If we had conviction that the profit contraction was near a reversal, subdued economic activity would be less worrisome. But in this cycle, corporate balance sheets are stuffed with excess leverage, underscoring that the risk of hitting stall speed is elevated.
Without balance sheet flexibility, depressed cash flow generation means that companies could be forced to take growth-sapping retrenchment measures. Seven out of the ten broad sectors are expected to show year-over-year profit contraction in the first quarter, a grim outcome.
Moreover, credit excesses extend beyond the corporate sector to investor positioning. Margin debt is near record levels in absolute terms, and compared with GDP and/or market cap. Market cap itself is extremely stretched relative to GDP. Both are challenging previous secular market peaks.
Moreover, thin individual investor cash holdings are more consistent with a market top than a market trough. At a minimum, these readings warn of paltry long-term returns from current levels. Worse, a low cash cushion combined with hefty margin debt creates an “air pocket” potential, and reinforces our U.S. equity strategists’ commitment to a defensive portfolio structure.
Bottom Line: We expect defensive sectors and industries to maintain their leadership role, even if the broad market stays in overshoot territory for a while longer as a consequence of the search for yield.