Debt is to markets what opium is to addicts. Each debt injection is a rush, the sensation of prosperity created out of thin air. After 30 years of piling on debt ever higher, it looks like the bender is coming to an end: Since the financial crisis, households and corporations have begun to hack away at their debts, while rich-world governments are solemnly promising austerity -- eventually.
After several years of pain, it's natural to think vigorous recovery is around the corner. This nicely fits the historical experience, where deep recessions are soon followed by brisk growth. However, recent history is misleading at best. The best analogues to the U.S. economy's current state are the latter half of the Great Depression and Japan's own lost decade, when debt binges gave way to painful decade-long deleveragings. From this perspective, U.S. stocks look worryingly overvalued.
A long slog
It's helpful to understand how the U.S. ended up with so much debt. Some of the blame rests with democracy. Politicians get elected by promising more bread and butter now, and the easiest way to do that is to borrow money or quietly underfund future liabilities (like pensions and entitlements). Our stateside neighbours aren't alone. Nearly all the big, modern democracies have accumulated massive debt and even bigger unfunded liabilities.
Encouraging democracy's spendthrift tendencies is the fact that debt creation leads to a temporary rise in incomes and asset prices as debt is recycled through the economy, gulling borrowers and lenders into thinking it's safer to assume even more debt. The process snowballs, often for decades, until debtors can no longer roll over their debts, leading to financial crisis. Economist Hyman Minsky dubbed this process the "financial instability hypothesis."
The chart that follows shows on the left axis total U.S. debt, both public and private, as a percentage of gross domestic product and on the right axis after-tax profits of the financials sector as a percentage of GDP. For most of U.S. history, total debt/GDP stood at less than 150%. However, system-wide leverage surged in the 1980s and again in the 2000s, thanks to a mix of financial deregulation and "innovation," massive deficit spending, and loose monetary policy. It peaked at 386% in late 2008.
Normally, deleveragings last until debt levels are brought back to historically "normal" levels -- for the United States, probably less than 200%. After three years, we've brought total debt as a percentage of GDP to only 355%. At current rates of deleveraging, it will take about a decade to get back to the pre-debt bubble leverage. This has typically been the case in past great deleveragings.
The sheer size of the debt bubble has fooled many into thinking that the past three decades are representative of how the economy and stock market will behave in the future. Investors who are used to 10%-plus annualised returns for risk assets have set their expectations too high. The world stock market produced only 4% to 5% real returns over the past century. During the long leg up the leverage cycle, the market grew much faster than that. On the leg down, a reasonable expectation is that it will grow more slowly. In particular, the past decade's surge in corporate earnings seems unsustainable. Aggregate after-tax corporate earnings as a share of GDP doubled to 10% today from the historical average of 5%. Warren Buffett himself said one had to be "wildly optimistic" to believe corporate profits can stay above 6% of GDP for very long.
Adjusting for leverage-induced earnings growth has startling valuation implications. One of my favourite valuation measures, Shiller P/E, averages real earnings over 10 years to smooth out the business cycle. With the S&P 500 touching about 1,300, Shiller P/E is about 21 -- 30% above its historical mean. A common criticism of the Shiller P/E is that it captures earnings hits from the 2008 financial crisis and the tech bubble's aftermath. However, the actual earnings figures show a different story: The dot-com bubble barely registers, and the unprecedented surge in profits before and after the 2008 financial crisis more than swamps out the sharp dip. If anything, Shiller P/E overstates the attractiveness of U.S. equities by almost exclusively capturing the past decade's abnormal, leverage-induced earnings surge. Worryingly, much of the earnings surge came from the financials sector, which benefits the most from rising debt.
Some might be wondering if my premise is correct. Perhaps the doubling of corporate earnings over the past decade can be explained by growing foreign sales. Of the S&P 500 firms that break out foreign and domestic sales, 46% of their 2010 sales came from abroad. Problem solved? Hardly. Two problems: 1) In 2003, before the huge earnings surge, foreign sales were 42% of total sales; and 2) only companies that do significant business abroad break out sales by region. If you compare total foreign sales with total S&P 500 sales, foreign share falls to 25%. Let's not neglect the fact that the majority of sales have been to other rich-world economies, which have also leveraged up over the past few decades.
Of course, it's possible we can avoid slow earnings growth. Productivity could surge thanks to new technological breakthroughs, emerging markets could buy more American goods, or maybe policymakers can keep the printing presses running. (Who says the party can't go on for another few years?) However, in my estimation, the odds tilt against a deus ex machina sustaining equity returns over the next decade.
Taking someone else's cake
The slow market growth implied by deleveraging is worsened by two trends, one inevitable and the other merely likely. The inevitable is the greying of America; retiring baby boomers liquidating stocks for bonds will push equity prices down, and they'll begin drawing upon Medicare. The likely outcome is higher taxes. In order to succeed, investors will have to save a lot more or outwit others. Implications of this new reality aren't pretty.
1) Buy-and-hold strategies won't re-create their respectable historical returns; investors have to work harder.
2) Lowering costs of all kinds -- taxes, trading spreads, expense ratios -- matters even more than before. A 1% expense ratio in a 4%-5% expected return environment is a risky proposition.
3) With downside risk higher and more likely to be permanent, buying an overvalued asset can punish your portfolio with little prospect of fast recovery.
4) Defensive equities -- those not dependent on sustained economic growth -- are a good idea.