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November 15, 2017 | Market Arithmetic and Balance Sheet Worries: Earnings vs Interest Payments

Mike 'Mish' Shedlock

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.
Junk bonds have been underperforming lately as widely noted. Albert Edwards at Society General also notes the underperformance of companies with poor balance sheet fundamentals.

Edwards Comments

“With bullishness sentiment at extremes, is it significant that my colleague Andrew Lapthorne noted in his widely read “Global Market Arithmetic” that despite the overall equity market continuing to hit all time highs, there has been a clear divergence in performance between companies with highly leveraged (bad) balance sheets and those who do not. Is this a straw in the wind that a bear market is arriving far sooner than most investors had anticipated? It might be.”

“And we think the high yield corporate bond market should have been revolting against balance sheet debauchment some time ago. That would be the normal state of things with net debt/profit ratios so very high (see chart below but note bottom-up data shows a far higher peak than this top-down Fed data but peaks normally occur as profits fall in recession).”

“We continue to highlight that it is not QE per se that has caused US companies to debauch their balance sheets. Japan is awash with QE but balance sheets are in relatively good shape. The problem in the US is how QE has worked its way through the financial complex.”

Mish Comments

US net debt to total assets is not quite at the 2008 peak. But what will those assets really be worth in the next downturn?

Also note that a handful of genuine cash cows such as Apple and Google distorted the debt ratios.

EBIT vs Interest on Debt

Here is one more chart from the “Global Market Arithmetic” report that Edwards mentioned.

Lapthorne notes that while average interest as a percentage of Earnings Before Interest and Taxes (EBIT) is healthy, the bottom 50% of the S&P isn’t.

This is at a time when interest expense is at or near record lows, and profits at or near record highs.

Lapthorne concludes, and I agree “It is difficult to envision a scenario in which this ends well.”

Mike “Mish” Shedlock

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November 15th, 2017

Posted In: Mish Talk

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