Debt and Valuations

The U.S. stock market was able to set a new closing all-time high last week exceeding the prior record set February 19th before the 34% selloff.

In other words, the market is now higher than it was when GDP was positive / expanding and unemployment was at 3.5% even though GDP contracted by about 33% in Q2 and millions and millions of people have become unemployed, the national debt has exploded and many businesses have since declared bankruptcy.

Valuations

That means the valuations are now more extreme than ever once again.

The first valuation metric I’m sharing is the Buffett Indicator, which has exploded to almost 180%. This is called the Buffett Indicator because in 2001 he said, “it is probably the best single measure of where valuations stand at any given moment.” The Buffett Indicator is simply the value of the total U.S. stock market divided by U.S. GDP.

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Recently Liz Ann Sonders shared another valuation metric (S&P 500 Forward P/E), which sits at its highest level since mid-2000 (Dot Com Bubble peak).

I don’t much care for this metric because its correlation to subsequent returns is relatively weak, but it is interesting nonetheless.

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Debt

The U.S. National Debt is about $26 trillion at the moment while annual GDP dropped to about $20 trillion in Q2. Therefore, the National Debt to GDP is about 130%!

This easily surpasses the prior record of 106% when we were fighting the World War II. The difference, however, between then and now is that today the private sector has FAR more debt as well. Back in World War II, the U.S. was in a depression throughout the 1930s and then rations were in place during the war so there was a forced deleveraging within the private sector.

So, when the national debt to GDP was at 106% in the 1940s the TOTAL debt between governments, households and corporations was only about 130%. Contrast that to today where households and corporations also have extreme levels of debt so that the TOTAL debt to GDP is almost 400%!

The debt will continue to act like an anchor on U.S. growth until the debt can be worked down.

In other words, imagine a household that has a mortgage on the house, maxed out their credit cards, both cars have huge loans, student loans, etc… That household has very little capacity to save, invest or spend as a large portion of their income must go to simply servicing the debt let alone paying it down or leaving enough discretionary income for other things.

This is essentially the state of the United States right now. As a country, we’re like a trust fund child who has spent all their inheritance AND has taken on debt. The debt is not being used to make productive investments in our future that can be self-funding but is being squandered on funding a playboy lifestyle we cannot afford.

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Stress Faults Appearing

We know this has been a horrible year in terms of corporate bankruptcies as we can see in this chart below comparing 2020 bankruptcies to 2009 (Great Financial Crisis) and 2002 (Dot Com Bubble Burst).

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We’re also seeing mortgage delinquencies surging from 4.4% in Q1 to 8.8% in Q2, which is the largest increase on record.

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What Does it All Mean

  1. Stop using the stock market as a proxy for the health of the economy.
  2. Do not chase the market higher. Only take on as much risk / volatility as your financial goals will allow without putting your goals in jeopardy in the next bear market.
  3. A debt deleveraging cycle is inherently deflationary, which the Federal Reserve will do anything to fight. Therefore, one potential outcome is that we first get deflation as a result of a deleveraging and then inflation as a result of the Fed’s policy response. Deflation / deleveraging may make the U.S. dollar more valuable temporarily while the Fed’s response will likely push the dollar down / push precious metals prices up.
  4. We, as a country, to ever achieve our potential growth once again, will need to go through a painful adjustment period where we shed the immense weight caused by tremendous amount of debt. The problem is that politicians and central banks around the world will not let this happen naturally and will fight it every step of the way, which will only serve to drag the process out to unnecessary lengths (e.g. Japan). It would be far better to have an extremely sharp, painful correction so we can quickly get on with the healing / growth process instead of dragging out the pain for many years to come.
  5. As far as portfolios go, for many people it may be prudent to be more conservatively positioned than “normal” to help buoy the portfolio when the bear market gets into full swing. After all, a 50% portfolio loss requires a 100% return just to get back to even while a 25% portfolio loss requires just 33% to get back to even. This may also help to preserve “dry powder” for when assets are priced cheaply once again. If you don’t have any dry powder than you cannot take advantage of sales / steep discounts on good assets when they arise. This is critically important if you’re nearing retirement or recently retired!
  6. Within portfolios, consider complimenting more traditional bond and stock assets with U.S. dollar exposure and precious metals like a barbell approach.

If none of this makes sense to you, or it makes sense but you’re not really sure how to proceed or how to weight various assets within your portfolio, reach out to me so I can help you identify prudent next steps and navigate this truly unique time in American history. The first step I take with new clients is producing financial projections that serve as the blueprint for all major financial decisions so we can be sure our decisions are informed, rational and objective instead of emotional or naive.

Disclosures:
Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.

Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.

This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.

Views provided here are current only as of the moment of posting and are subject to change at any time without notification.