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2022-09-16 07:00 by Karl Denninger
in Market Musings , 2301 references Ignore this thread
The Simple Facts On Equities And Debt
[Comments enabled]

No, the market is nowhere near a "buying point" or "bottom."

In fact its probably overpriced at 50% of today's prices -- even with the dump so far.

Here's why.

Have a look at that chart.

Corporations basically never pay off debt; they always roll it over.  Since 1980, roughly, the cost of money has always been cheaper, so every time that bond comes due and has to be rolled over the amount of money you must pay in interest on the new one is less.

This in turn means the amount the corporation pays in interest goes down and that means "E", or earnings, go up.

But -- this cycle presumes that rates will never rise.  That is, at worst the downward movement will cease, but never go the other way.

Why?

Because if it does (and it is and has for the last six months or so) then every time your bond comes due now you need to pay more in interest on the new one that replaces the old and that makes "E" go down.

"E" is simply what's left of what you take in after you pay expenses, of course, and if you have debt outstanding interest is one of your expenses.

People say The Fed "can't" raise rates.  Well, they are.  And worse, the TNX, 10 year Treasury, broke range and is likely headed to about 5% which means a "AAA" corporate bond should carry a coupon of somewhere between 5.5-6% because no matter how good that credit may be it is inferior to the US Treasury.

When the best credits out there roll over the next time, which they all will within the next couple to ten years, they will pay that 6% where they were paying 2 or 3%!  The only other option is to redeem the bond entirely which means forking up the face value in cash.

Take a firm that is regard as very well-managed -- Berkshire.  They have $119 billion in debt outstanding, and are certainly a AAA credit.  Let's assume that $119 billion currently carries a 2% coupon, so $2.38 billion in interest expense a year.  The firm's net income is $11.7 billion so what happens if the cost of carrying that debt doubles (say much less triples.)

That's a 20% whack off the earnings; if the cost triples its a massive 40%.

How does the "current" 58 P/E sound to you or even the so-called "forward projection" (commonly called a guess) if the earnings crash by nearly half?

Yeah, that's what I thought.

Oh, and this ignores input costs, which of course you can't.

As another example look at FedEx which reported last night.  Revenues largely met expectations but EPS missed by a third.  Where'd that come from?  Costs, obviously.  And, I might add, roll costs, that is, the spike higher in interest expense on outstanding debt are not yet showing up in any material size -- but they most-certainly will over coming quarters and years; it is unavoidable for anyone with outstanding paper.

PS: Given the quality of Berkshire's management and operational expertise what you're going to find in most other firms is worse -- and not a little worse either.  Buckle up.