1) Equities are not attractively priced any more. On most metrics, P/S, P/E and P/B, they are trading at a premium to their historical averages. Sales per share are at highs, as well. True, relative to fixed income, stocks still look interesting, but credit spreads are widening, and the key central bank has started to hike. Asset reflation regime might start to reverse.
2) Balance sheets are deteriorating, with increased debt issuance used to finance record levels of buybacks. US corporate financing gap has turned negative. This is typically not a good starting point.
3) US profit margins are showing increasing evidence of peaking. Profitability improvement was one of the key drivers of the 7-year long equity rally. This might be finished, as the profit margin proxy – the difference between corporate pricing and the wage growth – has turned outright negative for the first time since 2008. Buybacks have flattered earnings for a while now, but we would be surprised if these stay a potent support. Buybacks as a share of EBIT are already at ‘07 highs, and credit spreads are widening.
4) Fed tightening is happening very late in the cycle. Typically, the first hike takes place within 12 months of the end of last recession. This time around, we are close to 7 years. Could the Fed appear to be behind the curve, especially if inflation and wage growth picks up? More fundamentally, asset reflation worked during ZIRP to help equities. This could start to unwind.
5) Medium-term Chinese and EM backdrop remains challenging. CNY is back to highs vs EM FX. This could lead to another round of devaluations, possibly in Q1. This would be especially the case if the Fed were to be seen to be falling behind the curve. EM do not typically perform well against a backdrop of a strengthening USD. In addition, EM credit overhang is significant, and NPL upcycle could be just starting.
Importantly, the sector allocation in the event of a down market might not be typical, given that, during the up markets, the leadership was also not orthodox. The bull market was characterised by the leadership of Growth, Defensives and yield. The bear market could see some of the high P/E winners rolling over, not just the weakness in the traditional cycle sensitive names.