To arrive at an answer, let’s take the temperature of corporate-risk levels.
In the early and middle stages of market cycles, corporations provide value for their shareholders by eliminating inventory overhang, optimizing operations and improving efficiencies. By contrast, in late-cycle rallies, corporations typically lever up their balance sheets to accommodate more speculative strategies such as expanding current businesses, entering new businesses and increasing mergers and acquisitions (M&A).
The chart below shows two key leverage levels among corporate stock and bond issuers: debt-to-earnings and debt-to-assets.
Source: Bloomberg, as of 6/30/2014
Although corporate leverage has increased since 2011, it has not yet reached excessive levels. If we consider leverage to be a proxy for the market cycle, this suggests the cycle is mature, but not yet complete.
Some critics may argue the financial crisis was caused by excessive leverage, and therefore we can’t use historical leverage levels as an accurate gauge. That’s precisely why we removed the financials sector from our analysis. By excluding the leverage of banks and other financial institutions, we can reduce the distortions we would otherwise see in the data leading up to the financial crisis.
Current levels are still far below the peaks reached in the previous three market cycles.
- SPDR S&P 500 ETF (SPY | A-98)
- SPDR S&P 500 Dividend ETF (SDY | A-69)
- Guggenheim S&P 500 Equal Weight ETF (RSP | A-76)
- SPDR S&P MidCap 400 ETF (MDY | A-77)
Additionally, we are investors in high-quality credit and short-term high-yield debt, including CRED and HYS, which I mentioned above. These allocations make sense to us as part of broadly diversified portfolios in the current environment.
Evacuation Plan: Leave Early
In broad terms, we’re concerned about a dynamic that has been developing since 2007.
While the amount of outstanding corporate debt has expanded by 36 percent to $9.6 trillion, and credit ETFs assets have ballooned, corporate debt inventories held by the primary dealers and daily secondary market turnover have both declined significantly.
If dealer inventories and trading volume have fallen during benign credit conditions, where will the bidders be if the credit markets panic?
Note, we’re not predicting a crisis in the credit markets. Rather, we recommend investors take advantage of the current benign environment to plan out how they will respond when the market trends reverse. For more color on how Sage views this challenge, have a look at some of the previous pieces we’ve written on ETF.com addressing getting defensive in equities and diversifying fixed-income allocations.
A market correction is not an “if” but a “when” scenario. Just as surely as hemlines rise and fall in fashion trends, so too will the markets correct some day. The question is, Will you be ready?
Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.