What beat me was not having brains enough to stick to my own game – that is to play the market only when I was satisfied that precedents favored my play.” - Jesse Livermore, Reminiscences of a Stock Operator
There has been a lot of debate on the Reinhart-Rogoff hypothesis. When debt becomes excessive, growth slows. Most of the academic work tends to support their conclusion.
With that in mind, let’s take a sobering look at debt across the globe. It has increased by more than $57 trillion since the 2007 crisis and remains a significant headwind. Some countries are better positioned than others with stronger capital markets, currency advantages, and underlying wealth, but deflation is gaining traction.
Reinhart and Rogoff suggested that problems accelerated when debt reached 100% of GDP. I’ve seen studies suggesting the number is more like 40% to 50% and others suggesting it is much higher. The following chart, from one such study, looks at U.S. debt-to-GDP and suggests growth begins to decline when debt/GDP reaches approximately 45%. Today, total U.S. debt/GDP is 269%. Source.
While it would be nice to find a magic debt-to-GDP threshold number that signals a crisis, such findings have proven allusive. However, what I believe we can do is look at debt from a risk measurement perspective. For example, just as Median PE quintiles can tell us a lot about probable 10-year forward returns (high PEs equal low returns and low PEs equal high returns), I believe excessive debt can equally signal periods of low growth and high risk.
Like PE, we don’t know what the market will do this year or next, but what we do know today is that the stock market is expensively priced and 10-year forward returns will likely come in far below what most investors hope them to be. I look at the debt-to-GDP debate much the same way. Debt’s “a drag, man” and we should factor this into our portfolio construction thinking.
If the stock market is tempting you to go “all in”, now is the time to think otherwise. Now is the time to allocate to a broad set of risks and establish a process to hedge your equity exposure. The time to position aggressively in stocks will present itself again, but such opportunity shows up when it doesn’t feel like opportunity (such as in recession, cyclical bear markets and/or crisis).
As Livermore suggests in the quote above, stick to the game plan and position more aggressively when you are satisfied that precedents favor your play.
Do the precedents favor your play today? The evidence suggests otherwise – prices are high and commodity prices are sinking; too much debt is slowing growth.
Let’s take a look at debt around the globe. I share a great piece from
Debt and Deleveraging – McKinsey & Company
Summary of findings:
- We find that deleveraging since 2008 remains limited to a handful of sectors in some countries and that, overall, debt relative to GDP is now higher in most nations than it was before the crisis.
- Not only has government debt continued to rise, but so have household and corporate debt in many countries.
- China’s total debt, as a percentage of GDP, now exceeds that of the United States.
- Higher levels of debt pose questions about financial stability and whether some countries face the risk of a crisis.
- One bright spot is that the financial sector has deleveraged and that many of the riskiest forms of shadow banking are in retreat.
- But overall this research paints a picture of a world where debt has reached new levels despite the pain of the financial crisis.
- This reality calls for fresh approaches to reduce the risk of debt crises, repair the damage that debt crises incur, and build stable financial systems that can finance companies and fund economic growth without the devastating boom-bust cycles we have seen in the past.
“Reduce the risk of debt crises”? To that point I say good luck. Look back to all that set the stage for the last crisis. I remember writing about the probable failure of Fannie and Freddie, the insanity of no-doc mortgages and Greenspan’s “there is not a bubble” in the housing market.
Think back to 2007 to the seemingly endless amount of available liquidity created in Wall Street’s derivative sausage-making machine – CMOs and CDOs with layers of tranches and slices and dices of repackaged risk. Go even farther back in time: Here was Paul Krugman in a 2002 New York Times editorial: “To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.” Source.
The point isn’t to pick on Greenspan or Krugman, the point is that we do go through expansion and contraction and boom and bust and have for centuries. Unlike pee wee soccer, not everyone gets a trophy but to have the opportunity to create, compete and advance; that is what makes for a healthy state. Governments have become too large a part of the equation. “Reduce the risk of debt crisis”? Right. Somehow, Joseph Schumpeter’s creative destruction sneaks into my mind.
Joseph Schumpeter coined the seemingly paradoxical term “creative destruction” and generations of economists have adopted it as a shorthand description of the free market’s messy way of delivering progress. In Capitalism, Socialism and Democracy (1942), the Austrian economist wrote:
The opening up of new markets, foreign or domestic, and the organizational development from the craft shop to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. (p. 83). More here.
Not a bad thing. It is perhaps an important and healthy part of the process to get us to a better place. Put me firmly in that camp.
Ok – sorry for that detour. The next picture below sets the debt stage and I’ve included a few more select highlights from the McKinsey report:
- Since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. Developing economies account for roughly half of the growth and, in many cases, this reflects healthy financial deepening. In advanced economies, government debt has soared and private sector deleveraging has been limited.
- Government debt has grown by $25 trillion since 2007, and will continue to rise in many countries, given current economic fundamentals. For the most highly indebted countries, implausibly large increases in real GDP growth or extremely deep reductions in fiscal deficits would be required to start deleveraging.
- Shadow banking has retreated, but non‑bank credit remains important. One piece of good news: the financial sector has deleveraged and the most damaging elements of shadow banking in the crisis are declining. However, other forms of non‑bank credit, such as corporate bonds and lending by non‑bank intermediaries, remain important. For corporations, non‑bank sources account for nearly all new credit growth since 2008.
- Households borrow more. In the four “core” crisis countries that were hit hard—the United States, the United Kingdom, Spain and Ireland—households have deleveraged. But in many other countries, household debt-to-income ratios have continued to grow and, in some cases, far exceed the peak levels in the crisis countries.
- China’s debt is rising rapidly. Fueled by real estate and shadow banking, China’s total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany.
The report goes on (emphasis mine):
It is clear that deleveraging is rare and that solutions are in short supply. Given the scale of debt in the most highly indebted countries, the current solutions for sparking growth or cutting fiscal deficits alone will not be sufficient.
Government debt has now reached high levels in a range of countries and is projected to continue to grow. Given current primary fiscal balances, interest rates, inflation and consensus real GDP growth projections, we find that government debt-to-GDP ratios will continue to rise over the next five years in Japan (where government debt is already 234 percent of GDP), the United States, and most European countries, with the exceptions of Germany, Ireland and Greece.
It is unclear how the most highly indebted of these advanced economies can reduce government debt.
Attaining and then sustaining such dramatic changes in fiscal balances would be challenging. Furthermore, efforts to reduce fiscal deficits could be self-defeating— inhibiting the growth that is needed to reduce leverage.
My general view is that we are witnessing the beginning of a global sovereign debt crisis. Perhaps Greece will be the first meaningful domino to fall. The risk is the follow-on behavior of equally troubled neighbors – pressure is mounting to “cut the debt”.
The debt deleveraging cycle has yet to begin. Deflation has gained traction. Europe is center stage. Like a game of dominos, we’ll have to carefully watch what happens once set in motion. Greece, Spain, Japan, Portugal, France, Italy, China, U.S. - each desperate to dig out of a deep debt hole, beggar-thy-neighbor behavior takes hold. The currency wars are advancing. Pressure is building.
Simply writing down the debt comes with great consequence: pensions become impaired (as pensions are large holders of Greek, Italian, Spain sovereign debt). Write down the debt and the bank’s collapse. A mighty fine mess we are in - a 2008-like crisis should not be ruled out.
I have no answer as to how or when this all plays out (wish I did) but I do have ideas as to how you can put in place a disciplined process that can enable you to both seek growth (should the markets continue higher) and preserve your capital WHEN the next recession/bear market takes hold (whether in or absent of crisis).
Here are three things you can do:
Hedge your equity exposure. This will allow continued upside participation and help to minimize overall loss in periods of market crisis. One simple way is to buy out of the money put options. If the debt contagion spreads, counterparty risk may infect some of the largest U.S. banks. Consider deep out of the money puts on the iShares U.S. Financial Services ETF (IYG), 40% of which is made up of the banks with the largest derivative exposure (
Put in place a stop-loss risk management process. Study of past overvalued bulls suggests that a trailing stop 10% below the one-year high has been a good way of capturing the majority of gains without taking the full brunt of a cyclical bear. When such stop loss level is hit, increase bond exposure to iShares 20+ Year Treasury Bond (TLT) or SPDR Barclays 1-3 Month T-Bill ETF (BIL) until a new uptrend materializes. Alternatively, consider iShares MSCI USA Minimum Volatility ETF (USMV). When the European debt crisis shook U.S. stocks in 2012, the S&P 500 lost 11 percent and USMV lost about half that amount. Expect smaller upside but better downside.
Finally, allocate a portion of your portfolio to tactical strategies. Such strategies are typically rules-based disciplined trading strategies that seek to identify and position in ETFs showing the strongest price leadership. When leadership shifts, positions shift. Three ETFs showing strong relative price leadership today are iShares MSCI All Country Asia ex Japan ETF (AAXJ), WisdomTree Japan Hedged Equity Fund (DXJ) and iShares MSCI USA Momentum Factor ETF (MTUM). Energy, oil, natural gas, copper and commodity plays like PowerShares DB Commodity Tracking ETF (DBC) are showing the lowest relative strength and should be avoided until positive and strong price trends are re-established.
Do current “precedents favor” my play? Forward thinking coupled with a disciplined risk management game plan can prepare you to act when opportunity presents. For now, risk is high. Stay patient, nimble and prepared to execute your plan.
