One of the most interesting metrics to watch when interpreting the effects of an economic recession is the number of bankruptcies it provokes. Businesses come and go on a regular basis, even during normal economic times.
It is when the economy struggles that we see the quality of the business environment or which businesses are strong enough to survive. Also, the way the management leads during economic growth has strong repercussions when the recession hits.
Analysts have a plethora of financial metrics to look at and interpret the soundness of a business. First, the balance sheet. Low levels of debt are desirable, but not so low as to forgo the opportunity cost of missing important investment. Second, the income statement tells much about the bottom line – if the business is profitable or not. Finally, the cash flow statement. The ability of a company to generate cash flow shows its ability to remain solvent. Ideally, the sources of cash flow do not depend on one another, so that the contraction of one sector will not bring down the entire company.
Is It Time to Go Long in the Stock Market?
The United States is the home of capitalism. It is no wonder that the U.S. stock market dwarfs in liquidity the other markets in the world. Just to have a comparison, the U.S. total market capitalization exceeds $36 trillion. The second place belongs to China with $9.3 trillion, while Japan comes in third place with $6.1 trillion. In other words, the U.S. market capitalization is four times bigger than the Chinese one and bigger than the next eight markets in the world combined.
The chart above shows the number of bankruptcies in the United States, emerging markets, Europe, and other developed markets. As explained earlier, it should come as no surprise that the biggest number of defaults (i.e., bankruptcies) appears in the United States.
However what is interesting about this chart is that it also acts as a contrarian indicator. If we compare 2020 with the 2008-2009 Great Financial Crisis, buying the stock market when the number of bankruptcies rose to comparative levels made sense for the next business cycle.
What if the economic recession is behind us? What if a new business cycle started and the early entrants have a competitive advantage?
Of course, it may just be a coincidence. But when businesses fail in such numbers, it is usually a sign of bottoming because the sentiment reaches extreme negative levels. When that happens, a bottom is usually in place already.