Stocks don't get to stay at a new, higher level without the explicit, ongoing permission of the credit markets. The enormous market for corporate debt typically leads equities, and right now credit is giving the nod for stock investors to play on.
The yield on the leading junk-bond indexes is down around 5.5 percent, not far above the all-time lows of three years ago. Granted, stock valuations are a good bit higher now, but until and unless corporate debt markets wobble it's hard to say much dramatic or sustained downside in stocks.
Bank of America Merrill Lynch US high yield effective yield, 5-year
Which brings up the question of just how sturdy those credit markets are. Last week, a Wall Street Journal canvas of bond-fund managers found that those who know the junk markets best seem to like it least. Seasoned high-yield investors see little value at current levels, and it seems yield-chasing money is the marginal buyer.
Most of the segments of the economy that are showing either structural decline or late-cycle wear and tear have bearing on the credit markets: Chain retailers and their landlords have seen debt holders flee. The auto-loan market and broader consumer credit has rolled over from their best levels of the cycle. Energy issuers are no longer at the epicenter of credit weakness, but the prolonged softness of commodities is a drag.
This is all relevant because corporate leverage levels, in aggregate, are back at record levels, with total debt to cash flow matching the early-2007 highs. Companies have feasted on the generosity of bond investors for nearly a decade. This isn't pinching the stock market now because the bond market remains wide open and rates are so low.
But this is why investors should watch for any signs that the corporate-credit market is sniffing out leaner times to come.Might the party get too wild?
Various measures of financial conditions show the markets to be fairly lubricious, inviting plenty of speculative behavior. Any continued levitation of stock prices, especially if it's still led by the tech giants now up more than 25 percent on the year, will stoke more concerns about overheated capital markets decoupling from the economy.
Trader sentiment and options-trading patterns have reached short-term extremes typical of a market susceptible to stalling or perhaps even slipping back a few percent. Already, a chart showing the pronounced outperformance of the Nasdaq 100 index to the small-cap Russell 2000 is in heavy rotation as a putative dark omen, though it was far more monstrously lopsided in the late-'90s. So if this is to become a true and treacherous bubble there's room to go.
Nasdaq 100 relative strength vs. Russell 2000
Bank of America Merrill Lynch strategist Michael Hartnett has been on the money this year calling for what he's dubbed the "Icarus trade" to lift stocks deep into record territory as investors gain confidence in global growth and the benign efficacy of central banks.
Tracking this trade, Hartnett calculates that if the S&P 500 were to rise another 15 percent or so to 2822, it would make this the greatest-ever bull market. At the 2620 mark on the index, up 7.4 percent, the value of the domestic stock market to U.S. GDP would match its year-2000 peak. He figures this Icarus-like "overshoot" will continue "until [a] Wall Street bubble (not Main Street recovery) forces [the] Fed to tighten aggressively."
This doesn't seem a present danger, beyond the fact that the Fed seems on course for a June rate hike even with some mushy economic data lately. But a resolute Fed that starts explicitly focusing on financial excesses would be a new and jarring challenge to stocks at this level.What if bulls needed to count on policy?
A big reason the lack of progress on the Trump economic agenda hasn't held back the stock market is, investors had plenty of support from the fundamentals. Corporate-earnings growth has outpaced already-upbeat expectations and so far the forecasts for the full year are hanging in there. This has allowed the "Trump trade" sectors of banks, domestic cyclicals and infrastructure plays to give up much of their post-election gains without much hampering the broader market.
Forecasts for the second quarter are being trimmed at around the "usual" pace even as equity indexes climb, which could develop into a more unstable tension if aggressive projections for second-half profit improvement are eroded by any broader economic softening.
That's a lot of "ifs," but investors will certainly be less forgiving of stocks at current stout valuations if profits are no longer a cinch to climb by double-digits in 2017 – without help from tax or infrastructure policy that might not arrive in time.
Watch: Economy in slow and steady mode