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Who Is Funding Uncle Sam?

In, The Lowest Common Denominator, we quantified the extent to which growth of consumer, corporate, and government debt has greatly outstripped economic growth and our collective income. This dynamic has made the servicing of the debt and the ultimate pay back increasingly more reliant on more debt issuance.

Fortunately, taking on more debt for spending/consumption and to service older debt has not been a problem. Over the past twenty years there have been willing lenders (savers) to fund this scheme, even as their reward, measured in yield, steadily declined.

Unfortunately, two of the largest buyers/holders of U.S. Treasury debt (China and the Federal Reserve) are no longer pulling their weight. More concerning, this is occurring as the amount of Treasury debt required to fund government spending is growing rapidly. The consequences of this drastic change in the supply and demand picture for U.S. Treasury debt are largely being ignored.

Foreign Bond Holders

In our article, Triffin Warned Us, we provided a bit of history on the Bretton Woods Agreement. This pact from 1944 essentially deemed the U.S. dollar the world’s reserve currency. As a result of the agreement, foreign nations rely heavily on U.S. dollars for all types of international trade. For instance, if Uruguay sells widgets to Australia, Australia will most likely pay Uruguay in U.S. dollars. Because of the reliance on dollars for trade, Uruguay, Australia and almost every other nation holds reserves of dollars.

Foreign entities with dollar reserves maximize the interest they earn on reserve accounts with the objective of taking as little risk as feasible. Think of reserve accounts as savings accounts.  As such, foreign reserves are most often invested in “safe” U.S. Treasuries. As world trade has grown over the years, the need for dollar savings has grown in step and has resulted in more lending to the U.S. Treasury by foreign governments.

Recently the incremental appetite from foreign buyers, both private investors and governments, has declined. Prior to the last two years, the last instance with flat to negative growth over a two-year period was 1999-2000. During that period, the amount of U.S. Treasury debt outstanding was shrinking, and despite a decline in foreign ownership, foreign ownership as a percentage of bonds outstanding rose.

The graph below charts the amount and percentage of foreign holdings of public U.S. Treasury debt outstanding (excluding intra-governmental holdings such as social security administration investments), and total public debt outstanding. As highlighted, the divergence occurring over the past few years is without comparison in the last forty years. As a point of reference, the last time foreign entities meaningfully reduced their holdings (1979-1983) the ratio of U.S. Treasury debt to GDP was less than 40% (currently 105%). Needless to say, the implications of a buyers strike today are quite different.

Data Courtesy St. Louis Federal Reserve

Federal Reserve QE

During the financial crisis and its aftermath, government spending and debt issuance increased sharply. From 2008 through 2012, Treasury debt outstanding increased by over $8 trillion. This was three times as much as the $2.6 trillion increase during the five years preceding the crisis. 

Faced with restoring economic growth and stabilizing financial markets during the crisis, the Federal Reserve took the unprecedented step of lowering the target for the Fed Funds rate to a range of 0-0.25%. When this proved insufficient to meet their objectives, they introduced Quantitative Easing (QE). The implementation of QE had the Fed purchase U.S. Treasury securities and mortgage-backed securities (MBS) in open market operations. By reducing the amount of bonds held publicly they reduced Treasury and MBS yields which had the knock-on effect of lowered yields across a wide spectrum fixed-income securities. After three rounds of QE, the Fed had purchased over $1.9 trillion Treasuries and over $1.7 trillion MBS. At its peak, the Fed owned 19% of all publicly traded U.S. Treasury securities.

In October 2017, the Fed began balance sheet normalization, the process by which they reduce their holdings of U.S. Treasuries and MBS, in what is colloquially known as Quantitative Tightening (QT). Since then, they have reduced their Treasury holdings by over $200 billion. Although they have been shedding $50 billion a month between U.S. Treasuries and MBS, they intend to reduce and halt all reductions by the end of September. The following graph shows the size of the Fed’s balance sheet as well as its expected decline.

Data Courtesy St. Louis Federal Reserve

The Fed and Foreigners are MIA

As discussed, the Fed is reducing their U.S. Treasury holdings and foreign entities are not adding to their Treasury holdings. This reduced demand is occurring as the U.S. Treasury is ramping up issuance to fund a staggering $1 trillion+ annual deficit. The CBO forecasts the pace of heavy Treasury debt supply will continue for at least four more years.

Because foreign entities and the Fed are not buying, domestic investors are left to fill the gap. The graph below charts the change in U.S. Treasury debt issuance along with the net amount of domestic investor purchases (Total debt issuance less net purchases of foreign entities and the Fed.)

Data Courtesy St. Louis Federal Reserve

As highlighted in the yellow box, domestic purchases have indeed taken up the slack. The graph below shows investor breakout of net purchases from 2000 to 2015.  

Data Courtesy St. Louis Federal Reserve

Note that domestic investor demand accounted for roughly a quarter of the Treasury’s issuance. Now consider the period from 2016 to current as shown below.

Data Courtesy St. Louis Federal Reserve

Quite a stark difference! Domestic investors have bought over 100% of Treasury issuance.  

This leads to two important consequences worth considering.

  1. Given the amount of debt that is expected to be issued, will interest rates need to rise further to attract domestic buyers?
  2. If domestic investors are forced to buy 100% net Treasury issuance plus that which is sold by the Fed and foreigners where will the money will come from?   

Now, before answering those questions here is the punch line. According the Office of Management and Budget (OMB), Treasury debt is expected to increase by $1.086 trillion in 2019. As the Fed modifies their balance sheet reduction but does not resume buying, and foreign entities remain neutral, domestic savers will still be on the hook to purchase at least the entire $1.086 trillion in U.S. Treasury securities in 2019 alone. Looking beyond 2019, net debt issuance over the next ten years is expected to average $1.2 trillion per year, and that forecast by the CBO, OMB and primary dealers does not include a recession which could easily double the annual estimate for a few years.  

It is probable that, barring deflation or a notable stock market decline, higher interest rates will be required to attract marginal domestic investors to purchase U.S. Treasuries. It is also fair to say that the onus of buying more U.S. Treasuries that is falling on domestic investors will likely result in a higher savings rate which negatively effects consumption.

The bottom line is that investors will need to consume less and shift from other assets into U.S. Treasuries to match the growing supply. This presents a big problem for equity investors that are buying assets at record high valuations and are unaware of, or unconcerned with, this situation.


Just because something has gone on for what seems to be “forever” does not mean it will continue.

Deficits do indeed matter. The post Bretton Woods agreement formalizing a fiat currency global system had the support of all major developed world nations. Against better judgement and a lack of understanding about the implications, monetary policy was fashioned towards ever larger debt burdens. The story plays a bit like an old Monty Python skit:

Cleese: “The amount of debt we owe is creating a problem, sir.”

Palin: “Don’t be ridiculous! That’s pure horse hockey! It’s just a bloody flesh wound.”

Cleese: “But the amount of debt outstanding can no longer be described using numbers and we have no way of paying the interest.”

Gilliam: “Are you an idiot, man? We’ll issue more debt to pay the current debt we owe, of course!

Cleese: “But we’ve been doing that and the problem keeps getting worse and you say the same thing!

Chapman: “Is that a penguin on the telly?”

Now that we actually have to fund our debt, the reality is hitting home and diverting attention to “penguins on the telly” will do us no good. If foreign investors remain uninterested and the Fed avoids restarting QE, this situation will become much more obvious. Regardless, history is chock full of warnings about countries that continuously spent more than they had. Simply, it is completely unsustainable and the investment implications across all assets are meaningful.

Pulling Forward versus Paying Forward

Debt allows a consumer (household, business, or government) to pull consumption forward or acquire something today for which they otherwise would have to wait. When the primary objective of fiscal and monetary policy becomes myopically focused on incentivizing consumers to borrow, spend, and pull consumption forward, there will eventually be a painful resolution of the imbalances that such policy creates. The front-loaded benefits of these tactics are radically outweighed by the long-term damage they ultimately cause.

Due to the overwhelming importance that the durability of economic growth has on future asset returns, we take a new approach in this article to drive home a message from our prior article The Death of the Virtuous Cycle. In this article, we use two simple examples to demonstrate how the Virtuous Cycle (VC) and Un-Virtuous Cycle (U-VC) have benefits and costs to society that play out over time.

The Minsky Moment

Before walking you through the examples contrasting the two economic cycles, it is important to put debt into its proper context. Debt can be used productively to benefit the economy in the long term, or it can be used to fulfill materialistic needs and to temporarily stimulate economic growth in the short term. While both uses of debt look the same on a balance sheet, the effect that each has on the borrower and the economy over time is remarkably different.

In the course of his life’s work as an economist, Hyman Minsky focused on the factors that cause financial market fragility and how extreme circumstances eventually resolve themselves. Minsky, who died in 1996, only recently became “famous” as a result of the sub-prime mortgage debacle and ensuing financial crisis in 2008. 

Minsky elaborated on his “stability breeds instability” theory by identifying three types of borrowers and how they evolve to contribute to the accumulation of insolvent debt and inherent instability.

  • Hedge borrowers can make interest and principal payments on debt from current cash flows generated from existing investments.
  • Speculative borrowers can cover the interest on the debt from the investment cash flows but must regularly refinance, or “roll-over,” the debt as they cannot pay off the principal.
  • Ponzi borrowers cannot cover the interest payments or the principal on debt from the investment cash flows, but believe that the appreciation of the investments will be sufficient to refinance outstanding debt obligations when the investment is sold.

Over the past 20 years, investors have been witness to a remarkable sequence of bubbles. The first culminated when an abundance of Ponzi borrowers concentrated their investments in the equity markets and technology stocks in particular. Technology companies, frequently with operating losses, raised capital through stock and debt offerings from investors who believed excessive valuations could expand indefinitely.

The second bubble emerged in housing. Many home buyers acquired houses via mortgages payments they could in no way afford, but believed house prices would rise indefinitely allowing them to service their mortgage obligations via the extraction of equity.

Today, we are witnessing a broader asset price inflation driven by a belief that central banks will engage in extraordinary monetary policy indefinitely to prop up valuations in the hope for the always “just around the corner” wealth effect. Equity markets are near all-time highs and at extreme valuations despite weak economic growth and limited earnings growth. Bond yields are near the lowest levels (highest prices) human civilization has ever seen. Commercial real estate is back at 2007 bubble valuations and real assets such as art, wine, and jewelry are enjoying record-setting bidding at auction houses.

These financial bubbles could not occur in an environment of weak domestic and global economic growth without the migration of debt borrowers from hedge to speculative to Ponzi status.

Compare and Contrast

The tables below summarize two extreme economic models to exhibit how an economy dependent upon “Ponzi” financing compares to one in which savings are prioritized. In both cases, we show how the respective financial decisions influence consumption, profits, and wages.

Table 1, below, is based on the assumption that consumers spend 100% of their wages and borrow an additional amount equivalent to 10% of their income annually for ten years straight. The debt amortizes annually and is therefore retired in full in 20 years.  

Assumptions: Debt is borrowed each year for the first ten years at a 5% interest rate and ten year term, corporate profits and employee wages are 7% and 3% of consumption respectively, annual income is constant at $100,000 per year. 

Table 2, below, assumes consumers spend 90% of wages, save and invest 10% a year, and do not borrow any money. The table is based on the work of Henry Hazlitt from his book Economics in One Lesson.  

Assumptions: Productivity growth is 2.5% per year, corporate profits and employee wages are 7% and 3% of consumption respectively.

Table 1 is the U-VC and Table 2 is the VC. The tables illustrate that there are immediate economic benefits of borrowing and economic costs of saving. For example, in year one, consumption in Table 1 rises as a result of the new debt ($100,000 to $108,705) and wages and corporate profits follow proportionately. Conversely, table 2 exhibits an initial $10,000 decline in consumption to $90,000, and a similar decline in wages and corporate profits as a result of deferring consumption on 10% of the income that was designated for saving and investing.

After year one, however, the trends begin to reverse. In the U-VC example (Table 1), when new debt is added, debt servicing costs rise, and the marginal benefits of additional debt decline. By year eight, debt service costs ($10,360) are larger than the additional new debt ($10,000). At that point, without lower interest rates or larger borrowings, consumption will fall below the income level.

Conversely, in the VC example (Table 2), savings and investments engender productivity growth, which drives wages, profits, and consumption higher.

The graphs below highlight the consumption and wage trends from both tables.

As illustrated in both graphs, the short term justification for promoting the U-VC is prompt economic growth. Equally important, the reason that savings and investments in the VC are admonished is that they require discipline and a period of lesser growth, profits, and wages.

Debt-fueled consumption is an expedient measure to take when economic growth stalls and immediate economic recovery is demanded. While the marginal benefits of such action fade quickly, a longer-term policy that consistently encourages greater levels of debt and lower debt servicing costs can extend the beneficial economic effects for years, fooling many consumers, economists and business leaders into believing these activities are sustainable.

In the tables above, it takes almost seven years before consumption in the VC (Table 2) is greater than in U-VC (Table 1).  However, after that breakeven point, the benefits of a VC become evident as economic growth compounds at an increasing rate, quickly surpassing the stagnating trends occurring under the U-VC.

In the real world, VC or U-VC economies do not exist. Economies tend to exhibit characteristics of both cycles. In the United States, for example, some consumers and corporations are saving, investing, and generating productive economic gains. Productivity gains from years past are still providing benefits as well.  However, over the past 30 years, consumers have increasingly opted to borrow and consume in a Ponzi-like manner and neglect savings. In other words, the U.S. economy has increasingly favored “Ponzi” debt-fueled consumption and denied the benefits of savings and the VC. Then again, U.S. leadership has only encouraged these behavioral patterns through imprudent fiscal and monetary policies.

The U.S. and many other countries are once again approaching what has been deemed the Minsky Moment.  Similar to 2008, this is the point when debt becomes unserviceable and a sharp increase in defaults is unavoidable. Will the Federal Reserve be able to once again reignite “Ponzi” borrowing to suspend that outcome?


The U.S. and many other countries are forced to deal with the consequences of economic policy actions, borrowing, and consumption behaviors from years past. While the present economic situation is troubling, leadership is obligated to reflect on past choices and move forward with changes that are in the best interest of the country and its entire population. As our title suggests, we can continue to try to pull consumption forward and further harm future growth, or we can save and reward future generations with productivity gains resulting in greater economic growth and prosperity. 

Shifting direction, and “paying forward,” via more savings and investments and the deferral of some consumption, comes with immediate negative consequences to wages, profits, and economic growth. Nothing worth having is easy, as the saying goes. However, over time, the discipline is rewarded, and the economy can be on a more sustainable, prosperous path.

These economic concepts, tables, and graphs extend an accurate diagnosis of the “Death of the Virtuous Cycle.” They are intended to help investment managers better understand the costs and benefits of saving versus borrowing from a macroeconomic perspective. If successful in that endeavor, the substance of this article will afford managers better ideas about how to navigate a very uncertain investment landscape. The implications for the sustainability of economic growth and therefore long term asset returns are profound and the bedrock of all investment decisions. 

Goldman Sachs on Corporate Debt: Myopic or Self-Serving?

The biggest problem that most people have is that they read Wall Street research reports and they believe the Wall Street hype… Wall Street analysts are very, very easy to fool, they’re generally parrots for what management tells them.” – Sam Antar, former CFO Crazy Eddie

In 2018, Goldman Sachs underwrote 513 corporate debt issuance deals totaling $94.5 billion. They were paid an average fee of 0.48% or approximately $453.6 million for those efforts.

In a recent research report entitled, Corporate Debt Is Not Too High, Goldman Sachs discusses why they are not concerned with the current levels of corporate debt despite record levels of corporate debt when compared to the nation’s GDP as shown in the chart below.

Goldman’s argument cites the following four reasons:

  1. Corporate debt remains below the 2001 peak as a share of corporate cash flows and has declined as a share of corporate assets
  2. Lower interest rates and more stable cash flows, which help reduce the cost of debt, mean that equilibrium leverage is likely higher than most of the post-war period
  3. Corporate debt in aggregate has a longer maturity which has reduced the refinancing risk
  4. The corporate sector runs a financial surplus which implies that capital expenditures are less dependent on external financing and less vulnerable to a profit squeeze

As discussed in our article The Corporate Maginot Line, not only have corporate debt levels risen dramatically since the financial crisis, but the quality of that debt has declined markedly. With the post-crisis recovery and expansion, the full credit spectrum of corporate debt levels are significantly larger, but debt outstanding in the single-A (A) and triple-B (BBB) rating sectors have grown the most by far.

Unlike previous periods, the composition of corporate debt within the investment grade sector is now heavily skewed toward the riskiest rating category of BBB. BBB-rated securities now represent over 40% of all corporate bonds outstanding. Additionally, all sorts of other risky loans reside as liabilities on corporate balance sheets and are potentially toxic assets for banks and investors. Most notable are leveraged loans extended to businesses by banks to corporations.

Beyond the amount of debt outstanding, another consideration related to creditworthiness are the uses of cash raised by corporations via debt issuance. Have the proceeds been used productively to enhance the future earnings and cash flows of the company, thereby making it easier to service the debt, or have they been used unproductively, creating a financial burden on the company in the future?

In A Perfect World

In an environment where the economy continues to grow at 2% and interest rates remain low, corporations may be able to continue borrowing at the pace required to fund their operations and conduct share buybacks as they wish. The optics appear sound and, based on linear extrapolation of circumstances, there is no reason to believe that tomorrow will differ from yesterday. However, if things do change, this happy scenario being described by the analysts at Goldman Sachs may turn out to be naively optimistic and imprudent.

Let us consider Goldman’s four points one at a time:

  1. Corporate debt remains below the 2001 peak as a share of corporate cash flows and has declined as a share of corporate assets

Corporate debt as a share of cash flow may not be at the 2001 peak, but it is higher than every other instance since at least 1952. As seen in the chart below, this measure tends to peak during recessions, which makes sense given that cash flows weaken during a recession and debt does not budge. This argument is cold comfort to anyone who is moderately aware of the late cycle dynamics we are currently experiencing.

Using corporate debt as a share of corporate assets as a measure of debt saturation suffers from a similar problem. The pattern is not as clear, but given that the value of corporate assets tends to decline in a recession, this metric does not offer much confidence in current conditions. While not at or above prior peaks, debt as a share of corporate assets appears somewhat elevated relative to levels going back to 1952. Unlike debt as a share of cash flow, this metric is not a helpful gauge in anticipating downturns in the economy.

  • Lower interest rates and more stable cash flows, which help reduce the cost of debt, mean that equilibrium leverage is likely higher than most of the post-war period

Goldman’s claim is purely speculative. How does anyone know where the “equilibrium leverage” level is other than by reflecting on historical patterns? Yes, interest rates are abnormally low, but for them to continue being an on-going benefit to corporations, they would need to continue to fall. Additionally, those “stable cash flows” are an artifact of extraordinary Fed policy which has driven interest rates to historical lows. If the economy slows, those cash flows will not remain stable.

  • Corporate debt in aggregate has a longer maturity which has reduced the refinancing risk

This too is a misleading argument. Goldman claims that the percentage of short-term debt as a share of total corporate debt has dropped from roughly 50% in 1985 to 30% today. The amount of corporate debt outstanding in 1985 was $1.5 trillion and short-term debt was about $750 billion. Today total corporate debt outstanding is $9.7 trillion and short-term debt is $2.9 trillion. The average maturity of debt outstanding may be longer today, but the nominal increase in the amount of debt means that the corporate refinancing risk is much bigger now than it has been at any time in history.

  • The corporate sector runs a financial surplus (income exceeds spending) which implies that capital expenditures are less dependent on external financing and less vulnerable to a profit squeeze

According to Federal Reserve data on corporate financial balances, the corporate sector does currently have surplus balances that are above the long-term average, but the chart below highlights that those surpluses have been declining since 2011. The recent boost came as a result of the corporate tax cuts and is not likely to be sustained. Historically, as the economic cycle ages, corporate balances peak and then decline, eventually turning negative as a precursor to a recession. If corporate financial surpluses continue to erode, capital expenditures are likely at risk as has been the case in most previous cycles.


In a recent speech, Dallas Fed President Robert Kaplan stated that the high ratio of corporate debt to U.S. GDP is a concern and that it “could be an amplifier” if the economy turns down. A few days later, Fed Chairman Jerome Powell echoed Kaplan’s comments but followed them by saying, “today business debt does not appear to present notable risks to financial stability.”

“Today” should not concern Chairman Powell, tomorrow should. In that speech, entitled Business Debt and Our Dynamic Financial System, Powell contrasts some key characteristics of the mortgage crisis with current circumstances in corporate lending and deduces that they are not similar.

Someone should remind the Chairman of a speech former Chair Ben Bernanke gave on October 15, 2007, to the Economic Club of New York. Among his comments was this:

“Fortunately, the financial system entered the episode of the past few months with strong capital positions and a robust infrastructure. The banking system is healthy.”

That was exactly 12 months prior to Congress passing legislation to bailout the banking system.

As we suspected, you do not have to search too hard to find a Goldman Sachs report downplaying the risk of subprime mortgages in the year leading up to the subprime crisis.

In February 2007, Goldman penned a research report entitled Subprime Mortgage: Bleak Outlook but Limited Impact for the Banks. In that report, after elaborating on the deterioration in the performance of subprime mortgages, Goldman states, “We expect limited impact of these issues on the banks as bank portfolios consist almost entirely of prime loans.” Goldman followed that up in October 2007 publishing a report on financial crisis poster child AIG titled, Weakness related to possible subprime woes overdone.

Goldman Sachs and their competitors make money by selling bonds, being paid a handsome fee by corporate counterparties. Do not lose sight of that major conflict of interest when you read reports like those we reference here.

Even though it rots teeth and contributes to diabetes, Coca-Cola will never tell you that their soft drink is harmful to your health, and Goldman et al. will never tell you that corporate bonds may be harmful to your wealth if you pay the wrong price. Like most salespeople, they will always hype demand to sell to investors.

Banks will continue to push product without regard for the well-being of their clientele. As investors, we must always be aware of this conflict of interest and do our homework. Bank and broker opinions, views, and research are designed to help them sell product and make money, period. If this were not true, there never would have been a subprime debacle.

The Corporate Maginot Line

Since the post-financial crisis era began more than a decade ago, record low-interest rates and the Fed’s acquisition of $4 trillion of the highest quality fixed-income assets has led investors to scratch and claw for any asset, regardless of quality, offering returns above the rate of inflation. 

Financial media articles and Wall Street research discussing this dynamic are a dime-a-dozen. What we have not heard a peep about, however, are the inherent risks within the corporate bond market that have blossomed due to the way many corporate debt investors are managed and their somewhat unique strategies, objectives, and legal guidelines. 

This article offers insight and another justification for moving up in credit within the corporate bond market. For our prior recommendation to sell junk debt based on yields, spreads, and the economic cycle, we suggest reading our subscriber-only article Time To Recycle Your Junk. If you would like access to that article and many others, you can sign up for RIA Pro and enjoy all the site has to offer with a 30-day free trial period. 

Investor Restraints

By and large, equity investors do not have guidelines regulating whether or not they can buy companies based on the strength or weakness of their balance sheets and income statements. Corporate bond investors, on the other hand, are typically handcuffed with legal and/or self-imposed limits based on credit quality. For instance, most bond funds and ETFs are classified and regulated accordingly by the SEC as investment grade (rated BBB- or higher) or as high yield (rated BB+ or lower). Most other institutions, including endowments and pension funds, are limited by bylaws and other self-imposed mandates. The large majority of corporate bond investors solely traffic in investment grade, however, there is a contingency of high-yield investors such as certain mutual funds, ETFs (HYG/JNK), and other specialty funds.

Often overlooked, the bifurcation of investor limits and objectives makes an analysis of the corporate bond market different than that of the equity markets. The differences can be especially interesting if a large number of securities traverse the well-defined BBB-/BB+ “Maginot” line, a metaphor for expensive efforts offering a false line of security.

Corporate Bond Market Composition

The U.S. corporate bond market is approximately $6.4 trillion in size. Of that, over 80% is currently rated investment grade and 20% is junk-rated.This number does not include bank loans, derivatives, or other forms of debt on corporate balance sheets.

Since 2000, the corporate bond market has changed drastically in size and, importantly, in credit composition. Over this period, the corporate bond market has grown by 378%, greatly outstripping the 111% growth of GDP.  The bar chart below shows how the credit composition of the corporate bond market shifted markedly with the surge in debt outstanding. 

As circled, the amount of corporate bonds currently rated BBB represents over 40% of corporate bonds outstanding, doubling its share since 2000. Every other rating category constitutes less of a share than it did in 2000. Over that time period, the size of the BBB rated sector has grown from $294 billion to $2.61 trillion or 787%.

The Risk

To recap, there is a large proportion of investment grade investors piled into securities that are rated BBB and one small step away from being downgraded to junk status. Making this situation daunting, many investment grade investors are not allowed to hold junk-rated securities. If only 25% of the BBB-rated bonds were downgraded to junk, the size of the junk sector would increase by $650 billion or by over 50%. Here are some questions to ponder in the event downgrades on a considerable scale occur to BBB-rated corporate bonds:  

  • Are there enough buyers of junk debt to absorb the bonds sold by investment-grade investors?
  • If a recession causes BBB to BB downgrades, as is typical, will junk investors retain their current holdings, let alone buy the new debt that has entered their investment arena?
  • Will retail investors that are holding the popular junk ETFs (HYG and JNK) and not expecting large losses from a fixed income investment, continue to hold these ETFs?
  • Will forced selling from ETF’s, funds, and other investment grade holders result in a market that essentially temporarily shuts down similar to the sub-prime market in 2008?

We pose those questions to help you appreciate the potential for a liquidity issue, even a bond market crisis, if enough BBB paper is downgraded. If such an event were to occur, we have no doubt someone would eventually buy the newly rated junk paper. What concerns us is, at what price will buyers step up?  

Implied Risk

Given that downgrades are a real and present danger and there is real potential for a massive imbalance between the number of buyers and sellers of junk debt, we need to consider how close we may be to such an event. To provide perspective, we present a graph courtesy of Jeff Gundlach of DoubleLine.

The graph shows the implied ratings of all BBB companies based solely on the amount of leverage employed on their respective balance sheets. Bear in mind, the rating agencies use several metrics and not just leverage. The graph shows that 50% of BBB companies, based solely on leverage, are at levels typically associated with lower rated companies.

If 50% of BBB-rated bonds were to get downgraded, it would entail a shift of $1.30 trillion bonds to junk status. To put that into perspective, the entire junk market today is less than $1.25 trillion, and the subprime mortgage market that caused so many problems in 2008 peaked at $1.30 trillion. Keep in mind, the subprime mortgage crisis and the ensuing financial crisis was sparked by investor concerns about defaults and resulting losses.

As mentioned, if only a quarter or even less of this amount were downgraded we would still harbor grave concerns for corporate bond prices, as the supply could not easily be absorbed by traditional buyers of junk.   


Investors should stay ahead of what might be a large event in the corporate bond market. We recommend corporate bond investors focus on A-rated or solid BBB’s that are less likely to be downgraded. If investment grade investors are forced to sell, they will need to find replacement bonds which should help the performance of better rated corporate paper. What makes this recommendation particularly easy is the fact that the current yield spread between BBB and A-rated bonds are so tight. The opportunity cost of being wrong is minimal. At the same time, the benefits of avoiding major losses are large. 

With the current spread between BBB and A-rated corporate bonds near the tightest level since the Financial Crisis, the yield “give up” for moving up in credit to A or AA-rated bonds is a low price to pay given the risks. Simply, the market is begging you not to be a BBB hero.

Data Courtesy St. Louis Federal Reserve


The most important yet often overlooked aspect of investing is properly recognizing and quantifying the risk and reward of an investment. At times such as today, the imbalance between risk and reward is daunting, and the risks and/or opportunities beg for action to be taken.

We believe investors are being presented with a window to sidestep risk while giving up little to do so. If a great number of BBB-rated corporate bonds are downgraded, it is highly likely the prices of junk debt will plummet as supply will initially dwarf demand. It is in these types of events, as we saw in the sub-prime mortgage market ten years ago, that investors who wisely step aside can both protect themselves against losses and set themselves up to invest in generational value opportunities.

While the topic for another article, a large reason for the increase in corporate debt is companies’ willingness to increase leverage to buy back stock and pay larger dividends. Investors desperate for “safer but higher yielding” assets are more than willing to fund them. Just as the French were guilty of a false confidence in their Maginot Line to prevent a German invasion, current investors gain little at great expense by owning BBB-rated corporate bonds.

The punchline that will be sprung upon these investors is that the increase of debt, in many cases, was not widely used for productive measures which could have strengthened future earnings making the debt easier to pay off. Instead, the debt has weakened a great number of companies.

Bonds Burning, Equities Fiddling

It is said that while a massive fire consumed Rome in 64 A.D., Rome’s ruler, Nero, played his violin night and day. Since then the quote, “Rome burned while Nero fiddled,” has become a phrasing used when a palpable problem is ignored.

Currently, the bond market and the Federal Reserve are on fire, screaming at the top of their lungs that something is wrong. All the while, the stock market fiddles as if everything is normal. In this article, we explore the steep decline in bond yields to understand what is frightening bond traders.

The Fire

The following graphs and tables will help you appreciate the message emanating from the bond markets.


The first graph below charts Eurodollar contract spreads which provide us with market expectations changes for the Fed Funds rate in the future.

Each Eurodollar contract represents a forward three month LIBOR rate for a specific three month period in the future. LIBOR, or the London Interbank Offer Rate, is the base rate that foreign banks lend to each other, corporations and other entities. For example, the current third Eurodollar contract represents the three -month LIBOR rate from mid-December of 2019 to mid-March of 2020. When various calendar Eurodollar rates are compared to each other the differences in yields provides us implied expectations for changes in the Fed Funds rate.

Data Courtesy Bloomberg

Currently, as shown with the blue line above, the difference between the third contract starting in mid-December is 18 basis points (0.18%) less than the first contract starting in mid-June. The difference tells us that the Eurodollar market currently expects three month LIBOR to decline 18 bps (0.18%) between June and December of 2019.

Since October of 2018, the three curves, spanning three different time frames (6, 9 and 21 months), have gone from a consensus expectation of approximately 0.50% of rate increases over the next two years to 0.18-0.56% of rate decreases over the same period. The 0.75% to 1.00% shift is remarkable over such a short period. Global traders, banks, and corporations that account for much of Eurodollar/LIBOR activity, influenced by fluid Fed outlook changes, have made sharp adjustments to their economic forecasts.

Yields and Yield Curves

The next chart shows the shift of the U.S. Treasury yield curve since January of 2018. The table below it provides further perspective for yield changes and curve gyrations.  RIA Pro subscribers can better appreciate the shifting yield curve by reviewing the Latest Commentary from March 26, 2019. In that update, we provided an animated yield curve showing monthly yield curve movements since January 2018.

Data Courtesy Bloomberg

The graph below is based on an assessment of ten yield curves of varying time frames. As shown and labeled by the orange bar on the right side, half of them are currently inverted. Note that every time since the 1970’s that at least 50% of the curves were inverted a recession was soon to follow.

Data Courtesy Bloomberg

Negative Yielding Bonds

It is not just the Eurodollar and U.S. Treasury markets that think something is amiss.  The final graph provides a global perspective on rates. Specifically, it plots the amount of negative yielding bonds worldwide. Again, the changes to economic outlooks and central bank policy that have occurred since last fall are not just related to the U.S. but are global.

Graph Courtesy Bloomberg

There is nothing normal with a negative yield, and we take notice when such a large number of bonds are trading below zero.


Bond markets around the world are worried that economic growth and inflation are slowing drastically. In the U.S., expectations have shifted from a Fed that would gradually raise rates through 2019 and 2020 and continue to reduce their balance sheet, to a Fed that is likely to cut rates over the next six to nine months and has announced the end of balance sheet reductions.

As illustrated in the table below, changes in Fed policy are a durable recession signal as the end of rate hike cycles are frequently followed by a downturn in the economy. If the Fed follows the market’s lead and puts an end to the hiking cycle that began in 2015, then we might very well be looking at a recession shortly.

Table Courtesy David Rosenberg at Gluskin Sheff

Fueling the bond markets are statements from past and present Fed Governors that are not only dovish but discuss a resumption of QE and negative interest rates. Former Fed Chairman, Janet Yellen, recently said the Fed needs more tools to battle a financial crisis. This is the same Janet Yellen that, in June of 2017, stated that she did not believe we would have a financial crisis in our lifetimes.

The Fed is sounding the alarms.

The bond market is burning.

The equity market is fiddling.

It is highly unlikely they are both right.

Videocast- Has The Cycle Reached Its Tail?

On March 20th we published Has This Cycle Reached Its Tail? With the help of a badly drawn bird, the article described the economic and market cycle of the last ten years. Through an understanding of cycles and importantly, where we are in within a cycle, investors are provided clues on how to position our portfolios for what the cycle has in store.

We believe the current economic cycle is close to a turning point. This is incredibly important to managing wealth, as such we produced the following video that dives further into cycles.

View Part 1

View Part 2

The “Only Way To Win”

“Here’s the argument,” Thaler said. “The Raiders are down, and they will be getting these [four] picks to help them rebuild their team. I believe the only way to win in football is to have players who play better than their salaries. Let’s stipulate that [Kahil] Mack is getting top-of-market value for his services, so it will be hard for him to play better than his salary. Let’s also stipulate Mack is worth the money. But is Mack worth all that money plus four good draft choices?”

The following quote is from Richard Thaler, a Nobel Prize winner in Economic Sciences. His quote about the Oakland Raiders trading all-pro Khalil Mack to the Chicago Bears sheds knowledge well beyond the football field. Essentially Thaler argues that teams should seek undervalued players and trade (sell) players that are fully priced or overvalued. In investment terms, his quote can be translated into: buy stocks with upside and limited downside and avoid stocks with limited upside and significant downside.

To help make better sense of Thaler’s wisdom, we bring equity valuations to the forefront once again with a look at the ratio of price -to- sales (P/S). As we will show you the market has plenty of Khalil Macks.

Valuing Corporate Revenue 

Before presenting a current P/S ratio for a variety of indexes and S&P sectors, it is important first to consider two related concepts that frame the message the market is sending us.

Concept #1 – Investors should accept higher than normal valuation premiums when potential revenue growth is higher than normal and require lower than average premiums when potential revenue growth is lower than normal.

Consider someone who is evaluating the purchase of one of two ice cream shops (A and B). The two businesses are alike with similar sales, pricing, and locations. However, based on the buyers’ analysis, store A’s future revenue is limited to its historical 2% growth rate. Conversely, the potential buyer believes that store B, despite 2% growth in the past, has a few advantages that are underutilized and might produce a revenue growth rate of 10%. If stores A and B are offered at the same price, the buyer should choose to purchase store B. It is also likely that the buyer would be willing to pay a higher price for store B versus store A. Therefore highlighting that revenue growth potential is a key factor when deciding how much to pay for a business.

Purchasing a mutual fund, ETF or equity security is essentially buying a claim on a potential future stream of earnings cash flows, just like the ice cream business. The odds, therefore, of a rewarding investment are increased substantially when a company, or index for that matter, offering substantial market growth potential is bought at a lower than average P/S ratio. Value investors actively seek such situations.

Concept #2 – Corporate Earnings Growth = Economic Growth

Corporate earnings growth rates and economic growth rates are nearly identical over long periods. While many investors may argue that corporate earnings growth varies from the level of domestic economic activity due to the globalization of the economy, productivity enhancements that lower expenses for corporations, interest rates and a host of other factors, history proves otherwise.

Since 1947, real GDP has grown at an annualized rate of 6.43%. Over the same period, corporate earnings grew at a nearly identical annualized rate of 6.46%. Thus, expectations for future corporate earnings over the longer -term should be on par with expected economic growth, although short term differences can arise.

The graph below shows the running three-year annualized growth rate of U.S. real GDP since 1960.  While there have been significant ebbs and flows in the rate of growth over time, the trend as shown by the black dotted regression line is lower.

Data Courtesy: St. Louis Federal Reserve

As we have shared before, the combination of negligible productivity growth, heavy debt loads, and negative demographic factors will continue to produce headwinds that extract a heavy price on economic growth in the years ahead.  Barring major changes in the way the economy is managed or a globally transformative breakthrough, there is little reason to expect a more optimistic outcome. Given this expectation, the outlook for corporate earnings is equally dismal and likely to produce similar growth rates.


The following graphs are constructed using data from 1995 to the present. The blue bars represent the percentage of historical P/S data that are less than the current ratio. For instance, the first bar representing the S&P 500 has a P/S ratio which is in the 85th percentile of prior instances. The orange bar next to the blue bar shows how much price would need to fall for the P/S ratio to normalize. It is important to stress this analysis assumes no decline in sales which is a poor assumption if a recession were to occur.

Data Courtesy: Zacks

As shown above, the broad stock indexes and major S&P sectors all stand in the upper third and fourth quartiles of valuations dating back to 1995.

Interestingly note that utilities, a sector investors tend to flock to during market downturns as a safe haven, currently trades at its highest valuation in at least 25 years. We also discussed this anomaly in Defense is Good, Good Defense is Better. The other two sectors mentioned in that report, consumer staples and healthcare, are trading at less egregious valuations.


Based on the fact that many of the index and sector P/S ratios are at or near those of prior peaks, we are left to select from one of two conclusions as mentioned:

  1. investors are extremely optimistic about the potential for revenue growth, or
  2. investors are complacent, caught in the grasp of bubble mentality and willing to pay historically large premiums to avoid missing out on further gains

After further deliberation, however, there is a third possibility. Perhaps the lack of viable options for investors to generate acceptable returns, have them ignoring the risks.

Khalil Mack may be a great linebacker for the Bears and return the value they paid, but as Thaler put it, they should not expect much more. On the flip side, professional sports and stock market history has proven time and time again that overpaying is more often met with disastrous underperformance.

Shiller’s CAPE – Is There A Better Measure?

In “Part 1” of this series, I discussed at length whether Dr. Robert Shiller’s 10-year cyclically adjusted price-earnings ratio was indeed just “B.S.”  The primary message, of course, was simply:

“Valuation measures are simply just that – a measure of current valuation. If you ‘overpay’ for something today, the future net return will be lower than if you had paid a discount for it.

Valuation models are not, and were never meant to be, ‘market timing indicators.'”

With that said, in this missive I want to address some of the current, and valid, arguments against a long term smoothed price/earnings model:

  • Beginning in 2009, FASB Rule 157 was “temporarily” repealed in order to allow banks to “value” illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual “sale price” of a similar asset. This was done to keep banks solvent at the time as they were being forced to write down billions of dollars of assets on their books. This boosted banks profitability and made earnings appear higher than they may have been otherwise. The ‘repeal” of Rule 157 is still in effect today, and the subsequent “mark-to-myth” accounting rule is still inflating earnings.
  • The heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings is also a relatively new distortion.
  • Extensive cost-cutting, productivity enhancements, off-shoring of labor, etc. are all being heavily employed to boost earnings in a relatively weak revenue growth environment. I addressed this issue specifically in this past weekend’s newsletter:

“What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 221%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 28% during the same period.”

  • The use of share buybacks improves underlying earnings per share which also distorts long-term valuation metrics. As the WSJ article stated:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. 

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big “restructuring charge” that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

As shown, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

  • The extensive interventions by Central Banks globally are also contributing to the distortion of markets.

Due to these extensive changes to the financial markets since the turn of the century, I do not completely disagree with the argument that using a 10-year average to smooth earnings volatility may be too long of a period.

Duration Mismatch

Think about it this way. When constructing a portfolio that contains fixed income one of the most important risks to consider is a “duration mismatch.”  For example, let’s assume an individual buys a 20-year bond, but needs the money in 10-years. Since the purpose of owning a bond was capital preservation and income, the duration mismatch leads to a potential loss of capital if interest rates have risen at the time the bond is sold 10-years prior to maturity.

One could reasonably argue, due to the “speed of movement” in the financial markets, a shortening of business cycles, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the financial markets currently.

The first chart below shows the annual P/E ratio versus the inflation-adjusted (real) S&P 500 index.

Importantly, you will notice that during secular bear market periods (green shaded areas) the overall trend of P/E ratios is declining.  This “valuation compression” is a function of the overall business cycle as “over-valuation” levels are “mean reverted” over time.  You will also notice that market prices are generally “sideways” trending during these periods with increased volatility.

You can also see the vastly increased valuation swings since the turn of the century, which is one of the primary arguments against Dr. Shiller’s 10-Year CAPE ratio.

Introducing The CAPE-5 Ratio

The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s periods of “valuation expansion” are where the bulk of the gains in the financial markets have been made over the last 116 years. History shows, that during periods of “valuation compression” returns are much more muted and volatile.

Therefore, in order to compensate for the potential “duration mismatch” of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.

There is a high correlation between the movements of the CAPE-5 and the S&P 500 index. However, you will notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.

A key “warning” for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. The recent decline in the CAPE-5, which was directly related to the collapse and recovery in oil prices, has so far been an outlier event. However, complacency “this time is different,” will likely be misplaced as the corrective trend currently remains intact.

To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average. The importance of deviation is crucial to understand. In order for there to be an “average,” valuations had to be both above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time which is why the further the deviation is away from the “average,” the greater the eventual “mean reversion” will be.

The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.

Currently, the 56.97% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed five (5) other times in history. As stated above, while it is hoped “this time will be different,” which were the same words uttered during each of the five previous periods, you can clearly see that the eventual results were much less optimal.

However, as noted, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.

Again, as with the long-term view above, the current deviation is 44.19% above the Post-WWII CAPE-5 average of 17.27x earnings. Such a level of deviation has only been witnessed three times previously over the last 70 years in 1996, 2005 and 2013. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.

Is this a better measure than Shiller’s CAPE-10 ratio?

Maybe, as it adjusts more quickly to a faster moving marketplace. However, I want to reiterate that neither the Shiller’s CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be “market timing” indicators.

Since valuations determine forward returns, the sole purpose is to denote periods which carry exceptionally high levels of investment risk and resulted in exceptionally poor levels of future returns.

Currently, valuation measures are clearly warning the future market returns are going to be substantially lower than they have been over the past eight years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.

Shiller’s CAPE: Is It Really B.S. – Part 1