Are equities headed into a storm?
Photo Credit: Dubravko Butković. Source: Morguefile
The dollar is strong. Economic growth is moderate. Stock valuations are higher than average. Companies are levering up. And the Fed is expected to raise rates soon. What does this picture remind you of?
The risks of a market pullback are increasing. A rising dollar and weak commodity prices are depressing demand for industrial machinery in the developing world. At the same time, low interest rates are encouraging marginal commodity producers over here to borrow in order to keep producing, even as prices fall. Indeed, it looks like low interests rates might be contributing to the oil supply glut.
Source: Citi Research
In addition, some companies are issuing debt in order to buy back shares. GM’s planned share repurchase would absorb all their operational cash flow and preclude any material capital investment for the next five years, if they didn’t lever up. Auto demand has been strong, but is it that strong?
I’ve discussed before how low interest rates encourage additional borrowing to fund marginal projects. One reason they’re marginal is they might not pan out. The housing bubble and financial crisis should have taught us that more leverage means more risk and greater volatility.
The stock market hasn’t seen a significant pullback since the Euro crisis in 2011. While I don’t expect a bear market absent an economic contraction, the ride could get a little bumpy.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!