Breaking Down the Equities Bear Market

Part I - Looming Credit Default Risk And The Fall of Zombie Companies

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U.S. Equities Outlook

Today’s issue will briefly cover the current outlook of global equities. We have covered the deteriorating macroeconomic backdrop extensively, but today in particular, we want to examine the structural forces driving the U.S. equity market.

We are writing this piece as equities are closing down for the third quarter in a row for the first time since the GFC (global financial crisis). Today, the world is having a crisis of its own, in a similar yet very different manner. While the GFC was mainly a result of toxic loans and counterparty risk in the banking system, today we are facing the meltdown of the global everything bubble. Fueled by the lowest interest rates in recorded history, the valuations of every asset class on the planet exploded alongside debt levels.

As inflation has exploded across the globe from COVID-19 monetary and fiscal stimuli, combined with a global energy deficit, fixed income as an asset class has experienced a generational sell-off, while spiking yields in the process.

U.S. bonds with maturities greater than 10 years are experiencing their worst decline in percentage terms in the history of the data.

Source: Holger Zschaepitz

Aside from the sell-off in the bonds from an asset class, the sell-off subsequently means a rise in yields, which presents major problems for all participants of the economy, as credit expansion grinds to a halt and the game of musical chairs for dollars begins.

Particularly, in regards to equities, the spike in yields will come to present an increasing problem for over-indebted companies, of which have grown immensely since the GFC. Zombie companies are now a growing concern and are defined as companies with an interest coverage ratio <1  for three straight years (i.e., your profits don't even cover the debt plus interest you owe).

Source: Stansberry Research

As yields soar, this problem becomes even larger, and further puts strain on companies to roll over their debt.

As liquidity troubles turn into solvency risk, we can expect many of these “zombie firms,” and even some businesses that were thought to be strong, to go bankrupt, as balance sheets deteriorate from soaring expenses and higher interest rates.

The Darwinian process known as economic “creative destruction” is now being rapidly expedited by the Federal Reserve after its own policies attempted to stave off creative destruction for decades on end.

The monetary tightening will be felt, and many participants will go under as a result. Credit default swaps on investment grade and high-yield debt are exploding to new highs as we write.

The huge regime change in liquidity conditions has not yet been fully felt by the market, in our view. First liquidity risk, then solvency risk.

Shown below are the credit spreads for corporate issuers by credit rating:

When conducting analysis on the performance of equity markets since the GFC, a structural tailwind was the massive amount of buybacks corporates conducted, where with excess profits, corporations would buy and retire shares from the open market, reducing their float and increasing share price, with all else being equal. For many corporations, including some of the best and biggest names (like Apple, for example), debt-financed buybacks were all the rage.

As Treasury yields have increased, as well as corporate credit spreads, this structural tailwind no longer exists and rolling debt becomes increasingly difficult.

Similarly, a high volatility environment in equities and elevated levels of credit risk for the corporate names go hand in hand.

Let’s now turn an eye on some valuation metrics.

Overheated Valuations

As we've highlighted before, one main concern we still have is the current market valuations relative to history looking at equity price-to-earnings (P/E) ratios. We highlighted the CAPE ratio in one of our previous pieces which acts as a decent measure to show how overheated valuations can become throughout history.

If the idea that we’re currently in the middle of an “everything bubble” going through its deflating period still holds true, then we still seem far away from its conclusion. Even if we expect a reinflation of that bubble from desperate central bank policy in the future, have valuations really come down enough to justify that action in an environment where demand destruction and the reverse wealth effect have been at the top of the agenda?

Another way to visualize that is the rate of change in the regular S&P 500 P/E ratio. Currently, we’re still around 1 standard deviation above the historical average. We could easily see the ratio fall below the historical average in this cycle and that doesn’t even include increased negative impacts to prices based on a potential earnings recession as we go into the end of the year.

Source: Current Market Valuation

Ultimately now we live in a hyperfinancialized world and the share of held equities relative to all financial assets is coming down from a record high. This is a similar trend and story that we’ve seen play out in previous cycles. When U.S. equities are too sought after relative to all other financial assets, we’ve always seen mean reversion take shape. This is a telling chart for how demand destruction takes shape. As the chart measures the overall equities share for households, a major drawdown in equities results in major drawdowns of net worth on paper resulting in many feeling poorer.

As mentioned briefly, one of the supporters of sky high valuations WAS the sheer amount of stock buybacks in a ZIRP (zero-interest rate policy) environment during a period of record corporate profits.

Buybacks have been rising to record levels since the QE monetary policies after 2009 creating a passive bid for equities that look to be winding down rather quickly. Now we’re at a clear point where those buybacks have looked to reach their peak with a major decline in Q2.  

Source: Yardeni

Source: Yardeni

Final Note

Pain is coming. Even with an eventual slight pivot, the world has (at least momentarily) left the funny money bonanza of the last decade. With record debt levels across the economic picture, we look to firmly kick off the dominos of a debt deleveraging event.

While many expect a slight “pivot” in expectations or outlook from Fed members to steer the train back on the tracks, we believe it will take an absolutely massive fiscal and monetary response from policymakers to “fix” the result of this current crisis.In the meantime, we are in the unwind phase. Steady lads…

Part II - Not Your Average Recession: Unwinding The Largest Financial Bubble In History

Buckle Up

As with most major U.S. economic data releases these days, the short-term market direction can change on a dime. This week, the case was building and seemed rather likely for another bear market rally to take shape. Yet, the latest non-farm payroll data railroaded that case with a higher-than-expected number of jobs coming in for the month of September and a lower unemployment rate of 3.5% (down from 3.7%). It’s the “good news is bad” trend all over again as the market reprices a lower probability of an earlier Federal Reserve pivot playing out.

You know markets are unhealthy and on the edge when every major monthly data point can have such an effect. Expect another wave of volatility with one of the most anticipated CPI (consumer price index) inflation releases next week on Thursday, October 13. For the short-term trend for equities and bitcoin, that’s the only data that matters.

Take forecasts with a grain of salt but the Cleveland Fed is forecasting higher annual growth and month-over-month positive growth for every major inflation measure: headline CPI, Core CPI, PCE and Core PCE. The Fed wants to see month-over-month growth near zero or negative.

Market moves will still depend on data versus where consensus ends up. As oil prices rip higher today, it’s not the trend the Fed would want to see for the long term; for easing inflationary pressures, energy prices coming down was one of the main drivers of a lower August CPI print.

Source: Cleveland Fed Inflation Nowcasting

The unemployment rate is the economic cycle’s ultimate lagging indicator. But the turning point in unemployment and the subsequent rise does align with S&P 500 index bottoms and max drawdown periods. In other words, we rarely see the market bottom with low, declining unemployment like we have now. Unemployment rate along with many other metrics is the measure of “pain” that the Fed wants to see in their demand-destruction path.

Yet, they only see the unemployment rate going to 4.4% at peak in 2023 and 2024 from the 3.5% it is today — a mild rise not even worth 100 basis points. Of course, the Fed isn’t going to forecast 10% unemployment rate levels even if their models suggested that. The Bank of England forecasting a deep recession through 2023 recently was one of the first examples in history of a central bank forecasting that type of scenario (or reality).

It seems far off base, though, to think unemployment will peak at 4.4% with the speed and magnitude of current monetary policy changes. In fact, throughout history, we’ve never seen the unemployment rate increase by only one percentage point after a cyclical reversal. Arguably, we’re going through one of the fastest and most impactful cyclical reversals today. That’s where the real pain is left in this cycle. The drawdown in wealth across stocks, bonds and bitcoin is one thing; massive job loss, contracting economic growth and deflationary busts are another.


Valuing Equity Markets

In our September 30 issue, Looming Credit Default Risk And The Fall of Zombie Companies, we wrote about the increasing levels of credit risk arising across the global economy. In today’s edition, we hyperfocus on the earnings side of the equities market, given the traditional price/earnings ratio valuation many investors utilize when analyzing the equities market.

Below we share some of the most insightful charts displaying equity market valuations.

The story in 2022 so far for equities markets has been one about duration; as long-dated yields have rapidly repriced upwards, the forward price-to-earnings multiples for equity markets have fallen in tandem.

Source: Goldman Sachs Global Investment Research

In our view, what hasn’t been appropriately repriced has been the earnings component for equities markets. Forward earnings expectations are far too bullish given the historical precedent of what we are facing.

Given the near certainty of a looming global recession, we can look to previous recessions for a gauge as to what to possibly expect.

Source: Goldman Sachs Global Investment Research

The median earnings per share drawdown for S&P 500 companies during the previous 13 U.S. recessions was -13%. Current earnings consensus estimates are still positive heading into 2023.

Source: The Daily Shot

Earnings expectations have just begun to reprice lower for 2022, yet for some reason 2023/2024 estimates are still broadly bullish despite an extremely concerning market backdrop. We believe this is mispriced.

A fantastic chart from Fidelity’s Jurrien Timmer displays the revisions to earnings estimates during dollar strength and weakness from 1993. Given the dollar’s remarkable run throughout 2022, we also suspect a material amount of corporate revisions to start coming in.

Source: Jurrien Timmer, Fidelity

So what is the dollar doing today? Well… I’m sure you know, and it doesn’t usually result in good outcomes.

We strongly believe that earnings estimates will be revised further from here, raising the multiple of equities as a result of a falling denominator in the P/E multiple.

Source: Bloomberg Intelligence

Valuations have repriced lower due to the rising yield environment, but the credit risk, which we’ve covered in-depth previously, as well as the forthcoming earnings picture lead us to believe more pain is ahead.

Source: S&P Dow Jones

The earnings picture is uglier under the surface when you account for the fact that nearly all earnings growth has been due to booming energy prices — which isn’t consistent with a bullish economic outlook.

Source: Bloomberg Intelligence

On a similar note, we have a graphic from Patrick Saner, showing an estimate of global interest payments as a percentage of global GDP.

Source: Bloomberg Finance

Falling asset prices, soaring debt burdens, rising energy costs and a labor market that has yet to turn. It’s not a pretty picture out there, and we expect conditions in financial markets can materially worsen in short order.

Equities as a percentage of gross domestic product are still historically overvalued.

The liquidity tide is going out; the credit cycle is turning over. Our view is that these conditions will lead to dysfunction and a blowout of volatility across financial markets, and our conviction for that has only grown as of late.

The Fed, in an attempt to reign in domestic inflation, is going to break financial markets in the meantime, and the response will be a return to net easing policies.

It’s at this moment that the world will again come to appreciate the unforgeable costliness and programmatic monetary policy of bitcoin as an investable asset. While bitcoin is now simply moving in response to changes in the so-called liquidity tide, its proponents understand it is something much bigger than just a speculative asset. Rather, it is a digital age alternative to the current monetary order of central bank monstrosity.

For now, the liquidity tide is still pulling out, and for patient investors/savers, in time you will be rewarded.

Bitcoin as an asset is primed like no other to significantly outperform when a meaningful change in flows occur, and in our estimation, these flows will likely arrive with a distinct policy pivot.

Content Provided By:

Dylan LeClair (@DylanLeClair_) and Sam Rule (@samjrule)