Grant Williams - Equity Valuations

Excerpted from:  That Was The Weak That Worked: Part I
By Grant Williams
Things That Make You Go Hmmm...
December 30, 2013


The chart below, deflating the S&P 500 by the ongoing QE experiment, which I included a few weeks ago courtesy of Raoul Pal & Remi Tetot of Global Macro Investor, strips away the effect of the Fed's pumping and lays bare the market's real performance. It's one of the best charts I've seen this year, and it speaks volumes.

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Equity prices used to be a reflection of the strength of the underlying economy — after all, the component pieces of benchmark indices were functioning companies that existed in the real world where they need to manufacture something and sell it to a buyer in order to stay in business and make a profit.

So how have companies and the economy they constituted done in 2013? Well, the companies themselves have done incredibly well at tightening their own belts and squeezing every last drop of juice out of the lemons they've been handed. In fact, corporate profits have never been higher; and as a percentage of GDP they have scaled new and almost unimaginable heights, as the chart to the right demonstrates:

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But under the surface and in the wider economy, the story is very different, indeed, as the mountain of cash on corporate balance sheets has led to an avalanche of buybacks, which has in turn boosted earnings and given the impression that things are roaring, when in fact the true story is a familiar one of an increase in debt. And it's one that we saw not so very long ago:

(Karl Denninger): The second important thing to understand is that the other claim — "record corporate cash" — is true but intentionally misleading. What's also at records is corporate debt, and what you must look at is not tangible assets (which includes cash, of course) but rather such assets less obligations, that is, debt. And when you do and compare against equity prices what do you see?

Let's put not-so-fine a point on it — leverage, as expressed in the form of stock price to assets less liabilities, is at an all-time post-war high.

Yes, worse than 2000 and worse than 2007.

Assets less liabilities for corporations economy-wide are approximately where they were in the last quarter of 2004 or the first quarter of 2005. But stock prices are much higher in aggregate. That's the correct measurement of operating leverage relative to the market — not how much cash they have or how many dollars of earnings they return today. It's what the "corpus", that is, what your ownership interest as a stockholder (that's what you are when you buy stock) is that underlies your investment and thus how much you're paying for a given unit of tangible assets less liabilities.

This chart was bad at the end of 2012 — in bubble territory, for sure — which was a big part of why I didn't think we'd get through 2013. Well, we did — and now it's worse, because this is only updated through the end of September and of course the market has gone screaming higher in the last three months.

With that said, that which cannot go on forever won't, and this clearly can't — and thus won't. The only question is exactly when, and what, triggers the corrective move back down.