November 15, 2017
Stocks this year have surged to record highs on speculation that President Trump’s push for tax reform will help to boost the economy and give corporations a chance to reward shareholders with dividends and buybacks.
But the strong gains shouldn’t distract investors from some worrisome signs that portend of a market decline, Albert Edwards, global strategist at Societe Generale, said in a Nov. 15 report.
“Investors are beginning to punish the corporate debt and equity of highly indebted U.S. companies,” Edwards said. “Excess U.S. corporate debt is probably the key area of vulnerability that could bring down the QE-inflated pyramid scheme that the central banks have created.”
S&P 500 companies with solid balance sheets have risen more than 20 percent this year, while firms that carry lots of debt have barely budged, according to a chart cited in the report.
The past couple of bear markets did show early warning signs, Edwards said.
“I remember in early 2000…that the tech-heavy Jasdaq index had turned down sharply ahead of the Nasdaq March 2000 peak,” Edwards said. “I also remember out technical analyst pointing out the significance of the Nasdaq Composite failing to follow the lead of the Nasdaq 100 to make a new high at the end of March 2000.” The Nasdaq 100 was a narrower group of stocks that drove gains in broader benchmarks.
“These proved to be early warning signs of the subsequent September peak in the S&P,” Edwards said. “The 2000 bear market was clearly flagged if you knew how to read the technical and macro runes. The same was true in 2007.”
The Shiller P/E ratio, a measure of how expensive stocks are in relation to their earnings, is greater than 31 times. That’s higher than the 1929 peak of 30 times preceding the Great Depression, but less than the 44 times peak of the dot-com bubble.
Another worrisome sign is the extreme optimism of investors, which is a contrary indicator that stocks could lose value. Bullishness may indicate that investors have put all the money they can into stocks, leaving fewer buyers to drive prices higher.
“Sentiment indices, often a useful contrary indicator, have reached extremes of bullishness rarely seen,” Edwards said, citing data from the Investor Intelligence Sentiment Survey. “Comparisons with October 1987 are entirely justified.” That month, the Dow Jones Industrial Average crashed more than 20 percent for the biggest single-day loss in history.
Another important dynamic is the growth of the euro zone into the biggest net lender in the world, overtaking Asia. With the European Central Bank’s quantitative easing program of buying trillions of dollars of government and corporate debt, bond yields have dropped, giving European investors more incentive to chase higher yield in other markets like the U.S.
“One further metric worth noting is that it is the change in the net savings of any sector that drives GDP growth away from trend and causes recessions,” Edwards said. “Although the sector adjustments seem complete in the Eurozone, the size of the external surplus is now becoming a political as well as an economic issue.”
Rising U.S. Corporate Debt
The falling value of U.S. high-yield bond prices, or “junk” bonds issued by companies with the greatest risk of default, is also a warning sign. These companies become more vulnerable when interest rates rise as they seek to issue new debt or refinance.
The Federal Reserve has gradually tightened interest rates in the past two years after cutting them to record lows in the wake of the 2008 financial crisis. Investors estimate the Fed will raise rates 0.25 percentage points when it meets next month, especially since the unemployment rate is at a 17-year low of 4.1 percent. Wage hikes have remained weak during the recovery, helping to tame inflation.
“The high-yield corporate bond market should have been revolting against balance sheet debauchment some time ago,” Edwards said. “That would be the normal state of things with net debt/profit ratios so very high.”
Debt Ratios Vary by Region
Many U.S. and European companies have used the period of low interest rates to load up on cheap debt, partly to finance stock buybacks and dividends.
Japanese companies, by comparison, have cut their debt as the country has struggled with a stagnant economy since its asset bubble collapsed in the 1990s.
“The experience of two and a half decades of stagnation taught them that leverage is dangerous and regulators, banks and companies don’t want it in the face of deflation and soft demand growth,” Erik Norland, an economist at CME Group, said by e-mail.
“Japan’s overall level of debt (public + private) is colossal and dwarfs that of the U.S. and the euro zone (350 percent of GDP versus 250 percent),” Norland said. “The size of the public debt (more than 200 percent of GDP) might also crowd out private borrowing and/or damage confidence because of the expectation that taxes will eventually be raised to contain the growth of that debt.”