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Chart In Focus

Debt vs. Equity

Chart In Focus
November 26, 2015

I came across this chart this week on FRED.  For the uninitiated, FRED is the Federal Reserve Economic Database, operated by the St. Louis Federal Reserve Bank.  It is a genuine treasure trove for those who are into economic or financial data. 

Near-zero interest rates have led a lot of companies to issue debt at cheap interest rates, and to then use the proceeds to do share buybacks or other ventures to increase the value of their shares of stock.  Even Apple Corp. has issued debt, despite being a huge cash generator.  So one might reasonably believe that the total amount of corporate debt would be increasing relative to the value of equity (stock shares).

But this chart shows the opposite.  The value of corporate equity compared to corporate bonds is at an overvalued extreme.

The data are quarterly, and the most recent value is from Q2 of 2015.  The units on this ratio make it hard to do a direct comparison to stock prices.  So I downloaded the data, and put it into a spreadsheet to make a better direct comparison to the SP500.  Inverting this ratio makes that comparison much easier to visually evaluate.  

Debt to equity value ratio inverted

With this inverted scale, we see that when this ratio goes below 40% (i.e. higher in the chart on the inverted scale), that tends to mark an overvalued condition for the stock market.  Instances of readings less than 40% (i.e. high on this inverted scale) tend to be associated with important stock market tops. 

Zooming in a bit closer on just the past few years, we can see that the maximum risk for the stock market seems to occur once this inverted scale indicator goes through 40% and then turns down.

Debt to equity value ratio inverted

Seeing the debt versus equity at such an extreme is a bit of a mystery, given all of the reports we have been hearing about corporations issuing debt to buy back stock, which should presumably change that ratio to an undervalued condition for the stock market.  Perhaps it is a case of the bond-issuing companies not being able to keep up with the stock traders who are driving stocks up to higher values.  That’s the best explanation I can come up with. 

In any case, given the data that we have, it is a reasonable conclusion to say that stock prices (and valuations) are not cheap right now.  It does not make me confident about expecting any sort of meaningful upward movement for stock prices, at least not until after we have some sort of cleansing revaluation event (AKA a big price decline). 

Tom McClellan
Editor, The McClellan Market Report

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