Ten Reasons Why Bank of America Thinks U.S. Stocks Have an 'Elevated Risk of Correction'
(Bloomberg) -- With U.S. stocks sitting near all times, Wall Street strategists are getting more cautious about what's in store for the benchmark indexes over the near term.
To this end, Bank of America Merrill Lynch Head of U.S. Equity and Quantitative Strategy Savita Subramanian compiled a list of ten reasons (and 21 charts!) why U.S. equities are at "elevated risk of correction."
Subramanian notes that short interest as a share of float for U.S. stocks has hit a 12-month low. The upshot here was recently detailed by Citigroup Inc.'s Tobias Levkovich, who warned that investors were turning more bullish, taking the potential "sentiment 'oomph'" out of the market as short positions have been unwound.
The Most Hated Rally, in other words, is starting to get a bit of love.
Citigroup's U.S. economic surprise index has retreated sharply over the past month, signaling that the preponderance of data hasn't been solidly exceeding analysts' expectations. As U.S. stocks have loosely followed the gyrations of economic surprises over the past year, the recent breakdown in this relationship may signal rockier waters ahead.
While acknowledging that these metrics aren't the best indicators for where stocks will go over shorter time horizons, the strategist points to elevated levels of a bevy of metrics (including forward and trailing price-to-earnings ratios, as well as the Shiller cyclically adjusted P/E ratio, price to book value, and enterprise value to earnings before interest, taxes, depreciation, and amortization) as signs that stocks have gotten rich — and investors might not be willing to pay a steeper price.
Fund managers surveyed by Bank of America are desperate for more support for growth from fiscal policymakers — but projecting these hopes as expectations for what's to come may result in a letdown. Subramanian observes that the number of news stories containing the phrase "fiscal stimulus" surged in July.
Investors are similarly bullish on the prospects for earnings growth for S&P 500 companies, with year-ahead consensus estimates at their highest level in five years.
Earnings growth may be difficult to realize, the strategist cautions, with current top line performance looking soft. In fact, constant currency sales growth for firms outside of financials or energy has dropped to a three-year low.
Meanwhile, the world's second largest economy looks to be heading for another rough patch, Subramanian notes, with its manufacturing PMI dipping back below 50 (which points to contraction in the sector.)
Worries about China's economy roiled markets following the devaluation of the yuan in August 2015 and at the start of 2016.
Credit and Leverage
"Leverage is high and credit is slowly tightening, while appetite for equity issuance may also be drying up," she writes, highlighting high levels of indebtedness among S&P 500 companies once financials and tech are removed from the equation.
The upcoming U.S. presidential election could provoke an "uncertainty shock and a slowdown in business investment" that brings about higher volatility, warns Subramanian.
The central bank's interest rate forecasts suggest that the Federal Reserve will hike rates much more aggressively than investors expect over the next two-and-a-half years, which could bring about a loss of risk appetite, says Subramanian.
However, it's difficult to see the Fed being much more aggressive than the market anticipates if top line growth among major U.S. firms is indeed so difficult to come by and Chinese data turns particularly sour.
To adapt a phrase from T.S. Eliot, September has been the cruelest month for investors in U.S. equities — the only one in which the median return has been negative, going back to 1928.
To contact the authors of this story: Luke Kawa in New York at email@example.com, Blaise Robinson in Paris at firstname.lastname@example.org.