Legendary hedge fund manager Stan Druckenmiller laid out a gloomy message for the market at the Sohn Conference last week.
The Duquesne Capital founder said that the “bull market has exhausted itself” after eight years of a “radical monetary experiment.”
The Federal Reserve’s monetary policy over the last eight years has led to “unproductive” and “reckless” corporate behavior, Druckenmiller said.
“The doves keep asking ‘where is the evidence of mal-investment?’ Druckemiller said. He proceeded to show a chart of US non-financials' year-on-year change in net debt versus operating cash flow, as measured by earnings before interest, tax, depreciation and amortization (Ebitda).
He pointed out that the growth in operating cash flow peaked five years ago and turned negative year-over-year. Meanwhile, net debt has continued to climb.
“Never in the post-World War II period has this happened,” Druckenmiller said. “Until the cycle preceding the Great Recession, the peaks had been pretty much coincident. Even during that cycle, they only diverged for two years, and by the time Ebitda turned negative year over year, as it has today, growth in net debt had been declining for over two years. Again, the current 5-year divergence is unprecedented in financial history!”
It gets more disturbing. He pulled up a chart showing how US non-financial firms used corporate debt between 1995 and 2015. The purple in the graph represents share buybacks and M&A. The green represents capital expenditure.
He noted that the debt in the 1990s was used to finance the construction of the internet. Now most of that debt today is used for financial engineering as opposed to productive investments.
“Notice how the green dominates in the 1990’s and is totally dominated by the purple in the current cycle. Think about this. Last year, buybacks and M&A were $2 trillion. All R&D and office equipment spending was $1.8 trillion. And the reckless behavior has grown in a non-linear fashion after 8 years of free money,” he said.
He continued: “In 2012, buybacks and M&A were $1.25 trillion while all R&D and office equipment spending was $1.55 trillion. As valuations rose since then, R&D and office equipment grew by only $250 billion, but financial engineering grew $750 billion, or 3-times this! You can only live on your seed corn so long. Despite no increase in their interest costs while growing their net borrowing by $1.7 trillion, the profit share of the corporate sector peaked in 2012. The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18-times for the asset class.”
Druckenmiller later added that the market appears to be very overvalued.
“If we have borrowed more from our future than any time in history and markets value the future, we should be selling at a discount, not a premium to historic valuations. It is hard to avoid the comparison with 1982 when the market sold for 7-times depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18-times inflated earnings, productivity declining and no further ammo on interest rates.
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Livio S. Nespoli has been a broker, registered investment advisor, and financial publisher since 1985.