There is scant evidence that the character of the equity market advance is changing and the fact that weak balance sheet stocks are no longer outperforming strong balance sheet stocks is giving us pause (Chart 1).

Chart 1
Time To Pause And Reflect
Chart 1

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Using the Goldman Sachs equity baskets - that utilize the 'Altman Z-score' framework to select stocks - via Bloomberg, we find that the weak balance sheet over strong balance sheet share price ratio leads the broad market at both peaks and is coincident at troughs. The most recent peak occurred in early 2017 and it is rather surprising that a proxy for this ratio using the fixed income market, i.e. the total return high yield bond index versus the total return investment grade bond index, is moving in the opposite direction and not confirming the equity market's message (Chart 2).

This begs the question: Which market signal is right, stocks or fixed income, and what are the equity sector investment implications?

But before trying to answer these questions, we first zoom out and look at the broad U.S. debt picture.

How Will It All End?

In our travels and conference calls one common question keeps coming up: What will end all this? The short answer is that rising interest rates will eventually deal a blow to the debt overhang and the expansion will give way to a fresh deleveraging cycle. In other words, a whiff of inflation will entice the Fed to keep on raising the fed funds rate to the point where the business cycle turns down. As demand falters, a decreasing cash flow backdrop will not be able to service the debt overload, as both coupon payments and principal repayments will become a big burden. This will ignite a jump in the default rate, a message the yield curve is already sending (Chart 3).

Chart 2
Which Market Is Right?
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Chart 3
Has The Junk Default Rate Troughed?
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Peering back to the onset of the GFC, a U.S. financial sector debt crisis engulfed the world. Subsequently, this morphed into a government sector debt problem in the Eurozone and more recently into a non-financial corporate sector debt overhang mostly in the commodity complex and the emerging markets.

Debt Supercycle Lives On

The investment world is obsessed with China's excess debt uptake and that is a valid concern. However, investors should also be aware that U.S. debt has not been fully purged. Rather, it has moved around between different domestic sectors. The debt supercycle lives on.1 The implication is that an interest rate-induced debt bubble pricking would be deflationary, and thus identifying the U.S. domestic sector most exposed to such risk is important.

Chart 4 breaks down U.S. total debt into the four largest sectors using flow of funds data. While households and the financial sector have significantly de-levered, the government and the non-financial business sector have been picking up the slack and aggressively re-levering. While the Trump Administration has embarked on a two-year fiscal policy easing period that will add to the government debt profile, the nonfinancial corporate debt overhang is more vulnerable and thus troublesome in our view (fed funds rate shown inverted, Chart 5).

Worrisomely, since the GFC, nonfinancial corporates have been issuing debt and partially using this debt to retire equity and pay handsome dividends. According to the flow of funds data, the cumulative nonfinancial net equity retirement figure stands near $4tn over the past decade (middle panel, Chart 6). Undoubtedly, this has been a large contributor to equity market returns (top panel, Chart 6), and will likely gain further momentum this year on the back of the tax repatriation holiday. Some sell side equity retirement estimates for the S&P 500 hover around $800bn for calendar 2018 or roughly twice the past decade's annual average. AAPL's recent announcement of a $100 billion share repurchase program confirms that the buyback bonanza is persevering and will continue to boost equities. Clearly, such breakneck equity retirement pace is unsustainable and will converge down to a lower trend rate in 2019 and beyond, especially given the drying liquidity as the Fed continues to pursue a tighter monetary policy.

Chart 4
Debt Is Moving Around
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Chart 5
Tight Monetary Policy Pricks Bubbles, And...
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Chart 6
...Threatens To End The Equity Retirement Binge
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Introducing BCA's Sector Insolvency Risk Monitor (IRM)

The purpose of this Special Report is to identify debt soft spots and outliers in the U.S. GICS1 equity sectors. What follows is a financials statement-heavy analysis of sector indebtedness.

We introduce the 'Altman Z-score' sector analysis that gauges sector credit strength, with a rising score indicating improving health and a declining Z-score signifying deteriorating health.2 In absolute terms, a score below 1.8 warns of a possible credit event, whereas any reading above 3 signals that bankruptcy risk is very low (see appendix below).

Our analysis includes our flagship Bank Credit Analyst's Corporate Health Monitor framework that breaks down corporate health in the different sectors3 (see appendix below).

We also sift through a number of different stock market reported ratios/data to gauge each sector's health, with net debt-to-EBITDA and interest coverage at the forefront of our analysis, and try to identify outliers (see appendix below).

Finally, with the invaluable help of BCA's Chief Quantitative Strategist, David Boucher, we created our new insolvency risk monitor (IRM) per U.S. equity sector incorporating the respective 'Altman Z-scores', BCA's corporate health monitor readings and net debt-to-EBITDA ratios.

In more detail, we ranked each sector (ex-financials and real estate) on a monthly basis on each of these three measures. Then we used a simple average of the ranked measures per sector to come up with the final sector ranking. We also selected the median sector ranking per measure and used the average of the three metrics as a proxy for the broad market.4 This way we were able to compare each sector IRM to the overall market. Note that the IRMs are designed so that a higher IRM ranking means better solvency.

Charts 7 & 8 summarize the results and showcase this new all-inclusive relative ranking alongside relative share price performance.

Chart 7
Unsustainable...
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Chart 8
...Divergences
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Sector Outliers

Consumer discretionary stocks are the clearest outliers and the message from the relative IRM is to expect a significant underperformance phase in the coming quarters (top panel, Chart 7). AMZN's juggernaut is blurring the discretionary landscape given its 20% index weight, and artificially boosting relative share prices. Ex-AMZN, this early cyclical sector is behaving similar to previous episodes when the Fed embarked on a tightening interest rate cycle. We reiterate our recent downgrade to a below benchmark allocation.5

Consumer staples equities are steeply deviating from their increasing relative IRM score, underscoring that investors are unduly punishing staples stocks (second panel, Chart 8). We maintain our overweight stance and treat this sector as a small portfolio hedge to our otherwise general dislike of defensives (as a reminder we are underweight both the S&P health care and the S&P telecom services sectors).

Chart 9
Cyclicals Have The Upper Hand
Chart 9

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The utilities share price ratio is also deviating from the IRM relative reading (fourth panel, Chart 8). The implication is that extreme bearishness toward the sector is overdone and we reiterate our mid-February upgrade to a neutral stance.6

Energy stocks have fallen behind the energy IRM rebound reading (top panel, Chart 8). We expect a catch up phase on the back of the global capex upcycle, still improving debt profile, favorable underlying commodity supply/demand dynamics and firming oil prices. The S&P energy sector remains a high-conviction overweight.

The niche materials sector is also trailing the sector's slingshot IRM recovery. Keep in mind that, as expected, the materials IRM is one of the most volatile series (second panel, Chart 8). Materials manufacturers are capital intensive and high operating leverage businesses and despite the debt dynamic betterment since the recent global manufacturing recession, this sector is still saddled with a large amount of debt that makes it extremely sensitive to the ebbs and flows of global economic growth. We continue to recommend a benchmark allocation.

The remaining sectors' (tech, health care, telecom services and industrials) relative share prices are moving in tandem with their respective IRM readings (Charts 7 & 8).

In addition, we have complied all the cyclical and defensive IRMs in two distinct series and the relative IRM ratio is giving the all-clear sign to continue to prefer cyclicals over defensives on a 9-12 month time horizon (Chart 9).

So What?

In sum, the IRM is one new additional metric we are using to gauge the validity of our sector positioning and should not be used in isolation. To answer our original question, while the weak balance sheet versus strong balance sheet stock underperformance is alarming and we will continue to closely monitor this stock price ratio, it is premature to change our constructive overall equity market view on a 9-12 month horizon. We therefore continue to recommend a cyclical over defensive portfolio bent.

Finally, for completion purposes, the appendix below shows a number of debt-related indicators we track, including the absolute 'Altman Z-score' and corporate health monitor readings, in two charts per sector along with the cyclicals over defensives compilation and the overall market (ex-financials).

Anastasios Avgeriou, Vice President
U.S. Equity Strategy
anastasios@bcaresearch.com

  • 1 For a primer on the debt super cycle please refer to Box 1 in the BCA Special Year End Issue: "Outlook 2013: Fewer Storms, More Sunny Breaks," dated December 19, 2012, available at bca.bcaresearch.com.
  • 2 Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E. Where: A = working capital / total assets, B = retained earnings / total assets, C = earnings before interest and tax / total assets, D = market value of equity / total liabilities and E = sales / total assets. Source: https://www.investopedia.com/terms/a/altman.asp
  • 3 Please see BCA The Bank Credit Analyst Report, "U.S. Corporate Health Gets A Failing Grade," dated January 28, 2016, available at bca.bcaresearch.com.
  • 4 We refrained from using the top down computed S&P 500 'Altman Z-Score' and net debt-to-EBITDA as the financials sector really skewed the results and therefore opted to use the median sector 'Altman Z-score' and net debt-to-EBITDA as a proxy for the broad market because using the mean also skewed the results largely because of the tech sector. Staying consistent in our analysis, we also used the median sector BCA corporate health monitor to proxy the broad market.
  • 5 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com.
  • 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com.

Appendix

U.S. Non-Financial Broad Market I

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U.S. Non-Financial Broad Market II

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U.S. S&P Industrials I

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U.S. S&P Industrials II

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U.S. S&P Energy I

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U.S. S&P Energy II

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U.S. S&P Consumer Staples I

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U.S. S&P Consumer Staples II

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U.S. S&P Tech I

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U.S. S&P Tech I

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U.S. S&P Utilities I

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U.S. S&P Utilities II

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U.S. S&P Materials I

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U.S. S&P Materials II

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U.S. S&P Consumer Discretionary I

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U.S. S&P Consumer Discretionary II

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U.S. S&P Telecom Services I

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U.S. S&P Telecom Services II

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U.S. S&P Health Care I

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U.S. S&P Health Care II

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U.S. S&P Cyclicals Vs. Defensives I

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U.S. S&P Cyclicals Vs. Defensives II

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