Our Zone of Risk framework highlights a critical discontinuity between the performance of the corporate sector and corporate equity valuations. Profits accelerate in the early phases of an expansion and peak before or just within the parameters of the Zone of Risk. Meanwhile, corporate equity valuations continue to advance well after corporate profits peak and can rise throughout the Zone of Risk well into a recession (Chart 1).
Equally important, corporate liquidity also deteriorates during the Zone of Risk. In the months and quarters leading up to a recession, stock prices are vulnerable to earnings-related market revaluations and/or credit events prompted by deteriorating liquidity.
In the 2015 Zone of Risk report, we used the financing gap, which compares trends in internal cash to capital investment, as our preferred measure of corporate liquidity. In the current report, we extend this concept to include the whole balance sheet.
Specifically, we use the Federal Reserve’s Flow of Funds measure of net lending less miscellaneous assets for the nonfinancial corporate sector.1 We regard this as a more comprehensive measure of corporate liquidity because it takes into account the full scope of balance sheet management, including stock buybacks.
Stock buybacks have become an important and highly cyclical use of corporate cash. Whereas capital investment can run up to as much as $1.8 trillion at an annual rate, stock buybacks can equal another 20 to 30 percent of that amount.
Stock buybacks were running at about a $400 billion annual rate in mid-2017 and had been as large as $640 billion in mid-2016. The balance-sheet effects of stock buybacks, which increase dramatically over the cycle, are moderated to a great extent by offsetting corporate bond financing (Chart 2).
The effect of stock buybacks is particularly striking in the current cycle. Companies have suppressed working capital and capital investment in order to manage their cash. Thus, the more traditional financing gap hovers around zero.
Including the cash requirements associated with stock buybacks changes the picture considerably. While corporate liquidity deteriorates as the economic cycle progresses in both measures, the broader balance sheet measure of net lending has declined much more during this cycle than in the past because of buybacks (Chart 3).
Experience shows that equity valuation methods yield uncertain results at best, and are misleading at worst. Corporate profits closely track S&P earnings, both of which plateau as the cycle advances (Chart 4). As with many financial concepts, there are no good gauges of peaks until they are well established. Equity valuations are particularly fraught because they focus on forward earnings, which are always some multiple of the present.
Price-earnings ratios are also used to assess stock market risk. Here again, there are few calibrations for how high is too high.
The most significant contribution in this regard comes from Nobel Prize Laureate Robert Shiller, who presented his cyclically adjusted price-to-earnings (CAPE) ratio in his 2000 classic Irrational Exuberance.2 Despite the fact that the CAPE ratio is higher today than at any time since 1880 (with the exceptions of 1929 and 2000), Shiller himself cautions against drawing dire conclusions in the short term. In the long term, however, the market looks expensive, according to Shiller.3
The Zone of Risk framework shows that stock prices play a critical role in economic and financial stability both because of their own effect on wealth and because equity markets lead valuations in real estate markets. In the current zone, we make the following observations:
These conclusions argue for a stock market reset in the next year. The Zone of Risk is already a year longer than the past two cycles — due in part to a minor uptick in the downtrend in the equity and wealth cycles. Still, despite market optimism, these reversals are barely perceptible and appear to be small shocks in an overall deteriorating wealth trend rather than the beginning of a new cycle.
1 We exclude miscellaneous assets because they are mostly related to merger and acquisition activity, and thus highly variable, and contain intangible assets that do not constitute collateral that are subject to liens.
2 Shiller, Robert J. Irrational Exuberance. Princeton University Press, 2016.
3 Shiller, Robert J. “Caution Signals Are Blinking for the Trump Bull Market.” The New York Times, March 31, 2017.
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