Is the Corporate Debt Bubble Popping?

There is a simple reason why no matter what is attempted as a remedy, the current economic recovery is not near as robust as most would expect after five years.

There is also a simple reason why household incomes, the percentage of Americans employed, earnings growth, and pretty much every other economic indicator has slowed, flatlined, or been declining over the last decade.

The reason is this “recovery” has been entirely fueled by debt growth rather than equity growth.

Even worse, debt (NYSEARCA:JNK) has been the primary fuel for the economy now for 15 years and is resulting in a completely different reality from our economies of the past.

Back to School

In accounting 101, there is a simple equation that every student must learn.

Breaking down this equation helps explain what is really occurring in the economy and why if we continue on the current path things will never improve for the average American.  In fact, things will only get worse as equity (NYSEARCA:VTI) stays stagnant or declines at the expense of debt (NYSEARCA:DSU) creation.

One of the basic facets of accounting and the equation above is that when assets rise, either an entity’s (household, corporation, or government) debt (liabilities) or its equity (earnings) must also rise.  Assets must always equal liabilities plus equity, so either liabilities or equity (or both) must grow or shrink along with assets.

In economies past, the asset side of the equation grew because of organic earnings that outpaced debt growth.  Today the equation has flipped as assets are grown by a much larger increase in debt (NYSEARCA:IEF) rather than equity.

The accounting equation above also can be translated to the function below:

When economic entities are bought and sold, essentially their equity is bought.  Prices are paid based on “net debt”, or assets less liabilities which equals their equity value as shown in equation 2 above.  For the household this is referred to as “Net Worth”.  For corporations it is referred to as equity, but essentially equity and net worth are the same thing.

The amount a company is worth is whatever is left over in the assets less liabilities equation just as a person or household’s net worth is what is leftover after all debts are paid.  Any liabilities cancel out any assets, leaving just equity.

The assets of the household, corporate, and government since the year 2000 has expanded because liabilities are rising, not because of equity, and that is a major problem.

Looking at equation 2 above, this means equity and/or net worth is not increasing, and in many cases it is actually declining (more on that below) as liability growth offsets any asset growth.

Debt versus Earnings

In our recently released August ETF Profit Strategy Newsletter, I examined 13 different charts that explained why the current bull market is a façade driven by debt and money expansion and not by sustainable growth (NYSEARCA:IVW) like recoveries of the past.

Do you recall all the news articles about “record cash that is now sitting on corporate balance sheets” that the media keeps touting?

Newsflash: The record cash balance is because record debt has been issued to create that cash (NYSEARCA:VYM), not because of the implied earnings growth.  Today, companies leverage up in order to create cash as opposed to organically creating it from earnings.

WATCH: Proof Corporate Balance Sheets are Not Improving, but are Getting Worse

Did you know that S&P 500 earnings today are only 5% above their peak earnings in 2007 after inflation?  Seven years later, earnings are up less than 1% on average per year!

In fact there has been little real earnings growth since the year 2000, with an average inflation adjusted earnings growth rate of just 2% per year.

On the contrary, check out the following chart (in $Millions) which adds up the household, corporate, and government sector debts.  Since the year 2000 total debt has more than doubled, now approaching $40 Trillion and growing way faster than earnings.

Aggregate of Household, Corporate and Government Debt

Clearly the amount of debt (which must be repaid) is fueling a rise in assets, but how much has debt outpaced equity in America’s balance sheet?

This final chart was one of the 13 included in our recent subscriber research and shows that debt creation is occurring at a much quicker pace than equity creation.

Total liabilities (in red) has more than doubled since the year 2000, but stock market values are only up 30% during the same time.  This increase in debt has done little to the bottom lines and equity values as company earnings today are barely above what they were in the year 2000 or 2007.

The blue line shows that debt creation has far outpaced return on equity since 2000.

Debt Creation Versus Equity Creation

Taking this one step further, pre-2000 debt was issued for value adding projects as equity prices, earnings, and returns outpaced debt creation (the rising blue line above).  This was pretty typical for most decades pre-2000.

Since 2000, though, debt issuance has not contributed to a comparable rise in equity.

This means value (NYSEARCA:IVE) is not being created by the debt issued the last 15 years and is a major change from history, when increases in debt were used to fuel equity creating endeavors.

Instead, no doubt today we are in a debt bubble as debt has been issued not for long-term value adding projects, but instead to take advantage of short term rates for optical gains in asset balances and increasing short term cash on the balance sheet.

Debt is being issued primarily for financial engineering and short term gains rather than out of necessity to grow.  Even worse, eventually debt must be repaid.  Where will that cash come from?

The ETF Profit Strategy Newsletter keeps investors ahead of major market trends.  We use technical and fundamental analysis along with common sense to analyze the stock, bond, commodity, and forex markets.  The huge debt overhang is #2 on our list of 10 Mega Themes.  Check out our latest Newsletter to see the other major themes we are following and what to do about it.