US Strategy Weekly: Debt and Ownership

The 2020 gains in the popular indices are remarkable, yet surprisingly disparate. The Dow Jones Industrial Average is up 5.8% year-to-date. The S&P 500 has done somewhat better with a 14.4% gain. A sharp end of the year advance in small capitalization stocks drove the Russell 2000 to a year-to-date gain of 17.5%; however, it is the technology-laden Nasdaq Composite that is this year’s hard-to-beat champion with a 40.4% year-to-date gain. The Nasdaq’s performance has been extraordinary in 2020 and we would note that some bull market cycles do not experience a 40%+ gain and over the last 90 years the average gain in the S&P 500, prior to a 10% correction, has been 58%. Perhaps more significant is the fact that this 40.4% gain is nearly seven times the advance in the Dow Jones Industrial Average for the same time period. Since the March 2020 lows, the Dow Jones Industrial Average and S&P 500 have rebounded 62% and 65%, respectively. After recording fresh new highs this week, the Nasdaq Composite and the Russell 2000 have rallied 84% and 95.5%, respectively off those lows. It has been a spectacular year for investors, particularly since it also included the worst recession since the Great Depression and a bear market in earnings.

Investors have written off 2020 earnings and instead focused on the projected rebound in 2021 earnings. But even so, the stock market is not cheap. It is pretty clear that third quarter earnings estimates were better than expected but with third quarter earnings season practically complete, estimates are now stabilizing. In the week ended Friday, IBES consensus estimates rose $0.12 for 2020, $0.33 for 2021 and $0.43 for 2022. S&P Dow Jones consensus estimates were relatively unchanged and increased $0.05 for 2020 and $0.01 for 2021. Overall, the consensus estimates for 2021 are currently $169.18 for IBES and $166.20 for S&P Dow Jones. If one applies a 20 multiple to the IBES $169.18 forecast, it equates to an SPX target of 3384 for yearend 2021. The stock market is currently 8.5% above this target. While it is possible that earnings could outperform 2021 estimates, it seems the market has already factored positive earnings surprises in to current prices. More specifically, at SPX 3695, the 2021 year-end forecasted PE ratio for the S&P 500 is 22.2 X. The trailing operating PE ratio is 30.6 X which is higher than the June 1999 peak multiple of 29.3 X and the December 2001 peak multiple of 29.6 X.

Liquidity Wins
While we are worried about rich fundamentals, it is clear that the stock market is being driven by liquidity and as we have often noted it is not wise to “fight the Fed.” However, the market is priced for perfection, could be vulnerable to unexpected shocks and caution is warranted. As noted in previous weeks, some of our long-term indicators suggest that the market is apt to underperform over the next twelve-month period. However, this “underperformance” does not mean 2021 is destined to be a boring market. The new year could be an unusually volatile time including at least one big advance and a large decline. If so, investors should stay alert. It is wise to have stocks in one’s portfolio that can weather the volatility ahead and/or are good long-term holdings for good and bad times.

Assessing Debt and Ownership
Given our concerns about a liquidity driven market we are focused on factors that help define an equity bubble such as leverage, debt, and equity over-ownership. The Federal Reserve released financial data last week for the third quarter and it held few surprises.

Federal Debt Levels are Worrisome
Total outstanding US debt was a record $59 trillion in September, up from $53.9 trillion at the end of 2019. US debt represented 280% of nominal GDP in the third quarter, is up from 248% at the end of 2019 and is greater than the previous record of 273% of GDP recorded in 1933. See page 3.

Federal government debt grew at an annualized rate of 11.4% in the first quarter, 59% in the second quarter and 9.1% in the third quarter. It was a record $22.5 trillion in September and jumped from 87% of GDP in June to 106.3% in September. This compares to the record 110.3% of GDP recorded in 1944. Rising government debt is not a surprise given the fiscal stimulus provided during the shutdown; however, they are concerning when put into an historical perspective. See page 4.

Household debt is the second largest sector after the federal government, and it grew 5.6% in the third quarter due to an escalation in mortgages. The household’s total debt was nearly $16.2 trillion in September and represented 76.5% of GDP. However, this percentage is well below the 98.2% of GDP seen at the end of 2008 prior to the financial crisis in mortgages. In general, household debt has been fairly contained in 2020. The financial sector is also in good shape and its $17.3 trillion in debt represents 81.9% of GDP and is well below the 2008 peak of 123.7%. A healthy banking system is important for the overall economy and so is a financially stable household sector. Corporate debt actually declined in the third quarter after double digit growth in the first two quarters of the year. See pages 5 and 6. All in all, there were few surprises in this year’s debt accumulation, most of which has been due to fiscal spending. Our main concern for federal deficits would be sharply higher interest rates which would compound federal deficits going forward.

Stock Ownership Helps Net Worth but Needs Monitoring
The Federal Reserve also released household net worth and equity ownership data last week. After increasing a solid 12% in 2019, household net worth increased 4.4% in the first three quarters of 2020 to $123.5 trillion. In 2019, the increase in household net worth was due primarily to a 27.5% increase in equity holdings. In 2020 the increases in household net worth were a combination of a 16.6% increase in cash, due in large part to fiscal stimulus, and a 5.5% increase in tangible assets, primarily real estate. Equity holdings only increased 3.3% in the nine months ended September. This may be surprising to some, but remember, in the first nine months of the year the SPX gained 4.1% and the DJIA lost 2.7%. In short, it was a dull first three quarters. But we expect stock market gains will boost household net worth in the fourth quarter.

We are closely watching the relationship between equity and real estate ownership within the household sector. It is normal for residential real estate, or a home, to be a family’s main asset and thus represent the main pillar of net worth. But in the third quarter, the household sector showed equity holdings of $35.6 trillion, an amount that easily exceeded real estate holdings of $31.2 trillion. Since 1952, there have only been four other quarters in which equity ownership was greater than real estate ownership. These were the fourth quarter of 2019, the third quarter of 2018, the first quarter of 2000 and the fourth quarter of 1999. Each of these previous quarters were followed by sharp stock market corrections. More important, the two back-to-back quarters of high equity ownership in late 1999 and early 2000 represented the end of the 1997-2000 stock market bubble. See page 8. This is a worrisome precedent. We are also watching for extreme levels of equity ownership relative to total assets which could represent a saturation of demand. This can be measured as equities as a percentage of total assets and/or as a percentage of financial assets. In the third quarter, equities were 25.4% of total assets versus the 2000 peak of 26.4%. Equities were 22.6% of financial assets versus the March 2000 peak of 24.2%. Given the rally seen in equities in recent months, these percentages are apt to increase in the fourth quarter. In short, it is possible that equities are approaching an over-ownership situation. See page 9. In sum, the current advance has excellent momentum, but be alert to any and all pitfalls.

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