It’s Not Just Equities that are in a Bubble

Once again, the S&P500 barely moved. Last week, the large cap index moved up a tiny 0.18% on low volume. Volatility crept back down, but interestingly not back down to the lows of the year which were set in mid to late July. Are investors starting to hedge a little?

In terms of technical analysis, the S&P500 is still pinned against the upper end of most price ranges. That said, the lack of meaningful movement in price over the last several weeks means that upward momentum has stalled. Still, the big indicators are pointing upward—prices are above the 50 and 200 day moving averages, and the 200 day moving average is comfortably sloping upward. So until this changes, most investors will continue to “buy-the-dip” a strategy that has worked for 8 years in a row.

US macro news was mixed last week. Chicago PMI fell way below expectations. Personal income disappointed….showing zero growth. Construction spending also missed. ISM services plunged, missing expectations by a mile. But on the positive side of the ledger, pending home sales beat consensus estimates. ISM manufacturing also just barely beat estimates. International trade was not quite as bad as predicted. And the payrolls number beat expectations. But as usual over the course of this multi-year “recovery” in jobs, the bulk of the new job gains came from part-time, low-paying and unbenefited jobs; think bartenders and waitresses. At the same time, the good jobs continue to disappear. Also in the jobs report, both average hourly earnings and the average workweek only met expectations.

As much as all the historical data suggests that US equities are overvalued (on numerous, well-respected measures), it’s important to remember that overvaluation is also plaguing the US corporate debt markets. US corporate leverage has been climbing ever since the Great Recession ended in late 2009. And since much of the net buying of US stocks over the period has come from corporations themselves (not households, not pension funds, not hedge funds, etc.), it makes sense that — especially since the Fed has driven borrow rates to record lows — US corporations have been leveraging themselves to finance this stock buyback process. Operating cash flows alone, after funding capital expenditures, have not been sufficient to pay for all the stock buybacks over these past 8 years.

The result? US corporate balance sheets are as levered as they’ve ever been. And to all those who argue that this is not a problem because rates are so low, it’s important to remember that in almost all market and economic cycles in the past, when there’s a setback in US equities spreads on corporate debt tend to blow out. This means that while base Treasury rates or Fed Fund rates may remain low, the amount that corporations pay over and beyond those base rates usually explodes higher. And when this happens, the price of corporate debt plunges….mainly because debt investors begin to factor in a much higher “refinancing” rate to roll over all the existing corporate debt, which (unlike most US home mortgages) has terms of 0 to 10 years; in other words, interest rates get reset on US corporate debt much faster than they do on US mortgage debt which locks in rates for 15-30 years.

So while today, the spread on high yield debt in the US is near record lows. it’s important to remember that when the economic and market cycles finally turns down, there won’t be a safe place to hide capital in US corporate securities markets. Most likely, both US equity and US corporate debt prices will plunge at the same time.

This means that the most likely destination investors will try to move their money into will be into US Treasury securities or just plain cash accounts……assuming they can sell their corporate equity and debt securities at reasonable prices……to have the cash available to buy these Treasuries!


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