The S&P 500 is faking growth

Ten years ago, during the housing boom, the consumer was the most leveraged entity, taking out negative amortization mortgages, cashing out home equity, things like that. The consumer got a margin call, which was ugly—you know the story—and has spent the last seven years deleveraging.

While the consumer was taking down leverage, the US government was adding leverage, taking the deficit to over 10% of GDP at one point. But for the moment, even the government is deleveraging. 

Now it is America’s corporations that have been adding leverage at a furious pace. We’re on track for the fourth consecutive year of record-breaking corporate bond issuance.

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So when corporations sell bonds, what do they typically use the proceeds for?

In theory, the proper use for debt is to finance capital expenditures. Growth. But in this last cycle, that’s not what the money has been used for. Much of the borrowed money has gone into stock buybacks and dividends.

In fact, this year marked the largest net shareholder distribution for the S&P 500 (ex-financials) in ten years, which amounted to $196.3 billion in the third quarter.

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383 companies on the S&P 500 index bought back shares in the Q3, according to FactSet. And 130 of those companies spent more money on buybacks than they earned in the previous twelve months—the highest level since January 2009.

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Meanwhile, fixed capital expenditure dropped by 4.7% and totaled $157.1 billion in the same quarter, while the energy sector led the way with a 33.3% year-over-year drop in fixed capex.

It was the second consecutive quarter of declining fixed capex for the S&P 500.

Tweaking Balance Sheets with Borrowed Money

Now, there are good corporate finance reasons to lever up a balance sheet and conduct stockholder friendly actions, like buying back stock or paying dividends.

You can read about it in the corporate finance textbooks. For any company, there is an optimal amount of leverage. It’s even possible to be underleveraged.

But when you take out debt to buy back stock, leveraging the balance sheet in the process, you may be increasing the optics of how profitable the business is by increasing earnings per share. However, you are not actually changing the fundamentals of the business.

You are not actually increasing profitability. You are just rewarding one tranche of capital structure (common stockholders) at the expense of another one (bondholders).

This Can’t Go On Forever

In the short term, you can conceal from investors the fact that your business model is broken and you don’t have a plan. You can conceal it for a number of years, in fact.

That is the thing about finance; you can suspend the laws of economics in the short term, but not forever. It will always come back to haunt you.

There’s been so much debt issued—at such unfavorable terms and at such low interest rates—that the credit markets are more vulnerable than at any point in history. The warning signs have started to show in the junk bond market recently.

If we get even a mild recession then we are looking at 20% default rates. All it takes is a push.

Much of the 200% move in the stock market off the lows has been divorced from economic fundamentals and based solely off of financial engineering. It’s a self-reinforcing process that has worked for a while, but I don’t want to be around when it stops working. 

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A master in behavioral economics, Jared probes the mind of today’s market to gauge the trends of tomorrow. Following his intellectual adventures is a true thrill ride for every investor. Subscribe to his free weekly newsletter and don’t miss another one of his captivating conclusions.

Read the original article on The 10th Man. Copyright 2015.

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