For three years, the equity bull market has been driven by a dramatic improvement in corporate profits.
Margins and returns on capital employed have surged to levels not seen since the 1950s, towing share prices along behind. However, growth momentum peaked in the first half of 2006 and has been fading since.
There is not much chance of a re-acceleration in the near term. Indeed, with the level of returns on capital already high, risks are to the downside.
That is not to say we are looking down the barrel of a gun. As long as disappointments remain isolated and companies continue to show some profit growth though appropriate reinvestment of free cashflow and well judged use of leverage, the bull market can continue.
However, if news from the corporate sector deteriorates more generally, and corporate cashflow shows signs of coming under pressure, there are enough excesses in the system to spring some nasty surprises.
This dichotomy of outcomes puts fund managers in a dilemma. If Goldilocks happens, there is scope for a much bigger uplift in stock prices. However, if business conditions deteriorate more than expected, share prices could move equally sharply in the opposite direction because of the excesses that have built up in recent years. Where are these excesses? The most important is the much talked about build-up of consumer and, less well recognised, corporate debt.
Which of these two conditions – Goldilocks or debt deflation – is likely to prevail? We are inclined to the bullish view but we reserve the right to change our minds at short notice. We do not rule out the possibility that the bears capitulate early in the year, only to be vindicated later on. It would not be the first time.
Even if our short-term bullishness proves to be right, it is not a good time to forget about the risks that are building up in the background. When the downturn eventually comes, it could be an unusually ugly period for markets.
A lot of leverage in companies (private ones), markets (private equity/hedge funds/proprietary trading desks) and personal balance sheets (at least in Anglo-Saxon countries) adds up to a recipe for tough times.