the total value of our stocks to after-tax corporate earnings as calculated by the BEA, shall we?
Sources: Federal Reserve, BEA
By this measure, the valuation of our stocks is by no means cheap, but it is well below classic over-valuations like the late ‘90s internet bubble and the late ‘60s. Which leads to my last question (thank goodness, right?) for this post – how can stocks/GDP look so expensive while stocks/earnings is OK? Here’s how:
Business profits are at a near-record share of national income, especially after the corporate tax cut, while worker compensation is just off a record low. Will those trends reverse in the near-term? That is a critical topic, but one for a future post. For now, businesses are generally kicking butt. So…
To wrap up:
- Debt outstanding continues to be stable compared to GDP, which is a good sign for stocks.
- Accelerating debt growth is more likely near-term than a deceleration, which is also good for stocks.
- Stock valuations are only moderately high relative to earnings, so investors have recognized a lot, but not all, of the debt good news.
- So keep over-weighting stocks relative bonds. And root for the Tottenham Hotspurs!