Long-term Sentiment Indicators Suggest U.S. Stock Market Exuberance

Despite Fed tightening, the rise of populism threatening the disruption of global trade and supply chains, along with ongoing delays in U.S. tax reform and infrastructure spending legislation, there is no doubt that economic optimism is more persuasive in mainstream U.S. society today than it was relative to just six months ago. Sure, President Trump is in the process of dismantling Dodd-Frank, the EPA, and even the ACA (through loosening IRS rules on the “individual mandate”) through a series of Executive Orders, but such loosening of regulations is not necessarily bullish for corporate profits as they encourage more competition in such affected industries over time. In fact, loosening IRS rules on the “individual mandate” may even lead to the collapse of the U.S. healthcare system, as the “individual mandate” forms the core of the ACA by requiring young, healthy Americans to purchase insurance so they could subsidize older, less healthy Americans with pre-existing conditions. An ACA in the absence of the “individual mandate” will be credit-negative for most U.S. healthcare companies.

Historically, the Conference Board’s Consumer Confidence Index has not just acted as a reliable, coincident gauge of U.S. consumer sentiment, but also as a very reliable contrarian indicator for U.S. stock prices. While it has always been better in pin-pointing bottoms during a bear market, it has also worked well in calling significant stock market peaks over the last 35 years. This was true in the run-up of both the Consumer Confidence Index and U.S. stock prices leading up to the significant peaks in September 1987, July 1998, Fall 2000, as well as its “rounding top” during the first half of 2007. Just yesterday, the Consumer Confidence Index–by soaring through its September 1987 peak and hitting a high not seen since December 2000–gave us a “strong sell” signal on U.S. stocks. Figure 1 below shows the monthly readings of the Consumer Confidence Index. vs the Dow Industrials from January 1981 to March 2017.

consumerconfidenceSuch extreme complacency among U.S. mainstream society has morphed into “irrational exuberance” as retail investors, aided by near-record-high U.S. corporate buybacks, has also made its mark on U.S. margin debt outstanding. As of February 28, 2017, U.S. margin debt surged to an all-time high of $568.6 billion outstanding, more than $18 billion higher than its previous all-time high of $550.0 billion made in April 2015, just a few months before the onset of the July 2015-February 2016 global equity bear market. Over the last 12 months, U.S. margin debt outstanding has risen by $94.5 billion (see Figure 2 below)–its greatest 12-month rate of margin debt accumulation since June 2014.

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The Re-leveraging of Corporate America – Part II

We last discussed the increasing leverage in U.S. corporate balance sheets in our April 1, 2015 commentary (“The Re-leveraging of Corporate America and the U.S. Stock Market“), when we asserted that the combination of historically high U.S. stock market valuations, extremely high participation in the U.S. stock market by hedge fund managers (from a contrarian standpoint), and near-record high corporate leverage makes the U.S. stock market highly vulnerable to a major correction over the next several months.

At the time, we noted that U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. Moreover, U.S. corporate debt issuance was on track to hit a record high in 2015, buoyed by the ongoing surge in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a private equity sponsor exit), along with record share buybacks and the pressure to increase dividends. At the time, we noted that U.S. corporate debt issuance was on track to hit $1 trillion this year.

Since April 1, U.S. corporate debt issuance has continued to increase, although the pace has slowed down since concerns about the Greek debt crisis and the Chinese economic slowdown materialized this summer. Moreover–with energy and metals prices still underperforming–high-yield issuance has slowed down dramatically, although investment-grade issuance has continued to plough ahead. Nonetheless, U.S. corporate issuance has already set a record high this year, with nearly $800 billion of debt issued on a YTD basis (as of last Friday). At the current rate, U.S. corporate debt issuance could still hit $900 billion this year given the still-substantial pipeline of debt issuance driven by the recent frenzy of M&A activity.

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

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Moreover, U.S. net cash levels–that of Apple notwithstanding–have been crumbling under ever-increasing dividend yields, corporate buybacks, and M&A activity. Figure 2 below shows the substantial increase of debt/EBITDA ratios in Goldman’s universe coverage–especially since 2011–while companies with positive net cash levels are down by about one-third in the same time frame.

Figure 2: Rising Corporate Leverage While Cash Levels Continue to Decline

uscorporateleveragevscashDespite the August correction, we believe U.S. stocks remain overvalued. Combined with increasing and near-record high corporate leverage levels, this leaves U.S. stocks in a highly vulnerable position. With the Fed poised to begin a new rate hike cycle at the December 16 FOMC meeting , we believe there is a strong likelihood of a more substantial (15%-20%) correction in the S&P 500 from peak to trough sometime in 2016.