Look at the slide behind me. The doves keep asking where is the evidence of mal-investment? As you can see, the growth in operating cash flow peaked 5 years ago and turned negative year over year recently even as net debt continues to grow at an incredibly high pace. Never in the post-World War II period has this happened. Until the cycle preceding the great recession, the peaks had been pretty much coincident. Even during that cycle, they only diverged for 2 years, and by the time EBITDA turned negative year over year, as it has today, growth in net debt had been declining for over 2 years. Again, the current 5-year divergence is unprecedented in financial history!

And if this wasn’t disturbing enough, take a look at the use of that debt in this cycle. While the debt in the 1990’s financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments. This is very clear in this slide. The purple in the graph represents buybacks and M/A vs. the green which represents capital expenditure. Notice how the green dominates in the 1990’s and is totally dominated by the purple in the current cycle. Think about this. Last year, buybacks and M&A were $2T. All R&D and office equipment spending was $1.8T. And the reckless behavior has grown in a non-linear fashion after 8 years of free money. In 2012, buybacks and M&A were $1.25T while all R&D and office equipment spending was $1.55T. As valuations rose since then, R&D and office equipment grew by only $250b, but financial engineering grew $750b, or 3x this! You can only live on your seed corn so long. Despite no increase in their interest costs while growing their net borrowing by $1.7T, the profit share of the corporate sector peaked in 2012. The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18X for the asset class

Eoin Treacy's view

Here is a link to both transcript and the slides associated with the above presentation. 

The bearish points discussed by Stanley Druckenmiller above echo those discussed in the Subscriber’s Audio and in Comment of the Day over the last number of weeks and months but this fleshes out some of our concerns with hard figures. 

MBA syllabuses recommend financial engineering such as refinancing higher cost debt, buying back shares and raising dividends as efficient uses to which capital can be put not least because they help to support share prices. However the question from a medium to longer-term perspective is to what extent expansion, capital investment and R&D can compete with these objectives. 

The first group reap immediate short and medium-term benefits while the second group are more medium to long-term in nature. Considering the pressure boards are under to deliver quarterly results it is little wonder they tend to overweight the former rather than the latter. 

The fact this practice od debt expansion is global in nature is another major consideration. Europe is paying borrowers to take loans in an effort to avoid stagnation. Japan is betting everything on being able to reignite growth and inflation while China has been extending credit to support a zombie SOE sector. Rather than highlight the problems let us focus first on what a catalyst might look like that has the capacity to shake the status quo and secondly how likely it is to occur soon. 

In the USA, Velocity of Money has been trending lower since 1997. Expansion of the monetary base was justified in order for the Fed to achieve its mandate of promoting growth. However with a balance sheet of $4.5 trillion quite what the Treasury is going to do when large numbers of bonds need to be refinanced especially if that has to happen at higher rates is very much open to question. The most expedient solution would be for the Fed to simply cancel the debt as a book entry since the monetary expansion was but one arm of the government lending to another. However it represents a significant issue and corporations do not have printing presses like central banks.  

If we look at which asset class is likely to cause a problem, the bond market is where the clearest contradiction lies. Quite simply the market has been on a momentum fuelled rally based on the supposition that limitless quantities of bonds can be issued without ever having to worry about paying back the principal. As with any mania, anyone really worrying about the contradiction is considered a crank, crackpot or fool until the turn occurs and people begin to lose money. 

Negative interest rates in Europe and Japan, while the USA is beginning to normalise policy represents a major change in the ubiquity of monetary policy evident over much of the last decade. The fact margin debt appears to be rolling over and that this was also coincident with major stock market peaks previously is not something that can be ignored. 

Nevertheless, while we might agonise about the issues facing the global economy, bond and stock markets, the reality remains most central banks are still pumping and the USA is still a long way from tight monetary policy. Major refinancing is not required by the corporate sector for at least a couple of more years. Therefore it is more important than ever to monitor the price action because that is the only reality check that matters. Unless all the worries I have written about above gel with the price action they are irrelevant.  

The Dollar Index has now unwound its oversold condition relative to the trend mean so some consolidation of recent gains is looking likely. That should offer some respite to stocks but the Dollar has medium-term tailwinds that are likely to limit any pullback to a consolidation rather than a reversal.