Here is the issue with intangible assets.
Read the bolded sentence again.
The Debt Problem
The most significant problem for the majority of companies in the “value” space is debt. As we have discussed previously, in just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high.
“To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.
And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.” – John Mauldin
The debt issuance is problematic as companies used it for non-productive investments such as stock buybacks and dividend issuance as corporate profitability remained extraordinarily weak over the last decade.
As discussed in “The Importance Of The Buffett Indicator,” corporate profits are at the same level as in 2009, while markets are at all-time highs. Exactly where is the “value?”
Notably, corporate profits are a reflection of economic growth rates, and a “vaccine” will not cure the problem plaguing profitability long-term—the debt.
Value Needs Strong Economic Growth & Higher Rates
The problem with the “vaccine will lead to a value rotation,” is such would require more robust economic growth and higher rates for increased profitability.
- Banks – need higher interest rates
- Energy – needs higher oil prices
- Materials – needs more substantial economic growth driving physical investment.
- Industrials – same as materials.
Here is where the “rotation to value” runs into problems.
Let’s start with the banks.
If interest rates were to rise substantially, the economy contracts due to the economy’s massive debt levels. We showed this specifically in “The Fed Will Monetize All Debt Issuance..”
“In an economy laden with $75 Trillion in total debt, higher interest rates have an immediate impact on consumption, which is 70% of economic growth. The chart below shows this to be the case, which is the interest service on total credit market debt. (The chart assumes all debt is equivalent to the 10-year Treasury, which is not the case.)”
What about energy stocks?
No one believed me in 2017 when I stated that oil prices were going to remain low.
“With respect to investors, the argument can be made that oil prices could remain range-bound for an extremely long period of time as witnessed in the 80’s and 90’s.“
Energy companies still have a massive supply/demand imbalance that existed long before the “pandemic” hit the economy. While a vaccine may provide a short-term boost, the underlying fundamentals are still not supportive of a long-term rotation.
Energy companies, along with basic materials and industrials, need stronger economic growth.
That isn’t coming.
Weaker Economic Growth
A vaccine will not solve the longer-term problems plaguing weaker economic growth rates and stronger fundamentals.
As we discussed previously in the “One-Way Trip Of American Debt,” the economic growth rate has been undermined by the surge in debt over the last decade.
“Before the “Financial Crisis,” the economy had a linear growth trend of real GDP of 3.2%. Following the 2008 recession, the growth rate dropped to the exponential growth trend of roughly 2.2%. Instead of reducing the debt problems, unproductive debt and leverage increased.”
As stated, the sectors believed to be part of the “value trade” requires stronger economic activity. Such would lead to higher rates of inflation and higher interest rates.
As rates rise, so do rates on credit card payments, auto loans, business loans, capital expenditures, leases, etc., while also reducing corporate profitability.
In an economy supported by debt, rates must remain low. Therefore, the Federal Reserve has no choice but to monetize as much debt issuance as is needed to keep rates from substantially rising. The byproduct of those actions is weaker economic growth and lower rates of inflation. As shown, since 2009, inflation has consistently run well below the Fed’s target.
Unfortunately, higher levels of debt continue to retard economic growth keeping the Fed trapped in a debt cycle as hopes of “growth” remain elusive. The current 5-year average inflation-adjusted growth rate is just 1.64%, a far cry from the 4.79% real growth rate in the ’80s.
A “vaccine” for COVID-19 is entirely different than what is needed to cure the “debt problem.”
The Rotation Is Likely Short-Lived
Look back at the first chart above. Based on two-year forward earnings estimates, the Russell 2000 (small-capitalization companies) are trading at historical extremes. Compound valuation problems, with the debt problem, and the lack of actual “value,” the issue becomes more apparent.
Given the Federal Reserve’s monetary injections and suppression of interest rates, it is not surprising to see companies leveraging their balance sheets. As interest rates have plunged, corporations have hit a record issuance of debt to pay dividends and engage in other non-productive actions.
The increased leverage of corporate balance sheets is problematic, particularly given already weak revenue growth for S&P 500 companies.
The rotation from “growth” to “value” is inevitable. With that, we agree.
However, a “vaccine” doesn’t solve the problems plaguing economic growth, suppressing inflation, and keeping Central Bankers flooding the markets with liquidity.
Those problems can only get solved against a backdrop of devastation for the majority of investors. When there is a true reversion in leverage, debt, and valuations, the foundation for a “value rotation” will be laid.
Lance Roberts is a chief portfolio strategist and economist for Clarity Financial. He is also the host of "Street Talk with Lance Roberts," chief editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and LinkedIn.