Market crashes in the last century have come about every 6 years. However, towards the end of the long term debt cycle, which usually ends in an extraordinarily large crash, there is an equally extraordinary bull market.
For example, before the crash of 1929 and the Great Depression we had an ever growing 22 year bull market that snowballed into the “Roaring 20s”. More importantly the steep rise in asset prices in the 20s, or during any bubble, generally correlates to the size of the crash.
Mount Whitney, the tallest mountain in the lower 48, is right next to the lowest point in the lower 48 — Death Valley. The higher the high, the lower the low.
Since the biggest crashes come right after the biggest and hottest bull markets, how are we supposed to understand which bull markets are sustainable and which are not? What are the indicators that a crash could be coming? And most importantly, where are we today?
In short, all financial crises are proceeded by debt and all market bubbles can be measured by their valuations relative to output.
What we’ll discuss:
- Our levels of debt
- The health of the stock market
- Specific examples of stocks with extreme prices
- Signs of a bubble
- Solutions
The Short & Long Term Debt Cycle
National, business, and household debt is the most important piece in understanding our economy moving forward in the next decade or more (second to the monetary system, and the two are extremely related).
Corporate Debt
Companies are already at extraordinary levels of debt and they are not productively using debt.
Look at the great American institution, Boeing. According to their latest quarterly report, they have $161 billion in assets and $172 billion in liabilities… That ain’t good.
And before you blame COVID (the Fed will), look at 2019… it’s worse.
And how much money do they make (net income)? Last quarter was a loss of nearly $450 million (which is better than the quarters before COVID).
Boeing only survives by taking on more and more debt.
If you read the risk factors section of the 10q they even admit that the business is fine… as long as airlines start buying planes again, as long as no one misses a payment, as long as they can still attract lenders, etc…
In order for Boeing to survive everything in the economy needs to improve dramatically and then they can go back to barely surviving on debt.
(Believe it or not, I think Boeing is a more productive company than many of the other companies I’ll discuss later.)
Here’s the real point — Boeing paid $1.5 billion in interest payments… if it weren’t for debt alone, they would’ve had a billion dollar profit last quarter.
The difference between a healthy company and a zombie company is debt.
Look at the stocks that blew earning expectations out of the water for the last decade — Facebook, Apple, Amazon, Google, Microsoft, etc… What do they all have in common?
Very very low debt and very high cash flow.
Here’s what’s scary — 20% of all companies have had higher interest payments than profits for 3+ years. Even before COVID 20% of all companies are zombie companies living on debt alone and sinking into worsening financial conditions. This level of malinvestment is historical.
Debt Cycles
Corporate Debt to GDP:
https://www.longtermtrends.net/us-debt-to-gdp/
2009 was the “Great Financial Crisis”. It was a bad debt crisis (and therefore a collateral crisis), and yet look at how much higher corporate debt is, and even consumer debt!
I chose this chart, despite its exclusion of 2020 data, because for some reason, not all consumer debt charts include student loans. Here you can see that while mortgages aren’t much higher, student debt has ballooned. In 2021 it’s all worse.
One has to ponder, at what point is our debt unproductive? How much debt is too much debt?
I recently read A Brief History of Doom: Two Hundred Years of Financial Crises and there were two obvious themes…
First, that all major financial crises were proceeded by lots of debt. Period.
Second, that the bust was right after an acceleration of debt.
Our debt is increasing in size, in how unproductive it is, and it is now accelerating.
Stock Market Health
The Buffett Indicator
While debt is an indicator of stock market health, it isn’t the best predictor. After all, we’ve had high debt and a slowing GDP for a long time and stocks have been going up.
There is only one metric that I know of that has predicted the crash of every bubble and according to William Ziemba, the adjusted metric predicted 8 of the last 11 market crashes.
The Buffett Indicator is market value to gross national product. In other words, it’s the value of all the companies relative to the output they create.
http://www.currentmarketvaluation.com/models/buffett-indicator.php
Even though many of the companies in the dot com bubble produced little to no value, the stock market today is significantly more overvalued.
Today’s US stock market by nearly any metric is the most overvalued it has ever been.
Picking On Specific Companies
One sign of a bubble is an increase in fraud in the system. However, the SEC generally doesn’t come down on fraud until the company has lost money for shareholders (which… why not purse fraud before it gets out of control?).
While there are numerous recent accusations of fraud (Markapolos saying that GE is hiding bad underwriting, IBM’s insane accounting, Tesla’s multiple lawsuits for not disclosing that Solar City was insolvent(!) before buying it and profiting from it, etc…), I want to focus on something deceiving to most investors, intentional or not — profit.
The most common way of valuing a company is a multiple of its profit, known as Price-to-Earnings (PE).
If you were to buy a local laundromat and it had a PE of 2, it would take you 2 years before all money made was pure profit.
A company with a PE of 35, like Google or Apple for example, would take 35 years before you’d see any profit, unless the companies were able to grow and double their profits, then it would take 17.5 years. A big task, but I wouldn’t put it past either of these companies.
Example 1: GoDaddy
What better American institution than GoDaddy?
(Dollar amounts in millions).
Despite last quarter’s “profit”, their quarterly earnings shows that they have an accumulated deficit of $1.26 b-b-b-billion! Plus, they have negative $163 million in equity — meaning they have more debt than assets.
In other words, GoDaddy not only doesn’t make money, but they owe more money than they have assets. We’re living in the world of high debt.
Lastly… My favorite worthless company…
Example 2: HubSpot
HubSpot went public in 2014, a few years after Facebook but without any profits then, and without any profits now.
The reality is that there are an enormous number of stocks on the market that have not a shred of evidence that they can make their company profitable. The tech industry has become entirely speculative despite average output.
So how does a company that has never made a dollar of profit go over 7 years as a public company without ever having profit?
There are a few obvious answers. Debt, for one. Another, delusional investors who think that, like Facebook, they’ll be able to one day increase their profit margins (even though Facebook always had profit and is an extremely rare model that gains disproportionately more profit with growth, and every tech investor believes therefore all other tech companies can grow profits).
But the greater question is why would anyone lend this company money?
Economists describe this as selling a dollar for 90 cents. If I sold you a dollar for 90 cents, how many would you buy? You’d certainly buy as many as you can, right?
Similarly, it is easy for a company in a large market to sell a product, even if it’s unsustainable, as a loss. The more you lose the faster your “growth”.
Silicon Valley has once again become obsessed with growth, even without any evidence that they could be profitable, and the growth has become proof to bankers that they can repay the money. Plus, there’s more money than ever for lending and IPOs. Who needs evidence of profit when the IPO market will make you rich either way? Remind you of the dot com bubble?
Dalio’s Signs of a Bubble
Given that the economy is declining, heavily indebted, and fueled by increasing asset prices… It should give pause to those benefiting from the ever increasing asset prices.
In case all the above metrics don’t sufficiently exemplify the disconnect between asset prices and the economy, let’s move to discussing anecdotal evidence. How do those who have lived through a bubble describe it?
Luckily, Dalio has an incredibly thoughtful list of signs that you are in a bubble.
Dalio’s signs of a bubble:
- Prices are high relative to traditional measures
- “There is a bullish sentiment”
- There are purchases with high leverage
- Buyers have made exceptionally forward-extending purcharces (e.g., built inventory, contracted for supplies, etc.) to speculate or to protect themselves against future price gains.
- New buyers (i.e., those who weren’t previously in the market) have entered the market.
- Stimulative monetary policy threatens to inflate the bubble even more (and tight policy to cause its popping).
- Prices are discounting future rapid price appreciation from these levels.
Let me go through them and you judge yourself how relevant they are today.
Prices are high. Check. Higher than they’ve ever been before, even compared to the dot com bubble.
A bullish sentiment. This week should shed some light on just how crazy it is when people are trying to get rich off of dying brands… for no reason. Furthermore, there are now stock gurus teaching “stocks always go up”, literally.
There are purchases with high leverage. Very big check. I think we’ve been over debt enough, but if you look at speculative leveraged purchases of companies to SPACs, this is a crazy time to be in the market.
New buyers enter the market. My ex-Amish father-in-law is now on a trading app… So check mate.
Prices are discounting future rapid price appreciation from these levels. Think about how many cars and batteries Tesla would have to sell to justify their valuation.
Buyers have made exceptionally forward-extending purchases to protect themselves from speculation. I know someone who just spent a lot of money buying something because they were worried if they waited too long the prices could double. When else do you have that happen? Not often, I hope.
Stimulative monetary policy writing threatens to pop the bubble. Powell said that the Fed was going to ease off the gas in 2019 and when they tried the market tanked in the 4th quarter and they had to go back to stimulating. The stock market is on crack and needs more. As soon as you stop feeding it, pop.
Stimulative monetary policy writing threatens to inflate the bubble. This is the most relevant as I believe we’re living through this right now. During the COVID crash the Fed came to the rescue, like normal, but this time the market didn’t flatten or fall slower, it shot up like a rocket. Just in the last 9 months the Nasdaq has doubled!
Doubled! Our GDP didn’t double, our unemployment did! How does this make any sense? I believe the only thing that makes sense is that the Fed dumping money in caused a “melt up”.
A melt up is usually the part right before the crash where asset prices soar up due to the recent influx of cash.
In poker this is called going “all-in”, and when every fund manager and their father-in-law has jumped in the market, either we need some miraculous GDP growth to justify it, or there are no more “greater fools” to pass our shares off to.
People during a bubble forget, almost don’t believe, that the price is determined by the performance of a business. And if the business isn’t producing cash, the only way for the stock to go up is if someone is willing to pay you more for a share. That has been going on for quite a while.
Once we’re all “all-in”, the next step is a big one down.
In an erratic bubble people notice a “blow off top pattern”.
Here’s the DJI in 1929:
Here’s the Nasdaq in 2000:
Bitcoin in 2018:
Conclusion
Leading Indicators
Most of the evidence above is showing that we are in an asset bubble, but what are leading indicators of a crash?
Yes, a melt up / erratic stock prices can be (always have been?) an indicator that a bubble is about to pop, but what are indicators of a recession?
Let me give a few examples…
Employment data:
- Ever decreasing work force participation.
- Furthermore, 538 shows that it appeared unemployment was falling, but jobs lost permanently were greatly increasing (instead of being “cyclical”).
Economic indicators:
- 6,000 people missed housing payments and 26 million missed student loan payments, and this was in October!
Confidence indexes:
- Consumer confidence is down.
Solutions
Get out of overvalued stocks!
Move to cash. If we enter a deflationary stage, cash will not only be useful to buy cheap assets, but it could increase in value.
Get into undervalued stocks and stocks that will thrive in a recession. While even Berkshire Hathaway could take a tumble in the next couple of years, it is an example of an undervalued company, diversified, and with lots of companies that will do well in the coming decades (like energy).
Get a hedge. Personally I don’t believe in shorts (concave vs convex payoffs) but I have lots of long out-of-the-money put options on many overvalued companies and funds. These are 40 to 1 bets that pay off enormously in a crash, providing cash at the bottom. I view these as insurance contracts I plan to repurchase as they expire, if needed.
Another hedge would be treasury bonds as they are typically inversely related to the market. I have a small amount in 30 year treasuries.
In general, my portfolio allows me to benefit from the melt up, as I don’t know how long it will be. However, I’m in very safe stocks and I’m hedged to the eyeballs.
Closing Thoughts
If you invested in the summer of 1929 into the stock market, guess how long it would take you to double your money?
You wouldn’t double your money until the mid 1990s! 66 years later.
On the other hand, do you know how long it would take you to double your money if you bought the S&P in 1932? 1 year.
The risk-reward of trusting the Fed to dig us out of this hole seems grossly miscalculated.
“For what a man wishes he generally believes to be true.”
