07 December 2017

Exit Goldilocks – pursued by a bear

Equity markets are dangerously high and ripe for a correction.

by Frank O’Nomics

For global equity investors this really has been the best of times.  Inflation in the UK has picked up, but globally remains modest and it has been considerably outstripped by equity returns.  UK investors are 9% richer over the last 12 months if they are exposed to the FTSE 100, and up a healthy 17% if they follow the FTSE 250.  Such riches are in fact quite modest when compared to the likes of Europe, particularly Italy, which is ahead some 33%, and the US, where the S&P is up over 19%.  With high levels of employment and steady GDP growth are we in a Goldilocks economic scenario of growth being not too hot to generate inflation, and not too cold to prompt a recession?  The record levels achieved in US stocks has been accompanied by the lowest volatility in over 50 years – on a risk-adjusted basis the market has never performed better.  When one looks at the level of equity yields compared to cash there would seems to be ample justification for continuing to expect healthy returns.  However, when we look at just how expensive the equity markets have become on historic comparisons, the story is very different.

A favorite measure of the value of equities is the price earnings ratio.  This is just the price per share, divided by the earnings per share, or, put another way, how many years of trading it would take for earnings generated to equal the share price.  Robert Shiller adapted this concept to account for the stage of the economic cycle, introducing the CAPE, or cyclically adjusted price earnings ratio. When we look at this for the US, we can appreciate just how expensive markets have become.  The most disturbing feature is that the CAPE ratio is at levels previously seen just prior to major market crashes, in 1931, and 2001.  Those who argue that “this time it’s different” will claim that we are potentially in a much more extended cycle, given the ongoing proactive support coming from central banks, and that the non-cyclically adjusted levels of PEs are within the bounds of normality.  These arguments gain some support from the stance of the ECB who, while reducing quantitative easing, are nonetheless still supportive.  However, the stance of the MPC is has moved to neutral and the Fed will soon start to reverse the process.  A major driver of equity performance is about to end. 

There are other long-term measures that point to significantly over-valued markets, in particular the Tobin q ratio, which compares the value of the market to the replacement value of the assets.  While the US market has not quite hit the extreme levels seen in 2000, it is very close to the point achieved in 1929.   Many will point to high profit margins but there are some concerns regarding the reporting of such data – executive pay structure encourages the reporting of high profits, but once the numbers turn there is an incentive to make them as low as possible, thereby impressing the following year if they turn back up.  The other factor that has helped share valuations has been share buybacks, which have exceeded issuance in the US in each quarter of the last 8 years.  Once this support fades, stock markets may give the appearance of Wile E Coyote stepping off a cliff with an anvil around his ankle. 

Beyond the bigger picture there are also some shorter-term issues that may well at the very least spark a sharp correction. One of the most important features of most variables is that of momentum and one of the most important indicators  looks as if it is about to turn.  European GDP data has been particularly robust of late, and the best forward-looking indicators for GDP growth are the purchasing managers indices. These give a very good guide as to the state of order books and hence future production.  A neutral measure is 50 and recently the levels of PMIs for Europe have been running at a very high level of around 58.5.  However, such levels will be very difficult to sustain and there is a very strong correlation (around 70% for the Euro Stoxx 600) between the momentum of PMIs and the level of equity markets.  Playing the momentum of stock price movements can be very profitable, and this year such strategies have outperformed value-based approaches by 22%.  Neil Woodford (renowned manager of an £8bn fund) has pointed out the underperformance of “value” stocks compared to growth stocks and sees a stock market collapse as “inevitable”.  This may be an overstatement, but once momentum turns, the correction can be very sharp indeed.  Chart analysis from Deutsche Bank suggests a realistic possibility of a 10-15% correction in the level of European equities.

UK equities may not have seen the same rate of progress, but they will be very vulnerable to a correction in a European market that accounts for 50% of our trade.  In most years a 10% sell-off would be frustrating, but not unprecedented.  However, the volatility of markets has been exceptionally low for some time and a movement to this degree could spark something of a panic.

There you have it. A bigger picture argument that markets are overvalued, and a dangerous short-term factor.  As ever the danger of not being in markets if they carry on going up is a real one, at least in terms of opportunity cost.  Earnings per share have been rising, economic growth has been higher than expected in both China and Europe, and interest rates remain below inflation, and we still have the prospect of US corporate tax cuts.  However, if you have been able to benefit from the bull market, and given that it has been going on for some ten years now that is highly probable, it may well be time to adopt a much more cautious approach to your investments heading into 2018.



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