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Cash-To-Debt Ratio Demonstrates Why Riskier Assets Have Limited Upside Potential

Cash on corporate balance sheets grew at a 1% pace to $1.84 billion in 2015. That’s a record level of dollars on the books. On the other hand, debt grew at a clip of nearly 14.8% to $6.6 trillion from $5.75 trillion. That’s a 15% surge in debt obligations. In fact, American companies have grown their debt load at a double-digit annualized rate since the economic recovery began in 2009. Doing so has put corporations in a precarious situation – circumstances where cash as a percentage of debt is lower than at any time since the Great Recession. Obviously, the data points themselves are unnerving. Yet, the trend for cash as a percentage of total debt over time may be even more alarming. Consider what transpired between 2006 and 2008. Cash growth began to slow. Debt began to skyrocket. And cash as a percentage of debt steadily declined until, eventually, stocks of corporations found themselves losing HALF of their value. Are stocks set to log -50% bearish losses going forward? Perhaps. Perhaps not. Yet the notion that debt can perpetually grow at a double-digit rate without adverse consequences is about as inane as the idea that the U.S. government’s debt troubles are irrelevant to the country’s well-being. At least in the U.S. government’s case, its leadership can print currency and/or manipulate borrowing costs. (Note: That is not an endorsement of policy; rather, it is an acknowledgement of government power.) Companies? They’re at the mercy of the corporate bond market such that, when existing obligations are retired, new debt may need to be issued at much higher yields to entice investors. Think about it. Ratings companies like S&P may find themselves downgrading scores of corporate bonds to junk status due to ungodly cash-to-debt ratios. What’s more, yield-seeking investors might squeamishly back away from speculation if spreads between corporates and treasuries widen further. Additionally, Fed efforts to raise overnight lending rates may push junk yields further out on the ledge where the combination of widening spreads, rating agency downgrades and Fed policy direction collectively reinforce a negative feedback loop. By many accounts, low-rated bonds have been struggling for quite some time. Get a gander at the three-year chart of the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ) below. Granted, the bounce off of the February lows is astonishing. (Channel your gratitude toward a 70%-plus recovery in crude oil prices.) Nevertheless, the total return for JNK is a scant 1.4% over the three-year period. That is negligible reward for a huge amount of risk . In contrast, the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) offered a total return of 9.2% over the same period. That is low risk for reasonable reward. The problem may only get worse. At present, junk status (‘BB’) is the average rating for companies issuing bonds. How bad is that historically? It’s worse than before, during or after the financial collapse in 2008-2009. Indeed, you have to travel back to the 2001 recession to find an average rating as anemic as the one that exists right now. It is certainly true that when the European Central Bank (ECB) announced its quantitative easing (“QE”) intentions in the first quarter, the reality that they’d be acquiring corporate bonds as well as sovereign debt provided a fresh round of speculative yield seeking. Income producing assets that had been struggling under the worry of multiple Fed rate hikes in 2016 – emerging market sovereigns via the PowerShares Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA: PCY ), the SPDR Barclays International Treasury Bond ETF (NYSEARCA: BWX ), high yield via the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ), crossover corporates via the iShares Baa-Ba Rated Corporate Bond ETF (BATS: QLTB ) as well as the iShares Intermediate Credit Bond ETF (NYSEARCA: CIU ) – rocketed higher. On the flip side, the belief that yield-seeking and risk-seeking behavior will occur as long as central banks keep borrowing costs subdued is flawed. In the bond world, bad ratings eventually override yield-seeking speculation. In the stock world, stretched valuations eventually cap upside potential . It is worth noting, in fact, that the S&P 500 has been flat for 18 long months, which roughly corresponds to when corporate earnings peaked back on 9/30/2014 . Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

What Happens To ‘Hold-N-Hope’ Portfolios When An Economy Struggles To Expand?

Some analysts may dismiss 115 years of economic data. I do not. In particular, if one averages the results of four respected stock valuation methodologies, one finds that stocks are wildly expensive. Greater irrationality in stock price exuberance only existed during conditions prior to the Great Depression circa 1929 and the tech wreck of 2000. Consider the chart below. Based on the analysis by Doug Short, the widely cited Vice President of Research at Advisor Perspectives, the U.S. stock market is overvalued by 76%. It is worth noting that on all three occasions when the aggregate average approached two standard deviations above a geometric mean — 1929, 1999, 2007 — U.S. stocks collapsed by 50% or more. In addition, current valuation extremes surpass those reached in 2007. Investors should be mindful of the fact that Mr. Short does not typically offer “bearish” or “bullish” commentary. He usually provides investment and economic research, allowing others to draw their own conclusions. That said, he has served up bullet points on the high probability that market returns will be low over the next 7-10 years. Mr. Short has also mentioned that tactical asset allocation will be more important in the coming decade, as holding the S&P 500 for the next 7-10 years is likely to be “disappointing.” Keep in mind, elevated valuations in and of themselves may not provide much insight with respect to reducing risk in one’s portfolio. Years of valuation extremes can persist when other factors are at play. (Think central bank interest rate and balance sheet shenanigans.) Nevertheless, an economy that shows signs of stagnation coupled with signs of “risk-off” positioning can break the back of a stock market bull, particularly when interest rate manipulating, balance sheet expanding central banks are only running on fumes. I mentioned that the economy is stagnating and that signs of “risk-off” positioning are evident. Let me first address the economy. Corporations are not increasing their profits, as corporate earnings per share have declined for four consecutive quarters. Business revenue is even more abysmal. Companies have fallen back to 2012 levels with respect to revenue generation, and that does not even adjust for inflation. Click to enlarge Traditional retailers are struggling and some are disappearing (e.g., Wal-Mart, J.C Penney, Sears, Macy’s, Office Depot, Walgreens, Sports Authority, Sports Chalet, Aeropostale, etc.). Oil and gas? Yikes. According to reports on a Deloitte study, one-third of oil corporations may go belly up in 2016. The study focused on some 175-plus companies with more than $150 billion in debt. What about gross domestic product (GDP)? At a pace of 1% over the last six months, it is hardly expanding at all. Even the bright spot of job growth is deteriorating. Consider the Federal Reserve’s own Labor Market Condition’s Index (LMCI), which evaluates 19 unique indicators of labor market health. The LMCI peaked in April of 2014; its intermediate-moving average (6-months) peaked in August of 2014. (Note: S&P 500 earnings per share hit its all-time top in September of 2014, representing Q3 on 9/30/2014). Click to enlarge The 6-month moving average on the LMCI has not rolled into negative territory since the Great Recession (2007-2009). Before that, you’d need to look at the NASDAQ’s tech wreck and 2001 recession (2000-2002) for significant troubles in the well-being of the labor market. Does this mean that a recession is imminent? No. But it sure as heck means that labor market conditions are weakening. With “job growth” having been the one supposed saving grace in a slow-growing economy that required near 0% interest policy for seven-plus years, it seems optimism for a turnaround prior to a sell-off in risky assets would be misplaced. Of course, there are those that are keeping the faith with respect to stocks rallying well into the end of 2016 without a correction or bear. The thinking? As long as the economy muddles through, the Federal Reserve won’t be able to raise rates, and the dollar will move lower in the absence of tightening, and the lower dollar will help businesses increase their overseas sales and profitability. In other words, bad news will be good news for never-say-die hold-n-hopers. Unfortunately, there are a number of problems with the muddle-through scenario. Problemo numero uno? Household debt exceeds disposable personal income. Granted, Americans have been spending more than their take-home pay after taxes since 2001. Yet the modest deleveraging that occurred after the Great Recession has passed us by. Sooner or later, as families continue to accumulate increasing amounts of debt to spend more than they clear via disposable personal income, a retrenchment period comes to pass. Either households will be challenged in accessing credit (involuntary deleveraging) or they themselves will choose to borrow less in spite of ultra-low rates (voluntary deleveraging). Click to enlarge Economic data on consumption shows that the consumer has been softening. Bring disposable personal income into the picture, and the consumer is likely to weaken even more. The second problem for the muddle-through economy dream is the reality that “risk off” investing has been outperforming the U.S. market for 18 months already. 18 months. Consider the fact that three of the best performing assets in the 2008 systemic financial meltdown were the yen, the dollar and long-maturity treasury bonds. You could have invested in each via CurencyShares Yen Trust (NYSEARCA: FXY ), PowerShares Dollar Bullish (NYSEARCA: UUP ) and iShares 20+ Treasury Bond (NYSEARCA: TLT ). Over the last year-and-a-half, all three of these “risk-off” assets have beaten the SPDR S&P 500 Trust (NYSEARCA: SPY ). In sum, stock valuations are exorbitant, business sales are soft, consumption is strained, the labor market is weakening and “risk-off” assets are outperforming. Add it all up? There is limited upside reward for the risk one takes by remaining overexposed to equities and higher-yielding vehicles. If you normally leave 65%-70% in a diversified basket of stock (e.g., large-cap, mid-cap, small-cap, foreign, emerging, etc.), downshift to 45%-50% high quality larger-caps only. If you typically allot 30%-35% to diversified income (e.g., investment grade, cross-over corporate, high-yield, convertible, foreign, etc.), dial it back to 20%-25% investment grade only. The 25%/30%/35% that you raise in cash or cash equivalents by selling riskier assets at relatively higher prices will minimize portfolio volatility. More importantly, it will be the “dry powder” you require to buy “risk-on” assets at more attractive price in the future. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Are You Considering ‘Sell In May, Go Away?’

One of the signs that a stock market may be transitioning from a bull to a bear? Participants dismiss exorbitant valuations , cast aside disturbing shifts in technical trends, disregard economic stagnation and scoff at historical comparisons. For instance, it has been 352 days since the Dow Jones Industrials Average registered an all-time record high in May of 2015. Since the 1920s, when the Dow has surpassed 350 calendar days without recovering a bull market peak, the index has dropped at least 17% on nine out of 11 occasions. On average, the Dow has succumbed to 30% bearish price depreciation. Adding insult to injury here is that the Dow has failed to hold 18000 since it first notched the milestone back on December 23, 2014. That was 499 days ago. Equally compelling? Five days earlier (12/18/2014) marked the Federal Reserve’s final asset purchase in its third round of quantitative easing (QE3). In other words, the stock market has been unable to make any meaningful progress since the Fed stopped expanding its balance sheet. (Note: This also lends credence to research that attributes 93% of the current bull market’s gains to the Fed’s electronic credit/asset purchase interventions). “Forget corporate earnings, sales, the global economy, technical analysis and history, Gary. You’ve got to be a contrarian here because this is the most hated stock market ever!” I’ve heard this claim dozens of times now. Ostensibly, a lack of excitement for stock assets should push stocks back to record heights and beyond. And there may be some truth to the declaration. After all, corporations have been the only “net buyers” for more than three months, as the other participants (e.g., pensions, hedge funds, “Mom-n-Pop” retail, institutional advisers, etc.) have been “net sellers.” On the other hand, according to the National Association of Active Investment Managers, investment sentiment sits at its highest level since April of 2015. Putting that into perspective? A contrarian who recognized the uber-bullishness last year may have exited the market near the all-time record highs for the Dow and the S&P 500 in May of 2015. Similarly, we may once again be at a point where bullishness is overextended. Granted, the S&P 500 might only need to rise 4% from current levels to register an all-time record. In and of itself, that is relatively impressive. Nevertheless, the year over year and year-to-date outperformance of the S&P 500 by the FTSE Multi-Asset Stock Hedge Index (affectionately known as “MASH”) is reason enough to be wary. We’re talking about the collective success of several key components like the SPDR Gold Trust ETF (NYSEARCA: GLD ), the CurrencyShares Japanese Yen Trust ETF (NYSEARCA: FXY ), the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) and the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB ). Click to enlarge Click to enlarge Three-quarters of S&P 500 corporations have reported Q1 2016 earnings. And according to the S&P Dow Jones Indices website, as reported earnings estimates for the S&P 500 (3/31/2016) are now $87.48. The trailing twelve-month P/E? 23.4. “In the era of ultra-low interest rates,” you insist, “it simply doesn’t matter.” Well, then, perhaps you should investigate the four bear markets that occurred in the 20-year period (1936-1955) when the U.S. had similar 10-year yields, yet price-to-earnings ratios that were half what they are right now. Here is one thing that should not be ignored. When precious metals like gold and carry-trade currencies like the yen outperform stocks over 5-6 months as well as one year – when long-maturity U.S. treasuries and Japanese government bonds are behaving in a similar fashion – “risk off” has the edge over “risk on.” Should you sell in May and go away, then? From my vantage point, just make sure you’ve got a comfortable cash/cash equivalent cushion to buy riskier assets at more attractive valuations down the road. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.