John B Lounsbury CFP：After declining by more than 5% in the Grea

I apologize for the lengthy title. Brett Arends a started my thought process going and I ended up covering a lot of bases.

Brett Arends has an excellent article at Market Watch concerning many widely quoted and generally believed statements about the soundness of U.S. companies which are actually misleading. You've heard of the famous $1.8 trillion in cash that corporations are sitting on? Well, I bet you haven't heard about the $7.2 trillion in debt for these same companies, an all-time record. And we are not talking about the infamous Wall Street ogres here - these numbers are for U.S. nonfinancial companies.

Arends reports that a record has also been set for the ratio of debt to net worth, as shown in the following graph (click to enlarge images):



It is clear that U.S. corporations are not trying to correct a credit bubble; they are just blowing it bigger than ever.

Picture may be Distorted

The Smithers & Company graph above may be distorted by a decline in the net worth denominator. For example, if we assume that market capitalization has a constant ratio to net worth (a very gross assumption), market capitalization today is about 77% of the value at the 2007 high. If that ratio is applied to the 48% ratio shown in the graph the leverage is reduced to 37%. Caution: this 37% is simply offered as a point of discussion. Without access to the data behind the graph I can't offer something more definitive.

However, the suggested possible 37% leverage would not reflect a necessarily benign situation. Corporate debt has increased by $1.1 trillion since 2007 and has doubled in dollar amount since the late 1990s.

Loans are Down

Corporations have been cutting back on loans over the past two years, as shown in the following graph from the St. Louis Fed :



C&I (commercial and industrial) loans are approximately the same in outstanding principal as in early 2007 and actually about $150 billion less than the end of that year. Where has the growth in debt come from? Primarily from the issuance of corporate bonds. Investors have become increasingly risk adverse and the market keeps soaking up new bond issuance. And, increasingly, corporate issuance has been competing favorably with Treasuries.

Just this week, for example, IBM issued $1.5 billion in three-year notes with a 1% coupon. This is 20 bps (basis points) above the three-year Treasury at 0.80%.

Bond Bubble?

The Motley Fool has suggested that there may be a bond bubble forming and offers the following table of recent long-term corporate bond issuance to support the argument:



Two points about the data in the table:

1.Corporate bonds are not paying a lot more coupon than Treasuries (75 to 100 bps).
2.With assumed dividend increases bonds coupons will return less than dividends prior to maturity.
Investors appear to be assuming that there will be a depression.

This behavior is generally considered to be risk aversion. However, there is a risk assumed by these low yield long-term bond investors: inflation risk. If there is inflation anytime over the next 10-18 years, equity values may appreciate to at least partially compensate. Bond holders will receive an uninflated principal at maturity.

Why More Debt?

I think the simplest answer is like the George Mallory quote about why he kept returning to try to climb Everest: "Because it is there." Corporations may simply be taking advantage of historically low interest rates for no other reason than the money is there. It would be a good thing if this borrowed money were being put to good use to develop future production. That does not appear to be happening. After declining by more than 5% in the Great Recession, the private domestic investment component of GDP has recovered by only 1.8%, and 1.4% was in inventory build, not investment for future production.

I don't think that it is any coincidence that nonfinancial corporate cash "hoard" of $1.8 trillion is just $700 billion larger than the $1.1 trillion increase in corporate debt since 2007. Once the balance sheet is sorted out, a significant part of the "cash hoard" is an illusion.

Declining Usefulness of Debt

This section title is the same as an article written in the spring of 2009. Below is a graph from that article that has been recreated in various forms by others since and widely circulated in the blogosphere:



Note: This relationship was not originated by me, but has a deep history, some of which was outlined last year .

It is not likely that the recent increase in corporate debt will do anything to reverse the 45 year decline shown in the above graph. An increase in production is required. Padding the asset side of balance sheets and increasing debt for consumption are actions that simply drive the curve lower.

The Deflation Ogre

The risk that is on the front burner is that of a deflationary spiral. This is the focus of Fed policy and the Obama administration. In spite of all the actions to increase liquidity and to stimulate economic activity, response appears to be tepid. The primary activity stimulated has been concentrated in the upper income levels. There has been a double digit percentage increase in the population of millionaires based on liquid assets over the past 18 months. See report from

CNBC Power Lunch.

During the same time the number of employed has stayed depressed under 140 million and there has been a squeeze on real disposable personal income, shown in the following graph from the St. Louis Fed with added notation by the author:



While there are definitely deflationary pressures evident on Main Street, the efforts to combat them has largely been felt on Wall Street.

In the language of Dickens, it is the best of times and it is the worst of times. (Tale of Two Cities).

Disclosure: Long IBM and several other S&P 500 stocks. Long and short positions in some Nasdaq stocks.
About the author: John Loun*****ury John B. Loun*****ury Ph.D., CFP is a financial planner and investment advisor in Clayton, NC. Company: John B Loun*****ury CFP
Blog: piedmonthudson.wordpress.com