Major stock market indices have managed to eke out impressive gains during the first two weeks of the New Year – albeit on relatively low volume – as bearish concerns have failed to dampen investors’ enthusiasm for common stocks.
Amid the large uncertainties that hang over equity markets – from a potential disintegration of the euro-zone to the risk of a hard landing in China – the bulls argue that America’s corporate sector has rarely been in better financial shape and, insist that this strength is not reflected in stock prices. Is such opinion grounded in indisputable fact or just another example of Wall Street’s wishful thinking?
The bulls point to the fact that the non-financial sector’s outstanding debt relative to both the book and market value of equity is below the historical average, while cash as a percentage of total assets is at the highest level in more than three decades. Thus, it would appear that casual inspection of balance sheet data confirms bullish opinion.
However, it is important to appreciate that an informal glance at the headline numbers alone is not sufficient to make the bullish case, since major developments in the corporate sector over recent decades are simply ignored. Put in context, corporate sector balance sheets are not as stellar as the bulls would have the misinformed believe.
The American corporate sector has undergone a profound transformation since the 1970s, as the economy has de-industrialised and become increasingly services-based. This trend is confirmed by balance sheet data, where tangible assets such as property, plant and equipment, have dropped from more than 70 per cent of total assets in the early-1980s to below 50 per cent today.
All else equal, a service-based corporate sector would be expected to carry relatively low levels of debt for a number of reasons. First, the absence of hard assets to provide as collateral to lenders means that debt capital is often difficult to obtain at a reasonable cost. Second, and perhaps more importantly, the costs of financial distress are typically quite high.
The costs of financial distress include not only bankruptcy costs, but also large indirect costs that can have a material impact on a firm’s stock price. For example, the value of computer software is determined not only by the software, but also by the company’s implicit promise to provide continued support and development.
Should rumours of financial distress arise, this promise would be called into question and customers could decide to do their business elsewhere. The loss of revenue and resulting decline in the company’s share price could prompt key staff to leave and, the downward spiral well could become self-reinforcing. Thus, to minimise the costs of financial distress, companies whose value consists primarily of soft assets typically carry low levels of debt.
The corporate sector’s optimal capital structure is determined not only by the nature of its business but also the volatility of its cash flows. In this respect, it is important to note that the ‘great moderation’ in the volatility of economic activity observed in the years before the ‘great recession’ struck did not translate to more stable corporate cash flows.
Indeed, the volatility of cash flows was running at generational highs even before the global financial crisis unfolded, and the subsequent reduction in corporate leverage should be viewed as a rational response to the ill-advised debt build-up in advance of the economic meltdown, which saw debt to net worth jump from below 63 per cent in the summer of 2006 to almost 79 per cent by the end of 2008. In light of near-record cash flow volatility, today’s ratio of 66 per cent would appear to be far more reasonable than the high ratios witnessed through the debt-financed booms of recent decades.
A meaningful analysis of the corporate sector’s debt position reveals that balance sheets are not as stellar as the bulls believe and, the argument is weakened even further once the combined deficit on defined-benefit pensions and other post-employment benefits are considered. The inclusion of these two items pushes the ratio of debt to net worth up by roughly five percentage points to 71 per cent, which is close to previous cycle highs.
The bulls remain undeterred however, and note that cash as a percentage of total assets is at the highest level since the 1970s. However, the ratio of liquid assets to total assets is only three percentage points above its recent trough and two percentage points above historical norms.
A move of this magnitude is to be expected given that the unavailability of debt finance to all but the best of credits is likely to have prompted an upward shift in the desired level of precautionary cash balances. Thus, excess liquidity is likely to be far lower than the bullish consensus believes.
The strength of corporate balances sheets is widely touted as a reason to hold stocks. Investors should be aware however, that the argument does not stand up to close scrutiny and reflects Wall Street’s wishful thinking rather than hard analysis.
Previously posted on www.charliefell.com
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