Is It Time to Turn Bearish?

November 19, 2015

Is It Time to Turn Bearish? Photo

Old newspapers are a good source for learning about the history of the financial market, as they can provide insights about the current financial market. I recently came across this paragraph from an old CNN report from Dec, 31, 1999 which highlighted that, "...U.S. economy is poised to record the longest expansion in history...But despite the headlines about records...," only few investors of high-tech or telecom stocks came out as winners. The article pointed out that, "...most investors did not love 1999."

If we take a look at the table below, even though the Russell 3000 Index is relatively flat year-to-date in 2015, the majority of the companies comprising the Index have deteriorated, just like in 1999. From a technical analysis point of view, this is a sign of weakness. russell_chart2

This week’s chart shows that investment-grade credit spreads have widened this year, even though the S&P 500 Index went nowhere. In the last six years, leveraging on cheap debt and buying back shares has been a popular way for companies to boost earnings per shares (EPS). The benefit of higher EPS goes to equity holders because stocks trade with EPS; the price paid goes to bond holders because bonds trade with the balance sheet. After six years of buybacks, recent Goldman Sachs research shows the Aggregate corporate Net Debt/EBITDA (earnings before interest, taxes, depreciation and amortization) is at 1.6x, higher than the 1.4x in 2008. This increase in balance sheet leverage will eventually slow share buybacks; other drivers of earnings growth are slowly beginning to turn as well.

Low financing cost has been a driver for corporate earnings. This driver will slowly go away when interest rates starts to rise. Low wage growth is another driver for earnings; however, in the last quarter, we are hearing more and more companies raising wages, such as Chipotle Mexican Grill, Wal-Mart, Starbucks, HCA Holdings and Target, to name a few ( average hourly earnings released on November 6 also confirms this). At this phase of the economic cycle, I would expect to see more wage pressure, which is something I am monitoring closely. The last major driver is foreign sales. Between 2009 and 2011, foreign sales have been a bright spot for U.S. corporations because of higher growth overseas and a weaker dollar. We have now seen a reversal of this trend.

Key Takeaway: All this supports taking a cautious stance in the market; however, before we see the price and volume confirmation, we should be careful not to turn too bearish. The market has shown impressive resilience despite a potential interest rate increase, ISIS terrorist attacks, weak data from China and a relentless selloff in commodities. If I have to guess, my feeling is that plenty of investors see what I see and are taking a cautious or bearish stance in the market. When everybody is cautious, grinding higher becomes the pain trade, and this is what we are seeing in the market.

Tags: Uncategorized | Chart of the Week | Stocks | S&P 500 | Share buybacks | Bearish | Credit spreads | corporate earnings | EPS Growth

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