Wall Street experts are crying foul on an overlooked yet dangerous signal that a market meltdown is near

  • Wall Street experts are increasingly sounding the alarm on a troubling situation that's been building in the US market — one that could threaten the current market cycle.

  • Also complicating matters is the degree to which investors seem willing to ignore these mounting headwinds and keep their existing holdings.

It seems like every time Joseph Harvey opens the Wall Street Journal, he's presented with a fresh batch of signals that the current market cycle is nearing its conclusion.

Speaking at last week's CIO Global Forum in New York, hosted by UBS, Harvey told the room of attendees that he's been increasingly bombarded with red flags, even as the equity bull market has plowed ahead into its ninth year.

One recent story that caught his eye addressed the rapid surge in leveraged-buyout (LBO) activity, which is on pace to have the highest dollar volume of LBOs since 2007, according to Dealogic.

To him, this type of activity — which involves borrowing a bunch of money in order to buy companies, and is frequently done by private equity firms — is a glaring late-cycle warning. And while Harvey admits he has no idea when the inevitable downturn will strike, he's doing what he can to withstand the turbulence.

"Investors should absolutely be shifting their portfolios, given where we are in the cycle," Harvey told the crowd. "You should respect it, and get more conservative. I have in my personal portfolio."

His comments were echoed by another panel member at the UBS conference — Michael Fredericks, head of income investing for BlackRock’s multi-asset strategies team. He too has noticed the massive amounts of leverage being built up in the US market, and he's similarly troubled by what it means for the continued health of the current cycle.

A big part of it stems from the flawed investor mindset that, with so much money on hand, they have to buy something, even if it wouldn't be as appealing under normal circumstances. Fredericks has heard about the dilemma first-hand.

"Everyone I know from the private equity world is talking about companies to buy, and wanting to buy private companies," he told the crowd at the UBS CIO forum. "While the multiples they’re trading at are at levels they haven’t seen for a very long time, there’s so much cash on the sidelines that they have to put it to work."

An overlooked risk

The connective tissue between the arguments made by Harvey and Fredericks is two-fold: they involve private equity firms, and focus on exorbitant leverage. And while the massive debt loads held by both consumers and corporations is a widely-publicized issue, the role of private equity shops in amassing that leverage has largely slid under the radar.

With that being said, their behavior is slowly but surely starting to attract more attention, and not just within the hallowed confines of the UBS conference.

Jim Paulsen, the chief investment officer of Leuthold Group, expressed similar worries in a recent interview. A private equity meltdown isn't his base case, but rather a mounting risk that, in certain scenarios, could come out of nowhere to surprise investors.

"There’s been a big, outsized proportion of private activity in the economy and the financial markets, relative to the past," he told Business Insider by phone. "Whether you look at pensions or profit-sharing organizations, a lot of them have allocations to privates. They’ve become very popular, which is scary."

He continued: "You really don’t know a lot about valuations, or what their situation really is. I wonder if private valuations are much higher than we know, that they’re fairly illiquid, because a lot of it’s done in secret. That gives me some pause."

Record indebtedness

Elsewhere on Wall Street, JPMorgan also has leverage in its sights. In a recent client note, the firm argued the record levels of debt in the US are a clear late-cycle indicator — and sees tough times ahead, at least in credit markets.

"Record indebtedness for US and some emerging-market (EM) corporates and relatedly, record-low credit quality for indices of US high-grade credit, Euro area high-grade, EM sovereigns and EM corporate bonds affirm the vulnerability of this market," John Normand, JPMorgan's head of cross-asset fundamental strategy, said.

Normand also makes the interesting point that while investors seem to be getting anxious about market conditions, their positions haven't yet started reflecting that. He bases this assertion on discussions with clients, who have been increasingly interested in the market cycle, and when it might end.

In an ironic twist, the fact that those clients haven't yet started to adjust holdings as their worries mount is part of what's fueling the late-cycle environment. When investors ignore warning signs and remain fully invested for fear of missing out on more gains, that's when they get blindsided.

It's possible it'll take a catastrophic market event to shake investors out of their complacency. Until then, the late-cycle debt arguments are sure to keep piling up, so disregard at your own risk.

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