The recent decline in US corporate cash hasn’t raised a lot of eyebrows, but it has caused one of our equity-quality indicators to flash a warning. Since equity quality is one of the signals with a strong track record of predicting market sell-offs, should investors be worried?

According to Moody’s, US corporations’ cash holdings fell to a three-year low of $1.685 trillion in 2018. That cash was deployed in many different ways, but the overall decline triggered one of the signals that we use to track equity quality. As we’ve discussed, equity quality is one of four indicators that monitor the potential for an equity market sell-off.

Three Signals for Equity Quality

Of course, there are many ways to assess the underlying quality of corporate balance sheets, but we believe that three indicators do an effective job of highlighting conditions that suggest either deterioration or improvement in balance-sheet health:

1.Net debt issuance, which is new loans to corporations combined with changes in cash holdings

2.Net equity issuance, which aggregates equity capital raised offset by stock buybacks

3.Capital expenditures relative to depreciation and amortization

If any of these signals is unusually high, it could be a bearish sign for equity markets. The rationale boils down to an intuitive notion: corporate excess. As economic cycles advance, businesses tend to become overly optimistic. They’re prone to expect unreasonably high demand, and they respond by building excess capacity (funded by debt or equity capital), only to see demand eventually fall short. The technology, media and telecom bubble in the late 1990s is a classic example of overextension.