Traders work on the floor of the New York Stock Exchange, August 23, 2016.BRENDAN MCDERMID/Reuters
With U.S. stocks sitting near record highs, Wall Street strategists are getting more cautious about what's in store for the benchmark indexes over the near term. To this end, Savita Subramanian, head of U.S. equity and quantitative strategy at Merrill Lynch, compiled a list of 10 reasons why U.S. equities are at "elevated risk of correction."
Positioning
Ms. Subramanian notes that short interest as a share of float for U.S. stocks has hit a 12-month low. The upshot here was recently detailed by Citigroup Inc.'s Tobias Levkovich, who warned that investors were turning more bullish, taking the potential "sentiment 'oomph'" out of the market as short positions have been unwound.
The Most Hated Rally, in other words, is starting to get a bit of love.
Economic surprises
Citigroup's U.S. economic surprise index has retreated sharply over the past month, signalling that the preponderance of data hasn't been solidly exceeding analysts' expectations. As U.S. stocks have loosely followed the gyrations of economic surprises over the past year, the recent breakdown in this relationship may signal rockier waters ahead.
Valuations
While acknowledging that these metrics aren't the best indicators for where stocks will go over shorter time horizons, the strategist points to elevated levels of a bevy of metrics (including forward and trailing price-to-earnings ratios, as well as the Shiller cyclically adjusted P/E ratio, price to book value, and enterprise value to earnings before interest, taxes, depreciation, and amortization) as signs that stocks have gotten rich – and investors might not be willing to pay a steeper price.
Elevated expectations
Fund managers surveyed by Merrill Lynch are desperate for more support for growth from fiscal policy makers – but projecting these hopes as expectations for what's to come may result in a letdown. Ms. Subramanian observes that the number of news stories containing the phrase "fiscal stimulus" surged in July.
Investors are similarly bullish on the prospects for earnings growth for S&P 500 companies, with year-ahead consensus estimates at their highest level in five years.
Growth
Earnings growth may be difficult to realize, the strategist cautions, with current top line performance looking soft. In fact, constant currency sales growth for firms outside of financials or energy has dropped to a three-year low.
China
Meanwhile, the world's second-largest economy looks to be heading for another rough patch, Ms. Subramanian notes, with its manufacturing purchasing managers' index, or PMI, dipping back below 50 (which points to contraction in the sector).
Worries about China's economy roiled markets following the devaluation of the yuan in August, 2015, and at the start of 2016.
Credit and leverage
Leverage is high and credit is slowly tightening, while appetite for equity issuance may also be drying up," she writes, highlighting high levels of indebtedness among S&P 500 companies once financials and tech are removed from the equation.
Elections
The upcoming U.S. presidential election could provoke an "uncertainty shock and a slowdown in business investment" that brings about higher volatility, Ms. Subramanian warns.
The Fed
The central bank's interest-rate forecasts suggest that the Federal Reserve will hike rates much more aggressively than investors expect over the next two-and-a-half years, which could bring about a loss of risk appetite, Ms. Subramanian says.
However, it's difficult to see the Fed being much more aggressive than the market anticipates if top line growth among major U.S. firms is indeed so difficult to come by and Chinese data turn particularly sour.
Seasonality
To adapt a phrase from T.S. Eliot, September has been the cruellest month for investors in U.S. equities – the only one in which the median return has been negative, going back to 1928.