Leading Indicators Suggest Further Upside in Global Risk Asset Prices

Note: I know many of you reading this are either overweight cash or net short U.S. equities. Please don’t shoot the messenger: I am not personally biased to the upside – I am merely channeling what my models are telling me, and they are telling me to stay bullish.

In my January 31, 2016 newsletter, I switched from a generally neutral to a bullish position on global risk assets. Specifically:

  • For U.S. equities, I switched from a “slightly bullish” to a “bullish” position (after switching from a “neutral” to a “slightly bullish” stance on the evening of January 7th);
  • For international developed equities, a shift from “neutral” to “bullish”;
  • For emerging market equities, a shift from “neutral” to “slightly bullish”; and
  • For global REITs, a shift from “neutral” to “bullish.”

My bullish tilt on global risk assets at the time was primarily based on the following reasons:

  1. A severely oversold condition in U.S. equities, with several of my technical indicators hitting oversold levels similar to where they were during the September 1981, October 1987, October 1990, and September 1998 bottoms;
  2. Significant support coming from both my primary and secondary domestic liquidity indicators, such as the relative steepness of the U.S. yield curve, the Fed’s renewed easing bias in the aftermath of the December 16, 2015 rate hike, and a sustained +7.5% to +8.0% growth in U.S. commercial bank lending;
  3. Tremendous bearish sentiment among second-tier and retail investors (which is bullish from a contrarian standpoint), including a spike in NYSE short interest, a spike in the AUM of Rydex’s bear funds, and several (second-tier) bank analysts making absurd price level predictions on oil and global risk assets (e.g. Standard Chartered’s call for $10 oil and RBS’ “advice” to clients to “sell everything”).

In a subsequent blog post on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“), I followed up on my bullish January 31st prognostications with one more bullish indicator; i.e. the strengthening readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”) indicator which “suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last two times I discussed the CBGDI in this blog was on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“) and on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve upon the readings which we discussed several months ago (see Figure 1 below)–just 10 days after we turned bullish on global risk assets. Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in some cases, a re-acceleration (e.g. the economies of South Korea, New Zealand, Spain, and India) in global economic activity. So don’t shoot the messenger–but it appears that the rally in global risk assets coming out of the late-January-to-early-February bottom still has more room to run.

CBGDIMay2016

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)

uscorporatedebtissuanceNov2015

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.