Roman Chuyan, CFA
April 29, 2016
“There is some limit beyond which it becomes totally unreasonable to divorce highly elevated asset prices from sluggish fundamentals.”
~ Mohamed El-Erian, The Only Game In Town
The current bull market in equities has been nothing short of spectacular. It lasted for over seven years – the 2nd longest continuous rally in 90 years. From January 1, 2009, the S&P 500 achieved a total return of 170% (including dividends), or about 14.5% annualized. Not bad, thank you very much.
It is clear to most observers (at least to those who’s experience spans a complete market cycle) that equities are extremely overextended, globally. Every valuation measure imaginable is either very high or extreme. This includes stock averages relative to corporate earnings – both current (P/E ratio) and long-term (Shiller’s P/E) – especially since 2015 when earnings declined (see chart). It also includes stock capitalization relative to real assets (Tobin’s Q), to financial assets (average equity allocations), and to GDP.
S&P 500 Index and Earnings, 20 Years
Valuation isn’t the only factor that influences the market. The economy and corporate earnings growth also matter. High market valuation can, at times, be justified by strong economic growth and growing earnings. But not now. Earnings are declining (operating EPS were down 11% in 2015) for the first time since 2008-09. And the economy has stagnated, with initial estimate of Q1 annual real GDP growth of only 0.5%.
So, why are markets continue to be so elevated? The answer is simple: central banks. The Fed’s (and other CB’s globally) zero-interest-rate policy and bond-buying QE programs helped keep bond, stock and other asset prices elevated.
Fed’s Policies and the S&P 500, 10 Years
This brings us to the current dilemma in trying to determine the next significant market trend: negative fundamentals against the Fed’s support. Focusing on Valuation alone, the S&P 500 is overvalued by about 20%. It currently trades at TTM operating P/E ratio is about 21, compared to its historical average of 16.4 on this basis. This really-simple one-factor gauge suggests a 20% downside to get back to average valuation (which the market usually overshoots). Our other internal models suggest that valuation alone implies a 30% downside.
The Fed’s mandate, given by Congress in the Federal Reserve Act of 1913, is maximizing employment, stabilizing prices, and moderating long-term interest rates. In recent years, however, the Fed has taken its clues from financial markets, stepping up its stimulus at every sign of volatility. The most recent examples: FOMC’s dovish comments in January amid global market selloff, and again in March of this year. Chair Yellen’s, in her remarks in March, said that it is “appropriate” for the Fed to “proceed cautiously” in raising interest rates because of heightened global risks.
How will the tug-of-war between fundamentals and the Fed be resolved? I’m convinced that fundamentals will prevail, for a simple reason: the central bank (or the government at large) doesn’t control markets in a free-market, capitalist economy. The Fed, willingly or not, will eventually have to abandon its support.
As an investment manager, we have to find a way to generate good return for our clients in each period, so “eventually” isn’t good enough – a critical question is, When? Below are a few scenarios of how this might happen. In scenarios 2&3, this will be resolved very soon.
- Waning confidence that the Fed’s policies support the real economy
- Inflation, already at the Fed’s target, forces the Fed to raise rates
- Politics: expectations rise that Donald Trump is elected president and changes things at the Fed
Scenario 1: Waning Confidence in Central Banks
Despite being called unprecedented, policies applied by CB’s since the financial crisis have been tried repeatedly before – in Japan. Since the crash of 1990, Japan has had more than fifteen stimulus packages. The Bank of Japan has maintained a zero interest rate policy for over fifteen years, and implemented nine rounds of QE (the Fed has done three so far). These policies haven’t worked – Japan’s economy has rarely reached above 1% annual real growth since 1990, with frequent recessions. Japan’s experience highlights that monetary remedies of more debt and low (or zero) interest rates don’t work as a cure for the real economy.
The ineffectiveness of CB’s policies in stimulating the real economy has been getting more attention recently, and skepticism is rising, albeit slowly. The ECB and BoJ moving deeper into negative interest rate (NIRP) territory backfired this year: their currencies strengthened and their stock markets plunged. Most recently, when the BoJ’s announced on April 28 that it’s leaving policy unchanged, Japan’s equities sold off by 3.6% on that day and the yen rallied by 3%.
It’s becoming increasingly evident that the Fed’s policies not only didn’t stimulate the real economy – they caused major harm by reducing private business investment (see chart).
Sources: Noah Smith/ Bloomberg, data from Federal Reserve
Here’s how: record-low interest rates and confidence in continued stock market gains boosted expected returns from share buy-backs. As a result, corporate executives preferred share buybacks – which hit records in recent years – to real business expansion projects.
By accepted mainstream economic theory, business investment is considered to be the driver of productivity growth, which in turn, drives sustainable economic growth. Links to the Fed and to share buy-backs may come to the fore as the economy deteriorates further.
Scenario 2: Inflation
To summarize the inflation picture, while the Fed’s preferred inflation measure, at 1.6%, is still below the 2% target, core CPI inflation recently rose to 2.2%. Commodity rebound will push total CPI inflation (currently 0.85%) up to target, likely in only a few months. If PCE inflation follows these other measures, it will force the Fed’s hand in raising interest rates in order to moderate inflation, as its mandate dictates.
I will cover inflation in more detail, as well as Scenario #3, political risk, in a follow-up article – please stay tuned.
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