Catalysts for growth remain absent, increasing valuation and sentiment risk.

Equity valuations continue to imply expectations for either a rebound in ROA’, or an acceleration of growth. Investor sentiment also points to growing positive expectations. However, management sentiment remains subdued and investment indicators continue to point negatively, limiting potential for growth upside. Without this growth, bullish investor sentiment and premium market valuations imply potential for downside risk going forward....

Investor sentiment appears ahead of management action, spelling volatility.

For the first time in several months, management’s confidence around growth turned more positive in April.  However, investor sentiment has already grown rather optimistic, and equity market valuations are already pricing in ROA’ improvement.  If management’s confidence is confirmed in coming months, with renewed investment and a resumption of ROA’ expansion, equity markets are currently fairly valued.  On the other hand, if investor expectations are disappointed, the lower end of the recent market range may be retested....

• Our concerns about value destruction in Corporate China were highlighted in last month’s Seeking Alpha article, Economic Suicide in China, which garnered a number one ranking for readership in its category, and 75+ comments
• Much has been in the press about the problems with Chinese banks. However, we analyzed the aggregate performance of 850+ publicly-traded Chinese non-financial firms, adjusting for financial statement reporting distortions to get a clear apples-to-apples comparability over time and around the world...

• The optimists’ argument is that problems can be avoided in the short term. What about after that?
• Laurence Scofield and Joel Litman provide a research perspective on China from both top-down and bottom-up fundamental perspectives.
• China’s debt-to-GDP ratio today dwarfs that of Japan at the time it fell into crisis in 1989....

Throughout history, for a correction to turn into a bear market, a catalyst has been needed beyond valuation levels and earnings trends. Specifically, bear markets need credit destruction. The credit seizures can come from approaching debt maturity headwalls for corporations for which they greatly struggle to refinance. It has also come from excessive investor leverage, such as investor margin accounts. Today, corporate and investor balance sheets are not flashing signs that would imply the current correction could turn into a bear market. This current correction is looking similar to the opportunities we saw in October 2014 and Spring 2013 before that....

• Over the last few years, 70% of the largest 1,500 non-financials, representing over nine and a half sectors of the ten-sector economy, are generating returns –as measured by adjusted return on assets (ROA’) –that exceed long-term corporate average levels of returns (a.k.a. the opportunity cost of capital)....

• Earnings Call Forensics™ provide proprietary management sentiment signalsthat strongly suggest continued earnings improvement through efficiencies and cost-cutting, thereby supporting a sustained Return On Assets that are at 60-year high levels....

The subject of this month’s letter stems from the research behind and discussions at two Harvard Club events on oil debt and equity this past January in Boston and New York City.  With a mix of people from corporate, investment, and academic backgrounds, we had a lively discussion around the falling price of oil and its implications for the debt and equity of oil firms and the markets in general....

As any of our clients and students have seen for the past few years, our Market Phase Cycle patterns have been describing a bull market scenario, one which is not near expiring any time soon. Over recent years, any dips in the stock market have been opportunities to buy in further. The leading, lagging, and coincident signals that have driven this conclusion unrelentingly continue now....

• The U.S.’ current market earnings multiple of 18x is commonly seen as expensive when compared to the 15x-17x historical average.
• Investors need to consider the effect of the tax and inflation environments on the markets.
• During prior periods with similar tax and inflation environments, the market P/E ranged from 20x to 22x – indicating more upside still for the U.S....

• Aggregate US Corporate Profitability, as measured by Adjusted Return On Assets (ROA) Is Highest in 60+ Years.
• US Corporate ROA’s hit new highs in 2012 and 2013, now exceeding those levels in 2014.
• Underlying corporate management activities and discipline, including low corporate investment growth, supports continued – not a short-lived – ROA peak.
• The notion of “reversion to the mean” from peak levels is important if viewed in context. There is danger in calling for a reversion before it begins.
• A higher corporate ROA supports higher market valuations, making the market specifically NOT overvalued and more likely still undervalued....

We calculated ROI and growth in invested capital for approximately 1,000 of the largest firms in Corporate America over the last several decades. We then computed the aggregate embedded expectations of ROI and growth that are necessary to deliver the valuations we see in U.S. equities today. Finally, we examine this in context of a proprietary Business Growth Confidence Index that measures trends in management guidance over 6,000 earnings calls over several years....

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If the last hundred years of market cycles teaches anything, it’s that one can’t be a great equity investor without also being a solid credit analyst. Credit crunches and financing booms have killed and fueled bull markets. Analysis of the corporate credit markets today provides one fundamental reason for the stock market rally to continue. It’s not enough by itself; however, it is a necessary element. Our aggregate credit default swap calculation of the riskiest “high-yield” companies in the USA tells us that the financing fuel is coming and in a big way. That’s the “660 to 390” move that we’re seeing in aggregate CDS....