Corporate Debt / Market Cap as a predictor of forward returns

Earlier tonight, Matt Busigin tweeted a link to the series "Credit Market Debt as a Percentage of the Market Value of Corporate Equities" from the FRB's Z.1 report. After some back-and-forth with some other folks, Greg Merrill suggested that high debt to market cap looked like it it would correlate positively with forward returns. Intuitively, this works because, if we assume creditors are generally somewhat rational about underwriting standards, a sharp increase in Debt / Market Value would signify a sharp decrease in the value of equity from a level at which underwriters thought it was safe to lend. Stepping back, what we would be doing is measuring the "fair value" using debt as a proxy. 

After thinking about it for a few seconds, I decided to plot our the series against annualized forward returns, shamelessly mining for the forward period that offered the best correlation. After starting with 5y (R=0.5985), 7y (R=0.7069), 10y (R=0.8411) and 11.5y (R=0.8677). After peaking at 11.5y (46 quarters) the correlation starts declining again.

The actionable value of this exercise is questionable given the small sample size but, in my opinion, probably reflects the rational behavior of lenders and CFOs regarding debt levels.  The average Debt / Market Value ratio for the sample is 57%, which is 9.1% higher that the latest (Q3) reading of 47.9%. Since the end of Q3 the Wilshire 5000 has risen 6.84%, representing a market-cap increase of $1,229 billion. We currently have no estimate for net corporate debt issuance since the end of Q3 but, if we extrapolate Q3's 2.2% increase, we get an estimate of a current 45.8% debt to market-cap ratio, which would correspond to a pretty average 7.8% annualized forward return for the next 11.5y. This expected return stands in sharp contrast to much lower expected returns obtained with similar methods by John Hussman using non-financial market cap as % of GDP and the Price/Sales ratio of the S&P 500  as predictors. I should note here that this expected return also lies significantly above my own 10y expected return of just 4.5%.

Of course, the current Debt / Market Value lies in a particularly dense zone with significant dispersion, which--when combined with the 2.45% standard error of the linear regression--should give us pause as to the reliability of any such measure. In this particular casse, the expected total holding period is 132% and the -1 and +1 sd  bands would lie at 82% and 207% respectively--not exactly a Swiss watch.

How Much is $1 of Earnings Worth?

Investors often treat reported earnings as the "yield" of equities due to the wide availability of reported earnings and the ubiquitous Price-to-Earnings ratio, however this can be a misleading measure of the actual economic value created for shareholders if earnings are overstated during cyclical upturns and the subsequent adjustment during downturns is reported as one-time items or direct-to-equity adjustments. I propose an alternate measure, a sum of the change in reported book value and dividends paid out as a proxy for the economic value created in a period.

Over the last 22 years, every $1 of S&P500 reported earnings has only led to $0.76 of dividends + book-value gains. If you exclude 2008, the year in which reported earnings and the alternate measure previously described differ most, every $1.00 of earnings generates only about $0.84 of economic value to investors. The sample, admittedly limited in size, was obtained using Bloomberg. Bold red line indicates a slope of 1, lighter black line is a simple OLS regression trend-line with no intercept.

Change in BV + dividends vs reported earnings

Change in BV + dividends vs reported earnings ex-2008

EDIT: A reader helpfully pointed out that I left-out the effect of buy-backs, which accrue to the price of shares but are functionally equivalent to dividends. Lacking a time-series of total buy backs, I can't correct the post to include that. Additionally, any buy-back made at a P/B multiple of > 1 would  dilute BV per share. Assuming book value is understated is a reasonable assumption for companies where marginal investment turns out to be profitable or during inflationary periods where the nominal value of capital stock is understated as a result. My apologies for these careless omissions. I will not remove the post, but I think it is worth noting that these omissions make the prior analysis basically useless.

Just a small note on $NFLX and growth rates

According to the U.S. Census Bureau, the average household size is 2.6 people and the total US population is about 312,000,000, which gives us an approximate 120,000,000 households. If Netflix (NFLX) has 20,000,000 subscribers that is one-sixth of the households in the US. One-sixth might not seem like much, but take in mind only about 58% of American households get cable and Canada only has like 13M households.

According to this Arstechnica post, the U.S. has about a 60% broadband penetration rate. According to PEW Internet, this is closer to 66%. That gives us a total target market of 79.2 million households for "watch instantly", of which Netflix already captures 25%. While broadband penetration is likely to continue increasing, and so is the population, I would think that eventually their growth is becoming seriously limited in the U.S. While netflix does have some tailwinds in it's favor--like computer processing power getting cheaper and cheaper every year--barring signs of international expansion (outside of it's recent entrance into Canada), it seems to me like the growth rates like we've seen in the past will soon be history.

Let's look at what ValueLine has to say on growth rates:

OK, so revenues can grow from increasing prices, buuuuut, I feel like everyone I know with Netflix is actually downgrading it since "watch instantly" is generally good enough and the whole mail thing for newer titles just does not appeal to the instant gratification we want. We can just rent it from iTunes!

But, seriously, assuming no further price hikes and stable revenue-per-subscriber, we are talking about a tripling in the subscriber base to 60M. You may be thinking that's totally doable, but take in mind iTunes and Hulu are becoming real competitors, oh, and there's also that Cable TV thing...

I mean, if you want to buy the stock, whatever, I don't care, just keep in mind that fantastical growth rates are  not going to continue forever, at least not without international expansion. If you are buying NFLX betting pretty soon people in Europe, and Australia are all going to be watching Netflix, that's cool, just remember that outside of the rich first world, demand is likely to be very limited. Oh, remember that even if competitors eat Netflix's dust, you can bet your ass content providers will keep on trying to squeeze every dime they can out of Netflix, so keep an eye out for some compression in that net margin.

I mean NFLX is cool, it's one of my favorite services and I've been a paying member since it's first year of existence, but at the end of the day, it's just a content delivery method. Just like Hulu or cable or the FiOS TV service. The comparative advantage in the company lies in their recommendations and ratings database. Right now, they are using it as a way of keeping people from switching--nobody wants to lose all their ratings--but that's not a good long-term strategy. That data is a marketing and targeted recommendation wet dream and I'd love to see them find a way to monetize that. Amazon and Apple seem like the perfect candidates for that, as they would get the biggest benefit out of being able to deliver higher-quality targeted recommendations, but they are also competitors in the space, so I foresee no friendly cooperation in that space. If , however, Netflix suffers a sharp correction, I wouldn't at all be surprised to see an acquisition taking place.

Shut-up, WSJ: Bernanke Puzzled by Gold Rally

The WSJ reports:

“I don’t fully understand movements in the gold price,” Mr. Bernanke admitted. But he suggested it might be another example of investors fleeing risky assets and flocking to assets that are perceived as less risky, not only Treasury bonds, but also ones like gold.

It also might have to do with that quantitative easing (e.g. money printing) thing. Or maybe that competitive devaluation (e.g. fiat currency race-to-the-bottom) thing we are experiencing. We havn't seen major effects in price-levels as a result of the money printing because of both a lack of demand for loans, which has kept the money supply from materially increasing, but that doesn't mean people like it when you indiscriminately print money to buy $2 Trillion of shitty agency paper, Mr. Bernanke. Or, maybe, it's just a bubble.

In case you think you are just so smart buying gold to protect yourself from inflation and stick it to the man, you are not. The collectibles tax on bullion is 28%. That means that if the currency collapses and gold goes up 500% your nominal gain is 360%. If prices increase by 400% in addition to this, your real return is actually -8%.