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Correction Or Bear Market?

Summary

A dire scenario for equity indexes could be triggered by so many black swans that it may appear conspicuously vain to try to forecast one.

Even if I remain relatively optimistic for stocks until year-end, it could make sense to figure out the channels through which we could witness much lower equity prices.

Going through several charts, it looks like the ongoing environment is, in itself, enough to have a cautious view on equity return prospects.

I still consider that the current situation characterizes a correction, not a bear market.

But a rapid worsening of corporates’ balance sheet, well ahead of any dollar or oil risk, would undoubtedly entail a risk / bear scenario to materialize.

Some may think that higher yields could be detrimental to stocks but, as explained here, higher Treasury yields are not structurally detrimental to equities. It may also be suggested that a stronger dollar and structurally low oil prices could have a negative impact. The chart below shows an interesting pattern:

Stock returns and DXY have been positively correlated since 2008 when equity returns and oil prices remained negatively correlated (their current reading are zero actually). In such a context, a stronger dollar and lower oil prices would rather be positive, not negative, for stocks. I don't want to speculate here on a change in the correlation regime. For that reason I look for some other potential triggers for a further decline in stock indexes.

There are several ways to decompose expected return for stocks. The sum of the earning yield, share buybacks and expected capital gains is generally a good proxy.

1. Earning yields. it is important to bear in mind that the earning yield is the product of the ROE and the Book-to-Price ratio.

And an adverse scenario would definitely be a credit crunch. As can be seen below, there is a strong correlation between corporate credit/leverage and ROE.

In the current environment of contained supply of credit, a worsening of corporate access to external funding would be detrimental to the ROE of corporates. It is, as can be seen below, at the core of the continuity of the business cycle when the profit-share of GDP has reached an inflection point.

2. Share buybacks: the relative stability, over the last few years, of the buyback yield around 2% should not let us forget that it remains highly dependent of the cash flows generated internally. A decline in the self-financing ratio would be detrimental to this small component of expected equity returns.

3. Earning growth: There is a strong debate on whether GDP growth is a good proxy of earning growth. I prefer changes in the profit share of GDP. The chart below shows that the variation, over 2 years, of the profit-to-GDP ratio is a good leading indicator of earning growth. Even if the late nineties suggest that the EPS growth of listed companies can be resilient when macro profit decline, the ongoing fall in the profit share of GDP can be taken as another sign of decline in EPS Growth in the short to medium run.

Given that, over the last few years, the main contributor to equity return has been earning growth (since valuation made the bulk of the contribution in 2013/14), dire prospects for EPS would definitely be detrimental to expected equity returns.

4. M&A: Corporations have been either praised or criticized for their excess accumulation of cash over the last few years. As can be seen below, there is a link between internal funds and M&A. A decline in the internal generation of cash flow could also withdraw another supportive factor for the equity market.

Bottom Line: going through several charts, it looks like the ongoing environment is, in itself, enough to have a cautious view on equity return prospects. This is without taking into account the high level of uncertainty on 1) the Fed policy 2) the tools that will be used by China's authorities to deal with the structural slowdown.

The risks pertaining to expected returns of stocks that I have pointed out are not bound to happen bluntly nonetheless. They should be emerging smoothly over the course of the next few quarters, a pattern that is consistent with traditional economic cycles. For that reason I still consider that the current situation characterizes a correction, not a bear market.

Yet, given the ongoing macro, policy and liquidity risks (quantitative tightening, excess exposure on illiquid assets), a rapid worsening of corporates' balance sheets would undoubtedly cause a risk / bear scenario to materialize.


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