How to lie with data, edition 1,000,007 -- corporate debt to gdp

In yesterday's NBR show, the host showed the following graph of corporate debt to GDP:

He pointed out (1) peaks in the graph coincided with recessions and (2) "now we seem to be at a peak again," in both cases, implying that these debt levels suggest a recession is surely on its way.

Putting aside other causes of recessions, and not making a call on the possibility of a recession, both these points are mistakes, mistakes common to the interpretation of many data series. There also is another issue with the graph.

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On the first point, one should never confuse cause and effect. What most likely is happening is investors' appetite for debt falls during, and in the immediate aftermath of, recessions. Thus, companies cannot issue new debt and corporate debt levels naturally fall. In other words, it is far more likely that it is not the debt causing recessions, but the recessions causing debt levels to fall.

On the second point, there is simply no way to determine in a time series, with no intrinsic a priori natural maximal level, when you are at a peak, until well after the peak. That small declining squiggle could be important or completely irrelevant. Note there was a similar squiggle a bit earlier.

Finally, note the range on the y-axis. The range is too small. By using a small range, the graph looks much more dramatic, though misleading.

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What is most likely happening is with interest rates so low and starting to rise, companies are taking on debt, very likely, long-duration debt. Many companies, in particular large and stable businesses, can and should do this.

Debt has two general concerns -- one is the interest paid and the other is the principal. As interest rates are so low, companies likely have enough cash flow to pay the interest. Even when cash flow levels fall during a recession, with interest rates so low, interest payments are manageable, and companies likely have an ample buffer. Principal is a more serious concern and can put companies out of business in a hurry. Here, intelligent debt management matters. Debt maturities must be spread out, for instance.

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The irony in all this is this variable is very likely not the right statistic, at all. After all, cash may be thought of as negative debt. Thus, net debt, equal to debt minus cash, is far more interesting and relevant. Companies likely have staggeringly large cash balances these days.

Sector earnings for the S&P 500

(Data courtesy of Standard & Poor's)

Generally speaking, stocks follow earnings. For the financials, earnings have been recovering and, not surprisingly, the sector has staged a strong recovery since the mass hysteria of 2008/2009. (Of course, this was after quite a few of them crumpled and the rest were just one Bernanke put expiration date away from purgatory.)

Volatile earnings trends are more suited to traders than investors. Traders yearn for the volatility of prices. Investors should want a slow and steady rise up and to the right. They should not want to buy and sell. For this to work, they need sectors that do not go through stomach-churning drops every now and then.

Trends such as these are evident in graphs of sector earnings. (Even better are long-term graphs of sector earnings.) Consumer staples, for instance, is one such sector for long-term investors. Others are health care (though this one has too much government meddling) and possibly industrials. Earnings don't yo-yo around. Earnings trend slowly and up and to the right.

Still, a lack of volatility is not the only requirement for long-term investors. They also need growth. Thus, the utility sector is generally not a good choice. And valuations, as always, do matter. Finally, as has been proven time and time again, most analyst estimates are biased toward the optimistic end. Many analysts also miss the macroeconomic picture.

Bill Gross tells Abby Cohen her 2013 earnings growth rate forecast is "farcical"

The article is also revealing in the arguments made by Gross over the source of recent corporate profit growth:

"Corporate profits have come at the expense of labor. Wages as a percentage of GDP have declined to 54% from 59% in the past 10 years. That trend would have to continue for earnings to keep going up. Also, 30% to 35% of earnings growth in the past five years has come from lower interest expense. Most of you probably would agree that is coming to an end, as well. Corporations have to sell their products to somebody. They can't benefit when that somebody has depressed wages and high leverage. At some point the game begins to change. A forecast of 12%-to-13% earnings growth under such circumstances is not only extreme but almost farcical."

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Source: Business Insider

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Wages might be going down because corporations are moving labor costs overseas and technology is replacing many jobs.

If lower interest rates become a thing of the past, bonds will get cauterized and Bill Gross's bond funds will be clobbered. He states later that money have not "yet" vacated his funds.

Corporations are also selling their products overseas and wages there, at least in the developing world, are improving.

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All that said, 12-13% growth does seem pollyannish.