The Re-leveraging of Corporate America and the U.S. Stock Market

The U.S. stock market as of the end of 1Q 2015 is overvalued, overbought, and overleveraged. As we discussed in our weekly newsletters over the last couple of months, the S&P 500 is trading at its highest NTM (next 12 months) P/E and P/B ratios since early 2001, just prior to the bursting of the bubble in U.S. technology stocks. Note that today’s record P/E ratios are being accompanied by the highest corporate profit margins in modern history, which in turn are supported by ultra-low borrowing rates and a highly accommodative environment for corporate borrowing.

On the demand side for stocks, we also know that global hedge fund managers are now holding the largest amount of long positions in U.S. stocks (56% net long as of year-end 2014) since records have been kept. With the global hedge fund industry now managing $2 trillion in assets, we believe it is a mature industry–as such, we believe the positions of hedge fund managers could be utilized as a contrarian indicator. In addition, note that no major U.S. indices (e.g. Dow Industrials or the S&P 500) have experienced a 10%+ correction since Fall 2011. Coupled these with the immense leverage on U.S. corporate balance sheets–as well as the U.S. stock market–this means that U.S. stocks are now highly vulnerable to a major correction over the next several months.

According to Goldman Sachs, U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. U.S. corporate debt issuance is on track to hit a record high this year, supported by the ongoing rise in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a PE exit), and share buybacks and increasing dividends. In fact–at the current pace–U.S. corporate debt issuance will hit $1 trillion this year (see figure 1 below). Over the last 12 months, member companies in the Russell 1000 spent more on share buybacks and paying dividends than they collectively generated in free cash flow. Across Goldman’s coverage, corporate debt is up 80% since 2007, while leverage (net debt / EBITDA)–excluding the period during the financial crisis–is near a decade-high.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($billions)

uscorporatedebtissuance

We believe the combination of high valuations, extreme investors’ complacency, and near-record high corporate leverage leaves U.S. stocks in a highly vulnerable position. The situation is especially pressing considering: 1) the high likelihood for the Fed to raise rates by 25 basis points by the September 16-17 FOMC meeting, and 2) the increase in financial market volatility over the last six months.

Finally, investors should note that U.S. margin debt outstanding just hit a record high as of the end of February. Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators (including ones that may not be obvious, such as the amount of leverage utilized by hedge funds through the OTC derivatives market), as well as major peaks and troughs in the U.S. stock market. Since the last major correction in Fall 2011, U.S. margin debt outstanding has increased by 69%–from $298 billion to $505 billion–to a record high. In other words, both corporate America and the U.S. stock market have “re-leveraged.” With the Fed no longer in easing mode–coupled with extreme investors’ complacency and increasing financial market volatility–we believe U.S. stocks could easily correct by 10%+ over the next several months.

margindebt0215

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