Good Debt versus Bad Debt (Part 1)

Key Points

  • Total federal stimulus measures to combat the coronavirus now tops $4.6 trillion.
  • Our national debt stands at over $28 trillion, with the National Debt to GDB pushing 130%.
  • We’re far from the point of no return, but this is no reason to throw caution into the wind.

A third stimulus bill, called the American Rescue Plan Act of 2021 passed earlier this month, and it was signed by President Biden on March 11, 2021. The ARP Act aims to provide support as our national vaccination effort marches us to a saturation point (i.e., heard immunity), expected sometime in the summer of this year. So with all this federal spending, will the Government’s house of cards come crashing down soon after the coronavirus loosens its grip on our society and economy? Let’s explore where our real concerns should lay given this particular concern.

Print Away!

Earlier this month, Congress passes another stimulus bill related to the coronavirus. The bill tops out a whopping $1.9 trillion (give or take). And it includes an extension of unemployment benefits, a third round of stimulus checks, a child tax credit, aid to state and local governments, pandemic response payments, housing assistance, school support, aid for multi-employer pension plans, and a host of additional provisions (Source: Washington Post).

Prior to this bill (over the course of 2020), the federal government had already passed measures that amounted to over $2.7 trillion in outlays (Source: USASpending.gov). With this third round of relief, we’re now at $4,600,000,000,000 in federal stimulus outlays. And so one can’t help wonder, is fiscal disaster just around the corner? Are we in uncharted territory, and beyond the point of no return? And will we ever be able to pay down all of this debt before it crushes us all?

These are big questions with even larger implications. So let’s use history as our guide for some perspective on all this and see where we end up.

But this time is different, right?

There’s always a valid case that prior data doesn’t apply to a current environment. However, this particular argument can be made for any “current environment”. So rather than throw our hands up in the air or throw darts at a wall for deeper insight, it makes sense to lean on prior data, even if its with a grain of salt.

Liquidity injections (a.k.a fiscal stimulus packages by our federal Government) have been the name of the game for pretty much the last 40 years. Even so, over this period stock valuations have soared during the good times, and crashed back down doing the bad (as one would expect). However, on balance, the stock market has rewarded investors with frankly awesome returns over this period, averaging over 10% a year or so.

This broad market return is all the more fantastic given the low interest rate environment that has dominated a good part of this period. Granted CPI hovered around the teens during the early eighties, but rather than spiraling out of control, inflation rates have been falling steadily ever since (Source: US Inflation Calculator). Today, inflation hovers at around 1.7%, which actually implies a general sense of health.

You would think the constant pumping in of money by our Government over the last few decades would have led to exorbitant stock valuations. And you would be right in think so (to some extent). As compared to longer term averages, indeed, valuations have been higher over the last 40 years (on average) than the longer term average (going back to 1871). To put current market valuations into a longer-term perspective, in Chart 1 below we see the Schiller Cyclically Adjusted Price to Earnings Ratio going back to the late 1871 (using extrapolated data).

Chart 1: Shiller S&P PE Ratio from January 1, 1871 to March 1, 2021 (Source: LongTermTrends.net)

The Shiller S&P PE Ratio is similar to a price to earnings ratio on the S&P 500, where a higher ratio implies that the price of securities are relatively more expensive as compared to periods where the ratio is low. But the Shiller Ratio also accounts for inflation, and thus provides a more stable measure of overall market valuations over time (Source: Multpl.com).

As you can see, valuations are high right now, for sure (approaching 35x in Chart 1 above). Yet we are still below the bubble ratios of the Dotcom Bubble (2000), for example, when the ratio topped 40x. Nevertheless, there is a patent reversion notion with market valuation metrics; i.e., when they get too high, they eventually fall back down. Indeed, valuations can’t go up forever. And to put a fine point on it, stock valuations are undoubtedly in extreme bubble territory.

So what does this mean? Sell everything and run for the hills?

Unfortunately, one can’t easily use this valuation data to “outsmart the market”; i.e., a naive solution would be to sell when valuations are very high, and buy back when valuations are low (if only investing was this easy, we would all be billionaires by now). But market timing these types of things is a very hard problem (and almost impossible to do well over long periods, even though many (many) have tried).

Research suggests time and again, if you attempt to sidestep the bad days and only stay invested for the good days, you’re far more likely to end up worse off than had you simply stayed the course. There are many reasons for this, and my series on market timing goes into this far more detail, but at a high-level, those good days that you want to keep are very closely mixed up with those bad days that you want to avoid. So when you try to avoid the bad, you end up missing out on the good. There’s no easy solution here, and it’s hard to say that anyone has truly found a solution to this particular age-old concern.

“Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth” – John C. Bogle

As such, a buy and hold strategy that even had an investor purchase at “the worst time possible” would still have provided such an investor with a very solid return on investment. For example, an investor who would have gone “all in” the day after Lehman went under during the GTC would have been called crazy back then. After all, Lehman going under was just the beginning, and the market continued to crash for months afterward. But that same crazy investor would have averaged over a 10% annualized return over the next 10 years or so, which is a stellar return overall as we have noted above.

So yes, asset valuations are inflated due to QE. But besides staying the course, there’s not much one can do to “outsmart” the market given this seemly valuable information. Even so, we did experience an over 50% drop in stocks during the course of the Great Financial Crisis. Given this, there is something you can do to prepare. Indeed, if you do not have such a high risk appetite to stomach the ups and downs of the market, then there is a sensible solution out there. In this case, a lower allocation to equities is a great solution. i.e., rather than being at 70% stocks and 30% bonds, a you might be more comfortable with 30% stocks and 70% bonds.

Risk sizing your portfolio to your risk appetite is the single most important thing you can do to weather the inevitable market storm that just might be on the horizon. But as it goes with most risk measures, you don’t want to wait until the house is on fire to start investigate a sensible hazard insurance policy for your home. Being proactive is key.

But there is no free lunch. How can the Government continue to print massive sums of money?

As it relates to other markets around the globe, most of Europe has used “endless” liquidity in much the same way as the U.S. has, with largely similar results over the past 40 years. However, one Asian country does stand out as having taken this liquidity “too far”, and that’s Japan. The country has had exceedingly high debt to GDP for pretty much an entire generation, and it’s economy has been hampered as a result, no doubt.

Chart 2: Japan’s Debt to GDP Ratio through 2019 (Source: Trading Economics)

As you can see (in Chart 2 above), Japan’s Debt to GDP began to rise above 100% in the mid nineties, and now it’s well above 200%. And in Chart 3 below, you can see how Japan’s stock market has performed since the early 1990’s. As you can see, it’s gone nowhere even with all of this “liquidity”. After 30+ years, the Nikkei is still below its 1980s high.

Chart 3: Japan’s Stock Market Through March 2021 (Source: Trading Economics)

For comparison here’s the United State’s Debt to GDP (in Chart 4 below) over an even longer period (note this doesn’t include 2020 numbers yet, so those shocks will show up soon in the data and of course make things look much worse for pretty much the entire planet).

Chart 4: United States’s Debt to GDP Ratio through 2019 (Source: Trading Economics)

If the USA heads into a debt crisis similar to the one that has plagued the Japanese economy for the last generation, we should be really concerned, right? I think so. This would be a financial disaster. So much so that a Japan-like situation is a long-term concern of mine and has been top of mind for me since as long as I can remember. After all, why would anyone invest in stocks if returns over a generation are close to nothing?

Again, there may be no way to fully avoid this concern. But there is one solution that’s once again worthy of strong consideration. And that’s to diversity globally. Of course, a globally-diversified portfolio of stocks and bonds won’t eliminate a Japan-like death trap. But the chances of a single country falling victim to such a circumstance is certainly higher than the entire planet doing so. Idiosyncratic risk exists at the country level too, so spreading your risk around Earth is a great option, similar to how investing in a broad market index like the S&P 500 is better than just investing in IBM (even though nobody ever got fired for hiring IBM).

But to expand on this particular point, in the long-run, I have confidence that the planet as a whole will be better off for the next generation. This is only an educated guess on my part. But once again, there is some data to back up this line of thinking as well, and that’s by examining the growth in Global GDP over time (as showing in Chart 5 below).

Chart 5: Global GDP Through 2019 (Source: Trading Economics)

Since 1960, GDP has grown every year except one. This implies two things: first that negative GDP years are possible (but not very common). And after a negative growth year, the world economy just seems to continue onward and upward.

Additionally, even longer-term global production shows a similar pattern. In fact, the global economy has grown with a fair amount of consistency, generation after generation for thousands of years (Source: Wikipedia).

But of course, there is no guarantee here either. This trend may end with this last generation. Even so, I for one am an optimist. Not entirely because I have any special insights on what may come. It’s the historical data that backs up this understanding and provides me with comfort. But perhaps what clinches the deal for me is that if things really do end up worse for the next generation, then we likely have much bigger things to worry about than our investments. So from this perspective, if you’re Investing Forever, it’s not a bad idea to bet on the glass being half full rather than half empty.

Need More Help?

If you’re ever in need of guidance, these blog posts may be of help. But be sure to contact a financial, tax, or legal professional for guidance and information specific to your individual situation. And as always you can reach out to me directly here with questions or concerns about your personal situation.

Finally, if you want to see how your risk appetite stacks up, check out my free risk assessment here.

The End.