Home Economy WSJ: Pricey Stocks, High Debt Make a ‘Nasty Mix’ for Investors

WSJ: Pricey Stocks, High Debt Make a ‘Nasty Mix’ for Investors

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                WSJ: Pricey Stocks, High Debt Make a 'Nasty Mix' for Investors

The stock market’s rise to record highs amid sluggish economic growth have some investors worrying about a repeat bubble. This time around, public companies are taking on record levels of debt that might turn “ugly” if the economy slows, writes James Mackintosh in The Wall Street Journal.

“Companies have been loading up on debt based on two assumptions, shared by investors: that economic growth will be slow, and it will be steady,” he writes. “Low growth keeps interest rates low relative to inflation, while the expectation of steady growth means few worry about a bad year interrupting repayments.”

If these investor assumptions are wrong, corporate debt could hinder the rally that started in March 2009, when the U.S. economy was struggling to recover from the worst recession in 80 years. The S&P 500 has risen 10 percent since the Nov. 8 presidential election, when Republican Donald Trump triumphed on a bro-business platform of tax cuts, less regulation and more spending on roads, bridges and airports.

“Rather than expanding overall profit, companies have been boosting the return to shareholders by replacing equity with debt—a zero-sum transfer which cannot be repeated indefinitely,” Mackintosh says, citing data from Morgan Stanley on ratios of debt to operating cash flow.

“The market isn’t—yet—repeating the 2000 equity bubble or the 2007 debt bubble, but it has some of the worst features of both,” he says. “If investors turn out to be mistaken in thinking the economic cycle won’t turn down for years yet, it’s going to hurt.”

Michael Lewitt, the manager of the Third Friday Total Return Fund Lp. who has warned that stocks are in a bubble, said investors need to take heed of the Federal Reserve’s intentions to raise interest rates two more times this year.

“Easy monetary policy was a major tailwind for equities since the crisis; rising rates are now going to be a headwind though it will take Federal funds rate of over 2 percent to worry equity investors,” he said in the April 1 edition of his Credit Strategist newsletter. “While the nominal level of rates is still low, the increase in relative terms from zero is significant.” The Fed funds rate is about 1 percent after last month’s hike of 0.25 percentage point.

Higher rates not only lure some investors into bonds that pay a better risk-free rate of return, but they also can hurt the profitabilty of companies that payer higher costs on their debts. Both pressures are negative for stocks.

“With unemployment and inflation hitting the Fed’s targets a long time ago (that is, hitting the targets as the Fed interprets them, not as they actually exist in the real world) and with the stock market still trading at extremely rich levels, Yellen & Co. are out of excuses for keeping rates low,” Lewitt said of Janet Yellen, chair of the central bank.

The retail, energy and financial industries are losing steam after getting a lift from Trump’s victory.

“These are not the building blocks for another leg up in the market, but maybe computers and exchange-traded funds will carry the day and launch the indices to new highs until even they can no longer deny economic and company fundamentals,” he said.

Mom-and-pop investors have been putting record amounts of money into ETFs and passive trading strategies that buy stocks of entire industry groups or regions as a way of diversifying risk.

But Lewitt warns against blindly buying the market, especially if when broader indices are dependent upon a handful of the same stocks.

“At these levels, investors need to seek out those rare stocks that offer value, not indices that odder nothing but herd thinking and momentum,” he said. “Momentum can reverse very easily and one day investors are going to wake up and realize that the emperor is wearing no clothes.”

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