Stockwatch: Does an equities 'melt-up' guarantee a bust?

UK stocks have had a mixed January, reflecting year-end updates, thus our indices bumble along. Meanwhile, European equities continue to explore new highs after cumulative monetary stimulus, and US stocks are soaring almost daily.

The belief on Wall Street is that deregulation and tax reform are fuelling US business investment after years of wariness under President Obama; this coinciding with an upturn in the global economy, with the IMF predicting near-4% growth for 2018.

With interest rates still low, the search for yield continues and talk of an equities "melt-up" is hard to deny as momentum persists. So, should value-conscious investors go with the flow or get more defensive? Is scope for a more serious reversal being baked in?

I've broadly been bullish in these macro pieces, of a "Goldilocks" scenario where major economies are gaining momentum without excesses, i.e. keeping recessionary risks shallow. Investor sentiment has, until recently, shown plenty signs of caution, with lots of "crash warnings" and, despite some corporate balance sheets over-borrowed (after a long period of low interest rates), generally there are not as many flaky/over-stretched companies like in 1987 and 2000.

As 2018 gets underway, however, measures of optimism for US equities seem at record levels as money pours in, and this now being the longest period in history without a 10% market correction. Long-term buyers of US equities (funds) especially, need reasons to assume "this time it's different" from past booms.

Global outlook is benign…for now

Latest US corporate reporting is broadly strong, e.g. classic cyclicals such as Caterpillar Inc beating guidance and sounding positive for 2018. In the UK, year-end updates are quite mixed albeit no real trend of warnings to imply a wider downturn.

High street retail is knowingly under pressure and the economics of outsourcing in focus "post Carillion", yet these sectors have actually offered positive surprises, among them Pets at Home and Kier Group, the subject of a 16 January Stockwatch.  This pair jumped over 10% and nearly 20% respectively when resilient updates countered oversold stocks.

It's hard to find much that's shockingly new beyond typical ups and downs of corporate life, such as likely inventory issues hitting the AIM-listed shares of IQE Group.

International political risk is perceived as remarkably low: terrorist attacks have been largely contained by greater security and intelligence efforts. In raw financial terms you'd have to go back to the Twin Towers attack in 2001 as one that arrested markets.

Islamic State drifts off the fear horizon for Western media; Putin seems to be taking a rest from reclaiming the Russian empire; and after Jong Un traded insults with Trump, North and South Korea have decided to march together under a unified flag at the Winter Olympics. Any political "black swan" is elusive.

As for intrinsic financial risk, despite global debt increasing at a faster rate than GDP since 2008, bosses of the major global banks have insisted at Davos this last week that their operations are far more resilient than before the great financial crisis.

If you accept all this as true and is set to continue, then US equities remain the leading momentum play. But what could yet turn sentiment adversely?

Trump's stimulus contradicts Fed policy

The timing of US administration efforts to boost economic growth - 6% cited as a target last December - coincides with the Federal Reserve reversing monetary stimulus, to check incipient inflation and be in a position to cut interest rates again when a recession arrives.

In principle, that's a central bank's proper role: judging when to take the punchbowl away. In practice, the Trump administration is busy handing it round by way of "supply side" measures just when the US economy is near full employment. This is liable to mean higher wages, spending and prices.

Understandably, politicians have to deliver on their election pledges such as to level US corporate taxes with the rest of the world, remove firms' incentives to relocate and buy foreign operations, hold money in offshore accounts etc.

These are anomalies it's economically justified to change, beyond the nationalist slogan to "Make America Great Again". But if the Fed gets forced into sharper interest rate rises at a time of record global indebtedness - monetary stimulus having contributed to higher debt mountains since 2008 - then stockmarkets would tumble.

The US inflation rate is, therefore, a prime factor to follow, most recently at a manageable 2.2%. A rip over 3% would probably be needed to cause real worries.

US Republicans are turning antagonistic on trade

It's a live issue at the time of writing, with President Trump poised to address the World Economic Forum. This last week, US Commerce Secretary Ross has set his stage saying: "A trade war has been in place for quite a little while; the difference is US troops are now coming to the rampart."

Thus, four-year tariffs have been slapped on solar panels where Chinese firms predominate: a 30% tariff to be imposed in the first year reducing to 15% by the fourth. And on washing machines: a 20% tariff on the first 1.2 million finished units imported, and 50% of all subsequent units.

Trade tension between America and China tends to be cited as a principal threat to global growth, especially at the annual WEF Davos convention, where US government representatives are saying there will be more measures aimed at defending US commerce. What will be China's response?

Margin debt: liable to exacerbate any downturn

Record margin debt bakes in a market slump when this rising element of gambling money is forced to close out. Research by Dr Edward Yardeni, a US independent analyst, shows margin debt rising to record levels if broadly consistent with stock indices.

Charts since 1995 show the two as well-matched; it was mainly in late 2006 to mid-2007 that the rate of increase in margin debt greatly exceeded the rise in stock values, soaring from about $300 (£210) billion to $400 billion.

Borrowing to buy US stocks is at a record high near $600 billion, though its rate of increase still pegs the market rally. Bears may still argue this is colossal leverage to resolve in the event of a market correction, potentially exacerbating it. Charts for 2000 and 2009/09 show debit balances in brokerage accounts not just being eliminated but swinging to a similar extent of cash as traders dumped holdings.

Appetite for a renewed level of overall net margin debt then took less than three years, i.e. mid-2003, but only about one year, i.e. to end-2009, in the last crisis. So yes, margin debt can indeed enhance downside in a correction, but probably just leads to better bargains.

Is there a cash flow risk to US companies?

Take your pick whether strategists at Societe Generale offer analytic or entertainment value, given their persistently bearish views. The best-known is Albert Edwards, but his "global quantitative" colleague Andrew Lapthorne captures the early 2018 limelight, citing "steady decline in growth of net operating cash flow in US listed firms."

This, he says, excludes banks which have benefited from the start of interest rate rises, and oil companies bolstered by the recovery in crude prices. It coincides with a lower dollar and a decline/flattening in the yield curve (of interest rates versus bond maturities) I've similarly drawn attention to - as an historically reliable precursor to recessions, if it proceeds to slope downwards like in 2007.

Lapthorne warns that markets face a nasty surprise if the cash flow signal is correct and reinforces the yield curve view, although I wonder if the tax changes repatriating capital will, at the very least, blur the underlying trend as fund flow statements and balance sheets show rising cash.

US equities momentum invites defensiveness

Holding US stocks/funds is broadly a gamble on the crowd effect to drive prices higher, given the economic future is far from guaranteed and there's a sense of how "things just look too good to last." At some point the social trend changes.

Admittedly, the context is not like 1929 where the economy showed definite warning signals, and the stockmarket became volatile well before it crashed. And the risk has positive fascination: the US can pull down global markets, yet the next debacle may well be brief because, besides record margin debt, there's allegedly record global liquidity poised to pounce.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.