Baldwin Investment Management

Two Measures…

We have commented in the past about how unloved the stock market’s rally has been since 2009. “Walls of worry” have been climbed by some investors (i.e. those who kept “the faith”) as setbacks in markets around the world were sparked by currency worries, debt concerns, political machinations, trade wars and even viral pandemics. Despite all these dilemmas, corporate sales, earnings, cash flows and dividends kept rising for most companies while at the same time interest rates worldwide declined. This has been and is a powerful combination of support for equity prices and even today, while not inexpensive, stocks are not as expensive as they have been in the past, especially when considering the current level of interest rates.

Chart 1

Source: Online Data Robert Shiller

As the reader will note in Chart 1, long term interest rates as represented by the 10-year U.S. Treasury yield are at their lowest level ever since 1880. In the year 2000, the normalized Price/Earnings ratio (P/E) using 10 years of earnings on a rolling basis was nearly 45X and interest rates were about 5%. Today, the P/E ratio is 30X and interest rates are <1%. With interest rates this low, investment alternatives to stocks (like bonds or cash) seem unattractive and equities would seem to have more room to run.
How do people, companies or nations go bankrupt? Too often the analysis stops at looking at the amount of debt owed by an entity or a person. Indeed, the level of debt owed is important. But more important is the amount of debt service, i.e. the interest payments that need to be made to service the debt and that number vs. Gross Domestic Product (GDP) in the case of a country analysis. Since the Great Recession of 2009, pundits have worried aloud about ever rising debt levels in America – and well they should for someday that debt will have to be repaid. In fact, the outstanding debt balance of the U.S. government is approximately at the same level it was after WWII as a percent of GDP: 110% of GDP. That’s a scary number, but we hasten to add the U.S. survived before with that level of debt. So, while the absolute level is staggeringly high, the servicing of that debt is not so daunting as seen in the following chart.

Chart 2

The important point we want to make is that as long as any borrower has enough liquidity to service debt, no matter how large, then that borrower will not go bankrupt. The U.S. has a “debt habit” which needs to be broken. Unfortunately, this is not the time in the economic cycle to be tackling the problem, as the U.S. is in a recession. Happily, because interest rates are so low and according to the Fed, they are slated to stay low for a couple of years, America can easily service its debt burden. So, we are not concerned about this issue right now, but no one should remain complacent.